When You Got Them By The Liquidity Their Hearts and Minds Soon Follow.

This mornings title is of course a play on words on the phrase made famous by Chuck Colson, "Special Council" to President Richard Nixon.  Colson, a hard nose Marine and a convicted "obstructer of justice" had a cartoon on his wall reading, "When you got them by the balls, their hearts and minds will soon follow."  As a funny aside, I did a google search to make sure that I was correctly attributing this statement to Chuck Colson.  On the way to confirming this I saw another quote, "I never trust a man unless I have his pecker in my pocket!"  That was from President Lyndon Baines Johnson.  If you think about it, from 1964 to 1974 the White House was occupied by some pretty mean hombres!

Anyway, I digress.  This morning there is an article in the Financial Times "Worries Remain Even After CDS Clean-Up".  The article does a very nice job illustrating the efforts to bring some sort of operational order to the unwieldy, gigantic market.  Since the collapse of Bear Stearns;

"The industry has pushed through 10 years worth of changes in just a few months," said Athansassios Diplas, a managing director of Deutsche Bank.  "This is a complete transformation of the CDS industry."

This is certainly good news.  Silly little things like the settlement process, trade confirmation, uniform language, etc., were neglected for far too long.  To be fair to Tim Geithner, this was one thing that he was very publicly concerned about early on in his years at the NY Fed.  What troubled me was how the article ended;

In the meantime, regulators might still push for legislation which could curb CDS, ranging from mandatory exchange trading to requiring traders to hold underlying positions in bonds or loans. "There are some people who still believe the market should not exist at all", said Brian Yelvington, analyst at Creditinsights.  "Despite the huge clean-up that has taken place in the CDS industry there are discussions as to the usefulness of the market versus what some perceive as its destructive nature"

To quote Smokey the Bear.."Matches don't start forest fires....people do."  The natural reaction to the disaster wreaked on our financial system is to blame products like CDS.  It is true that CDS allowed raiders to make huge profits while taking down institutions like Bear Stearns.  However what took down Bear and Lehman and AIG and Merrill and Morgan Stanley and Goldman (I include the last two because without Uncle Sammy coming to the rescue, Stanley and Goldman were dead meat..maybe GE will end up in this category too) was the combination of extreme wholesale funded trading strategies that took huge asymmetrical, firm-busting bets on illiquid products.  Leverage plus illiquidity is a known recipe for disaster.  This is not something we just learned in the last two years.  It is a timeless lesson that we just seem to forget every decade or so.

I believe it all starts with funding liquidity.  Many years ago as a young lad working for the Office of Thrift Supervision, we began modeling institution's capital exposure to interest rate risk.  While the tendency seems to be to focus on the asset side of the balance sheet, we spent a lot of time on the liability side of the balance sheet.  We did this because the S&L crisis of the 1980's couldn't have happened without something called "brokered deposits".  Brokered deposits were "hot or wholesale" money.  They were placed at the institution by brokers looking for the highest FDIC or FSLIC insured deposit rate.  This funding was "easy" to get (meaning you just had to jack your rates high enough to attract the funding...which was a hoot when sick institutions sucked deposits out of healthy ones due to the fact that lenders didn't care about sick vs healthy when both were 100% government insured!).  Therefore, when we modeled a bank's liabilities we differentiated greatly between wholesale deposits and retail deposits.  Retail deposits were deposits that the bank received from its customer franchise.  These deposits were what we called "sticky".  While wholesale deposits leave the bank at the drop of a hat when something better comes along (sounds like my junior high school dating career) retail deposits "stick around".  There is HUGE value to retail deposits and they go a long way to mitigate interest rate risk.

Now, when we look at the above mentioned investment banks, as well as AIG and GE, who were posing as a insurance company and a corporate conglomerate, we see that all these firms relied on ruthless, wholesale funding.  A large bulk of their operations and "investment strategies" relied on the commercial paper markets, brokered deposits for their banking entities and prime brokerage cash (for hedge funds).  I can see prime brokerage cash being thought of as sticky retail funding because it's a big pain in the ass for a hedge fund to change prime brokers.  However, once solvency became an issue, these companies liability structures became their own worst enemies. 

For example, Bear Stearns.  In late 2007 and early 2008, there were not many people running around saying Bear was insolvent.  Maybe Bear was, but nobody was really saying it or thought it at that time.  However, what "smart" investors knew at the time was that Bear relied very heavily on the $ billions of prime brokerage cash it held for hedge funds.  I truly believe that Bear was taken down by a criminal conspiracy, potentially by its own clients as well as proprietary Wall Street trading desks.  How you say?

1. A few large hedge funds, some of whom are looking at a lousy 2008 after a lousy 2007, were looking for a monster score.  They know Bear is WAY overweighted in the residential mortgage game.  They also know that Bear is very dependent on the prime brokerage model to not only generate lots of earnings, but also to fund themselves.  I'm sure this view was reinforced for years every time a large Bear prime brokerage customer brought up the idea of moving some or all of their business.  Within minutes somebody very senior at Bear must have been on the phone, soothing the customer, fixing whatever problem they had and ordering lunch for the entire hedge fund!
2. The hedge funds turned this prime brokerage dependency on Bear as they correctly perceive the shakiness of Bears balance sheet.  I'm going to bet that they began buying credit default swap protection on Bear, probing the deep out of the money short-dated put options (right to sell BSC) and checking the stock borrow conditions for shorting BSC.
3. The hedge funds then very publicly (meaning known to the Street) yanked their prime brokerage cash from Bear, causing a liquidity panic.  Remember, this is before an investment bank could go to the Fed.
4. I am going to guess that jumping into the mosh pit to make a killing were the Wall Street banks that were the recipient of the hedge funds prime brokerage cash.  They also knew how dependent Bear was on that cash.  These guys got a head start.  I am sure, through their proprietary trading desks, they began buying CDS protection on Bear and shorting the crap out of BSC too.
5. Both hedge funds and proprietary desks (which are really the same animal) probably engaged in the kind of nasty naked short selling that got such publicity last summer, giving Bear the final shot to the head.

That's what I think happened to Bear Stearns.  Lehman, Merrill, AIG and the rest have their own grizzly stories, not so grizzly as Bear's because I believe that was an organized criminal conspiracy, but grizzly enough.  What was the culprit in all these cases, CDS?  non-naked short-selling?  I don't think so.  The culprit was the glaring weakness of these firms liability structures.  This weakness allowed the market to quickly expose the issue of these firms solvency. 

The real problem was the failure of anyone with any authority to point out the dangers that we had previously seen just twenty years ago in the S&L crisis.  We had bad assets, highly leveraged with wholesale funding structures.  We can get rid of CDS and we can reintroduce the up-tick rule for short selling stocks.  However, if we don't smarten up on the regulatory risk management side, what has happened in the last two years will just happen again with a different financial instrument used as the weapon of choice. 

Comments

[supra kids shoes]

Good stuff as per usual, thanks. I do hope this kind of thing gets more exposure.

[eric]

Fair point. I kind of got off a run there.

[BK]

Very New Yorker'ish blog entry. Lots of words, no pictures, takes more than 2 minutes to read. Suggest trying to incorporate some of your choice music and video clips to keep things entertaining in these long ones.