Tuesday, September 15, 2009

Size matters... a lot

As part of our on-going discussion of what's better today vs. a year ago, there is a question of what have we "fixed?" In other words, among problems within our financial markets that caused the crisis, have any of these been addressed?

To me, the most disturbing is the problem of Too Big To Fail (TBTF). I'm an ardent believer in free markets, but its obvious that certain institutions (ahem, Lehman) became so intertwined with other institutions that we couldn't afford to let them fail. The demise of one firm would cause the failure of others, feeding a generalized panic and thus making the panic a self-fulfilling prophesy.

If you want to minimize the government's involved in the financial system, we have to find a way to address this Too Big To Fail problem. Have we made progress? Hardly. Here are the top 15 financial institutions within the Russell 3000 a year ago, ranked by assets. (Note I had Bloomberg produce the previous Fiscal Year assets so its possible the dates don't match up institution by institution, but it should be close enough. Asset figures in $billions.

  1. Citigroup: 2,187
  2. Bank of America: 1,716
  3. J.P. Morgan Chase: 1,562
  4. Goldman Sachs: 1,120
  5. AIG: 1,048
  6. Morgan Stanley: 1,045
  7. Merrill Lynch: 1,020
  8. Wachovia: 812
  9. Wells Fargo: 575
  10. MetLife: 559
  11. Lehman Brothers: 504
  12. Prudential Financial: 486
  13. Hartford Financial: 360
  14. U.S. Bancorp: 238
  15. Bank of New York Mellon: 198

That's a total of $13.4 trillion in assets. Note I excluded Fannie Mae and Freddie Mac from this list. While they certainly lived in the Too Big to Fail world, they were also a totally different situation compared with other firms.

I then calculated these 15 firms' assets as a percentage of all assets for the whole group.


This wouldn't be total U.S. financial assets, because I used a list of public companies as the universe. Still, should be instructive.

Alright, what about today? Here is the top 15 right now. Here I've removed AIG as they are technically still in these indices.

  1. J.P. Morgan Chase: 2,175
  2. Citigroup: 1,938
  3. Bank of America: 1,818
  4. Wells Fargo: 1,310
  5. Goldman Sachs: 885
  6. Morgan Stanley: 659
  7. MetLife: 502
  8. Prudential Financial: 445
  9. PNC Financial: 291
  10. Hartford Financial: 288
  11. U.S. Bancorp: 266
  12. Bank of New York Mellon: 238
  13. SunTrust Banks: 189
  14. State Street: 174
  15. SLM Corp: 169

That's $11.3 trillion, a significant drop off from a year ago. But as a percentage of all assets, that's still 56% of all assets. Is that progress on the TBTF front? Hardly.

I suppose its fair to say that we aren't going to get the size of these institutions smaller over night. But not all of these firms are smaller. I'd argue J.P. Morgan, Bank of America, and Wells Fargo are more TBTF now than last summer because of subsequent mergers.

Another point is that it isn't all about size either. Look at the 2008 list. Lehman only had $500 billion in assets, but it wasn't the asset level that made their failure so catastrophic. It was the fact that Lehman was a counter-party to so many derivative transactions. It was that Lehman was a prime broker to so many hedge funds. It was that Lehman's credit was owned by so many money market funds.

Let's say Lehman had failed just as it did, but all its prime brokerage accounts remained in tact and all its derivatives contracts remained in force. In other words, let's just say that the government back stopped both those elements of Lehman's business. What would the consequences have been?

Basically that would have worked very similarly to FDIC insurance on deposits. I was with a group of friends this spring, one of which was a customer of a local Baltimore bank. I commented that I didn't think that bank would survive the next 6 months. (It has survived so far, but its still circling the drain.) Anyway, the woman asked if she should withdraw her money. I said it doesn't really matter since she didn't have over $250,000 with the bank. Worst that happens is that there is some red-tape around getting your money back. I don't know if she closed her account or not, but its fair to say that the FDIC insurance creates a distinct lack of urgency.

As a free-market capitalist, and assuming a world without government intervention is unrealistic, wouldn't a FDIC-style insurance pool for prime brokerage/derivatives make a lot more sense than putting the government in a position of buying equity in banks?


David Merkel said...

Particularly egregious is bailing out bank holding companies, as opposed to banks. Of themselves, HCs have little systemic risk.

dis said...

I agree that a FDIC-style insurance pool for prime brokerage/derivatives, but I would have their insurance premium rise strongly with their size and leverage

Anonymous said...

Apply standard current margin rates to investment banks and insurance companies that apply to corporate or individual accounts in the commodities, options, bond and stock categories.

A 1930s era move to raise the amount of reserve funds a company needs to have to back up its bets would do much to curb over leveraging.

Require creators of ABS, CMBS and the like to hold on their books 20% of each and every class of those bonds and report their value on both a mark to market and a mark to model fashion.

Require counterparty reporting that reports for each CDS type swap:

a) Mark to model value
b) Mark to market value
c) Last known trade date, price, trade size
d) Face value (or approximate face value) of covered instrument
e) Method for determing face value
f) Type of underlying security/index
g) Original cost basis
h) Gain/Loss on the investment
i) A note about if it is an offsetting position adn what it offsets

Accrued Interest said...

The derivatives thing is so f'ing easy. Just make it all exchange-traded. CDS, swaps, everything. When Lehman failed, did guys who trade exchange-listed options panic? Not like the CDS guys! I know we're supposedly working toward this end, but its taking way too damn long.

As for prime brokerage, it was withdrawals from PB that sunk Bear. Lehman wasn't as dependent on PB as Bear, but wouldn't it have been nice if Bear could have survived?

Basically we need to get to a place where a large financial firm can make mistakes and the tax payers don't have to foot the bill. Its OK if there is some amount of fall-out, but no government will stand by while a Lehman-sized fall out hits. Its politically impossible to play Herbert Hoover, no matter what your ideology.

I'd rather have government programs that protect semi-innocent by-standers (e.g. counter-parties) and hurt actual owners of the companies that wind up failing. As it was, we had government making it up on the fly.

Anonymous said...

Public list can only better things:

- the listed options market did not fail during Lehman's failure

An easier case study would be to answer "How do we setup/disclose a market for municipal auction rate securities?" Would having a public listing and public market for them have kept the auctions from failing?

chris said...

Banks become TBTF because there's every incentive to become TBTF. Creditors know they'll be made whole. Adding another safety net only increases the incentives to shoot for the moon. We need to ensure that creditors work harder to keep their company in check by removing safety nets like FDIC insurance.

leftback said...

LB is interested in the issue of what happens if QE ends next week, as per FOMC statement Wednesday next. QE extension would be dollar bearish and equity bullish, while QE ending would be $ bullish.

LB notes Geithner statement last week on plans to withdraw support from market and notes PIMCO says it is increasing holdings of govies.

LB believes that long IG:short HY and long Tsys:short TIPS, also long USD:short CAD might be good trades going forward.


Opinions from

PNL4LYFE said...

I think a clearinghouse would solve the problems of the CDS market without hamstringing it by limiting the customization of contracts. All counterparties would face the clearinghouse and have no credit exposure to one another. The clearinghouse could regulate the market by monitoring exposures of all counterparties to individual credits. It could set margin requirements sufficient to protect itself. I just can't see what an exchange would accomplish that a clearinghouse wouldn't. The price discovery for market participants is already better for CDS than it is for a lot of cash instruments.

Igor said...

The problem with Lehman wasn't the counter party risk per se ... it was the fact that counter party risk was unknown, and unknowable

Most CDS trades at big sell side firms are (still) tracked in spreadsheets on each trader's desk. The desk head has no way to figure out the desk's total exposure in real time -- or even end of day.

Each trader's assistant types (often by hand) the positions into another spreadsheet at the end of month (or quarter at some places) and then the accounting department aggregates the exposure with a week or two lag.

The risk department has no way of looking at near real time positions, and no effective way to independently price the CDS trades.

A year after Lehman, and two years after the credit mess started -- the banks still have no automated systems to measure their CDS exposure end of day, much less real time

Dick Fuld probably didn't really know the risk on his books. Ditto the management of Bear Stearns, who were playing bridge when their firm collapsed.

Whether these CEOs met their fiduciary duties when they allowed massive leverage on a business they whose risk they couldn't monitor is another question that has been conveniently overlooked by the SEC