October 26, 2009

Joshua Rosner
646/652-6207
jrosner@graham-fisher.com

The House Financial Service Committee’s Bill Poses Systemic Risk

The House draft bill written by Rep. Barney Frank (D - MA) – along with several former
Fed attorneys and Treasury staff and consultants -- includes the resolution authority
language discussed in the press. It will also generally mimic the White House's systemic
risk regulator language, its securitization language, and the language of Financial
Institutions Subcommittee Chairman Luis V. Gutierrez (D-IL), which directs the FDIC to
assess deposit insurance fees based on assets rather than deposits.

Unfortunately, this bill is one more act of sleight of hand by a congress that, to the
detriment of the public, fails to see that banks are there to serve the public good and can
be regulated with such a goal.

An honest bill would recognize that any institution that is "Too Big to Fail" should be
given economic ‘incentives’ (through prohibitively high capital levels and insurance
assessments) to shrink or sell off business units. The notion that we do not have the right
to break up anti-competitive and oligopolistic businesses flies in the face of antitrust laws
and ignores the valuable lessons in growth demonstrated by Teddy Roosevelt’s trust
busting. Those legislators who are truly seeking to protect the public interest and
desiring to be worthy of re-election, should demand that legislation spell out, in
plain English, that the entire capital structure of a TBTF institution be wiped out,
and its holding company held responsible as a source of strength, before taxpayers
are exposed to a single dollar of loss. If nobody will add such language, call your
elected representatives and ask them how difficult it is to work all day in kneepads.

Rather than require the break-up or shrinkage of those institutions, this bill suggests we
leave the institution in tact until it becomes ‘troubled’ and instead subject it to
greater oversight by the same Fed that mismanaged prudential oversight of
precisely those largest financial holding companies at the center of the crisis. Keep
in mind that even on the 1-5, best to worst, secret rating scale regulators use to
define ‘troubled institutions’ BofA was only a 3 and it has been speculated that Citi
was only a 2 even as they were begging the government for support. Should we wait
until an institution is really even worse then they were?

This Trojan horse of a bill will recognize and codify the view that we must accept
and agree to live in a world where there are institutions that are TBTF. We have
chosen to head in the opposite direction from the responsible approach suggested by both
Bank of England Governor Mervyn King1, who wants to break up TBTF institutions, and
other European regulators who are likely to oversee the breakup of TBTF institutions

1
http://www.scribd.com/doc/21406275/Mervyn-King-Speech-Break-Up-Banks

Please refer to important disclosures at the end of this report.

Weekly Spew October 2009

ING and Lloyds.

Each of the elements of this historic and flawed approach was carefully negotiated in
close coordination with most of the interested parties – well, at least the bankers and their
friends. Mock hearings will be this week and the complete bill will be marked up mid-
week next week. When the hearings begin, the public should demand to know how many
of these “experts” have ever taken monies as consultants or employees of the “Too Big
To Fail” (TBTF) banks or the Federal Reserve System. You can play along with the game
show at home by watching the testifying “experts” closely. Try to keep score of how
many of them identified the collapse of our credit markets in 2006 or 2007. You can go
on to the bonus round and score which of these “experts” expressed a view or highlighted
the risk that the Fed’s “emergency powers” would create a moral hazard and be used to
bail out our banks. Importantly, Senator Chris Dodd put these powers into legislation in
the dark of night in 1991 at the request of Goldman Sachs and other large beneficiaries of
government support in this crisis 2. Perhaps I expect too much of these policy experts,
after all, in May 2007 even Tim Geithner3 and the intelligent and considered Fed
Vice Chairman Don Kohn4 didn’t, in the face of over 100 mortgage lender failures
and specific direct warnings5, fully consider the risks that a crisis was already upon
us.

As part of this Japanese-style kick-the-losses-down-the-road kabuki style drama,

Secretary Geithner desires that TBTF institutions to write a "living will" so that when
(not “if”) they end up in trouble, there will be a road map for investors and regulators to
follow. This is honorable, but far from requiring banks or their managements to submit to
the still more honorable tradition of Hara-kiri.

2
http://www.washingtonpost.com/wp-dyn/content/article/2009/05/29/AR2009052903403.html?hpid=topnews
3
http://www.ny.frb.org/newsevents/speeches_archive/2007/gei070515.html (see: “The dramatic changes we’ve seen in
the structure of financial markets over the past decade and more seem likely to have reduced this vulnerability. The
larger global financial institutions are generally stronger in terms of capital relative to risk. Technology and innovation
in financial instruments have made it easier for institutions to manage risk. Risk is less concentrated in the banking
system, where moral hazard concerns and other classic market failures are more likely to be an issue, and spread more
broadly across a greater diversity of institutions.”)
4
http://www.federalreserve.gov/newsevents/speech/kohn20070516a.htm (see: “There are good reasons to think that
these developments have made the financial system more resilient to shocks originating in the real economy and have
made the economy less vulnerable to shocks that start in the financial system. Borrowers have a greater variety of credit
sources and are less vulnerable to the disruption of any one credit channel; risk is dispersed more broadly to people
who are most willing to hold and manage it. One can see the effects of these changes in the reduced incidence of
financial crises in recent years.”)
5
http://www.hudson.org/index.cfm?fuseaction=hudson_upcoming_events&id=350 February 15, 2007, Hudson
Institute: “How Resilient Are Mortgage Backed Securities to Collateralized Debt Obligation Market Disruptions?”
(See, as example: “We therefore maintain that the shrinkage in RMBS sector is likely to arise from decreased funding
by the CDO markets as defaults accumulate. Of course, mortgage markets are socially and economically more
important than manufactured housing, aircraft leases, franchise business loans, and 12-b1 mutual fund fees. Decreased
funding for RMBS could set off a downward spiral in credit availability that can deprive individuals of home
ownership and substantially hurt the U.S. economy. As described in detail in section II.A, the CDO market adds
liquidity to the RMBS market in a highly leveraged fashion by funding lower-tranche MBS securities, and the
experience of the ABS markets in the early 2000s illustrates that the liquidity provided by CDOs is very fragile.”)

-2-
Weekly Spew October 2009

The story of an “unlevel playing field”:

Those who argue against a more proactive reduction in risk and size of TBTF
institutions will, as they always do, revert to an argument that strikes a natural
chord in every American’s heart: ‘Doing so would create an unleveled international
playing field for our institutions relative to their international competitors’. Level
playing fields are a worthy goal; this is not a relevant argument. Instead, this tired line
must be resoundingly dismissed on several counts:

 Those countries with the largest banks as a percentage of GDP (Iceland,

Ireland, Switzerland) demonstrated that a concentration of banking
power can cause significant sovereign risk and tilt global economic
playing fields away from you.
 The likely breakups of ING, Lloyds and KBC suggest that it is we who
seek to support an unlevel playing field where we subsidize our TBTF
banks while other nations recognize the policy failures of moral hazard.
If we continue down this path we will likely be at risk of violating
international fair trade regimes.
 When the “unlevel playing field” argument is cited, why don’t
community bankers demand to know why it is ok to disadvantage the
8000+ community banks relative to our largest banks, all in the name of
protecting big banks from governmentally- subsidized international
competition?
 There is no longer any evidence that, beyond a cost of capital advantage
that comes with implied government support, there are sustainable and
tangible economies of scale arising from being the largest. The financial
supermarket concept has been proven a failure.
 We must demand that our legislators no longer allow unelected officials
at the independent Federal Reserve to sign international accords created
by the TBTF banks through supra-national bodies like the Basel
Committee.
 Are we to believe that if we did not have such large and globally
dominant firms, US borrowers might be paying more that the 29%
interest that several of the TBTF firms are now charging on their card
accounts?
 Perhaps we should think about what advantage our population has
gained as a result of our financial institutions being such a large part of
our economy or being globally dominant6.
 Since when did we accept a national strategy of following rather than
leading? When we do what is right, others follow. As example, consider
6
http://www.creditcardguide.com/creditcards/news/credit-card-interest-rates-jump-29-99/

-3-
Weekly Spew October 2009

the bank secrecy havens – they made money for a bit. Now, even the
Swiss and the Cayman authorities are coming around to our view.
 We are already at a disadvantage given that the largest foreign banks
operate in the US without any tier one capital requirement and yet most
large foreign banks have not built a bricks and mortar presence here.
Nobody screams about their undercapitalization nor has that
undercapitalization caused deposits to migrate to foreign banks.

Having provided preemptive arguments against their notion I would point out that by
getting out of the TBTF game, we will have a more robust and economically competitive
economy where no players have a governmentally-conferred advantage or subsidy. Such
a leveled playing field will begin the process of regaining credible markets and attracting
stable foreign capital. Let other nations pursue misguided policies of protecting
uneconomic and anticompetitive businesses. Such an approach will allow our taxpayers
to avoid having to be part of the next banking bailout crisis.

New GSEs for you and me:

The Administration’s preferred approach, which is politically cynical, re-creates a

class of special public companies that, because of their ties to the government,
receive the benefit of a GSE-like “implied government guarantee”. For background,
for the better part of the past 10-years market participants were increasingly convinced
the GSEs (Fannie and Freddie) could become unstable. Even so bondholders viewed the
companies as low credit risks. It was assumed that if they into trouble they would be
bailed out with taxpayer dollars and without significant losses being forced upon
bondholders. As a result of this belief, the GSEs had a significantly lower cost of capital
than their non-“special” and fully private competitors. No matter how much Treasury, the
Fed, the White House or Congress said that the government did not stand behind the
obligations of the GSEs the markets did not accept that view and, when push came to
shove and the GSEs were taken over by the government last September it was the
taxpayer that was place on the hook for up to $400 billion of GSE losses. GSE creditors
walked away from the accident and even equity holders, who had always been paid to
take the first loss, were not wiped out. So, are we expected to believe that these TBTF
institutions will not be provided a lower cost of capital by the markets based on the
understanding that the government will always stand ready to fund their losses?
Moreover, from where in history can we draw comfort that when a macro crisis
hits, regulators and policymakers will assess the cost of the losses on other TBTF
institutions rather than arguing that that might lead to a contagion risk? As
witnessed in this crisis, a withdrawal of liquidity from one systemically risky
institution can lead to both a withdrawal of liquidity to its peers and also a
contagious decline in asset values leaving all undercapitalized at the same time.

If there is a positive to the GSE model and the “implied government guarantee” it is that

-4-
Weekly Spew October 2009

these companies will provide all legislators, regardless of their political affiliation, with a
constant stream of lobbying dollars in return for help in stymieing regulators. The
lobbying and campaign dollars the TBTF banks are spending to convince officials that
their derivatives books were never at risk and their credit trends are stronger are welcome
in Washington. In a testament to Washington’s love affair with large financial firms
Jamie Dimon has been repeatedly dubbed Obama’s “favorite banker”7. Even so, there is
still a massive lobbying dollar hole left by the withdrawal of the largess that disappeared
with the predictable collapse of Fannie and Freddie8

Contingent capital is neither contingent nor capital:

While it is not yet clear if the absurd notion of "contingent capital" (define this term in
parentheses the first time you use it) will be referenced in legislation or left to the
regulatory hacks to codify in rulemaking, it is gaining support in the Fed as witnessed by
recent comments from Governor Tarullo9 and NY Fed President Dudley10. Rather than
requiring banks to raise and hold significantly more (good, old’ fashioned) equity capital,
they want banks to use "contingent capital" or debt that converts to equity in cases of
precipitously falling equity values.

Contingent capital is a deeply flawed notion proposed by academic economists who

should either be permanently be locked up in institutions or sent off to a vast wilderness
where they can no longer threaten the broader population. Equity is equity, there is no
substitute. As long as the Federal Reserve retains the "13.3" emergency powers11
one must expect that when a TBTF institution is imperiled or required to convert
their contingent debt to contingent equity the TBTF institution will lobby hold
legislators and regulators hostage to the notion that such a conversion would cause a

7
http://open.salon.com/blog/saturn_smith/2009/07/20/the_delicious_jamie_dimon_obamas_favorite_banker
8
(see, as example: “A Coming Nightmare of Homeownership” By GRETCHEN MORGENSON Published: October 3,
2004
http://query.nytimes.com/gst/fullpage.html?res=9D04E2D81338F930A35753C1A9629C8B63&sec=&spon=&pagewa
nted=all and “WALL STREET COVERS ITS FANNIE MAE” NEWSWEEK From the magazine issue dated Oct 18,
2004
http://www.newsweek.com/id/55276 and “Fannie's Fans Must Be in Denial” Published: December 19, 2004
http://www.nytimes.com/2004/12/19/business/yourmoney/19watch.html and “Why Fannie And Freddie Are Fidgety”
Businessweek, July 30 2007 http://www.businessweek.com/magazine/content/07_31/b4044051.htm
9
http://www.federalreserve.gov/newsevents/testimony/tarullo20090930a.htm (see: “A number of other initiatives are at
an earlier stage of policy development. A good deal of attention right now is focused on mitigating the risks of
systemically important financial firms. Two of the more promising ideas are particularly worth mentioning. One is for a
requirement for contingent capital that converts from debt to equity in times of stress or for comparable arrangements
that require firms themselves to provide for back-up sources of capital.”)
10
http://newyorkfed.org/newsevents/speeches/2009/dud091013.html (see: “For initiatives in this area to be effective,
we need to make progress on… tougher regulatory requirements, including the use of a contingent capital instrument
that would automatically replenish equity capital in times of stress.”)
11
Supported by former Administration Treasury nominee and lawyer to the industry, H. Rodgin Cohen (see:
http://newsbusters.org/blogs/tom-blumer/2009/03/13/so-why-did-h-rodgin-cohen-withdraw-treasurys-no-2-press-
curiously-not-cu who also provided support for Citi’s move into insurance before Glass Stegal was repealed) and
placed in legislation by Chris Dodd at the request of the Empire Goldman Sachs (http://www.washingtonpost.com/wp-
dyn/content/article/2009/05/29/AR2009052903403.html )

-5-
Weekly Spew October 2009

market panic and lead to counterparties pulling secured lines and withdrawing
liquidity… hmmm, sound familiar?

Moreover, unless there are clear and specific prohibitions against banks investing in
each other’s “contingent capital notes”, we will increase systemic risk by
engendering precisely the entanglement and interconnectedness that defines
systemic risk. We have witnessed the problem of interconnectedness in this crisis in at
least two situations; banks and insurers investing in each other’s trust preferred securities
(TRUPS) and becoming exposed to not only declines in the equity value of their TRUPS
but also to losses on their investments in other banks’ TRUPS. We have also seen the
damage caused by regional banks outsized exposure to GSE preferreds. Lastly, unless
market participants saw through the contingent capital notion and considered it to carry
an “implied government guarantee”, the cost of issuance of the notes would be at a
prohibitively high rates.

Salvaging regulatory reform for the good of our public:

There remains some hope for those who would like to see real regulatory reform. The
first chance for the public to force a more real reform on Washington will come as the
public, begins to wake to the realization that, absent the government largess, bank credit
trends demonstrate the economy is hardly stable and the banks credit trends can no longer
be hidden behind unsustainable improvements in capital markets business. A second
chance for meaningful reform might come as a result of a more disturbing change. If the
government’s reckless “a golden egg in every pot” approach to trying to pull forward
future demand is stopped by an unlikely bout of mass sanity or by a U.S. variant of the
“Soros v the Bank of England”12 moment that too could be a catalyst for meaningful
reform.

To be clear, passage of the components of this set of House Financial Services

Committee regulatory reform bills does not ensure that Senator Dodd (D - CT), who
intends to introduce his bill in November, will have any luck moving it. In fact,
sources suggest that Mitch McConnell (R - Kentucky) sees Senator Dodd as
vulnerable in his re-election campaign and is encouraging Republicans not to
support his bill. Senate Banking Committee Minority Leader Richard Shelby (R - ALA)
continues to suggest he will not negotiate any regulatory reform legislation unless it
meaningfully addresses GSE reform. While it is unclear if this is a hard line or an
opening position but he has also made it clear he will not entertain the Fed in the role of
either “il capo di tutti capo” of prudential financial regulators nor will he accept Ben
Bernanke wearing a pinky ring and playing systemic risk regulator. On the later Dodd is
seemingly in agreement.

Democrat leadership appears to believe Shelby is merely posturing and that, even
12
http://en.wikipedia.org/wiki/Black_Wednesday

-6-
Weekly Spew October 2009

though the reform language on OTS derivatives, consumer protection, TBTF, and
systemic risk are laughably weak, it will be impossible for Republicans to convince
the public that they are holding up reform legislation for honest and political
reasons, rather than merely political ones. Democrats expect that they will be able to
shift the debate from a debate on what would constitute good public policy to one of "the
Republicans are a party of "No" ". I will predict that passage of this legislation on a
partisan vote would have more negative implications for Democrat re-elections than
the passage of a healthcare reform bill on a party-line vote. Americans hate their
healthcare insurers but like their pharmacists and doctors. Americans hate their
banks and have grown to hate bankers and their bailouts far more.

Even so, populist acrimony should not be directed at "the" bankers, rather it should be
focused on the “Too Big to Fail” bankers. Perhaps we will ultimately force them to wear
scarlet letters. Maybe we will tie them to rocks and throw them in water to determine if
they are witches. It is urgent for the public to see that their greatest allies in pursuit of
good public policy on most of these issues are institutional investors, who bet that market
forces ultimately prevail and rebalance to equilibrium, and also those small community
bankers who largely stuck to their knitting, made plain vanilla loans, didn't arbitrage
regulatory capital rules, remained sufficiently well capitalized relative to their exposures.
It is those two groups that suffer because the implied government backstop of the TBTF
crowd is resulting in small banks being forced to compete for business at an economic
disadvantage. It is institutional investors that now have to chase assets bid up by to those
TBTF institutions that speculate and take on more risk as a result of their “implied
government guarantee”.

Make no mistake, the TBTF crowd is still controlling both Congress and most regulators
as witnessed by all the focus on secondary reform items rather than resolution authority
and an end to TBTF. If you are TBTF you are too big and must shrink or be broken up. If
we achieve this these bankers will be better and more focused on risk management and
we wouldn't have to even care as much about other secondary issues.

-7-
Weekly Spew October 2009

1- This report is not directed to, or intended for distribution to or use by, any person or entity who is a citizen
or resident of or located in any locality, state, country or other jurisdiction where such distribution,
publication, availability or use would be contrary to law or regulation or which would subject Graham Fisher
or its subsidiaries or affiliated to any registration or licensing requirement within such jurisdiction. All
material presented within this report, unless specifically indicated otherwise, is under copyright to Graham
Fisher & Co. (GF&Co). None of the material, or its content, nor any copy of it, may be altered in any way,
transmitted to, or distributed to any other party, without the prior express written permission of Graham
Fisher & Co. (GF&Co).

2- The information, tools and material presented in this report are provided to you for information purposes
only and are not to be used or considered as an offer or the solicitation of an offer to sell or buy or subscribe
for securities or financial instruments. GF&Co. has not taken any steps to ensure that the securities referred to
in this report are suitable for any particular investor. The contents of this report are not intended to be used as
investment advice.

3- Information and opinions presented in this report have been obtained or derived from sources believed by
GF&Co to be reliable, but GF&Co makes no representation as to their accuracy or completeness and GF&Co
accepts no liability for loss arising from the use of the material presented in this report where permitted by
law and/or regulation. This report is not to be relied upon in substitution for the exercise of independent
judgment. GF&Co may have issued other reports that are inconsistent with, and reach different conclusions
from, the information presented in this report. Those reports reflect different assumptions, views and
analytical methods of the analysts who prepared them.

4- Past performance should not be taken as an indication or guarantee of future performance, and no
representation or warranty, express or implied is made regarding future performance. Information, opinions
and estimates contained in this report reflect a judgment at its original date of publication by GF&Co and are
subject to change. The value and income of any of the securities or financial instruments mentioned in this
report can fall as well as rise, and is subject to exchange rate fluctuations that may have a positive or adverse
effect on the price or income of such securities or financial instruments. Investors in securities such as ADRs,
the values of which are influenced by currency fluctuation, effectively assume this risk.

-8-