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Doing Well By Doing Financial Reform

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There's a thing called socially responsible investing where
(1) you invest other people's money,
(2) poorly,
(3) but it's okay because you're doing it not to make them money but to save the whales, er, penguins, and they like penguins, so they keep paying your fees. This is a good racket as rackets go but it turns out that people mostly don't like penguins as much as they like money so it is sort of a limited racket. The trick if you can manage it is to appeal to people who like penguins to give you other people's money, because people typically like penguins more than they like other people having money. This can be great for you and also for penguins, and for the right value of "you" and "penguins" can be a diabolical way to achieve real social good, which is my favorite.

Two great recent stories in that vein. One is a proposal to use eminent domain to seize underwater mortgages and refloat them. The idea, schematically, is (1) seize property,* (2) sell it back to homeowner at fair value, and (3) lend money to the homeowner to pay for the house, which the municipality then uses to pay fair value to the mortgage lender whose collateral was seized in step (1). Any dope of a municipality could presumably get their act together to do (1) and (2), but the problem is (3) coming up with the money for new mortgages to pay fair value to the old mortgagee. You could see why oh I don't know BANKS would not like this scheme - it will cost them in servicing rights and refinancing fees and second-lien writedowns** - and so the money has to come from non-banks. Some folks think they can find the money, for a small fee of course, and so are roadshowing the idea to municipalities. It seems to be popular in California, go figure.

The other is this gloriously cynical play from TCI to try to extract some value out of Lloyds Bank while also improving the stability of the British financial system, maybe. Basically Lloyds Bank has issued some securities called "cocos," which stands in finance-acronymese for "contingent capital securities" (count the O's), and also called "ECNs," which stands for "Enhanced Capital Notes," which at least starts with the letters "ECN" but really quick side note when a security-acronym has "Enhanced" in it you know there was a failure of imagination by the acronym maker and probably by the person who designed the thing. I'll guess that Enhanced Whatever Securities have caused more heartbreak than Regular Whatever Securities.

ANYWAY these ECNs are high-coupon bondy-type-things that convert into stock if Lloyds' capital ratios get low enough, meaning that they absorb losses before regular unsecured debt, never mind deposits and whatnot, get hit, and thus provide some protection to depositors and authorities though not as much as common stock does. TCI seems to have bought some of them back in the day, and now wants Lloyds to buy them back - by exchanging them for common stock - at above-market prices. Normally the way you do this is you call the company and try to negotiate a trade, and so basically transactions happen at around market prices though with a fair amount of variance depending on who wants the trade more.

But TCI figured that they could light a fire under Lloyds by convincing their regulator to make Lloyds buy back the bonds. I am in love with TCI's letter, which goes in part like so, emphasis added:

I urge the FSA to clarify as soon as possible that the Lloyds ECN's do not constitute core equity capital nor effective loss-absorbing capital additional to common equity. ... The effective loss-absorbing capital of Lloyds Bank [disallowing the ECNs] is currently only at 7% of core equity capital, as measured by Basel 3 rules, versus the 10% required. ...

Clearly, the most effective option for raising the capital ratios of Lloyds from their currently inadequate levels is for Lloyds to offer an exchange offer of these ECN securities into common equity. ... Legally, these securities cannot be coerced into such an exchange offer, so it must be done on commercially appropriate terms.

If Lloyds executed such a debt to equity exchange offer, it would benefit from a much higher earnings base .... The economy would beenfit from a better capitalised bank with less pressure to aggressively shrink lending to the economy. Shareholders would benefit because the new bank would have a much higher equity capital base of ₤10bn and hence be a safer bank.

TCI denies that it owns ₤1bn of the coco bonds so perhaps I am being totally unfair highlighting that sentence. But! What could be better than negotiating with a bank whose regulator has forced it to buy - but which can't force you to sell?*** Why trade at market prices when you can create fire sales (or, in this case, fire exchanges)?

One thing to notice is who is doing these things: TCI, a hedge fund that sort of sounds like a charity, and Mortgage Resolution Partners, a ... thingy ... backed by an interesting assortment of finance miscreants and politically connected people and once run by Phil Angelides, the former chairman of the Financial Crisis Inquiry Commission, which was just a little too perfect so he's since left in a cloud of "come on, really?" Also Mortgage Resolution Partners is lining up the financing with the help of investment banks, and those banks are not Goldman and JPMorgan. They are, instead, Westwood Capital and Evercore, who I'm going to guess are not heavily into the second-lien game.

Some smartpeople have argued that a key benefit of the Glass-Steagall rules that separated commercial and investment banking was that it diffused the effect of well funded financial industry lobbyists. Here's Adam Levitin:

Because of Glass-Steagal, the financial services industry did not present a monolith in terms of lobbying, and a Congressman could afford to take a stand against one part of the industry because there would be campaign contributions forthcoming from the other parts of the industry. ... In the agencies, each part of the industry had its pet group of regulators who would push back against other regulators when they thought that there was an encroachment on their turf, which is the basic nature of deregulation---allowing greater activities than previously allowed. ... The result of a politically fragmented financial services industry was to hold deregulation at bay for quite a while.

You don't have to believe that Glass-Steagall was good or that deregulation is bad to like the idea of some diversification in political action. And you don't have to believe that refinancing via eminent domain, or recapitalizing Lloyds, are good ideas to be charmed by MRP's and TCI's efforts. Asset managers who own mortgages, investment banks that securitized them, and commercial banks that service them and own underwater second liens, all have incentives to be a bit plodding on refinancing, while nobody really has a financial incentive to move quickly on refinancing except borrowers and who cares about them since they don't even have money? You'd expect this situation to lead to a below-optimal level of refinancing and there's some evidence you'd be right. And who exactly wants higher bank capital levels? (I mean, besides regulators and stuff, but again, where is their money?)

The answers, I suppose, are "Mortgage Resolution Partners" and "TCI," respectively - concentrated holders who will, for a small cut of the profits, stick up for the public good (as they conceive it), which differs from the public good (as Jamie Dimon sees it). They at least suggest that most people who want financial reform are on the wrong track, calling hearings and writing comment letters and whatever. If they really want reform, they need to make it into a commercial opportunity.

A solution for underwater mortgages: Eminent domain [Reuters]
Investors tout controversial "condemnation" for housing fix [Reuters]
Eminent domain for underwater mortgages could have biggest impact on bank [Reuters]
TCI pushes for £10bn Lloyds ‘coco’ conversion [FT]
A CoCo critique, Lloyds edition [FTAV]
Lloyds Should Boost Capital With Debt Exchange, Hohn Says [Bloomberg]

* I actually think the idea is to eminentize the loan rather than the house, because if you swipe the house then the lender still has recourse to the borrower beyond the value of the collateral? Doesn't matter for our purposes though. Also, if you are reading and you or your loved ones work in socially responsible investing, I was just kidding, I'm sure it's great at both making money and saving things, sometimes you have to crack a few eggs to be schematic, sorry.

** And ... losses on first mortgages that they actually own? Is that even a thing any more?

*** A further piece of genius here is the anticipation of an obvious concern: if a big rich hedge fund convinces a regulator to force a third party to give it money in off-market transactions, that looks ... bad, right? Like some sort of creepy influence-peddling, even if the big rich hedge fund's arguments are totally correct and public-spirited and you have no proof of conflict or corruption? Maybe someone at the FSA was promised a job at TCI down the line? How do you avoid that suspicion of a conflict of interest? Perhaps by suggesting another, bigger conflict of interest on the other side?

The main obstacle to such an exchange offer would be the position of the UK Government holding 42pc of the common shares of Lloyds. They will be concerned with the politics of selling equity, although they will like the fact that the more capitalised Lloyds is, the closer it becomes to being able to grow rather than shrink its asset base. [Recall above that "shareholders would benefit" from TCI's plan - they just don't know it yet - ed.] This is likely to lead to the government preferring to keep the status quo, to maximise its possible equity value by keeping leverage high at the expense of the right regulatory decision. So, in other words, the UK government, as both effective regulator and controlling shareholder, is conflicted in this issue.

This is beautiful work is it not?