Examples Confirming Regulators Contribute to Financial Instability

In two earlier posts (see here and here), the theory of how regulators through their monopoly on all useful, relevant information on financial institutions and structured finance products both contribute to and perpetuate financial instability was laid out.

This post is going to focus on two examples to show how this theory holds up in practice.

Both examples are courtesy of Chris Whalen in this week's Institutional Risk Analyst.  For those of you who do not know Chris, he knows banks inside and out and offers a highly regarded service that rates each bank's riskiness.  Once per week, through the Institutional Risk Analyst, he shares his insights.

The first example is the recently completed stress tests in the US on which Chris observes:

While the US central bank did not provide results for specific institutions, the assumptions in the Comprehensive Capital Analysis and Review (CCAR) are more instructive than the Big Media seems to notice. Indeed, a close reading of the CCAR document provides a compelling argument for why the Fed should not be supervising financial institutions. 

For example, the Fed has a down 6% for housing prices in its "stressed scenario," but that is about where we are now. Incredibly, the central bank also has a down 5% for HPI [Housing Price Inflation] in 2012, again in a "stressed" scenario. This implies that the Fed's "normal" estimate for HPI is positive for 2011-2012? Hello? 

Chris comments highlight one of the ways in which financial regulators with their information monopoly contribute to financial instability.

The market is dependent on the regulators to analyze the data correctly.  Chris is a very able analyst who happens to be in the business of assessing the riskiness of banks, but he does not have access to the same data to run his own stress tests on the banks.

What he does have is the ability to analyze the assumptions used by the regulators in testing the data.  Based on the facts cited and the tone of his comments, it is unlikely that Chris believes either the regulators analyzed the data correctly or the outcome of the test.

If the goal of the stress tests is to restore market confidence and increase financial stability, it appears to have had the opposite impact on Chris.   He finds the stress tests as providing a compelling argument for the Fed being stripped of its bank supervision authority.

Is the reaction by Chris to the US stress tests unusual?  According to the NY Times Dealbook article on the bank stress tests, the answer is no.

Still, some bank analysts doubted whether the stress tests were all that stressful. “Although they still have the economy in a recession in 2011, they have home prices down an additional 10 percent,” noted Frederick E. Cannon, the chief equity strategist at Keefe, Bruyette & Woods [an investment bank that for many years focused only on the banking industry]. “A lot of people are already expecting that in the current environment.” 

In any case, Friday’s results did not mark the end of stress tests; in fact, they are only the beginning. The Fed plans to make the kind of review that was just completed an annual event.

Have European financial regulators with their information monopoly done better than the Fed?

No.  The first round of stress tests showed banks in Ireland, like Allied-Irish, to be adequately capitalized.  Within months, these banks had to be nationalized.

What about the current round of stress tests in Europe and, in particular Ireland?  According to an article in the Independent, analysts do not feel these stress tests will be better than the first round of stress tests.

Details of the 'shocks' in the European tests, many of which will also be included in the more imminent Irish stress tests, were revealed yesterday to clamouring criticism from analysts who deemed the tests too lax. 

Meanwhile, Anglo Irish Bank chairman Alan Dukes yesterday said the worst-case property scenarios Irish banks were being tested against looked "too rosy", a view echoed by property giant Savills. 

Bloxhams' chief economist Alan McQuaid said all the details that had emerged about the stress tests led him to believe Ireland's banks could need an injection of more than the €35bn allowed for in the bailout. 

... The EBA has vowed to make this year's version more robust, but analysts at Citi yesterday said they remained "sceptical of the ability of these new bank stress tests to reinstate market confidence". 

The sentiments were echoed by analysts at Credit Sights who said "anyone looking for a worst-case scenario rather than a moderate stress test will be disappointed". 

The Irish version of the stress tests are also coming under criticism for being too lax, with experts hitting out at the worst-case assumptions that commercial property prices will fall by a maximum of 70pc from the peak and house prices by a maximum of 60pc. Mr McQuaid said the picture emerging of the stress tests meant the banks "will swallow up the entire €35bn earmarked for it".

The analysts' responses suggest that at best they see the stress tests as much ado about nothing and at worse a confirmation that the regulators do not understand how to analyze their monopoly information correctly.

Unfortunately for the regulators, the market has experience with and substantial losses to show for when the regulators fail to accurately analyse the data (see sub-prime mortgages and CDOs).  As a result, the plan to make stress tests an annual event would appear to be an attempt to remind the market that it is dependent on the regulators to analyze data correctly and to encourage financial instability.

The second example is the potential losses by the GSEs related to private mortgage insurance on which Chris observes:

Many of the mortgages that the MI's [private mortgage insurers] pretend to insure are actually 'rejected" upon default. The act of "rejection" is not the same as rescission and, in effect, amounts to the MI pretending that the loan was never insured in the first place. Litigation typically ensues. 

... the biggest exposure to the MIs lies with loans sold to the GSEs.  

... in the case of the MIs, the question of mere restatements is entirely inadequate to describe the public disclosure shortfall.  Few claims made against MIs are paid because they have no capital, especially compared with their total exposure. Instead of raising real capital or trying to shed risk exposures, senior officials from the MIs instead spend money on litigation and lobbyists. 

... MIs have much less "capital" than insured losses.  Premiums paid over the past two years were used to pay past claims, NOT rebuilding reseves.  If the smiling image of Charles Ponzi  comes to mind, then you've got the idea. 

... Most MI contracts are written against GSE guaranteed loans and pay only after all losses are known. Until a year ago, when the FASB changed the rules on accounting for securitizations, the GSEs would leave defaulted loans in pools and pay investors principal and interest as though the loan was still money good. The FAS 166/167 rule change forced the GSEs to buy bad loans back from investors for cash, but the same rule change allowed the GSEs to value delinquent loans at a higher value than the expected loss estimates would suggest. 

In the last year, problem loans started popping up on the balance sheets of the GSEs, but Fannie and Freddie have so far refused to press the MIs for payment. Remember that MI pays only at the end of the default process, when the total loss is realized.  And the GSE only just completed the review of losses for the 2004-2008 period.  As the GSE warehouse of delinquent and defaulted loans grows by billions of dollars each month, there is still no demand for payment from the MIs by the FHFA. As we noted in an earlier comment, we figure that there is as much as $200 billion in defaulted loans sitting on the books of Fannie and Freddie at cost -- that is, close to par value. Neither GSE details the total amount of defaulted loans on its books. 

... Both investors and Congress need a lot more details about the purchases of defaulted loans by Fannie and Freddie. We need to know exactly how many dud loans have migrated back to the GSEs, what their loan loss reserve is, how much of that loan loss reserve is "covered" by the MIs and how much "capital" the MIs have against these exposures.   The GSE are letting dead loans sit on their books in part to avoid recognizing the losses, an event that would drive many of the MIs into bankruptcy. If you look at how slow the process of final loss recognition by Fannie and Freddie is proceeding, then you'll understand why the publicly disclosed loss rates reported by Fannie and Freddie have been falling.
Instead of demanding insurance payments, the GSEs are doing everything in their power to keep the MIs looking like going concerns so that they can count the MI "receivable" as a good asset. 

... If there was a proper mark-to-market on the MIs (like all proper insurance/reinsurance businesses do), then the MIs would be massively insolvent. The GSEs would have to take another huge amount of capital from Treasury. Geithner and the GSEs are trying to avoid it, and to date are getting away with it. Sad to say, nobody at the FHFA seems to have a clue about this issue.  But we understand that a certain independent minded committee chairman on Capitol Hill is preparing for hearings on this monumental act of fraud against the taxpayer, not to mention the holders of GSE debt. 

This example highlights another way in which regulators with their information monopoly contribute to financial instability.

The information monopoly encourages regulators to implement extend and pretend policies.  After all, they have data that the market does not have and they are in a position to influence its disclosure to other market participants.  These policies always fail, but not before a period of time has elapsed in which economic decisions are distorted.

The reason that extend and pretend policies always fail is that financial regulators miss that analysts like Chris Whalen understand their role in our financial markets under the FDR Framework is to trust, but verify.  They trust the government when it says that everything is ok.  Then they start digging around to find the facts that verify the accuracy of this statement.

The only question with extend and pretend policies is how long will it take before the market analysts ferret out enough information to show the statement is wrong.  When that happens, the market is subject to financial instability.

Unfortunately, this financial instability is not limited by the actual facts, but is driven by worse case assumptions as the actual facts to anchor the market are not available due to the regulators' information monopoly.