April 12, 2008
Quasi-fiscal scoundrels 4: helping banks
When I hear or read the words ‘off-balance-sheet financing’ or ’special purpose vehicle’, warning lights begin to flash and I grab for my obfuscatometer. Off-balance-sheet financing is any form of funding that avoids placing the owners’ equity, liabilities or assets on the balance sheet of a firm or other legal entity. The most common way to achieve this is by placing those items on some other entity’s balance sheet. A standard approach is to create a special purpose vehicle (SPV) and place assets and liabilities on its balance sheet. An SPV is a firm or other legal entity established to perform some narrowly-defined or temporary purpose.
There are circumstances (possibly as many as one percent of the reported occurrences of SPVs), where such entities are created to achieve true efficiency gains. For instance, creating a separate legal entity for certain activities may better align incentives for risk-sharing or may avoid conflict of interest. The overwhelming majority of SPVs are, however, created for nefarious and/or dishonest purposes: evading or avoiding regulation (and associated financial burdens and constraints or reporting obligations); tax avoidance or tax evasion; accounting shenanigans, including the circumvention of ceilings on the budget deficit or debt of public entities; and hiding assets or liabilities from scrutiny by interested parties. These often clever schemes are always economically equivalent to a much more straightforward on-balance-sheet arrangement.
In a recent Comment in the Financial Times, my old friend Professor Luigi Spaventa makes a proposal to mitigate the liquidity crunch, that involves the use of a state-sponsored SPV to purchase illiquid assets from financially distressed private banks. I propose throwing out the SPV bathwater while keeping the liquidity-enhancing baby.
Specifically, in a discussion of the credit crisis and the problem of banks being stuck with large amounts of illiquid assets, Spaventa notes that “Previously unthinkable options are therefore entering the debate, such as the use of public money to acquire all the toxic waste that is polluting banks’ balance sheets. But, even if the worst comes to the worst, does one need to go this far?” He goes on to say that “Some form of public intervention would therefore be required to solve co-ordination problems. Outright purchase of the illiquid credit-based securities in the banks’ portfolio would be neither desirable nor necessary. A publicly sponsored entity could be mandated to issue guaranteed bonds to be offered to banks in exchange for (and with the same maturity as) those assets.”
Spaventa also proposes that the (potentially toxic) assets of the banks be valued at a discount to their face value. This discount should reflect their default risk. They could, for instance, like the Brady bonds issued in exchange for non-performing emerging market debt in 1989, be issued at either par value with a below-market yield, or at a hefty discount and market yield, but those are technicalities.
Assume the SPV has on its balance sheet only the former private bank assets and the bonds it issued to the private banks in exchange for these assets. What Spaventa proposes would have the government receiving an up-front guarantee fee from the SPV and incurring a liability in the form of the contingent obligation to pay the holder of the bonds issued by the SPV in case the former private bank assets are insufficient to meet debt service on the SPV bonds. In an ideal world the guarantee fee and the fair value of the government’s guarantee would be the same. There would be no change in the properly calculated net worth of the government. There also would be no subsidy from the government to the private banks, even though value of what the SPV pays the private banks for their assets exceeds what the private banks could have obtained for these assets in the illiquid private markets. That is the miracle of market failure and of divergent private, public and social valuations. The SPV is a pure veil from a substantive, economic perspective.
The reason governments like the SPV arrangement is that, in many cases, the governments accounts, both for domestic and international reporting purposes, would record the guarantee fee as current government budget receipts. The contingent liability represented by the guarantee would not be recorded as a liability in the balance sheet. Only if, at some future time, the guarantee would be called, because the SPV defaulted on its bonds, would the government’s liability, no longer contingent but realised, show up in the accounts, as an outlay. With myopic governments, who know they may not be in office if and when the SPV defaults, the future is a much discounted concept.
It would of course be equally inappropriate to count the maximum value of the realised exposure as a liability. That would be the face value of the former private bank assets; unless default with zero recovery value is a certainty, that overstates the fair value of the state’s exposure.
Spaventa’s SPV proposal is, from an economic point of view, if the SPV pays the right (fair) price to the state for the guarantee, equivalent to the outright, direct purchase of the private bank assets by the state, through a swap of the bank assets (at a proper discount to face value) for Treasury bonds. The fair value of the guarantee in the SPV arrangement equals the difference between the face value of the bank assets and the value of the Treasury bonds the private banks would receive if there were an outright purchase of these assets by the state.
Under this direct outright purchase agreement, the state would end up with liabilities equal to the additional Treasury bonds transferred to the private banks and with financial assets equal to the fair value of the former private bank assets. Provided these have been valued properly, marked-to-fair value assets and liabilies would go up by the same amount, with no change in government net worth, just like under Spaventa’s SPV proposal.
Another transparent, but from an economic point of view equivalent alternative to Spaventa’s government-sponsored SPV with a state guarantee for the SPV debt, would be for the state to directly guarantee the private bank assets, with the banks keeping these assets on their balance sheets. The cost to the banks of the guarantee would be the same as the cost of the guarantee paid by the SPV to the government under Spaventa’s arrangement. It would also equal the difference between the face value of the private bank assets acquired by the government and the value of the Treasury bonds the banks end up with in the case of the outright purchase of bank assets by the state.
As stated earlier, giving standard accounting conventions, Spaventa’s preferred implementation of the government guarantee of the private bank assets - doing it in a roundabout way by having the Treasury guarantee the bonds issued by some publicly sponsored (no doubt off-balance-sheet) entity (i.e. by an SPV) - only serves to obscure who is taking on what risk. The state-sponsored entity does not take on any risk. It is the state, which guarantees the bonds issued by the SPV, that assumes the risk, in exchange for the guarantee fee.
I have no problem in principle with a special entity acquiring the bank assets and managing that portfolio as an agent of the state. Managing a portfolio of banking assets is not a skill commonly found in the public sector, so it makes sense to contract it out. But this solution is acceptable only if the contingent liability acquired by the government is fully accounted for on the government’s balance sheet. In practice, getting an SPV to acquire the private bank assets with a sovereign guarantee for the SPV bonds issued to acquire the assets would allow the government to keep both the liabilities and the assets out of the public sector balance sheet. In the short run, only the receipt of the guarantee premium from the SPV would show up in the government accounts. The fact that the guarantee may be called upon if the former bank assets now held by the SPV fail to perform is out of sight and out of mind.
The original ‘Brady bonds’ were also an unnecessarily complicated, extensively window-dressed re-arrangement of a very simple underlying write-off of debt and trade of risk exposure.Private banks’ balance sheet in the US carried lots of non-performing emerging market loans. These loans were swapped for long-term ‘Brady bonds’ with the same remaining maturity. The terms of the swap implied a market value for the non-performing loans that represented a steep discount on the original face value. These Brady bonds (which were the liabilities of the original borrowing governments) were collateralised by US Treasury securities of corresponding maturities purchased by the issuers and held in escrow at the Federal Reserve. I believe the US Treasury securities were purchased by the debtor governments at market value from the US government.
The Brady bonds were completely redundant in this arrangement. The debtor governments could simply have exchanged the (discounted) non-performing loans directly for the US Treasury securities they had purchased. Indeed, since US Treasury securities are nearly perfectly liquid, the debtor governments could simply have bought back their discounted non-performing loans at the agreed discount, using US dollars (or indeed any convertible currency), leaving the decision on how to invest the money (in US Treasury securities or anything else) to the creditor banks. So the Brady bond experiment was just another example of complicating something fundamentally very simple, without changing its economic substance.
In the Brady bond scheme the creditor banks took a hit relative to their original valuation - at par - of the loans they made; the borrowing emerging market governments (mainly Latin American) made a matching gain. There was no fiscal subsidy to anyone, assuming the borrowing governments paid fair market prices for the Treasury debt they put in escrow at the Fed.
In Spaventa’s scheme, as long as the SPV pays the government a fair fee for the guarantee on its bonds, there is no public sector subsidy either, even though the private banks clearly benefit from the transaction (economics is almost never a zero sum game - in a distorted equilibrium, it can be a positive or a negative sum game). There is only a public sector subsidy if the SPV does not pay a fair fee for the guarantee. In that case, the difference between the fair fee and the fee actually paid is a subsidy either to the SPV or to the private banks. The equivalent outcome when the state engages in direct purchases of private bank assets would be achieved if the state paid more than the fair (default risk-adjusted) value for the assets.
Since in the Spaventa SPV or direct outright purchase approaches the private bank assets are bought at a discount relative to their face value, there clearly has been some redistribution between the original borrowers from the banks (whose liabilities correspond to the assets the banks are now trying to get rid of) and the banks. But that distributional issue is distinct from any fiscal transfer from the Treasury to the private banks under the Spaventa or direct outright purchase proposals.
Honesty in government and accountability of government to its masters, the electorate, are far more important than the resolution of the current financial crisis. So even if there were no equally effective alternative to the disguised outright purchase by the state of illiquid or impaired assets proposed by Spaventa, the SPV solution should still be rejected, because it undermines the transparency of the public accounts. The voters have the right to know the exact extent of the exposure to private credit risk that the state is assuming. Hiding that exposure in some state-owned or state-guaranteed off-balance sheet vehicle would undermine democratic accountability.
Fortunately, there is no need to choose between financial stability and democratic accountability. The easiest way to make sure the government achieves the economic substance of what Spaventa proposes without any accounting window dressing is for the government to acquire the illiquid private bank assets outright through a direct purchase. This could be done through an agency of the Treasury or by even the central bank, as long as the accounts of the central bank are consolidated with those of the general government sector, to get a full and fair representation of the assets and liabilities of the sovereign.
If the government were to purchase illiquid assets (through whatever vehicle)from banks, is it equitable and efficient for government to require of the the benefitting banks (who would, presumably, sell voluntarily)that they make undertakings in furtherance of the public policy goals-aversion of drastic shrinking of intermediary balance sheets- that motivated the public sector offer to purchase assets? In particular, should government insist, as part of the deal, that selling banks do things like build up their capital base by suspending dividend distributions for some period of time and hold minimal excess capital over the regulatory minimum? Measures like these would, it seems to me, help ensure that public funds accomplish what they intend without applying coersion.
Posted by: Daniel J Aronoff | April 12th, 2008 at 6:49 am | Report this commentTaxpayers having to bail out the private sector in some parts of the world is small beer by comparison. Taxpayers can also be obliged, for the public sector, to meet trillions of pounds of off-balance sheet liabilities; for (unfunded) pensions and many other debts - liabilities that are shown on private sector balance sheets. http://burningourmoney.blogspot.com/2008/04/enron-debt-ticker.html
International Accounting Standards?
Posted by: Slightly Optimistic | April 12th, 2008 at 11:25 am | Report this commentRe comment by Daniel J Aronoff: I agree that, apart from proper, default-risk-reflecting pricing of the assets offered by troubled banks as collateral or for outright sale to the public sector, further conditions may be useful. I would support requiring that private firms involved in extraordinary public sector support operations refrain from dividend payment for at least a year, and/or be required to engage in rights issues of at least a given magnitude within some given period of time.
Posted by: Willem H. Buiter | April 12th, 2008 at 1:10 pm | Report this commentMaybe the BofE should be the buyer of such rights issues instead of toxic waste SPVs? Get seats on boards of banks and their renumeration committees too.
The financial sector must return to its role as servant, not master of the global economy.
Posted by: Tim | April 13th, 2008 at 1:42 pm | Report this commentWillem Buiter confuses 3 issues. I think I agree with him his general stance on all of them, but the position is clearer if they are stated separately:
1. To deal with illiquidity, government obligations should be offered to be swapped for or attached to the financial institutions’ assests that have become illiquid; at a proper price. This is urgent and immediate. “Action this day”.
Posted by: David Heigham | April 13th, 2008 at 5:26 pm | Report this comment2. Financial institutions taking up this offer can and should accept effectively policed conditions to secure them against getting in a similar mess again. Equally for “Action this day.”
3. Governments can and should forswear keeping liabilities and assets off balance sheet. This is extremely important. Government accounts are a basis for decision. Hiding relevant parts of the accounts is going to distort decisions as surely as blacking out parts of cars’ windscreens will lead to accidents. However this is an issue which goes far beyond the scope of issue 1. A wide range of entitlements of and against governments are kept off balance sheet in current public accounting conventions (e.g both my pensions). Getting even most of them properly into the accounts is going to take time; even without the procrastination the UK Government has shown over its “resource accounts”. This calls for a committment for completed action by a day named in advance; a committment and day preferably agreed internationally so governments can press one another to get on with it. The IMF is ludicrously short of things to do - this could well be a job for them. It is all about better finacial decision making and consequent greater world financial stability.
The word “balance” has significant meaning here. When you take something “off-balance”, you are doing just that. In other words, balance is good (think yoga or buddhism), off-balance (think checkbook) is not good. On that note, what do you call Fannie Mae, Freddie Mac and Sallie Mae. Do they qualify as “off-balance sheet financing”. How about the Bear Stearns portfolio. The U.S. goverment did about 36 hours of due diligence on that one, is that one off-balance sheet too?
I still want to know when we are going to start talking about employment and jobs and stop talking about saving Wall Street and their housing derivative ponzi scheme. The first shoe of unemployment is hitting now with the loss of jobs related to the housing downturn (construction, materials and related transportation industry) and the second shoe to drop is coming real, real soon (Wall Street, mortgage brokers and “derivatives” of). This is where the U.S. consumer will slow abruptly, as the rich guys are the ones still generating most of the consumption momentum. Directly related manufacturing driven economies such as India, Korea, Japan and China will feel it next and the commodity driven regions of Africa, South America and the Middle East will not be too far behind. Globalism is a beautiful thing, isn’t it.
The smart economists are spending their time thinking about how to put the very soon to be available labor around the world back to work. There is the most incredible economic opportunity out there today given all the heavy baggage the bourgeoisie is carrying around. The question is, will the entrepreneurs take advantage of it?
Posted by: Doug Wolkon - Author of The New Game | April 13th, 2008 at 9:40 pm | Report this commentDid Spaventa actually propose that his SPV be off the government’s balance sheet?
Posted by: JonA | April 14th, 2008 at 8:49 am | Report this commentIf this transfer of illiquid assets has to happen - and I’m not convinced - then the last thing we would want is that these assets be lost from view in the Treasury or central bank accounts. Therefore, they do need to be in an “SPV”, with proper accountability.
Whether this is to be off the public balance sheet should be a matter for appropriate OECD watchdogs who seem to have made a decent fist of standardising these definitions lately.
The problem is that U.S house prices are driven by demand - and demand has been driven by the massive relative size of the Baby Boomer Generation. The next two generations (X and Y) are much smaller. With slipping demand coupled with oversupply anyone holding low equity no recourse mortgages is likely to find themselves owning a property they don’t want. Regardless of who the owner is without demand prices will fall. Giving cash to the banks only socializes the losses- it doesn’t stop the fall in prices.
Posted by: Matt | April 14th, 2008 at 3:32 pm | Report this comment[…] more news from across the pond, Willem Buiter refines a proposal for governments to purchase illiquid debt without actually endorsing the idea in so many words; in another post, A Sovereign Portfolio […]
Posted by: PrefBlog » Blog Archive » April 16, 2008 | April 17th, 2008 at 2:08 am | Report this commentMassive buying of puts and shorting stock in Bear Stearns
On March 10, 2008, the closing price of Bear Stearns was 70. The stock had traded at 70 eight weeks prior. On or prior to March 10, 2008 requests were made to the Options Exchanges to open new April series of puts with exercise prices of 20, and 22.5, and a new March series with an exercise price of 25.
Their requests were accommodated and new series were opened March 11, 2008.
Since there was very little subsequent trading in the call series with exercise prices of 20, 22.5 or 25, it is certain that the requests were made with the intention of buying substantial amounts of the puts. There was, in fact, massive volumes of puts purchased in those series which opened on March 11, 2008.
For example, between March 11-14 inclusive, there was 20,000 contracts traded in the April 20s, 3700 contracts traded in the April 22.5s, and 8000 contracts traded in the April 25s. In the March 25s there were 79,000 contracts traded between March 11-14, 2008.
Question: Why did the options exchanges not open the far out of the money puts for trading the first time that BSC hit 70, when the Aprils and Marchs had far more time to expiration. Certainly if the requesters were legitimate hedgers or speculators, buying the March and April with two and three months to expiration was more appealing.
Answer: The insiders were not ready to collapse the stock and did not request the exchanges to open the new series then.
Second Request and Accommodation
On or prior to March 13, 2008, an additional request was made of the Options Exchanges to open more March and April put series with very low exercise prices even if that meant those March put options would have just five days of trading to expiration. The exchanges accommodated their requests, knowing that the intentions of the requesters was to buy puts. They indeed bought massive amounts of puts. For example the March 20 puts traded nearly 50,000 contracts (i.e. contracts to sell 5 million shares at 20). The March 15s traded 9600, the March 10s traded 13,000 and the March 5s traded 6300 all on March 14 (the first day of trading of the new March series).
The introduction of those far-out-of-the-money put series in the April and March months immediately before the crash, provided a vehicle whereby extreme leverage was available to the insiders. In other words if you had $100,000 and you knew that Morgan would buy Bear Stearns at two dollars, you could make five to 10 times more on the $100,000 by using the $100,000 to buy the newly introduced March puts. This is so because the soon to expire far out-of-the-money puts were far cheaper than the July or October out of the money puts. And that is why the inside traders requested the exchanges to introduce the far out of the moneys just days before the crash.
But this scenario has enormous implications. It means that the deal was already arranged on March 10 or before. That contradicts the scenario that is promoted by SEC Chairman Cox, Fed Chairman Bernanke, Bear CEO Schwartz, Jamie Dimon of J.P. Morgan (who sits on the Board of directors for the New York Federal Reserve Bank) and others that false rumors undermined the confidence in Bear Stearns making the company crash, notwithstanding their adequate liquidity days before. I would say that the deal was arranged months before but the final terms and times were not determined until maybe March 7 or 8, 2008.
On March 14, the April 17.5s, the 15s, the 12.5s and the 10s traded 15,000 contracts combined. Each put gives the right to sell 100 shares. So for example, these 15,000 April puts gave the purchaser(s) the right to sell 1.5 million shares at prices between 10 and 17.5. Those purchasers expected to make profits on 1.5 million shares because they knew the deal was coming at $2.00.
That is the only plausible explanation for anyone in his right mind to buy puts with five days of life remaining with strike prices far below the market price. So there were requests, during the period of March 10 to 13, to the exchanges to open the March and April series for buying massive amounts of extremely out-of-the-money puts, which were accommodated by the Options Exchanges. Did the Exchanges aid and abet the insider trading scheme? We are not able to have a clear opinion on that.
Media Statements of adequate liquidity
Reuters, however, on March 10, 2008 was citing Bear Stearns sources that there was no liquidity crisis and that there was no truth to the speculation of liquidity problems. And none other than the Chairman of the Securities and Exchange Commission on March 11, 2008 was stating that “we have a good deal of comfort with the capital cushion that these firms have.”
We even had the “mad” Jim Cramer proclaiming on March 11, 2008 that all is well with Bear Stearns and that the viewers should hold on to their Bear Stearns.
And on March 12, 2008, Alan Schwartz CEO of Bear Stearns was telling David Faber of CNBC that there was no problem with liquidity and that “We don’t see any pressure on our liquidity, let alone a liquidity crisis.”
The fact that the requests were made on March 10 or earlier that those new series be opened and those requests were accommodated together with the subsequent massive open positions in those newly opened series is conclusive proof that there were some who knew about the collapse in advance, while Reuters, Cox, Schwartz and Cramer were telling the public that there was no liquidity problem.
This was no case of a sudden development on the 13 or 14th, where things changed dramatically making it such that they needed a bail-out immediately. The collapse was anticipated and prepared for, even while the CEO of Bear Stearns and the SEC Chairman of the SEC were making claims of stability.
What was the reason that Cramer, Cox and Schwartz were all promoting Bear Stearns immediately before its collapse. That will be speculated upon for years to come.
Cramer has admitted that “truth” was not his friend and that he manipulated stocks to influence investors behavior. Was this one of his acts? But no apologies from Cramer as he claims now that he was referring to keeping money in Bear Stearns Bank not in Bear Stearn’s stock.
Compelling Evidence of Insider Trading
To prove the case of illegal insider trading, all the Feds have to do is ask a few questions of the persons who bought puts on Bear Stearns or shorted stock during the week before March 17, 2008 and before. All the records are easily available.
If they bought puts or shorted stock, just ask them why. What information did they have access to which the CEO and the SEC did not have? Where did they get the info? Why are Cramer, Cox, Paulson, Faber, and Schwartz not subject to a bit of prosecutorial pressure to get to the bottom of this?
Maybe the buyers of puts and short sellers of stock just didn’t believe Reuters, Cox, Schwartz, Cramer, and Faber and went massively short anyway buying puts that required a 70% drop in a week. Maybe they had better information than Schwartz or Cox. If they did then that’s a felony, with the profits made subject to forfeiture.
April 4, 2008 Congressional Hearings on the Bear Stearns Bail-out. I watched both sessions and drew the following conclusions.
In the first session there were the following witnesses. Bernanke of the Federal Reserve Board, Cox from the SEC, Geithner representing the New York Reserve Bank and an incidental player Mr. Steel from the Treasury. The only Senators that seem to be willing to attack these bankers were Bunning, Tester, Menedez and Reed. All the rest were useless and very respectful.
Absurdities
All witnesses did their best to keep their stories consistent but they did slip up a bit. They all agree that the bail-out was necessary without any proof that it was.
They all agreed that what caused the cash liquidity to dry up within one day was the rumor mongers. Apparently it is claimed that some people have the ability to start false rumors about Bear Stearns’ and other banks liquidity, which then starts a “run on the bank.” These rumor mongers allegedly were able to influence companies like Goldman Sachs to terminate doing business with Bear Stearns, notwithstanding that Goldman et al. believed that Bear Stearns balance sheet was in good shape. (Goldman between March 11-14 warned their average customers that Bear Stearns stock was “hard to borrow” for shorting due to the fact that other customers had used up all of the stock available for borrowing for short sales) .
That idea that rumors caused a “run on the bank” at Bear Stearns is 100% ridiculous. Perhaps that’s the reason why every witness were so guarded and hesitant and looked so mighty strained in answering questions.
Loans to J.P. Morgan total $55 Billion from the Fed
The Private New York Fed lent $25 Billion to Bear Stearns and another $30 billion to J.P. Morgan. So the bail out cost was $55 billion not the $30 billion that is promoted. This was revealed at second session of the Senate hearings in a James Dimon response to a question from Senator Reed.
Who gets the $55 billion? J.P. Morgan got the money on a loan pledging Bear Stearns assets valued at $55 billion; $29 Billion is non-recourse to Morgan.
Effectively the Fed got collateral appraised by Bear Stearns at $55 Billion for a loan to J.P. Morgan of $55 Billion.
If the value of the secondary facility of $30 Billion ($29 Billion of which is non-recourse) is worth only $15 Billion when all is said and done, then J.P. Morgan has to pay back only $1 Billion of the $30 Billion and keeps the $14 Billion the the Fed loses. If the $25 Billion primary facility is worth only $15 Billion when all is said and done, J.P. Morgan has to pay $10 Billion of the $25 Billion received. If J.P Morgan can not pay, then the Fed loses the $10 Billion.
If after all is said and done the $25 Billion primary assets are sold for more that $25 Billion, the difference goes to J.P. Morgan regardless of the outcome on the secondary facility of $30 Billion. No matter how you cut it, J.P. Morgan wins. If the $55 Billion assets turn out to be worth only $20 billion when all is said and done, J.P. Morgan owes $1 Billion on the $30 Billion and the difference between $25 Billion and the value received on the primary facility.
The Fed would have been far better to just buy the assets at Bear’s and J.P.Morgan’s valuation. Now best the Fed can do is get their money back with interest and the worse they can do is lose about $25 -$40 billion.
John Olagues - Truth IN Options
Posted by: rats in the whorehouse | April 17th, 2008 at 1:36 pm | Report this comment