Capital Markets - News and analysis

Paul Calello and Wilson Ervin explain how a bail-in instead of a bail-out at Lehman could have worked. In hindsight the idea sounds compelling:

Economist: From bail-out to bail-in, Jan. 28, 2010

"A bail-in during the course of that weekend could have allowed Lehman to continue operating and forestalled much of the investor panic that froze markets and deepened the recession.

How would it have worked? Regulators would be given the legal authority to dictate the terms of a recapitalisation, subject to an agreed framework. The details will vary from case to case, but for Lehman, officials could have proceeded as follows. First, the concerns over valuation could have been addressed by writing assets down by $25 billion, roughly wiping out existing shareholders. Second, to recapitalise the bank, preferred-stock and subordinated-debt investors would have converted their approximately $25 billion of existing holdings in return for 50% of the equity in the new Lehman. Holders of Lehman’s $120 billion of senior unsecured debt would have converted 15% of their positions, and received the other 50% of the new equity.

The remaining 85% of senior unsecured debt would have been unaffected, as would the bank’s secured creditors and its customers and counterparties. The bank’s previous shareholders would have received warrants that would have value only if the new company rebounded. Existing management would have been replaced after a brief transition period."

Source: Excerpt from the article linked to above

In its "week ahead" section The Economist mentions the talks about Greece's shaky finances:

"JUDGMENT will be passed on the Greek government's budget-cutting plans by the European Commission on Wednesday February 3rd. The country's public finances are in a parlous state and fears that the markets may lose faith in Greece altogether were only partly allayed when it recently raised €8 billion ($11 billion) in the bond market. Amid fears that Greece may not present a credible plan for fiscal austerity, talk is circulating of a bail-out, perhaps through a big fund underwritten by the commission or France and Germany, that could offer loans, albeit at punitive rates, to see Greece past this tight spot. And Greece is not the only member of the euro-zone with wobbly public finances."

There are in fact other Euro-zone members with financial stress, as following chart shows:

Related:

Should Greece get help from other EU states, the financial support must be accompanied with strict rules for another way of public financial management. Maybe Chile could be a role model for its fiscal discipline:

Achieving Long-Term fiscal Discipline: A Lesson from Chile

NYT: How to Reform Our Financial System, Jan. 30, 2010

Bonaparte, Yosef , Kumar, Alok and Page, Jeremy K., Political Climate, Optimism, and Investment Decisions (January 22, 2010). Available at SSRN: http://ssrn.com/abstract=1509168

Abstract:

"This paper shows that people's optimism towards financial markets and the overall economy is dynamically influenced by their political affiliation and the existing political climate. Republicans (Democrats) are more optimistic and they perceive the markets to be less risky and more undervalued when the Republican (Democratic) party is in power. These optimism shifts are more pronounced among individuals with lower financial sophistication. Further, when the opposite party is in power, investors lower their forecasts of market returns, keep own portfolio return forecasts unchanged and, therefore, appear more overconfident. These shifts in optimism, overconfidence, and perceptions of risk and reward influence people's investment decisions. Specifically, investors with a pessimistic view of the domestic economy exhibit strong propensity to invest in foreign stocks and in the domestic setting, they gravitate toward less risky, familiar local stocks and trade more actively. Investors improve their raw portfolio performance when their own party is in power, but the improvement in risk-adjusted performance is economically small."

NYT: Soros Endorses Obama’s Plan on Banks, Jan. 27, 2010

DAVOS, Switzerland — The billionaire investor George Soros said on Wednesday that he supported President Obama’s proposal to limit the size of banks. But he warned that it was too early to put such a plan in place and that it did not go far enough. read more

It seems that there is a lot of pressure on investors to get above average returns. This was also the case prior to the subprime crisis, when global imbalances lead to massive cash pools in countries such as China. Should Greece fail there is a certain expectations that it will be bailed out by EU member states.

FT: Investors flock to Greek bonds, Jan. 25, 2010

International alarm over Greece’s debt crisis abated on Monday when investors flocked to buy the government’s first bond issue of the year, an indication that it may run into less trouble than anticipated in meeting its short-term financing needs.

Investors placed about €20bn ($28bn, £17bn) in orders for the five-year, fixed-rate bond, four times more than the government had reckoned on. However, in a sign that Greece is being made to pay for years of fiscal profligacy, the bond carried a record high interest rate spread relative to the rate for German bonds, the eurozone’s benchmark. read more

Stanford University economics professor John Taylor claims that the market’s panic wasn’t due to the institution’s bankruptcy but that it was more about the government’s response a week later.

Federal Reserve Chairman Ben Bernanke on Monday invited the Government Accountability Office to audit the central bank’s involvement in the U.S. rescue of American International Group Inc. In a letter to Acting Comptroller General Gene Dodaro. With this step he tries to soften criticism of the bail out:

Bernanke Letter to Mr. Dodaro

Here is a latest message about the Fed's AIG bailout:

FT: Fed makes ‘a killing’ on AIG contracts, Jan. 20, 2010

The "Fed boys" have not been stupid at all when structuring their deals. The procedure of the bail out is another matter. One has to take into account that such bail outs have been done under enormous time pressure and insecurity. Good to know that the "boys" kept clear head when it came to business matters!

Related:

This is a paper which should have substantial implications for the way Board of Directors structure CEO payment.

The CEO Pay Slice, Lucian A. Bebchuk, Martijn Cremers,and Urs Peyer, Harvard Law School, Yale School of Management, INSEAD, October 2009

"We investigate the relationship between the CEO Pay Slice (CPS) – the fraction of the aggregate compensation of the top-five executive team captured by the CEO – and the value, performance, and behavior of public firms. The CPS may reflect the relative importance of the CEO as well as the extent to which the CEO is able to extracts rents. We find that, controlling for all standard controls, CPS is negatively associated with firm value as measured by industryadjusted Tobin's Q. CPS also has a rich set of relations with firms’ behavior and performance: in particular, CPS is correlated with (i) lower (industry-adjusted) accounting profitability, (ii) lower stock returns accompanying acquisitions announced by the firm and higher likelihood of a negative stock return accompanying such announcements, (iii) higher odds of the CEO’s receiving a “lucky” option grant at the lowest price of the month, (iv) greater tendency to reward the CEO for luck due to positive industry-wide shocks, (v) lower performance sensitivity of CEO turnover, (vi) lower firm-specific variability of stock returns over time, and (vii) lower stock market returns accompanying the filing of proxy statements for periods where CPS increases. Taken together, our results are consistent with the hypothesis that higher CPS is associated with
agency problems, and indicate that CPS can provide a useful tool for studying the performance and behavior of firms."

We have heard many reasons for the financial crisis (e.g. greed of investment bankers, government regulation of mortgage markets, global imbalances etc.). The greed of shareholders, putting pressure on managers has not been discussed heavily so far. Find here a good paper about the subject:

Erkens, David, Hung, Mingyi and Matos, Pedro P., Corporate Governance in the 2007-2008 Financial Crisis: Evidence from Financial Institutions Worldwide (December 17, 2009). ECGI - Finance Working Paper No. 249/2009; CELS 2009 4th Annual Conference on Empirical Legal Studies Paper. Available at SSRN: http://ssrn.com/abstract=1397685

Paper Abstract:

"This paper investigates the role of corporate governance in the 2007-2008 financial crisis, using a unique dataset of 296 financial firms from 30 countries that were at the center of the crisis. Paradoxically, we find that while boards and shareholders appear to have executed their monitoring role by replacing poorly performing CEOs during the crisis, they also seem to have encouraged investments in subprime mortgage related assets that led to large losses during the crisis. Further exploration of the relation between governance and shareholder losses finds evidence consistent with shareholders having encouraged managers to take aggressive risks before the crisis, but does not find evidence consistent with boards having done so. Instead, our findings suggest that reputational concerns of board members explain why firms with more independent boards suffered from worse stock returns and recognized larger writedowns during the crisis. In particular, we find that firms with more independent boards were more likely to raise capital during the crisis, even though this came at a great cost to existing shareholders. In addition, we find that firms with more independent boards were more likely to disclose writedowns, which made it appear as if these firms recognized larger writedowns than other firms. Overall, our results are inconsistent with the losses during the financial crisis being the result of lax oversight by boards and investors. Rather, our results are consistent with risk-taking encouraged by shareholders and reputational concerns of directors having contributed to the losses."

The heads of the surviving, large Wall Street investment banks testified before the Financial Crisis Inquiry Commission – a group chartered by Congress to look into the causes of the 2008 financial collapse. The video is quite long. Not recommended to be looked at work! ... productivity gap...

Ben Bernanke outlines his thought on this in a letter to Dodd and Shelby, Chairman resp. member of the Committee on Banking, Housing, and Urban Affairs:

Bernanke letter to Dodd and Shelby

Find here a political FT article by Robert Reich, former US labour secretary and now professor of public policy at Berkeley.

FT: Why Obama must take on Wall Street, by Robert Reich, Jan 12, 2010

Leading bankers were invited to a Washington hearing. Without any doubt better regulation of banks is needed. However, currently the buck is passed back and forth between bankers, politicians and central bankers. Bankers divert blame away from their institutions and lay it on mortgage lending practices, the Fed Chairman claims that the low interest policy of the past did not create the real estate bubble and many politicians do not take into consideration that wrong regulations in the market for mortgages could also have contributed to the crisis. Here is a Guardian article about the latest Washington hearing:

Guardian: Wall Street's leading bankers admit: we made mistakes, Chief executives accept some activities were 'improper' in testimony to commission, but remain defiant over pay, Jan. 13, 2020

Leading Wall Street bankers said today they underestimated the severity of the financial crisis and apologised for making mistakes as a US government commission began its inquiry into the root causes of the banking meltdown.

In a dramatic hearing, the chief executives of four of the world's biggest banks, led by Lloyd Blankfein of Goldman Sachs and Jamie Dimon of JP Morgan, faced tough questioning over their role in the crisis, which ended with the US industry being bailed out with $360bn (£221bn) of taxpayer's money and saw ­unemployment rise to a 26-year high. read more

Regulating the financial industry in an appropriate manner is in fact a difficult task. Regulators have to keep in mind that government will never be a better banker than the now hated Wall Street managers. Regulatory measures should be market oriented and be defined around three major elements:

•Transparency, especially with regards to complex financial derivatives
•New rules limiting bank leverage
•Reform of compensation practices

White House Economic Adviser Christina Romer discusses "ridiculous" bank bonuses: