Saturday, 21 January 2012

Survivor Bias and TBTF Tyranny

It's time to write again about insolvency, as the MF Global failure and the Greek debacle raise new troubling concerns.

As I wrote in Ring Fences and Rustlers before Lehman failed in 2008:

The key to having a happy insolvency, if such a thing exists, lies in ensuring that when a globalised bank goes bust, all the best assets are inside your borders and subject to seizure by [your banks or] your liquidators on behalf of your creditors.

If one were cynical, and one believed that Lehman was going to be allowed to fail pour encouragement les autres one might wonder if Lehman was quietly bidden – or even explicitly ordered – to sell off its foreign holdings and repatriate the proceeds to asset classes within the US ring fence. This would ensure that US creditors of Lehman received a satisfactory recovery at the expense of foreign creditors. It would also contribute to a nice pre-election illusion of a “flight to quality” as US dollar and assets strengthened on the direction of flow.

If one were really cynical, one might even think that a wily bank supervisor might arrange to ensure 100 percent recovery for its creditors with a bit of creative misappropriation thrown in the mix. Broker dealers normally hold securities and other assets in nominee name on behalf of their investor clients. Under modern market regulation, these nominee assets are supposed to be held separately from a firm’s own assets so that they can be protected in an insolvency and restored to the clients with minimal loss and inconvenience. Liberalisations and financial innovations have undermined the segregation principle by promoting much more intensive use of client assets for leverage (prime brokerage and margin lending) and alternative income streams (securities lending). As a result, it is often very difficult to discern in a failed broker who has the better claim to assets which were held to a client account but reused for finance and/or trading purposes. The main source of evidence is the books of the failed broker.

On the wholesale side, margin and collateralisation in connection with derivatives and securities finance arrangements mean that creditors under these arrangements should have good delivery and secure legal claims to assets provided under market standard agreements. As a result, preferred wholesale creditors could have been streamed the choicest assets under arrangements that will look above suspicion on review as being consistent with market best practice.

The official report of the court appointed examiner confirmed my worst suspicions. We now know that the Federal Reserve Bank of New York and the SEC co-located staff inside Lehman from March 2008 to oversee the global repatriation of assets and cash in the run up to the insolvency in September. The Fed kept Lehman on life support during this period with more than $20 billion of liquidity which it paid back to itself from Lehman cash on the day Lehman filed for liquidation. In the meanwhile, from March 2008, Lehman looted its affiliates and client accounts worldwide by using prime broker and securities lending mandates to lend assets to the US affiliate which were sold (hence the sharp fall in Eastern Europe and Asian markets and growing volatility eleswhere from March 2008) and the proceeds streamed to US creditors as margin payments on derivatives and other obligations. The official receiver elected not to challenge the cash transfer to the Federal Reserve or any of the transfers of cash or securities made to major Lehman counterparties and creditors.

Those following the MF Global failure have noted a strikingly similar pattern of conduct by JP Morgan in advance of failure as occurred with Lehman, although without obvious official mandate. Yves at Naked Capital has been covering the parallels admirably. Carrick Mollenkamp, Lauren Tara LaCapra and Matthew Goldstein at Reuters have provided a very substantive story of how JP Morgan used its superior knowledge of MF Global's trading and credit position to enrich itself at the expense of MF Global and its clients before precipitating the MF Global failure.

I am concerned that MF Global demonstrates that the too-big-to-bail banks have found a new and almost riskless way to make outsize profits. Because derivatives, repo and liquidity are so very highly concentrated now, and leverage is at pre-crisis levels again, these few players can rig the markets and liquidity to choose when and how their clients fail. Their top down view of clients' trading and custody portfolios and cash positions and flows puts them in a position to exercise tyranny. They can game their clients, taking advantage of superior information, credit and liquidity to ramp or crash targeted markets as needed to precipitate a crisis. They can demand the choicest assets as collateral, setting very high over-collateralisation thresholds, and then exercise during post-failure turmoil to retain everything they hold at rock-bottom prices.

In today's low volume markets, a crash or squeeze is even cheaper and less risky than ever before. Instead of working for their clients' success, an unscrupulous clearing bank - or several operating in collusion - can profit on engineering market instability or turmoil.

If one were a conspiracy theorist, one might suspect that such games were being played now in global markets. Perhaps gold is being used as collateral for margin and cash liquidity, sold by counterparties to bring the price lower, leading to margin calls for even more. A crisis arising from a major default (Greece, Portugal, a huge bank) would force the price lower still, when the collateral would be exercised on default. Following on, the price might rocket again to enable the conspirators to seize outsize profits. Just a scenario, mind you! (Although, I note that Lehman's counterparties reported record profits through much of 2009.)

What is left of the global markets becomes a game of engineered survivor bias. Only those operating outside the law and with unlimited regulatory forbearance can win while the rest of us lose. As I noted in 2008, after Lehman failed, in Financial Eugenics, "It's not your survival they're engineering."

I don't say absolutely that what I describe is actually happening. But it may be. Certainly market conditions are ripe for it, and MF Global reinforces the pattern.

Now over to Greece. I find the PSI (private sector involvement) negotiations for Greece's restructuring of its debts troubling because it shows the same determination to engineer survivor bias. One of the core principles of insolvency law is that all creditors of like standing should be treated equally in the resolution. The PSI approach is starkly contrary to this principle, despite the evidence that Greece is well and truly insolvent. First, the official bond holders (central banks, supranationals, governments and the ECB) are excluded from mark-downs of their debts, preferring to impose the burden of capital losses entirely on the private sector bond holders. Second, the private sector bond holders are divided between those with an interest in preventing a declaration of default (either unhedged or have written credit default swaps) and those who will profit from a default through claims on credit default swaps. Rather than being represented equally in the negotiations through a creditors' committee, the negotiations are being driven by the Institute of International Finance, a trade lobby of just the biggest banks. Why the IIF should have credence as representing hedge funds, pension funds and insurance companies holding Greek debt is beyond me.

Once again we see centuries of jurisprudence and decades of statutory law and market practice cast aside for the convenience of a handful of big banks. They argue that abandoning our principles is desirable to prevent destabilisation of the financial system - again. I am wondering if a system that requires constant sacrifice of all the principles of market price discovery, rule of law and equitable treatment of like behaviours is worth stabilising.

If the Greece negotiations fall apart, and Greece defaults, is it likely that the banks will embrace the rule of law and let their contracts stand? Or will they try to "reinterpret" their obligations or once again seek taxpayer reimbursement for their losses?

Tyranny takes many forms, but the essence is arbitrary exercise of power or despotic use of authority. Given their willingness to throw principles out the window whenever profits are threatened, it seems we are confronting a tyranny by a handful of bankers. Perhaps we should embrace some sacrifice of stability to forestall a more stable and much more dangerous tyranny.

UPDATE: Excellent, thorough analysis of the Greek debt situation is up on ZeroHedge: Subordination 101: A Walk Thru For Sovereign Bond Markets in a Post-Greek Default World. Well worth your time to read the whole thing as a primer on the potential pitfalls of all outcomes of the Greek debacle for global sovereign bond markets. Conclusion about the high stakes of the current standoff reads:
Finally, while we have no prediction of whether or not any of the above happens, one thing we are sure of: if the runaway central planners of the world believe they can legislate their way into an upper hand over the bond market, in ever more desperate attempts to avoid the day of reckoning, they will fail without any shadow of a doubt. Because demand for risk comes first and foremost from a sense of stability, of fair and efficient markets, and equitability: something which has long been missing in the stock market, and which may very soon be taken away, by force, from the bond market as well.


Richard said...


Fascinating what bankers can get away with when their actions are all hidden by opacity.

First, there is your Lehman example. It requires opacity for assets to be reshuffled so that preferred creditors end up with a security interest in the good assets, while everyone else fights over the bad assets.

If your Lehman theory is correct, then requiring financial institutions to disclose on an on-going basis their current asset, liability and off-balance sheet exposure details should put an end to this bad practice as everyone could see what was happening.

Second, we have the Greece debt negotiations. It appears that they are being carried out to minimize the damage to the banks -- either the banks that hold the debt or the banks that wrote credit default swaps.

The question is why? One could argue that it is the fear of contagion that is driving the negotiations. More specifically, how to avoid contagion.

Contagion is a phenomenon that is unique to opaque financial systems. If everyone knew which banks held Greek debt or wrote credit default swaps, they would know who had the losses. There would be no surprises.

Both of the examples you provided suggest that opacity is a critical element for the tyranny of TBTF.

While it might not completely eliminate this tyranny, transparency might dramatically rebalance the system.

Mark said...

LTCM was a dry run. In fact, I can think of other examples before that where banks managed to secure assets as collateral, dominate a customer relationship for trading position and wait for the opportunity to push a market to collect against the impoverished customer. It can happen on relatively small scales - such as taking advantage of known or suspected stops against losing positions - as well as ones big enough to bring down a large enterprise or even a country. Many of these ideas were developed by Italian bankers in the 14th century - 1345 and all that.

Knute Rife said...

It isn't hard to dictate when your customers will fail when you can stuff an offering with hand-picked bilge, sell it as cherry-topped marzipan, and then bet against it on your own behalf, and the regulators care not a whit.

Blissex said...

«They argue that abandoning our principles is desirable to prevent destabilisation of the financial system - again. I am wondering if a system that requires constant sacrifice of all the principles of market price discovery, rule of law and equitable treatment of like behaviours is worth stabilising.»

That is code for "preserving the voters' 401ks and pension funds".

Voters will endorse enthusiastically any scam no matter how lurid as long as they think that their pension and saving accounts are being "protected".

The finance industry have fully persuaded these petty speculators, who are the vast majority of voters, that they are on the same side, and they have an unassailable mass of political endorsement on their side.

«Second, we have the Greece debt negotiations. It appears that they are being carried out to minimize the damage to the banks -- either the banks that hold the debt or the banks that wrote credit default swaps. The question is why?»

The answer is pretty obvious, and it is pension and savings funds. If the big french and german banks blow up, so do most pension and savings funds, including life assurance companies, directly or indirectly. It is the same reason why AIG was rescued in the USA: all those life assurance policies, and all those pension and savings funds heavily dependent on AIG continuing to exist in some form.

No political class want to be lynched by masses of middle class middle and older aged "savers" who discover that their savings and pensions have disappeared.

One of the big aspects of modern finance is that it is "capitalism without capitals" as all the big guys just run on credit/margin, as only the bug savings, pensions, and insurance funds have got real money.

Blissex said...

BTW the whole political and financial game I just described is summarized in a very clear statement by the exceptionally clever Grover Norquist:
«The 1930s rhetoric was bash business -- only a handful of bankers thought that meant them.

Now if you say we're going to smash the big corporations, 60-plus percent of voters say "That's my retirement you're messing with. I don't appreciate that".

And the Democrats have spent 50 years explaining that Republicans will pollute the earth and kill baby seals to get market caps higher.

And in 2002, voters said, "We're sorry about the seals and everything but we really got to get the stock market up.

As to "managed" bankruptcies, in the USA they are as traditional as Thanksgiving as deTocqueville wrote in the 1830s:
«Consequently, in the United States the law favors those classes that elsewhere are most interested in evading it. It may therefore be supposed that an offensive law of which the majority should not see the immediate utility would either not be enacted or not be obeyed.

In America there is no law against fraudulent bankruptcies, not because they are few, but because they are many. The dread of being prosecuted as a bankrupt is greater in the minds of the majority than the fear of being ruined by the bankruptcy of others; and a sort of guilty tolerance is extended by the public conscience to an offense which everyone condemns in his individual capacity.

PeterJB said...

Good piece LB
The Law is now merely a false perception; tyranny rules supreme.

Fungus FitzJuggler III said...

What do you think of that other LB, Turnbull?

He led a republican movement that guaranteed the monarchy for another twenty years. Clever clogs!

Fred93 said...

You mentioned JP Morgan, but didn't go into detail about the bad things they've done re MF Global.

This article describes some of the agressive legal tactics JP Morgan is using against MF Global customers, and suggests we boycott JP Morgan.

Anonymous said...

Thanks for exposing the predator-prey approach of the large financial organizaitons towards their clients. And yes, these are timeless tactics. Mark - Italian bankers in the 14th century?! - Wow. (My first reaction was "this read like the Count of Monte Cristo"... financial revenge as written in the mid-1800s. No doubt there were antecedents long before the 1400s, too.)

Now that capitalism (or at least corporate crony capitalism) reigns supreme worldwide, it must run itself to excess before its next historical antithesis can be given life. We are seeing the excesses building up now.

It will be an ugly trip.

And yes, part of the problem is that we cannot all retire on pensions. There simply isn't enough accumulated wealth in the world for all the savers to own a large enough slice to pay for a comfy old age. The bankers' push to optimize pension balance sheets at the expense of the real economy is yet another tragic consequence of misplaced incentives and agency costs...