Extreme Measures III: Cambiz Alikhani at the Financial Times

As concern about tightening conditions in the credit markets and the continued erosion of the US supbrime and broader housing market has grown, so too have calls for Extreme Measures to combat these snowballing problems.

The first was from Bill Gross at Pimco, who suggested that the US government “rescue” the 2 millionish homeowners who stood to lose their homes. A second came from Gillian Tett, the capital markets editor at the Financial Times, who argued that investment bankers should decompose CDOs and other structured credits into their constituent parts. It’s a nice sounding idea that is completely unworkable. Willem Buiter’s and Anne Sibert’s proposal that central banks act as market makers of the last resort almost qualified by virtue of being a radical departure from current practice. However, it fails to meet the standard by virtue of being not insanely difficult to implement (Buiter and Sibert claim the Fed and other central bankers have the statutory authority to go this route).

The latest sighting is an article by Cambiz Alikhani of Arundel Iveagh Investment Management in the Financial Times, “Banks should form a bail-out vehicle to ease the credit crisis.” He begins with a suitably dramatic synopsis:

Over the past few months a modern day pyramid scheme of colossal proportions has begun to unwind. The sheer scale of it is clogging up the arteries of the financial system and has led to major disequilibrium within global credit markets.

His proposal on the surface sounds attractive:

This credit crunch could be alleviated by removing from the system the debt that created the problem in the first place….

It may therefore be appropriate for a core group of leading financial institutions to consider the idea of a “bail-out” vehicle that would be capitalised with the purpose of providing both pricing for the market and a source of demand for paper that cannot find another home.

The fact that such a vehicle is funded by financial institutions rather than governments would not only shield regulators from the accusation of “moral hazard” but could actually involve them in a very pro-active way.

They could play an important role in providing transparency with regards to the scale of the problem and with regards to the different pricing mechanisms used by different banks for exactly the same type of paper.

Thus regulators such as the Securities and Exchange Commission in the US and the Financial Services Authority in the UK could play the pivotal role of referee, while central banks provide the appropriate level of liquidity that the system needs in the meantime.

Alikhani invokes the LTCM bailout and the establishment of Resolution Trust Corporation as successful examples. Yes, they were successful, but neither is a precedent for this idea.

Let’s start by examining a few of the numerous practical impediments, then the relevance of LTCM and the RTC.

First, the formation of such an entity among private sector on a voluntary basis has no precedent, and for good reason. There are so many contentious issues that are zero sum (or likely to be treated by tough Wall Street negotiators as zero sum) to make it well night impossible for them to find common ground. What assets would be included? What sort of initial capitalization and ongoing support (working capital and expenses) would each firm provide? What would the governance structure be?

Let’s look at one issue that might seem to be simple, “What assets should be included?” To solve this problem on a good-faith basis, the various players would need to discuss what their exposures are so they would have an idea in aggregate of what the new entity’s funding requirements would be. But these firms are competitors and position information, even on an aggregate level, is tremendously sensitive. The likelihood of them exposing that is about zero. They all know that that information can and will be used against them.

Second, the formation of this entity is to solve a problem, namely the lack of a market (or at least an active, well functioning market) for certain types of debt. One impediment is considerable uncertainty as to what the paper (such as many CDO tranches) is worth (note that “uncertainty” may really be code for “there are no bids” or “the sellers know that the bids are likely to be so far below what they are willing to accept that they aren’t even willing to try to find a buyer.”)

Yet you need an answer to that very same problem, how to price the various assets, in order to establish the bail-out entity. In other words, this is a circular problem. Setting up the vehicle requires an answer to the very problem that it is supposed to solve.

Go through the mechanics. The banks create a new entity. They have to transfer the doggy assets into the entity. To transfer them, they need to assign a value (both the price in the accounts of each bank for the removal of the assets, and the price at which they are valued in the new entity, which presumably has to be the same number). Now this may all seem to be moot, since what they’d get back is equity in the new entity. But how much equity they receive and how much in credit facilities and/or cash funding they also provide presumably is proportional to the value of the assets they contribute. Someone who put in $1 billion of doggy assets gets half as big a stake as someone who puts in $2 billion (and presumably also has half the voting rights and funding requirements). So these values do matter.

Alikhani notes in passing that the banks almost certainly are carrying similar assets on their books at different values now: “They could play an important role…. with regards to the different pricing mechanisms used by different banks for exactly the same type of paper.”

You have to solve the problem before you capitalize the entity, not afterwards.

Third, it isn’t clear at all that it is desirable to have large scale price discovery of these assets. Alikhani is making the mistake of assuming that ownership is concentrated in relatively few hands, presumably among the large investment banks.

But this dubious paper is scattered widely in the investor community. It’s held by hedge funds, pension funds, banks, insurance companies, and other asset managers. And at least in the case of CDOs, there are also derivative exposures against some of these instruments (credit default swaps were one of several means to achieve credit enhancement).

What happens if you have widespread price discovery? Hedge funds and other asset managers will have to remark their positions. Any leveraged players (certainly hedge funds, perhaps some other fixed income managers) will face margin calls. That will force more selling, and could lead to the collapse of some hedge funds (note that some funds have already failed in the absence of a market clearing). Discovery of the magnitude of the losses also would lead to panic among investors, and could (as it did in August) lead to redemptions at funds suffering only minor losses, which nevertheless added to selling pressure.

Losses and failures of leveraged players puts the loans at risk. The investment banks who are presumably sponsoring the formation of this entity could set in motion a chain of events that create large losses in their prime brokerage businesses. That’s a scenario they’d want to avoid at all costs.

In fact, what would be the best outcome for the financial community is very gradual price discovery, so the losses eke out gradually over time and the repricing of credit is orderly. Whether this can or can be made to come about is a completely different question. I sincerely doubt this will happen, but similarly, I can’t imagine the financial community voluntarily accelerating price discovery unless they somehow thought the consequences of not doing so were worse. I don’t think they would perceive there to be a compelling case, given the downside outlined above.

To return to the LTCM and RTC examples: neither is germane to this idea. There is a common, and widely held perception that the Fed brokered the rescue of LTCM. In fact, Peter Fisher, head of the NY Fed’s trading desk, had been asked by LTCM to look at its positions (by then it was an open secret that the firm was on the ropes). Fisher called the major investment banks and banks that were credit providers, ascertained that all wanted a work-out rather than a collapse, but no one was willing to put himself at a negotiating disadvantage by trying to lead such an effort.

Roger Lowenstein recounts the negotiations at the Fed’s offices in considerable detail in his book, “How Genius Failed”:

Fisher spoke for just a few minutes. He said the Fed was interested whether the private sector could find a solution that wold avoid a chaotic liquidation – one that would spare the system. Otherwise, he adopted a neutral stance, intentionally staying aloof from the particulars. [Herb] Allison [of Merrill Lynch] said, “It was like he had rented out a hall.”

Lowenstein notes that it was unprecedented for the Fed to summon executives from other firms together and even offer a very generalized proposal, and the bankers understood that the Fed had in essence recommended that it would serve them to solve this problem. But it is still important to remember that that is all the Fed did.

Also recall that LTCM was an existing entity, with a well defined set of positions that were readily valued. So there was no need to worry about who would manage the entity (although there was an issue about oversight). The biggest issues were how much each firm should cough up, how long the investment should be and what the arrangements with the LTCM principals should be (they had to be paid something to complete the wind-down; otherwise, they might as well abandon the firm).

As for RTC, the comparison is even less germane. The S&L assets fell into the government’s lap by virtue of it having provided deposit insurance to the failed entities and by being their primary regulator. There was some pressure to sell the assets, both because it required a considerable amount of working capital to fund the assets (which became increasingly controversial) and because the overhang of unsold assets was perceived to be detrimental to the surviving banks in the same geographical area as the dead thrifts.