Capital can’t be measured
Simon Johnson and James Kwak are absolutely right. Sure, “hard” capital and solvency constraints for big banks are better than mealy-mouthed technocratic flexibility. But absent much deeper reforms, totemic leverage restrictions will not meaningfully constrain bank behavior. Bank capital cannot be measured. Think about that until you really get it. “Large complex financial institutions” report leverage ratios and “tier one” capital and all kinds of aromatic stuff. But those numbers are meaningless. For any large complex financial institution levered at the House-proposed limit of 15×, a reasonable confidence interval surrounding its estimate of bank capital would be greater than 100% of the reported value. In English, we cannot distinguish “well capitalized” from insolvent banks, even in good times, and regardless of their formal statements.
Lehman is a case-in-point. On September 10, 2008, Lehman reported 11% “tier one” capital and very conservative “net leverage“. On September
25 15, 2008, Lehman declared bankruptcy. Despite reported shareholder’s equity of $28.4B just prior to the bankruptcy, the net worth of the holding company in liquidation is estimated to be anywhere from negative $20B to $130B, implying a swing in value of between $50B and $160B. That is shocking. For an industrial firm, one expects liquidation value to be much less than “going concern” value, because fixed capital intended for a particular production process cannot easily be repurposed and has to be taken apart and sold for scrap. But the assets of a financial holding company are business units and financial positions, which can be sold if they are have value. Yes, liquidation hits intangible “franchise” value and reputation, but those assets are mostly excluded from bank balance sheets, and they are certainly excluded from “tier one” capital calculations. The orderly liquidation of a well-capitalized financial holding company ought to yield something close to tangible net worth, which for Lehman would have been about $24B.
So Lehman misreported its net worth, right? Not according to the law. From the Valukas Report, Section III.A.2: Valuation — Executive Summary:
The Examiner did not find sufficient evidence to support a colorable claim for breach of fiduciary duty in connection with any of Lehman’s valuations. In particular, in the third quarter of 2008 there is evidence that certain executives felt pressure to not take all of the write‐downs on real estate positions that they determined were appropriate; there is some evidence that the pressure actually resulted in unreasonable marks. But, as the evidence is in conflict, the Examiner determines that there is insufficient evidence to support a colorable claim that Lehman’s senior management imposed arbitrary limits on write‐downs of real estate positions during that quarter.
In other words, the definitive legal account of the Lehman bankruptcy has concluded that while executives may have shaded things a bit, from the perspective of what is actionable within the law, Lehman’s valuations were legally indistinguishable from accurate. Yet, the estimate of net worth computed from these valuations turned out to be off by 200% or more.
Advocates of the devil and Dick Fuld will demur here. Yes, Lehman’s “event of default” meant many derivatives contracts were terminated prematurely and collateral on those contracts was extracted from the firm. But closing a marked-to-market derivatives position does not affect a firm’s net worth, only its exposure. There may be short-term changes in reportable net worth as derivatives accounted as hedges and not marked-to-market are closed, but if the positions were in fact hedges, unreported gains on other not-marked-to-market assets should eventually offset those charges. Again, the long term change in firm net worth should be zero. There are transaction costs associated with managing a liquidation, but those would be minimal relative to the scale of these losses. Markets did very poorly after Lehman’s bankruptcy, but contrary to popular belief, Lehman was never forced into “fire sales” of its assets. It was and remains in orderly liquidation. Last July, more than 9 months after the bank fell, Lehman’s liquidator reported that only a “fraction” of the firm’s assets had been sold and the process would last at least two years. Perhaps the pessimistic estimates of Lehman’s value were made during last year’s nadir in asset prices, and Lehman’s claimed net worth looks more reasonable now that many assets have recovered. But if Lehman’s assets were so profoundly affected by last Spring’s turmoil that an accurate September capitalization of $28B shifted into the red by tens of billions of dollars, how is it plausible that Lehman’s competitors took much more modest hits during that period? Unless the sensitivity of Lehman’s assets to last year’s markets was much, much higher than all of its peers, Lehman’s assets were misvalued before the asset price collapse, or its competitors assets were misvalued during the collapse.
We get lost in details and petty arguments. The bottom line is simple. The capital positions reported by “large complex financial institutions” are so difficult to compute that the confidence interval surrounding those estimates is greater than 100% even for a bank “conservatively” levered at 11× tier one capital.
Errors in reported capital are almost guaranteed to be overstatements. Complex, highly leveraged financial firms are different from other kinds of firm in that optimistically shading asset values enhances long-term firm value. Yes, managers of all sorts of firms manage earnings and valuations to flatter themselves and maximize performance-based compensation. And short-term shareholders of any firm enjoy optimistic misstatements coincident with their planned sales. But long-term shareholders of nonfinancial firms prefer conservative accounts, because in the event of a liquidity crunch, firms must rely upon external funders who will independently examine the books. The cost to shareholders of failing to raise liquidity when bills come due is very high. There is, in the lingo, an “asymmetric loss function”. Long-term shareholders are better off with accounts that understate strength, because conservative accounting reduces the likelihood that shareholder wealth will be expropriated by usurious liquidity providers or a bankruptcy, and conservative accounts do not impair the real earnings stream that will be generated by nonfinancial operations.
This logic inverts for complex financials. Financial firms raise and generate liquidity routinely. Many of their assets are suitable as collateral in repo markets. Large commercial banks borrow freely in the Federal Funds market and satisfy liquidity demands in part simply by issuing deposits that are not immediately withdrawn. For large financial firms, access to liquidity is rarely contingent upon a detailed audit by a potential liquidity provider. Instead, access to liquidity, and the ability to continue as an operating firm, is contingent upon the “confidence” of peer firms and of regulators. Further, the earnings of a financial firm derive from the spread between its funding cost and asset yields. Funding costs are a function of market confidence, so the value of a financial firm’s real future earnings increases with optimistic valuation. For a long-term shareholder of a large financial, optimistically shading the firm’s position increases both the earnings of the firm and the “option value” of the firm in difficult times. It would be a massive failure of corporate governance if Jamie Dimon or Lloyd Blankfein did not fib a little to make their firms’ books seem a bit better than perhaps they are, within legal and regulatory tolerances.
So, for large complex financials, capital cannot be measured precisely enough to distinguish conservatively solvent from insolvent banks, and capital positions are always optimistically padded. Given these facts, and I think they are facts, even “hard” capital and leverage restraints are unlikely to prevent misbehavior. Can anything be done about this? Are we doomed to some post-modern quantum mechanical nightmare wherein “Schrödinger’s Banks” are simultaneously alive and dead until some politically-shaped measurement by a regulator forces a collapse of the superposition of states into hunky-doriness?
Yes, we are doomed, unless and until we simplify the structure of the banks. When I say stuff like “confidence intervals surrounding measures of bank capital are greater than 100%”, what does that even mean? Capital does not exist in the world. It is not accessible to the senses. When we claim a bank or any other firm has so much “capital” we are modeling its assets and liabilities and contingent positions and coming up with a number. Unfortunately, there is not one uniquely “true” model of bank capital. Even hewing to GAAP and all regulatory requirements, thousands of estimates and arbitrary choices must be made to compute the capital position of a modern bank. There is a broad, multidimensional “space” of defensible models by which capital might be computed. When we “measure” capital, we select a model and then compute. If we were to randomly select among potential models (even weighted by regulatory acceptability, so that a compliant model is much more likely than an iffy one), we would generate a probability distribution of capital values. That distribution would be very broad, so that for large, complex banks negative values would be moderately probable, as would the highly positive values that actually get reported. If we want to make capital measurable in any practical sense, we have to dramatically narrow the range of models, so that all compliant models produce values tightly clumped around the number we’ll call capital. But every customized derivative, nontraded asset, or unusual liability in a bank’s capital structure requires modeling. The interaction between a bank holding company and its subsidiaries requires multiple modeling choices, especially when those subsidiaries have crossholdings. A wide variety of contingent liabilities — of holding companies directly, of subsidiaries, of affiliated or spun-off entities like SIVs and securitizations — all require modeling choices. Given the heterogeneity of real-world arrangements, no “one-size-fits-all” model can be legislated or regulated to ensure a consistent capital measure. We cannot have both free-form, “innovative” banks and meaningful measures of regulatory capital. If we want to base a regulatory scheme on formal capital measures, we’ll need to circumscribe the structure and composition of banks so that they can only carry positions and relationships for which we have standard regulatory models. “Banks’ internal risk models” or “internal valuations of Level 3 assets” don’t cut it. They are gateways to regulatory postmodernism.
Regulation by formal capital has a proud and reasonably successful history, but has been rendered obsolete by the complexity of modern financial institutions. The assets and liabilities of a traditional commercial bank had straightforward, widely acceptable book values. For the corner bank, discretionary modeling mattered only in setting credit loss reserves, and the range of estimates that bank officers, external auditors, and regulators would produce for those reserves was usually pretty narrow (except when all three colluded to fake and forbear in a general crisis). But model complexity overwhelms and destroys regulatory capital as a useful measure for large complex financial institutions. We need either to resimplify banks to make them amenable to the traditional approach, or come up with other approaches more capable of reigning in the brave new world of banking.
Some sources: Yves Smith has been phenomenal on the Lehman bankruptcy. Regarding estimates of the hole that appeared in Lehman’s balance sheet, see “$75 Billion Needlessly Lost in Hasty Lehman Bankruptcy Filing?” and “So Where, Exactly, Did Lehman’s $130 Billion Go?“. Neither Yves nor I remotely buy the “hasty bankruptcy” explanation, see my comments above, the previously cited article, and the always acerbic Independent Accountant. Comments on the pacing of the Lehman liquidation are from the CNBC video embedded in Yves’ piece. The $24B estimated tangible for Lehman is computed by taking its September 10, 2008 shareholder equity and subtracting intangible assets reported on Lehman’s last available balance sheet.
This essay also owes something to Frank Partnoy’s excellent “Make Markets Be Markets” presentation.
Update: Somehow I managed to get the date of Lehman’s bankruptcy wrong. Takes talent, I know. Thanks to commenter mindbender for setting me straight!