When I first saw Laurence Ball’s 218 page NBER paper “The Fed and Lehman Brothers”, my first reaction was that this was too long to read. During the crisis, I had waded through 2200 pages (not counting appendices totalling close to 2000 pages) of the report of bankruptcy examiner Anton Valukas. But so many years after the crisis, Lehman fatigue sets in even for persistent readers like me. I am glad however that I overcame my initial reluctance and read this paper. Incidentally, NBER found the paper too long and so they relegated it to a “supplemental file” and posted an 18 page summary as the main paper. I think this is stupid – if you wish to read it at all, I would suggest you read the full paper (the 18 page summary is a waste of time). If you do not have access to NBER, you can read the full paper at the author’s website.
Ball puts together evidence scattered over many different sources to demolish the claim by the Fed that they lacked legal authority to rescue Lehman. The legal requirement was only that any loan should be secured by adequate collateral. Since Lehman had a large amount of unsecured long term debt, its assets (even at very pessimistic valuations) exceeded its short term debt by a wide margin. Therefore Lehman could have provided adequate collateral to the Fed to support a loan large enough to replace its entire short term debt. Lehman would then have been able to remain open for several weeks or months (until the long term debt fell due). This could have enabled Barclays to buy Lehman – the stumbling block to that deal was that Barclays needed a shareholder vote to complete the transaction and without a Fed loan, Lehman could not have survived that long. Even if that deal did not happen, an orderly liquidation of Lehman would have been possible. Ball’s point about long term debt is a valuable contribution to the Lehman literature. In credit risk modelling, it is well known that long term debt is less problematic than short term debt. In the famous KMV model, default risk measurement uses the sum of short term debt and half long term debt. But I have not previously seen this insight applied to Lehman.
Ball is also able to establish that the decision not to lend to Lehman was taken by Treasury Secretary Hank Paulson, though legally Paulson had no role in this decision which was the exclusive province of the Fed. This is of course evidence that the powers to lend to distressed institutions should be moved out of the central bank to a separate resolution corporation in order to safeguard the independence of the central bank.
Let me add that I am firmly of the view that the decision to let Lehman fail was the correct one. If today the US seems to be the only country to have put the crisis behind it and to be on the recovery path, much of the credit should go to the bold decision to let Lehman fail. Countries which spent years in denial and tried to muddle along have fared much worse. It is unfortunate that those who took this correct decision have not had the courage to admit this, but have chosen to hide behind the fig leaf of a non existent legal barrier. Ball’s paper set the record straight on this and ensures that future historians will know the truth.
Mon, 18 Jul 2016
Nearly two years ago, I wrote a blog post in which I strongly criticized the insistence of the Basel Committee on Payments and Market Infrastructures (CPMI, previously known as CPSS) that payment and settlement systems should be able to resume operations within 2 hours from a cyber attack and should be able to complete the settlement by end of day. I described this demand as reckless and irresponsible because it ignored Principle 16 which requires an FMI to “safeguard its participants’ assets and minimise the risk of loss on and delay in access to these assets.” I argued that in a cyber attack, the primary focus should be on protecting participants’ assets by mitigating the risk of data loss and fraudulent transfer of assets. In the case of a serious cyber attack, this principle would argue for a more cautious approach which would resume operations only after ensuring that the risk of loss of participants’ assets has been dealt with. Shortly thereafter, I was glad to find the Reserve Bank of India echoing these sentiments (in less colourful language) in its Financial Stability Report.
Almost two years later, the Basel Committee (CPMI) has issued new guidance that reflects a much more responsible approach to 2-hour recovery. The Guidance on cyber resilience for financial market infrastructures published late last month states:
An FMI should design and test its systems and processes to enable the safe resumption of critical operations within two hours of a disruption and to enable itself to complete settlement by the end of the day of the disruption, even in the case of extreme but plausible scenarios. Notwithstanding this capability to resume critical operations within two hours, when dealing with a disruption FMIs should exercise judgment in effecting resumption so that risks to itself or its ecosystem do not thereby escalate, whilst taking into account that completion of settlement by the end of day is crucial. FMIs should also plan for scenarios in which the resumption objective is not achieved.
This is a welcome sign that regulators are more pragmatic and are not allowing market participants to form unrealistic expectations. As Regulation Asia wrote about last week’s outage at the Singapore Exchange (SGX):
Trying to lead the public to think a resumption is possible, without knowing if it is really possible only degrades credibility with each successive retraction and announcement.
Sat, 02 Jul 2016
During the Great Moderation, the US Treasury market came to be dominated by official investors – Asian central banks and the reserve funds of oil producing countries. During the last couple of years, these flows have gone into reverse. With oil around $50 a barrel, most oil producers are liquidating their reserves rather than adding to them. In Asia too, reserve accumulation has slowed down if not reversed with China in particular depleting its reserves as it deals with capital flight.
The massive selling by official investors has been more than balanced by large scale buying by private investors. Some of this is clearly visible in the official data (see for example, slide 10 in Torsten Slok’s presentation at the Brookings event last month on “Negative interest rates: Lessons learned...so far”). I suspect that the official figures understate the true extent of this shift because at least a part of the official selling would be from offshore vehicles that are not clearly identifiable as official holdings.
If this trend continues, I believe this could have serious implications for the volatility in US Treasury yields. As long as the net buying was dominated by price insensitive reserve managers whose mandates restrict them to very safe assets anyway, the volatility of yields would have been quite muted. But the private buyers are much more unconstrained in their portfolio choices and are also much more sensitive to risk-return opportunities in the market. For example, a large part of Chinese capital flight amounts to Chinese external assets moving from the government (PBoC/SAFE) to private investors. Unlike the PBoC or even SAFE, private investors can invest in corporate bonds, equities and real assets anywhere in the world, and have no special preference for US Treasury.
In today’s environment of flight to safety, US Treasury is well bid on the basis of risk-return expectations. But that could easily change and then long term UST yields might have to move a lot to equilibriate supply and demand. At that point, we will see the true consequences of UST becoming a playground of hot money instead of a long term store of value.
The following posts appeared on the sister blog (on Computing) during the last few months.
SWIFT hacking threatens to erode confidence in financial sector (Cross posted on this blog also)
Bangladesh Bank hacking is yet another wake up call (Cross posted on this blog also)
Tweets during the last few months (other than blog post tweets):
- 18 June 2016
- Paul Milovanov: "Arbitrageurs are the angels of entropy." http://ftalphaville.ft.com/2016/06/17/2166705/please-lets-stop-saying-us-primary-dealers-are-required-to-make-markets/
- 16 March 2016
- Heisenberg Unprofitability Principle: you can profit from a market anomaly or publicly disclose it, but not both http://macro-man.blogspot.in/2016/03/the-only-thing-that-goes-down-more.html
- 4 February 2016:
- Bank of Japan Governor: "I am convinced that there is no limit to measures for monetary easing" https://www.boj.or.jp/en/announcements/press/koen_2016/data/ko160203a1.pdf