Sunday, May 8, 2011

On the FDIC's Hypothetical Resolution of Lehman

When the FDIC published a paper showing how it would have resolved Lehman under Dodd-Frank’s Title II resolution authority, Yves Smith, as is typical anymore, rushed to denounce it as an outrageous fraud, even though it’s painfully obvious that she didn’t read the entire FDIC paper. (It’s equally obvious that she’s never bothered to read Title II.)

I debated whether or not to even respond to Yves’ criticisms of the FDIC paper (see also here), because they’re hardly even worth the time. It’s also clear that Yves is going to believe what she’s going to believe, facts be damned, and that I’m not going to change her mind. So I don’t write this with the expectation that I will persuade Yves that she’s wrong. I just want to correct some of the egregious misinformation. Some of Yves’ criticisms, like the one that relies on an unsubstantiated rumor from friggin’ Zerohedge, are definitely not worth my time.

Criticism #1: Assumes everything is governed by a single, uniform legal framework

No, it doesn’t. The fact that she thinks this just proves that she didn’t read the entire FDIC paper (which was only 19 pages). The FDIC talked about how it would have coordinated with foreign regulators, including the UK’s Financial Services Authority (FSA), and also how it would have dealt with Lehman’s UK broker-dealer subsidiary, known as LBIE. The FDIC clearly stated that it would have structured the deal so that LBIE was also sold to Barclays. (And Barclays had, in fact, agreed to purchase Lehman’s holding company (LBHI), US broker-dealer (LBI), and LBIE, so you can’t argue that this is fantasy.) The FDIC also stated:

“By completing a sale at the time of failure of the parent holding company, the acquirer would have been able to ‘step into the shoes’ of LBHI and provide liquidity, guarantees, or other credit support to the newly acquired subsidiaries. Were the FDIC unable to promptly complete such a transaction, it could provide any necessary liquidity to certain key subsidiaries, such as LBIE, pending a sale of those assets.”
The FDIC is a national regulator, so it doesn’t have the authority to seize foreign subsidiaries, but the FDIC can structure its “purchase and assumption” agreements (P&As) however it damn well pleases. The FDIC is well within its rights to insist that any acquirers of the holding company under a P&A also take a key foreign subsidiary, such as LBIE. Moreover, Barclays’ acquisition of the holding company (LBHI) would have obviated the need for LBIE to file for bankruptcy in the UK, since LBHI funded and backstopped LBIE’s trading obligations.

So the FDIC does not assume a single legal framework; it just assumes that LBIE wouldn’t have to file for bankruptcy in the UK — an assumption which is entirely justified.

Criticism #2: Egregious underestimation of Lehman losses

This is a non-sequitur, and not even a good one. For one thing, Yves confuses creditor claims with creditor losses, so her so-called “gap” analysis is fundamentally flawed. That’s Bankruptcy 101. More importantly, there’s simply no getting around the fact that Barclays had, in fact, agreed to buy Lehman on Sunday, September 14th, if it could leave behind a $62bn pool of “bad assets” (which would’ve been financed by a consortium of Wall Street banks). The fact that Yves thinks that’s a bad deal is irrelevant. It’s perfectly reasonable for the FDIC to assume that Barclays would have agreed to a deal that Barclays had, in fact, agreed to.

Criticism #3: Assumes unrealistic 90 day preparation time

Yves claims that any heightened FDIC presence would have immediately triggered a run on Lehman. This is pure hogwash. First, the FDIC would already have an on-site presence at Lehman under its Title I “resolution plan” authority. And the type of information that the FDIC would be requesting is the exact same information that the FDIC’s normal on-site personnel would be routinely requesting. Second, huge, market-moving information about things like mergers are successfully kept under wraps all the time. It’s not difficult to set up a secure data room and force people to sign draconian NDAs. Surely Yves knows this. If she doesn’t, then, well, that’s another matter entirely. Finally, remember when the news broke back in the summer of 2008 that the New York Fed had on-site examiners at Lehman who were sending daily reports to Geithner and Paulson about Lehman’s liquidity, and the market freaked out? Yeah, neither do I. That’s because the news never broke, and the market never freaked out.

Criticism #4: Assumes a derivative contract termination process out of a parallel universe

This is perhaps the most egregious — and revealing — mistake that Yves makes. It shows just how little she (and Satyajit Das, who she quotes extensively) really know about the resolution authority. Das throws around a lot of fancy terms and describes a lot of scary-sounding problems with derivatives, but his entire analysis is based on the flawed premise that counterparties would have had the right to terminate their derivatives. Let me make this as clear as possible: there would have been no derivative contract termination process for the vast majority of Lehman’s derivatives under the resolution authority. Just like in FDIC resolutions of regular depository institutions, section 210(c)(10)(B) of Dodd-Frank prohibits counterparties from exercising their right to “terminate, liquidate, or net” their derivatives for one day after the FDIC is appointed as the receiver, during which time the FDIC can transfer the failed company’s derivatives to another financial institution. This supersedes the “Automatic Early Termination” clause in the ISDA Master Agreement.

This is exactly what the FDIC describes happening with Lehman: if Yves and Das had bothered to read the entire FDIC report, they’d know that the P&A transactions would have transferred the holding company, the US broker-dealer, and the broker-dealer’s derivatives dealing subsidiaries (LBSF and LBDP) to Barclays. Because these transfers would have occurred simultaneously with the FDIC’s appointment as receiver, the derivatives counterparties would not have had an opportunity to exercise their termination rights. Period. That’s why the FDIC paper didn’t address how termination and set-off rights work in different jurisdictions. Also, Das claims that the FDIC paper includes “no recognition of how collateral held against trades would work.” Again, yes, it does. (Seriously guys, read the paper.) From page 17:

“Lehman’s derivatives trading was conducted almost exclusively in its broker-dealer, LBI, and in LBI’s subsidiaries. As a result, Barclays’ acquisition of the broker-dealer group would have transferred the derivatives operations, together with the related collateral, to Barclays in its entirety as an ongoing operation.”
Finally, Das claims that LBIE was entirely funded by LBHI. I never said that LBIE was entirely funded by LBHI. But it was absolutely, indisputably dependent on LBHI for the vast majority of its day-to-day funding. From the LBIE administrator’s first Witness Statement:

“As part of its global treasury management, the Lehman Group operated a centralised treasury function. Accordingly, LBIE did not have control over bank accounts. Instead, payments were made into and from accounts maintained at group level (that is, at LBHI level). During each trading day, LBHI transferred cash to enable the Lehman Group companies, including LBIE, to meet their cash requirements during that day. The companies within the Lehman Group were therefore reliant upon receipt of that cash from LBHI each day to enable them to meet their obligations.”
That’s about all I can stomach right now. Like I said, I don’t expect Yves to change her mind, or admit that she was wrong. That’s fine. She can believe whatever she wants to believe. I just wanted to demonstrate that her criticisms are baseless and ill-informed. If anyone wants to have a real discussion of the resolution authority, I’m willing. But I’m done responding to criticisms of the Title II resolution authority from people who can’t be bothered to actually read Title II.

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