Jefferies Doesn't Need Your Stamp Of Approval But A Little Praise Might Be Nice

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There's that famous line that "Every banker knows that if he has to prove that he is worthy of credit, however good may be his arguments, in fact his credit is gone." It is sort of inspiring to see Jefferies refute that with a combination of (1) pretty good arguments and (2) still existing. At the core of their argument is, basically, "we are not as reliant on fickle overnight funding as you think." From their letter to clients, shareholders, friends, Sean Egan, etc.:

To be clear at the outset, we do not use or rely on "wholesale funding," a catch-all term typically used to refer to funding other than core deposits, such as brokered deposits, foreign deposits or commercial paper. We do not have any unsecured overnight borrowings ....

We finance a portion of our long inventory and cover some of our short inventory by pledging and borrowing securities in the form of repurchase or reverse repurchase agreements, respectively. About 87% of all our repo activities use collateral (or inventory) that is eligible for repo transactions with clearing utilities. ... Put differently, 87% of our repos end up with clearing utility counterparties who are blind to the Jefferies’ name in the same way that we are blind to their names. ... The remaining 13% of our repo activity is currently contracted for a term that, on average, exceeds 80 days. ...

Finally, at any time we are concerned about our inventory funding rollover, we obviously have the alternative of reducing inventory through sales in the market. Given the mix of inventory we carry, this is a straightforward exercise, as evidenced by the actions we took two weeks ago and since then in respect of our European sovereign inventory book.

What I take away from that is:
(1) If you believe it, then you should probably feel okay facing JEF on its funding trades, but
(2) if you believe it, then it doesn't really matter: JEF just isn't particularly at the mercy of whimsical short-term funding.

For what little it's worth, I believe it, because if JEF were at the mercy of short-term funding markets then Richard Handler would probably have his own appointment with Maxine Waters by now. A Jefferies mainly reliant on overnight name-specific funding, even one with a squeaky-clean European debt book, would not be taking victory laps quite so enthusiastically. As Andrew Ross Sorkin writes about the other $40 billion non-TBTF broker-dealer that was in the news for European exposure this fall:

MF Global didn’t go bankrupt because it lost money. Instead, it lost something much more important: confidence. Investors were so worried about the firm’s prospects that they rushed to withdraw what money they had left. They were afraid that if the value of MF Global’s European sovereign debt fell, it could take down the firm. Ironically, it increasingly appears that MF Global’s sovereign debt bet would have paid off if the firm were still in business.

Now, I think that's maybe oversimplified a bit: the concern for MF counterparties was less that its short-term European debt position would cause billions of dollars of losses to MF Global, and more that other counterparties would freak out and pull money and bad shit would happen so they might as well get out first. It's Bagehot's point: if you have to defend your credit, it's gone. Jefferies just didn't have to defend its overnight credit all that urgently. But, yes, Sorkin is certainly right that MF Global's solvency was not what done it: it was the quick demise of its funding, in the form of repo haircuts, that seems to have done them in. That and all the stealing.

Anyway these thoughts rattled around my brain when I read this:

The Federal Reserve told the largest U.S. banks to test their loan portfolios and trading books against a severe recession and a European market shock. The most severe point of the test will assume a 13 percent unemployment rate and an 8 percent decline in U.S. gross domestic product. Some 31 bank-holding companies are being asked as part of their 2012 capital plan review to project revenues, losses and capital positions through the end of 2013 using four different scenarios, two provided by the Fed and two defined by the bank.

Which, look, great: it'll be good if banks can afford to take an 8% GDP decline in stride from a capital perspective. It'll even be great if they can afford to see market dislocations like they saw in 2008:

Six institutions with large trading operations will have to estimate potential losses from a hypothetical “global market shock,” the Fed said. That shock will be based on market price movements seen during the second quarter of 2008, the Fed said, and include a scenario involving “sharp market price movements in European sovereign and financial sectors.”

Now of course it is good and important for banks to have lots of capital, and it would certainly be nice for them to have positive equity even if asset prices crater 2008-style. But a lesson of Bear and Lehman and AIG and MF Global is that capital is nice but liquidity is what matters. A further lesson is that bank capital is an imponderable mystery, a way of describing the relation of certain inputs to certain outputs rather than a reflection of how much shareholders would get on liquidation. Never forget: AIG was extremely well capitalized and just had a little liquidity glitch that allowed the government to steal $25 billion from its shareholders. (Wait, is that not true?)

Of course the stress tests are a good idea. If the Fed officially says "every bank is gonna be just fine even if things get terrible," then that should at the margin increase confidence in the banks. That will in turn improve their chances of maintaining funding if things get terrible: counterparties may be slightly more likely to say "sure, JPMorgan has undisclosed European exposures, but the Fed said that their assets exceed their liabilities even if those exposures turn to shit, so my overnight unsecured funding is money good." It's better than some alternatives like, I don't know, leaking that regulators think that a huge bank is danger for undisclosed reasons relating to "governance, risk, capital and credit."

But they're a good idea because - assuming that the banks pass, which I expect they will - they are a third-party, quasi-objective defense of the banks' credit. They're not an especially good reflection of what would happen in an escalating Euro crisis, where (1) liquidity in general would dry up, (2) funding from European banks, which seems to be a big thing, would be a particular problem, and (3) roving bands of peasants, led by Sean Egan, would stalk Wall Street carrying torches and hunting for the next bank to burn down. It's easy to believe that all of the big banks, at least on a model basis, will be solvent pro forma for an 8% GDP downturn and 13% unemployment. It's hard to believe that all of them will actually have access to necessary short-term funding in a world where those things have happened.

But, of course, liquidity is peculiarly self-fulfilling. Having the Fed stamp you "needs improvement" can't help you in the funding markets. Having them stamp you "A-OK, even in the worst of all possible worlds" probably helps at least a bit. And surely perking up confidence among bank counterparties is the main goal of the stress tests.

Trusting Transparency Will Work [DealBook]

Fed Requires Top 31 U.S. Banks to Submit Annual Capital Plans [Bloomberg]

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