Business Law Prof Blog

Church Leaders Comment on the Market: Oops

Church leaders are using the economic crisis, as are politicians, to air old grievances about trading markets and capitalism.  They should all take note of the problems of the Archbishop of Canterbury, Rowan Williams,  the head of the Anglican Church, and his fellow Archbishop, John Sentamu of York.   Williams took a position on the banning of short selling and Sentamu called traders who profited from falling prices "bank robbers and asset strippers."  Both were informed that the Church of England uses both practices when it invests its own assets.  The Church loans its stock, for a fee, to short sellers and invests heavily in hedge funds that use shorting in their trading strategies.  Tisk, Tisk.

The Ban on Short Selling List

We now have learned that the companies on the "no-short selling list," which were supposed to be financial companies, include CVS, Ford, GM, IBM, NYSE Euronext, GLG, Fortress and ICE.  These are not financial companies; they have some finanical operations.  Why not just put all companies on the no-short list that are in economic difficulty: Your earnings are falling by, say, 10% over the same quarter last yeear, you are on the list.  What a joke.  We should not have a "no-short" list at all; now it is expanding like a fast growing cancer to more firms and more overseas markets.   

Mark-to-Market Accounting Gets a Bad Rap

Mark-to-Market accounting is a rule of transparency -- companies have to discuss the fair value of assets on their balance sheet.  One can criticize the mechanics of the rule on illiquid assets or in times of extreme market distress (when there is a lack of a market equilibrium price) but one should not attribute bank's capital problems to the rule. Bank's capital problems come from two other sources, both legal:  1) Statutory/administrative capital requirements and 2) contracts (most, commonly swap agreements).  When a bank has to reduce asset values it can fail its legal or contractual capital requirements.  The legal capital requirements are the real problem and need revision -they are too inflexible.  The contractual capital covenants are the bank's own fault and can be defined however they want -they just were lazy and too content with simplistic language.  Modify mark-to-market accounting rules only to accomplish fair value transparency; modify legal capital requirements to account for market distress; and leave firms to draft better capital requirement covenants in contracts.

Good Gracious: Interbank Lending Dries Up on Government Bailout Package Uncertainity

The reason for panic, the lockup in the commercial paper and interbank lending markets, led to Paulsen's $700 B asset purchase proposal.  I have, here, advocated direct relief for those markets, beyond what the Fed has already done.  But now we learn that the Paulsen/Bernanke proposal has made the interbank lending market worse, not better.  Uncertainty over asset purchase mechanics has led banks to hoard cash and refuse to lend to other banks.  Wonderful.

And it is not just interbank lending.  Gross, the very savvy manager at Pimco, said he was offered a six-month Morgan Stanley note at a yield of 25%, 25%, and he turned it down. There is too much uncertainty in the market "Where no one trust anybody: no one trusts any price."  By adding uncertainty to market prices with bailout negotiations, the Fed has heaped gasoline on a fire.

Economists Have Rediscovered Chapter 11, Sort Of

I am amused by the international economists, and many American economists, who suggest that a better solution to the bailout is a government directed reorganization of troubled financial institutions which, failing to raise cash, should be forced to swap their debt for new equity. Eureka!  This, of course, is called Chapter 11 in the United States. Many foreign countries do not have such a procedure and think we should not have one either.  Moreover, many in this country believe Chapter 11 to be seriously flawed.  Indeed, if we cannot put our financial institutions into Chapter 11 because of time problems, complexity, hold-up value, contentious, inferior decisions makers, and so on the we need to reconsider Chapter 11 once we decide to avoid it with a government directed special version for the current crisis.  In any event, it is academic, as Congress, Paulsen, and Bernanke are headlong bent on an inferior alternative, a massive government purchase of toxic assets.

Buffett Steals Goldman Stock

Buffet bought $5 b in Goldman Sachs preferred stock, giving him close to 62% of all the Goldman preferred stock outstanding.  The catch, he gets a 10% dividend (above the market rate for preferred stock recently issued by investment banks.  Moreover, he gets an in-the-money warrant on common stock worth $1.8 B, so he is really buying the preferred stock for $3.2B with a 10% dividend on $5B.  His warrant is for $5B of common at an exercise price of $115; the stock is trading at $125 a share. If he exercises the warrant he will hold 6% of the common as well as 62% of the preferred.  Contrast Buffet's deal with our $700B effort to pay above market prices for MBSs.  Can we swap Buffet for Paulsen??

Wednesday's Panic

We read that Paulsen and Bernanke became convinced of the need for the $700 B bailout last Wednesday when the country's commercial paper market locked-up.  Late Tuesday, Putnam Investors announced that its Prime Money Market Fund, holding $12.3 B had "broken the buck," it was worth 97 cents on the dollar.  The Fund held commercial paper from AIG.  On Wednesday, institutional investors withdrew close to $170 B from money market funds (retail investors did not; they actually increased their money market holdings).  Institutional investors knew what many retail investors did not that the funds also hold MBSs and ABSs backed notes (rated AAA) as well.  Most retail investors assume that commercial paper consists of short term notes from blue chip companies or government units, rated AAA.  The retail market does not know that AAA notes from SPVS holding mortgages have been included in the pool for several years. 

Paulsen and Bernanke watched as the commercial paper market locked up, funds were not buying the new commercial paper; they were selling their paper to generate cash to pay for the redemption's.  This meant that operating companies needed cash to make payroll and pay supplier could no longer "roll" expiring commercial paper or sell new paper.  Paulsen and Bernanke, at that point, knew for certain that the economy was in deep, deep trouble.

The Fed immediately guaranteed money market funds loses, up to $50 B each, loaned money to commercial banks so they could buy AAA asset-backed notes, and purchased short term notes of Fannie Mae, Freddie Mac, and the Federal Home Loan Banks.  Paulsen and Bernanke also decided to ask Congress for $700B to buy toxic mortgages and mortgage backed securities going after "the core of the problem."

Why not just have the Fed buy at auctions, AAA rated MBS commercial paper?  It would cost much less (the government losses would be minimal if any); AAA rated commercial paper is easy to price and to auction; it would free up the commercial paper markets for all operating companies; and it would let the MBSs markets in subordinate securities clear.  If the commercial paper market failure is the critical event, the core of the problem would seem to be separating the commercial paper market from the mortgage market and letting the mortgage market clear.  We would not then be faced with 1) how to price mortgage backed securities 2) whether to buy from foreign banks 3) whether to buy newly transferred or newly issued securities 4) whether to hold equity 5) whether to cap executive salaries 6) whether to create an oversight panel and 7) whether to stop foreclosures.

   

Today's Hearings on the Bailout: Price???

Bernanke and Paulsen were before the Senate Banking Committee today asking for power to spend $700 billion on mortgages and mortgage backed securities.  Senators asked the critical question repeatedly and in several different forms:  How will your price the mortgages and the MBSs that you will buy???  When the government buys it will destroy market prices -- what the government will pay will be the market price.  I laughed when I read Bernanke's prepared statement in which he noted that the government needs to buy these assets to give "liquidity" to illiquid assets, which will happen, and to re-establish "price discovery" in the private markets, which the buyoout will surely not do.  The goverment buying price will be the only "price discovery" we will see and it is not private.  The answers of Bernanke and Paulsen to the basic question were evasive -- we learned only that the Treasury wanted the flexibility to do whatever it deemed to be in the best interest of the country -- be they auctions or something else.  Only Bernanke, in a moment of peak, revealed that the Treasury would buy at "hold to maturity" prices rather than "fire-sale" prices.  What does this mean? Does it means that Treasury will price toxic junk as if the payors will not default?  I hope not.  If so, whoever holds this stuff will get a tremendous windfall.   

New Rules on Bank Stock Purchases

A crisis reveals the weakness in some silly rules and drives government, under extreme pressure, to sanity.  The rules on private equity purchases of bank stock, recently revised, are an example.  Prior to the new rules, if a private equity fund bought a so called "controlling" stake in bank stock, the Fed classified the fund as a "bank holding company" subject to direct federal regulation (including investor limitations).  A "controlling stake" was liberally defined to include 10% of voting stock, board seats, and even talks with CEO.  Private equity funds, holding $400 billion on the sidelines in cash, have stayed away from bank stocks -- and banks need cash.  So the Fed redefined "controlling" stake.  A private equity firm can own 33% of the stock as long as only 15% is voting, can hold two board seats (if there is another larger shareholder) and can hold talks with the bank's CEO.  Will private equity now get in?  More now than before.

Question for Presidential Candidates At the Debates: Who is the Next Secretary of Treasury?

At the presidential debate coming up in a few days the public needs to know who the next Secretary of the Treasury will be; expecially if the bailout bill passes in its current form.  Supreme Court appointments are secondary to the importance of a new Secretary who will have unreviewable power to dole out $700 billion taxpayer dollars and to loan money to investment and commerical banks and, apparantely operating companies in exchange for stock.  We need to know, for example, if McCain has another hairbrained suggestion like Cuomo for the new Chair of the SEC (will he pick Rep. Barney Frank for Treasury?).

Goldman and Morgan Register as Commercial Banks

Goldman Sachs and Morgan Stanley, our last two free standing investment banks, registered as regulated bank holding companies, capable of acquiring commercial banks and, in essence, agreeing to the heavier regulation of the Fed over commercial banks.  It was a stunning announcement, prompted no doubt by the need to access federal money, as commercial banks can, and by the need to buy a more stable commercial operation so as to reduce volatility by getting access to customer deposits.  Both banks will have to change some of their business operations (shed assets, close some trading operations, and reduce leverage). Amazing

Paulsen in A Game of Chicken with Congress

A Democratic Congress wants a piece of the bailout bill to call their own -- lower executive compensation or more affordable housing-- and will push Paulsen to add provisions to the bill.  It will be a game of chicken, with escalating rhetoric, and we will see who blinks.  My guess, Paulsen will blink -- expect something on the government holding equity positions in sellers of toxic MBSs and executive compensation.  By the way, why no hearings on the crisis?  Normally we get grandstanding hearings whenever an opportunity for a public condemnation is present.  Why none now?  Answer: Because leaders in Congress have too much dirty laundry in the crisis and does not want it aired out.

Obama Shorts the Market

Obama has a short position in the market; when it goes down his vote total goes up.  Moreover, he is doing what short traders often do, running a bear raid for over a year and one-half, by talking down the market and the economy ("Bush has messed up the economy....").  His high profile in the press aids the lack of confidence in the market by the millions which hear him daily, all of which helps the market sag making his position more valuable.. 

Government Pricing in its Purchase of MBSs

Under Paulsen's Plan we will bail out foreign banks with taxpayer money -- but wait, this is a minor issue, the major issue is how the government will price what it will buy.  The government will buy mortgages and MBSs, securities backed by mortgages.  At what price?  There are several options, all bad.  1) The government will declare a class of MBSs it will buy and then hold a reverse auction, buying those that are priced the cheapest.  Problems:  a) How to "Class" MBSs; b) We will buy the worst stuff ("toxic" in the words of Wall Street) that is included in the class, rewarding those that hold the toxis stuff: and c) Those with courage will price even toxic stuff high and wait -- for the next in a sequence of auction that they know will come. 2) The government will buy investor by investor in negotiated sales. Problems a) Favoritism b) Uniformity accross multiple sales and c) Lack of time to do due diligence on individual sales (government as "sucker")   3) The government will put money into package deals (block purchases) that include private buyers [See Bearn Stearns Buyout].  Problems: Strategic behavior by both a) private buyers and b) sellers and c) it takes too long, the government wants to buy now (which is why strategic behavior by others, who know your deadline, is possible -- ask any negotiator).  Again, I repeat, buy commercial paper -- it is liquid and uniform, easy to price, and will grease the markets until they find a bottom.

Are Supreme Court Selections Critical to Election? No, "Its the Secretary of the Treasury, Stupid."

The new bailouts may take pressure off the politization of the Supreme Court selection process.  Who will the new President select as Secretary of the Treasury??  The Secretary of the Treasury confirmation hearings will be the new show and the new focus.  After all, the Secretary will be running the mortgage industry, the insurance industry, the major exchanges, the banking industry, our foreign policy with foreign central banks, and the automobile industry,  all with limited judicial oversight.   

Paulson Asking Congress for Authority to Buy $700 B MBSs: Congress Should Say No

Paulson and Bernanke have told the public that the administration will draft legislation authorizing the Fed to buy up to $700 billion of mortgage backed securities (MBSs).  The MBSs securities have plummeted in value and jeopardize the balance sheets of the world's banks; the banks are struggling to meet capital requirements that enable them to loan money. AIG, for example, went under and threatened to default on its commercial paper;  the commercial paper market panicked and money fled to treasuries.  Without commercial paper most operating industries in the United States cannot met operating costs (payroll).  Panic set in as Paulson and Bernanke watched the commercial paper market implode on Wednesday.  So Paulsen and Bernanke will "go to the core" of the problem and relieve the world's banks of their rotting MBSs.  Three problems cropped up immediately: 1) Who can sell??  a) The first sub point is which banks are included?  Are United States taxpayers going to bail out foreign banks?  Initially the answer was no -- then yes only if they have "headquarters" in the United States and then yes if they have a "substantial presence" in the United States (which are most all large foreign banks).  Even a no was a problem as foreign banks could sell MBSs to US banks that could then sell to the government (an indirect bailout).  b) Do we leave out American hedge funds and other investment pools when we are including Chinese banks?  It may not matter as hedge funds race to sell to banks that can sell to the government.  2) At what price?? And who decides?  The bill looks to give the FED open ended authority to buy and does not set a price.  The price is critical, of course, and since the United States will be in the market there is no trading market -- the United States, not any trading market will set the price.  If the price is too low and financial companies get an incredible windfall (remember, some companies have recently bought MBSs at huge discounts); if the price is too erratic or impulsive -- not all MBSs are the same -- some companies get unjustified advantages and some get the shaft.  3) Can homeowners now default without penalty??  Once the government holds the MBSs, what incentive to the homeowners have to pay on their mortgages?  Do they have an incentive to default?  Congress is threatening to tie the bailout to homeowner default protections ("we want homeowners to keep their homes").  Moreover, the asset managers in the SPVs that issued the MBSs, with the government owning all the bottom end junk securities in their SPVs may not have much of an incentive to act on defaults that only affect the tranches owned by the US. 

I hope I have convinced you that this is a mess, that the government officials, in their panic, do not seem to be worrying about how whatever system they put in place can be gamed, and it will be gamed, by clever world-wide financial actors.

An alternative solution:  The Fed should buy commercial paper if the market does not, not MBSs.  Let rotten MBSs rot.