EXTRACTING SAFETY-NET SUBSIDIES FROM MERGERS, ACQUISITIONS, AND LEGALLY DOUBTFUL BALANCE-SHEET SURGERY

1. FDIC Conference on Mergers and Acquisitions of Financial Institutions (November 30, 2007) EXTRACTING SAFETY-NET SUBSIDIES FROM MERGERS, ACQUISITIONS, AND LEGALLY DOUBTFUL BALANCE-SHEET SURGERY Edward J. Kane Boston College Edward J. Kane, Boston College

2. Edward J. Kane, Boston College

3. Key Ideas • As in S&L Mess, unresolved agency problems in government make Safety-Net Subsidies Endogenous Variables that increase with the Size, Complexity, or Clout of any Too-Difficult-To-Fail (TDTF) Megainstitution. • Gaming by Regulated Firms: Doubtful Balance-Sheet Surgery is Encouraged by FIN 46 (2003) and Basel Capital Requirements, whose burdens can be minimized by seeing that Off-Balance-Sheet ABCP Conduits are supported by 364-day credit facilities from sponsors and Z shares that are held by nonbank investors. • Credit-Rating Organizations underestimated risks in structured securitizations and re-securitizations by poor modeling and by not acknowledging legal and documentation risks. • Losses in current turmoil are driven by interest-rate increases on positions whose true riskiness is now being priced. Edward J. Kane, Boston College

4. Déjà vu: Highly leveraged conduits whose asset duration is only a few months longer than that of its ABCP liabilities can have as much interest-rate risk exposure as an old-fashioned S&L. • Fundamentally, the current turmoil is not a liquidity crisis caused by fire-sale pricing. • Upward movements in risk assessments and risk premia destroy net worth when Edward J. Kane, Boston College

5. “Difficult” in TDTF and “Mega” in Megainstitutions are Shorthand for Size, “Importance,” and Especially Complexity 1. Too Complex for Authorities to Liquidate 2. Too Complex for Authorities to Monitor and Discipline Adequately: Preference for Collateral Loans Over Requiring Prompt Recapitalization when Large Losses Emerge or Threaten 3. Constructive Ambiguity About Thresholds for Size, Complexity, or Importance Means That: The More Size, Complexity, or Political Clout a firm enjoys, the Firmer and Fuller that Institution’s Likely Access to Conjectural Guarantees Edward J. Kane, Boston College

6. The Market Capitalization of Any Megainstitution Has Two Pieces: • Stockholder-Contributed Capital: SC • Government-Contributed Risk Capital: GC a. Credit Enhancements Inherent in Safety Net b. Value to a Stressed “Recognized Dealer” of Being Able to Extract Subsidies by Outbidding other Dealers for Fed Repurchase Agreements During a “Credit Crunch” [TDTF Theory: GC Grows with Size, with SC Leverage, with Herding (which creates systemic risk), and with Opaque Risks to which SC is Exposed.]

7. Edward J. Kane, Boston College

8. Effects of TDTF: Distorts Bank Booking Patterns, Banking Competition, and Merger/Acquisition Incentives • TDTF Rewards Managers for Making their Bank and Holding Co. Large or Complex Enough to Assure Fuller Coverage by TDTF Conjectural Guarantees • TDTF Subsidizes Activities that Make a Very Large Institution Riskier, Larger, More Complex, or Politically More Important. Edward J. Kane, Boston College

9. Potentially TDTF Organizations(Stern & Feldman, 2004, pg. 39) Edward J. Kane, Boston College

10. GIANT BANKS NEED LESS ENTERPRISE-CONTRIBUTED CAPITAL Moody’s assessments of banks’ likelihood of getting “systemic support” when needed Edward J. Kane, Boston College Source: American Banker (3/7/07)

11. Crude Model of Merger Incentives Under Basel • Let GC = Safety-Net Capital. Assume Markets Enforce a Capital Ratio of Market Capitalization to Tangible Assets (A) of x%. • The Capital Market’s Effective Requirement for Shareholder Capital Falls when TDTF Cuts In: • Implication: Consolidation of Industry Assets into Megainstitutions Reduces Transparency and Economizes on the Amount of Private Capital the Financial Industry must hold.

12. FDICIA May Have Cut Back TDTF Subsidies When it Was Enacted in 1991.But Evolution of Regulatory and Market Environments Since its Passage HaveRe-Energized TDTF Incentives. 1. Interstate Banking and Branching Efficiency Act of 1994 Expanded Domestic Merger Opportunities 2. Sea Change in Size, Complexity, Risk Concentration, and Global Importance of Largest U.S. Institutions Restored their TDTF Status. Edward J. Kane, Boston College

13. Structured securitizations of bank loans may be regarded in part as risk-shifting rather than risk transfer: Victims are creditors and safety net managers. Loan originators and SIV sponsors transform traditional default and interest-rate risks into hard-to-understand counterparty and funding risks that in distressed times can pass back for reputational reasons from securitization vehicles.For example, SIVs that book complex swaps and structured securitizations create reputation-driven loss exposures for sponsors which lack transparency for regulators and creditors.

14. Risk-Shifting Possibilities are expanded by complex structured securitizations, given authorities’ delay in subjecting them to capital requirements or establishing an information system able to collect meaningful data on bank exposures. • Night football metaphor: • a. No lights on the field for fans or refs; • b. Players and coaches wear infrared goggles (CRO & Risk- management analytics); • c. Scoreboard lights up only when a big score is made; • d. From time to time, audience sees injured players carried off the field and put into ambulances (e.g., Bear Stearns) Edward J. Kane, Boston College

15. Credit-Rating Organizations Over-Rated the Highest-Quality Tranches of Structured-Finance Obligations • Process of Rating Securitized Debt is a Negotiation that starts with Issuer specifying its desired rating. The CROs compete by specifying structure and level of credit support needed to obtain it. • Severe Conflict of Interest Between Reputation and Revenues exists in Rating Structured Securitizations (more than 40% of Moody’s 2005 Ratings Revenue came from such deals) • CRO’s aggressive judgment that an adequately documented “true sale” of loan pool has taken place (necessary to spin pool off originator’s balance sheet) has no legal standing and is undermined by CRO claims that it is “unreasonable” to rely on their “mere opinions” which are not “investment advice”. • CROs should have discounted their ratings on Complex Securitizations for legal and documentation risks.

16. Subordination Pattern Structured securitizations determine what tranches get first claim on payments from underlyings The levels of risk-absorption below AAA and AA tranches investors have declined mightily over time. Subordination level Edward J. Kane, Boston College

17. The major incentive weakness faced by federal regulators is the political and practical difficulty of establishing and maintaining vision and deterrency at CROs and major derivatives-trading institutions. The FDIC is at a disadvantage because: 1) Derivatives-trading institutions’ principal supervisors are housed in other federal agencies that have incentives to treat them as Too Big to Discipline Adequately. 2) Such firms and major CROs are too big, too complex, and too politically well-connected to fail and unwind (TBTFU).

18. Recycling of Excuses for Implicit Bailouts In times of turmoil, Blame-Avoidance Norms imbedded in US regulatory culture and bureaucratic framework support collateralized lending to loss-making institutions: 1. Nationalistic Loyalties: It is one’s bureaucratic duty to help major U.S. institutions to compete in global arenas 2. Mercy Norm: It is wrong to “KICK” stockholders of an institution that is down. Officials feel a bureaucratic duty to strive to alleviate their pain. 3. Nonescalation Norm: It is wrong to risk turning a financial “mess” into a national disaster. Any policy action that lowers the risk of contagion to other US institutions is potentially justifiable.

19. Red Flags for Early Intervention Rapid and concentrated growth in risky and opaque innovative activities or strategies Deficient Risk Management: Underdiversification of Risk accompanied by weaknesses in Verification and Underwriting Procedures Aggressive Accounting for Loss Exposures Resistance to using Market Valuations Outsourcing of Due Dilligence to Entities that merely “Represent and Warrant” use of Proper Procedures. Edward J. Kane, Boston College

20. Safety-net managers lose money only because norms governing their behavior sustain inattention to their loss-control system. Parable about Thanksgiving party at a parochial school: Goal was to control student access to apples and cookies What red flags does Basel not require REGULATORS to look at? Edward J. Kane, Boston College

21. Accountability • Suppose one of the top U.S. derivatives banks or securitizers (perhaps Countrywide) is insolvent today. • How accountable are principal regulators for loss exposures shifted to the FDIC via Fed repurchase agreements, FHLB advances, and loss-making SIVs. • In the aftermath, would the press be able to establish: • 1) Who knew when? • 2) Who didn’t want to know? • 3) Who simply let things happen? Edward J. Kane, Boston College

22. We can benchmark efficient loss control for a government deposit insurer by identifying the contracting solutions that a parallel private guarantor would demand to control the guaranteed party’s ability to shift loss exposures onto the entity bonding its obligations. Edward J. Kane, Boston College

23. Effective Guarantor Loss Control Combines Three Elements: 1. Vision (Disclosure Obligations: Establishing Appropriate Monitoring Rights and Procedures) 2. Enforceable Intervention Rights: Building & Exercising a capacity to Deter and Price Risk-Shifting. 3. Incentives for System Adaptation: to Build and Preserve Vision and Deterrent Rights in the Face of Waves of Banking-Industry Innovations that are Specifically Designed to Reduce Vision and Enforceability Edward J. Kane, Boston College

24. Benchmarking Vision and Intervention Rights • A private deposit insurer would insist on: • Covenants preventing good assets from being collateralized in specified circumstances without the insurer’s explicit prior approval and establishing that bank counterparties cannot enforce collateral rights without triggering appropriate cross-default rights for the insurer. • Receiving deterrent rights to price or otherwise control ex ante all loss exposures that off-balance-sheet entities and unverified outside warranties might impose on the insurer. Edward J. Kane, Boston College

25. Government Officials are Used to Soldiering on in the Face of Inadequate Staffing and Authority Even though she has trouble reading, understanding what is being said to her, and discussing important issues, a Pennsylvania woman still feels she has a future in politics. State Rep. Jane Baker, who suffered brain injuries in an auto accident, said she is still going to seek re-election because she is “virtually unemployable” outside the state legislature. Boston Herald 10-28-01 Edward J. Kane, Boston College

26. To minimize rescue costs, potential private rescuers begin by negotiating • 1) adequate disclosure of unrealized losses and continuing loss exposures and 2) a formal claim to future profits • To control moral hazard, the rights of rescued shareholders must undergo severe dilution. • To earn fair compensation for their preservation efforts, government rescuers must establish for their agency and for taxpayers an appropriately large equity or warrant position on the upside of the rescued firm.

27. Bureaucracy of Zombie Preservation • Three counterincentives interfere with pursuing a market-mimicking approach to rescue and support underinvestment in disaster planning & prevention. • Decision-making horizons of incumbent top regulators are seldom more than a few years in length (need for deferred compensation and fair-value budgeting for implicit subsidies) • Mercy and Nonescalation Norms extend the life of zombie firms • Disaster myopia (Guttentag & Herring) undermines timely prevention: • Definition: Disaster myopia exists when authorities systematically underestimate the frequency of crisis pressures and long-term incentive effects of implicit bailouts.

28. TDTF Institutions Choose Regulators and Jurisdictions for Transactions that Offer High Preservative Content as well. Edward J. Kane, Boston College