April 16, 2008

The latest report of nefarious skullduggery involves the possibility that banks have under-reported the yields paid on interbank borrowing to avoid looking desperate, resulting in a quote for LIBOR that understates the true rate. Naked Capitalism republishes an extract from the WSJ article; the British Bankers’ Association has threatened to ban any bank caught misquoting rates.

Speaking of the BBA, they have recently released a response to proposals for increased/changed regulation … most of it is UK-specific, but they have strong views on the funding of a central deposit insurer:

We are strongly of the view that a pre-funded deposit protection scheme is inappropriate for UK market. We believe that there should be greater appreciation of the limited ability of deposit protection schemes to save a troubled bank and the impracticality of devising a scheme large enough to cope with the failure of a large UK institution.

We have significant concerns over the competitiveness impacts on the UK financial sector of moving to a pre-funded deposit protection scheme. The costs of moving to a pre-funded scheme would be significant and would have a harmful effect on banks’ competitiveness and their ability to lend to business and individuals alike. The industry has already sustained a significant cost increase from the removal of coinsurance and, subject to further consideration of the issues involved, would be prepared to take on the additional costs of a move to gross payments.

We note that in the US scheme, operated by the FDIC, the pre-fund was created for the purposes of closure and/or failure of a large number of small entities operating in that market. It is not set up to resolve problems in a bank the size of Northern Rock nor does the US system necessarily need a pre-fund to operate. Consumer confidence is driven by expectations that money can be retrieved in a crisis. We believe it would be impractical to build up a UK fund of sufficient size to deliver his. The United States ex-ante scheme of $49bn, built up over many years and in relation to circa $4 trillion insured deposits, is approximately equivalent to Northern Rock’s retail deposit base prior to the run. So unless it is a small institution that is in distress there would not be enough in the fund to head off a run.Whilst a pre-funded scheme would provide a ready pool of liquidity in the event of a bank default there are other more efficient means of delivering liquidity for prompt payout.

FDIC insurance is backed by the “full faith and credit of the United States Government”. We believe that a similar arrangement whereby the UK government provides support for an FSCS deposit scheme which borrows funds only when required provides the most effective balance for achieving a credible scheme in the eyes of the consumer whilst minimising costs to the industry.

In an update to my post Is Crony Capitalism Really Returning to America, I confessed to some confusion regarding the rationale for brokerages having such enormous chunks of sub-prime on their books:

Taking the last point a little further, I will highlight my confusion as to why the brokerages are taking such enormous write-downs on sub-prime product. This has never made a lot of sense to me

. The WSJ (via Naked Capitalism) has provided a much more venal rationale than the one I suggested at the time:

In August 2006, one Merrill trader fought back when managers pushed to have the firm retain $975 million of a new $1.5 billion CDO named Octans….

The result was a heated phone conversation with Merrill’s CDO co-chief, Harin De Silva, who was out of the office. Mr. De Silva urged the trader to accept the securities….The alternative was to let the deal fall apart, which would leave Merrill holding the risk of all the securities that would have backed the CDO.

In the end, Mr. Roy’s group took the $975 million of securities on the firm’s books….a step that helped the firm hold its top rank in CDO underwriting and led to an estimated $15 million in fee revenue…

Pressures rose in early 2007 as the housing bubble lost air. Merrill set out to reduce its exposure, in an effort referred to innocuously as “de-risking.”

It could have sold off billions of dollars’ worth of mortgage-backed bonds that it had stockpiled with the intention of packaging them into more CDOs. But with the market for such bonds slipping, Merrill would have had to record losses of $1.5 billion to $3 billion on the bonds, says a person familiar with the matter.

Instead, Merrill tried a different strategy: quickly turn the bonds into more CDOs.

Doing so was no longer a profitable enterprise….Still, executives believed that so long as all they retained on their books were super-senior tranches, they would be shielded from falls in the prices of mortgage securities….

In the first seven months of 2007, Merrill created more than $30 billion in mortgage CDOs, according to Dealogic, keeping Merrill No. 1 in Wall Street underwriting for this type of security.

The call for comments, Financial stability and depositor protection: strengthening the framework. At issue are the following notes regarding UK deposit insurance:

1.48 On 1 October 2007, the FSA changed the FSCS compensation limit applying to deposits so that 100 per cent of an eligible depositor’s losses up to £35,000 are covered. The FSA proposes that this limit will continue to be applied per person per bank, and without any co-insurance below the limit. The FSA intends to consult on a review of the FSCS limits in all sectors and other changes to the compensation scheme. The Authorities will also work with the financial sector to explore alternative ways for individuals to cover amounts above the threshold, as the Treasury Select Committee has recommended.

4.42 The Authorities have considered the possibility of making depositors a preferential class of creditor, (i.e. to introduce depositor preference), but the likely adverse consequences of this for other creditors in insolvency proceedings and for banks generally, in terms of increased costs of credit, shorter loan periods and increased demand for collateral, appear to make this undesirable in the UK context. It is therefore proposed that the claims of the FSCS and depositors (whose claims are not settled by the FSCS) will continue to rank alongside the claims of other ordinary unsecured creditors. While a bank liquidator will have a duty to assist the FSCS to effect a repaid payout (i.e. to process depositor information at an early stage), the funding for any payout to depositors would be provided by the FSCS.

5.53 The Treasury Select Committee has identified two disadvantages of a ‘pay as you go’ approach to financing the FSCS:

2 Responses to “April 16, 2008”

  1. […] as in the Fed’s TSLF, or “trade”, as in Willem Buiter’s idea mentioned yesterday. I think the former is a great idea, provided that the loan is at a penalty rate; I have yet to be […]

  2. […] exercise, not because anybody in management really wanted them to do anything. I noted on April 16 one particularly nasty report with respect to a Merrill Lynch CDO offering of a corporate finance […]

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