Lehman Anniversary: What's Different? What's Still the Same?

Lehman Anniversary: What's Different? What's Still the Same?

Overview: On the anniversary of the Lehman failure President Obama addresses Wall Street in order to build consensus for his administrations' regulatory reform plan. Banks are lobbying hard against the new consumer protection agency and Congress is slow in adapting proposed rules for a systemic risk regulator, or the regulatory regime for OTC derivatives, and a new non-bank resolution mechanism. At the international level, the G20 finance ministers reached a tentative agreement on September 5 (to be finalized by G20 leaders in Pittsburgh on September 24-25) on a review of capital requirements, the need for coordinated exit strategies, the adoption of macro-prudential policies, and eventually align remuneration incentives with the long-term performance of banks. There is also agreement international coordination with regard to OTC derivativesand hedge fund regulation as well as a consistent set of accounting rules.

What's Different?
* The Bank of International Settlements' comprehensive response to the global banking crisis which was formulated in response to the G20 finance ministers' agreement (September 7, 2009): Capital requirements will be strengthened across the board with systemic banks facing higher charges. A larger share of common equity will be mandated. Countercyclical reserve requirements will be mandated. A liquidity requirement will be considered, as will an overall leverage ratio. Risky trading activities will face higher capital charges as well as complex securities in order to minimize regulatory capital arbitrage.
* Moreover, the G20 finance ministers vowed to align remuneration incentives with the long-term performance of banks.
* OTC Derivatives Central Counterparties (CCP): There is new consensus that a central counterparty is necessary to reduce potential knock-on effects (systemic risk) from the failure of a large player. However, the riskiest products are not standardized enough for a clearinghouse and therefore remain exposed to bilateral counterparty risk which regulators want to mitigate by imposing higher capital charges and disclosure of aggregate position holdings.
* There is new recognition that derivatives can have an economic impact. Stanford Professor Darrell Duffie writes in a Pew research report that "at the bankruptcy of Lehman a large quantity of interest-rate swap hedges that had been provided by Lehman needed to be quickly replaced. Other dealers, themselves under financial stress, were willing to provide these hedges only at swap rates below government yields." (09/01/09) This led to the persisting negative swap spread phenomenon in the 30-year U.S. and other government bond markets, once considered a "mathematical impossibility" unless unsecured bilateral swaps were perceived as safer than government debt. A persistent negative basis was also observed in the corporate bond market. Analysts note that balance sheet constraints prevent market participants from arbitraging the price discrepancy away.
* Further transmission channels from derivatives to real economy include corporate credit lines which are increasingly based on CDS performance. This transmits counterparty risk inherent in the CDS premium to the corporate sector (cash spreads themselves measure credit and liquidity risk). This might systematically understate credit risk in normal times and overstate credit risk in times of stress, thus introducing procyclicality, according to an ECB report released in September 2009. Furthermore, there is the empty creditor phenomenon that provides "overhedged" bondholders with an incentive to push for bankruptcy instead of restructuring.
* A new paradigm of economic thought is voiced by economist Keiichiro Kobayash at VoxEU: "The existing theoretical structure of macroeconomics is incapable of addressing macroeconomic performance and the stability of the financial system in an integrated context." The author proposes a paradigm shift to explicitly include the financial sector, credit markets and asset/collateral prices in standard economic modeling.

What's Still the Same?
* Too big to fail banks are now even bigger and leverage has increased across the board. With the incorporation of insolvent competitors and the forced re-intermediation of formerly off-balance sheet vehicles, the leverage ratio of global banks has jumped to around 40-50 in the U.S., Europe, and the UK in 2008. (InvestorsInsight, 07/19/09) As of 2010, up to US$900 billion of remaining off-balance sheet vehicles will have to be consolidated.
* Meanwhile, systemic banks benefit from implicit and explicit government backstops, whereas a resolution regime for all systemically large and complex institutions a la Fannie and Freddie, for example--arguably one of the most important measures-- is stalling in Congress amid waning political support. (Dealbook, 09/08/09) There is strong lobbying against the Consumer Protection Agency, whose fate is unclear. It is not decided yet who will be the systemic risk regulator: the Fed or the Systemic Risk Council.
* The lack of any disciplining mechanism represents an incentive for large players to engage in risky trading activities with value-at-risk (VaR) measures back at record levels in Q2 2009 for the top five banks, with US$1.04 billion at risk to be lost at any given trading day. This "represents an 18% increase from a year earlier and is up 75% from the $592 million in the first half of 2007, according to regulatory filings." (WSJ, 09/09/09)
* August 2009 TARP Oversight Panel Report: Toxic assets are still on banks' books. They are likely to be found in the Level 3 accounting category (mark-to-model) due to valuation difficulties. As of Q1 2009, the large banks have US$657 billion of Level 3 assets on their books. Public-private investment program is poised to start in October 2009 but it is unclear if banks will want to sell despite the government subsidies, or if buyers will want to get involved in a government program.
* Commercial Real Estate (CRE) Risk: Fitch (via RiskCenter): "While CRE loans, excluding the more problematic construction and development portfolios, represent more than 125% of total equity for the 20 largest banks rated by Fitch, the risk is even higher for banks with less than $20 billion in assets, as average CRE exposure represents more than 200% of total equity for these institutions." (08/19/09) Fitch announces ratings review by September.
* Dependence on wholesale funding markets is likely to remain an issue. "In the year up to September 2009, Western banks have issued $645 billion of bonds without government guarantees, according to Dealogic, a research firm. But the idea that the banking system can improve its funding profile at the same time as it weans itself off explicit state guarantees looks wildly unrealistic. This partly reflects the sheer volumes of debt involved. As well as turning over existing short-term borrowings of some $18 trillion, Western banks have to refinance longer-term debts that are maturing at the rate of about $1.5 trillion a year. With securitization markets damaged (approximate funding hole of US$2 trillion) and confidence in banks battered, that will not be easy." (The Economist, 09/03/09)

Review

The large reliance on uninsured wholesale funding and the declining value of collateral led to immediate ripple effects in the already challenged repo market (see NBER report by Gary Gorton and Andrew Metrick), and in the money market funds invested in Lehman's commercial paper (e.g. the Reserve Primary Fund.) Similarly, in the off-balance sheet universe, counterparty risk is measured by the replacement cost of bilateral hedges with another counterparty, minus any collateral posted. For example, the European Central Bank (ECB) reports that "as participants sought to replace terminated positions, [credit-default swaps] spreads widened by up to 40 basis points for investment-grade CDS and by around 100 basis points for sub-investment grade CDS." Re-hypothecated collateral proved in many cases difficult to access. AIG's total US$372 billion net protection seller position in the bespoke market (according to an AIG release via the ECB report, not captured in Depository Trust & Clearing Corporation data) shows the perils of credit-risk concentration due to one-way bets as compared to balanced bilateral exposures as is the norm for dealer banks. (The latter is shown for example in US$5.2 billion payout on US$72 billion of contracts with Lehman as a reference entity registered in the DTCC data warehouse; see FT, 09/11/09.) CDS are different from interest-rate derivatives in that the former are subject to jump-to-default risk (heavy right tails) (ECB). Recent research in network theory shows that sound CDS risk management by a central counterparty requires liquidity reserves proportional to gross rather than net exposures. (Rama Cont, Andreaa Minca & Amal Moussa, Columbia University)

Lehman's total assets in 2007 were US$691 billion. Of these, long positions in trading assets (45%) and short-term collateralized lending (44%, e.g. reverse repos) were the main positions. On the liabilities side, long-term debt (18%), equity (3%) and other short-term debt (8%) complemented short positions in trading (22%) and collateralized borrowing (37%). The remaining 12% were "payables," including the cash deposits of Lehman’s customers, especially its hedge fund clientele. ("Receivables" on the asset side were 6%.) "Hedge fund customers’ deposits are subject to withdrawal on demand, and proved to be an important source of funding instability," noted Tobias Adrian and Hyun Song Shin in a September 2009 Bank of France stability report.