Friday, September 30, 2011

Thanks to European investor lawsuits sheer stupidity of labeling RMBS and ABS deals highlighted

Shortly after the Issuers and Wall Street tried to sell the magic elixir of 'labels' to the European Central Bank and the Bank of England, European investors in residential mortgage-backed securities (RMBS) reminded everyone why labels on ABS deals are worthless.

According to an article in the Chicago Tribune, JP Morgan and Bank of America were hit with lawsuits from European investors who claimed that they were sold securities where the quality of the underlying mortgages did not meet the representations in the offering document.  If this is true, a label on the front of the offering document would have made no difference.

The only way to prevent this from occurring is by providing all market participants, including the investors, with current performance information on the underlying assets.  That way, market participants can verify that the representations made about the assets in the offering documents match the actual quality of the assets.

It is time for the ECB and the BoE to stop talking with and being misled by Issuers and Wall Street and to give your humble blogger a call so that an ABS data warehouse can be built that will actually restore investor confidence in purchasing ABS deals.
JPMorgan Chase & Co and Bank of America Corp were hit with new lawsuits by investors seeking to recover losses on $4.5 billion of soured mortgage debt, expanding the litigation targeting the two largest U.S. banks. 
Sealink Funding Ltd said between 2005 and 2007 it bought nearly $2.4 billion of residential mortgage-backed securities (RMBS) from JPMorgan and $1.6 billion from Bank of America in reliance on offering materials that were misleading about the quality of the underwriting and underlying loans. ...
Another plaintiff, Landesbank Baden-Wurttemberg, raised similar claims in a separate lawsuit against JPMorgan over $500 million of RMBS that it said it bought.

From a Reuter's article,
The lawsuits accuse the banks of packaging large amounts of high-risk mortgages by such issuers as Countrywide Financial now owned by Bank of America, and Bear Stearns and Washington Mutual, now owned by JPMorgan, in pursuit of higher profit. 
"This misconduct has resulted in astounding rates of default on the loans underlying the defendants' RMBS and massive downgrades of the (investors') certificates, the vast majority of which are now considered 'junk,'" the lawsuits said....
In a separate lawsuit filed on Thursday in the same court, Britain's Barclays Plc was sued by Germany's HSH Nordbank AG, which said it lost $40 million after being misled into buying risky RMBS. A Barclays spokeswoman did not immediately return a call seeking comment. 
Banks face many lawsuits by mortgage securities investors seeking to hold them responsible for losses on debt that once seemed safe but turned toxic once the housing and credit crises began more than four years ago.

UK regulator Adair Turner questions if macro-prudential regulation will work

In a Reuter's article, Adair Turner, who sits on the UK's Financial Policy Committee which is responsible for macro-prudential regulation and is the chairman of the UK's Financial Services Authority, questions whether too much is expected of macro-prudential regulation.  The goal of macro-prudential regulation is to reduce the extremes of the credit cycle.

Under the FDR Framework, not a lot is expected of macro-prudential regulatory authorities.

Governments are responsible for ensuring that market participants have access to all the useful, relevant information in an appropriate, timely manner.  Market participants are responsible for all gains and losses on their exposures and therefore have an incentive to use this information in assessing the risk of their exposures.

With the responsibility for all losses, market participants have an incentive to not have a larger exposure in any area than they can afford to lose.  As a result, the peak of the credit cycle should be lower.

With the responsibility for all gains, market participants have an incentive to increase their exposure when risk is low relative to returns.  As a result, the trough of the credit cycle should be higher.

Potentially, macro-prudential regulatory authorities could step in if they think that market participants are mis-pricing risk (at the peak and trough of the credit cycle).
The financial regulator cautioned on Thursday not to expect too much from a new breed of watchdog that seeks to spot and tackle system-wide risks before they destabilise markets.... 
"We should be very cautious of expecting too much of macro-prudential policy: if it manages to dampen excesses of the upswing of the credit cycle, that in itself will be a major achievement, making future downswings less harmful," Financial Services Authority Chairman Adair Turner said.... 
Turner said in a speech at Southampton University it was a more difficult question whether macro-prudential policy could actually help revive the economy. 
"A crucial issue at this point in the cycle is, therefore, whether macro-prudential policy has a role to play in stimulating rather than constraining credit supply and demand, whether it can be used to 'push' as well as to 'pull'," Turner said. 
Turner said the FPC would have to become far more involved in judging the "socially optimal" level of credit at the more micro sectoral level, as he was "not very confident" that market mechanisms can get it right. 
Regulators also need to take further action to curb risks from newer areas in the financial system such as structured securitised credit and trading, Turner said.

The head of Europe's markets regulator calls for disclosure

A Bloomberg article reports that Steven Maijoor, the head of Europe's markets regulator, called for banks to provide market participants with adequate disclosure on their sovereign exposures to dispel uncertainty.

Mr. Maijoor confirmed this blog's argument that it was the lack of transparency into the structured finance securities and who held them that triggered the solvency crisis that began on August 9, 2007.  He then suggested that a similar lack of transparency into bank sovereign debt holdings threatens to exacerbate the solvency crisis.

Regular readers know that for banks adequate disclosure is current asset and liability-level data.  It is only with this data that market participants can assess the risk of the banks for themselves.
The head of Europe’s markets regulator warned banks to be consistent in their valuations of sovereign debt amid concern some lenders have failed to record sufficient losses on Greek bonds. 
Steven Maijoor, chairman of the European Securities and Markets Authority, likened the lack of transparency about banks’ individual holdings of government debt to the subprime mortgages that triggered the credit crisis. 
“Lack of transparency regarding exposures to subprime mortgages created a situation of uncertainty about the financial positions of banks,” he said in a speech in Vienna today, according to a transcript released by ESMA on its website. Recently, “a lack of transparency from banks on their exposures to sovereign debt and related instruments are generating new suspicions about the conditions of individual banks and this requires similar answers in terms of transparency.”

Thursday, September 29, 2011

Will adding a label indicating minimum standards entice investors to buy European ABS deals? No!

A Bloomberg article reports that European issuers of ABS securities and a broker/dealer controlled lobbying group, the Association for Financial Markets in Europe, want to introduce a label indicating that the assets backing a structured finance deal meet a minimum standard.  According to the article, they are doing so to make the ABS securities more attractive to buyers.

There is zero chance that labeling the ABS securities will make them more attractive to investors.  This is just another attempt by the issuers and Wall Street to avoid having to disclose the current performance of the underlying collateral.

Why will this label not make the securities more attractive?
  • The minimum standards for the underlying assets are already covered by the representations and warranties made in the deal documentation.  Since the information is already in the deal documentation, the label offers absolutely zero new information.
  • The fact that the underlying assets met the minimum standards at one point in time does not mean that they still meet this standard at a future point in time.  For example, look at the decline in performance for so-called Prime mortgages in the US.  A label conveys zero useful information for valuing a deal in the secondary market.  Without current performance data, investors in the secondary market are blindly betting on the contents of a brown paper bag.
Disclosure of current performance data for the underlying collateral is the only way to entice investors to buy ABS securities.  It is only when investors know what they own that they will return.
The Association for Financial Markets in Europe and European Financial Services Round Table lobby groups are working on plans to label asset-backed notes that reach certain standards as Prime Collateralized Securities, according to two people familiar with the matter. 
A PCS working group, which also comprises investors, is scheduled to meet today to discuss the timing for the project and how to get better regulatory treatment for the debt, said the people, who declined to be identified because the discussions are private. 
The industry groups are working on the quality-assured brand after issuance in the asset-backed securities market in Europe tumbled by more than 80 percent since its pre-credit crunch heyday. Sales stalled in 2008 after bonds linked to U.S. subprime debt slumped, prompting investors to shun the hard-to- value securities. 
“In principle it’s a good initiative, but the implementation is very complex because of the different market practices in each European country,” said Alexander Batchvarov, the London-based head of structured finance research at Bank of America Corp. 
The PCS label would be designed to take account of new and existing regulation, said the people. Deals would need at least two triple-A credit ratings and reveal enough information about the underlying loans to be eligible for the liquidity operations of the European Central Bank and Bank of England, the people said. The ECB, BOE and European Investment Bank have been consulted on the plan, according to the people. 
As this blog has previously documented, the ECB and BoE have disclosure requirements for the underlying loan performance information that are inadequate for complying with Article 122a of the European Capital Requirement Directive.  Both Moody's and S&P have testified before Congress that these disclosure requirements are not adequate for timely rating (the equivalent of valuation) of the securities.

The inclusion of two triple-A credit ratings does not make ABS securities more attractive.  Investors learned from the sub-prime/CDO debacle to not rely on the credit ratings when it comes to valuing and investing in structured finance securities.
... The quality tag will be available for bonds backed by residential mortgages, small- and medium-sized company loans and consumer loans, the people said. 
“To make this initiative work it’s key to get the ECB and BOE to give the labelled issues better treatment in their liquidity operations, or to persuade the European Commission to require less capital for banks and insurance companies that buy these bonds,” Bank of America’s Batchvarov said.
Since September 2008, the ECB and BoE have been the major "buyer" for these securities. These securities are "purchased" by being eligible to be pledged to the ECB and BoE for their liquidity operations.

The goal of the ECB and BoE is to bring private investors back to the market so that they do not have to fund these securities.

Simply slapping a label on these deals will not work to attract investors.  The ECB and BoE know that it will take disclosure of current performance data for the underlying assets.

Wednesday, September 28, 2011

SEC looks at S&P use of 'dummy' assets in rating CDO

The Wall Street Journal reported that the SEC is looking at S&P and its use of 'dummy' assets in rating CDOs.

Whether or not the SEC pursues this case against S&P, the use of 'dummy' assets makes the case for asset level (loan-level) disclosure for all structured finance securities.  Simply put, the SEC is looking at the issue of how can you value/rate a security when you do not even know what is in the security.

Your humble blogger has been making this point about the need for current asset-level disclosure for structured finance securities since before the credit crisis.  Without this disclosure, market participants do not have all the useful, relevant information in an appropriate, timely manner.

It is nice that the US government in the form of the SEC has come out and formally agreed with me on the need for current asset-level disclosure for structured finance securities.
U.S. securities regulators are zeroing in on the use by Standard & Poor's of fictitious "dummy" assets when it assigned a triple-A credit rating to a $1.6 billion mortgage-bond deal that imploded during the financial crisis, according to a person familiar with the matter. 
S&P's parent company, McGraw-Hill Cos., said Monday that it had received a so-called Wells notice from the Securities and Exchange Commission. A Wells notice is the agency's warning to financial institutions that they could face civil charges. McGraw-Hill said the SEC is weighing civil enforcement action against the firm for its ratings on a collateralized debt obligation called Delphinus CDO 2007-1 issued in July 2007 as the housing market was taking a turn for the worse. 
The SEC is alleging violations of federal securities laws, McGraw-Hill said in a news release. The company said S&P has been cooperating with the regulator on its probe into Delphinus. A spokesman for the SEC declined to comment.
Lawmakers, regulators and investors have trained their cross hairs on S&P and its peers for assigning rosy ratings to thousands of complex securities that were later downgraded within the span of a few months, deepening the crisis. 
The S&P investigation is one of a number of probes by the SEC's enforcement division, headed by Robert Khuzami, into the complex mortgage-bond deals known as collateralized debt obligations. 
CDOs, which are pools of subprime mortgages and other assets that were sold in slices to investors, had emerged before the crisis as popular and profitable products on Wall Street. But the housing market's collapse exposed both the banks and their investors to billions of dollars in losses and left in its wake a raft of legal and regulatory headaches. 
S&P originally assigned its highest rating to the deal based on "dummy," or hypothetical, assets, then maintained that triple-A rating even though bankers had replaced them with lower-quality assets that didn't meet the firm's ratings standards, according to emails among S&P analysts that were disclosed in congressional testimony. 
Jack Chen, a former Moody's analyst who now runs his own consulting firm, said it isn't uncommon for credit-rating firms to use "dummy" assets to determine a final rating for a CDO, because some of the deals may have assets traded in later. 
What is problematic with S&P's rating of Delphinus is that the assets that replaced the "dummy" assets were of a lower quality than those hypothetical assets S&P had used to issue the ratings, said Mr. Chen, who has reviewed the S&P emails that were released. 
Frank Raiter, a former S&P managing director who had retired by the time Delphinus was rated, told lawmakers in April 2010 that S&P's dependence on fictitious assets that were later replaced by lower-quality securities "looks like a bait and switch."
Had the investors had current asset-level data, it would not have been possible to do a bait and switch.  Investors would have been easily able to see that the assets did not meet the quality standards that were represented in the offering documents and would not have purchased the deal.

Irish lending expertise in looting taxpayers to Greece

According to an article in the Irish Times, the staff of the Irish central bank are advising their counter-parts at the Greek central bank on how to plot a resolution of the Greek banks and restore confidence in the Greek banking system.

At first blush, this seems reasonable.  After all, the Irish banking system has experienced a similar run on its banks as the Greek banking system.

So what can the Irish central bankers advise their Greek counter-parts on?

The Irish central bankers could advise their Greek counter-parts on their experience hiring firms like BlackRock, Barclays and Boston Consulting to run a stress test and reorganize the banks.

Specifically, they could share
  • how 30 million euros was paid to these firms for a solution that your humble blogger stated before the firms started would neither restore confidence nor stop the run on the banks' deposits;  
  • that the run on the Irish banking system has continued months after the results of the stress test and reorganization were announced; and 
  • that the ECB recently committed to paying 4 million euros for a report due in November 2011 on how to restore confidence in the Irish banking system.
Most likely though, the Irish central banker will advise their Greek counter-parts to spend lots of taxpayer money on a similar stress test and reorganization.  

Like Wall Street, the advice will be better for the advisor than for the recipient.  
  • For the advisor, it provides cover lest Irish taxpayers question the wisdom of the stress test and reorganization - the central banker's defense is 'it must be a good idea because someone else did it too'; kind of like lemmings jumping off a cliff.  
  • For the recipient, it provides an opportunity to loot the Greek taxpayer (or the EU taxpayers given that Greece is having difficulty repaying its debt).  After all, it cannot be justified on the grounds that it will restore confidence or stop the run on the banks.
Alternatively, the Irish central bankers could advise their Greek counter-parts that they wished they had pursued the only proven solution for restoring confidence and ending bank runs.  This solution involves implementing the FDR Framework and providing disclosure to all market participants of the current asset and liability-level data for each bank.
SENIOR OFFICIALS from the Central Bank have played a walk-on part in the unfolding Greek tragedy, prompting their counterparts in Athens from the wings on how to plot a resolution for their banks. 
Performing a role close to that of an all-knowing Irish Oracle at Delphi, two officials travelled to Athens in July and again earlier this month to advise the Greeks on how they stress-tested the Irish banks in an attempt to draw a final line under the banking crisis. 
The troika gods of the European Commission, the European Central Bank and the International Monetary Fund have looked favourably on the Irish stress tests as a winning formula for assessing risks in banking sectors in other struggling euro zone states.
Despite all evidence to the contrary that the stress tests were not a winning formula.  So maybe having Greece engage in this activity is to provide cover to the European Commission, the European Central Bank and the International Monetary Fund too!
The cost of bailing out the Irish banks has not increased since the March 2011 tests, the fifth attempt in more than two years to put a final bill on the banking disaster. 
Apparently success is defined as the Irish government not having to put more equity into the banking system for 6 months.  A measure of success that Warren Buffett would say is very similar to firing an arrow and then drawing a bullseye around where it has landed.

This definition of success has a couple of flaws.  First, it is not clear that the Irish government has access to the financial resources to put additional capital into the banks.  This is a bit of a problem given that the Irish Times reports that house prices continue to fall.  Second, bank equity is an easily manipulated accounting construct.  Simply practicing extend and pretend results in bank equity being higher than it would be if losses were realized.
As a result of the purported success of the Irish tests, the Central Bank was asked to send a delegation to Athens earlier this summer to help the Greek authorities handle their own banking woes.
"We can confirm that following a request from the Bank of Greece a small team from the Central Bank of Ireland travelled twice to the Bank of Greece to share experiences gained," a Central Bank spokesman said...
The officials advised the Greeks on the process followed in the Irish tests and how the test results influenced the reconstruction of the Irish banking system around the two "pillars" of Bank of Ireland and Allied Irish Banks. 
Two Greek banks were among eight lenders that failed EU-wide stress tests of 90 banks in July. 
Bank of Ireland and AIB both passed the EU tests the previous year, but the results were undermined when the Government was forced to seek bailout loans from the EU and IMF four months later. 
The subsequent Irish stress tests of the banks in March 2011 were not carried out exclusively by Central Bank officials, however. As part of their scrutiny, they called in consultants, including US asset manager BlackRock Solutions, to assess losses on the loan books of the Irish banks. 
BlackRock has since been recruited by the Greek central bank to evaluate the country's banks, which would be among the losers in a default by Greece. 
The Central Bank spent €30 million on external consultants to verify the tests on Bank of Ireland, AIB, EBS building society and Irish Life and Permanent. The results of the tests raised the cost of bailing out the banks by €24 billion to €70 billion. About €64 billion is being injected by the State.
And still the run on the Irish banking system continues as the failure to disclose current asset and liability-level data means that nobody knows if the banks are solvent or not.

Did the UK's Financial Policy Committee recommend that UK banks stop lending to EU banks?

By charter, the UK's Financial Policy Committee is suppose to look at potential sources of financial instability and direct both bank supervisors and banks to take steps to minimize the impact of these sources of instability.

Not surprisingly, the FPC focused its attention on unsustainable sovereign debt levels in Europe and the potential for contagion across the EU banking sector.

To minimize the impact of these sources of instability, the FPC recommended that banks increase their liquidity and capital.

Perhaps I am missing something, but isn't the most effective way for a UK bank to achieve this result is for the bank to stop providing loans to the European interbank lending market?  By hoarding their cash and putting it into short-term UK government debt, the bank improves both its liquidity and capital (on a risk-adjusted basis).

In short, the FPC appears to have called for the UK banks to contribute to both the run on the European banks and the freezing of the interbank loan market.

Does having UK banks hoard liquidity really increase financial stability?  Something tells me that increasing the risk to the EU economy of having its banking system collapse does not improve the UK's financial stability.

From the UK's FPC statement from its policy meeting on September 20, 2011: 

... Since its previous meeting there had been severe strains in financial markets, which stemmed in large part from continuing concerns about the sustainability of external and internal debt positions of some countries, especially in the euro area. Anxiety about the consequences of these issues for banks had increased materially and, in turn, the perceived vulnerabilities of banks were adding to strains in financial markets.
The Committee recognised that dealing with the problems facing the international financial system as a whole would require long-term reforms to tackle unsustainable debt positions and the cumulative and persistent loss of competitiveness in a number of euro-area countries. But given the scale of current risks, the Committee also discussed the need for shorter-term measures to reduce the risk of a significant disruption to financial stability, and so to the supply of credit to UK households and firms, which could feed back through the economy to increase the pressure on the financial system. 
UK banks had made progress over the past two years in building up their capital and liquidity, which had placed them in a somewhat stronger position to withstand adverse developments whilst maintaining the supply of credit to the economy. The Committee had advised UK banks in June that, if their earnings were strong, they should seek to build capital levels further, given the risks to the economic and financial environment. But events had lowered the likelihood that banks would be able to strengthen their balance sheets in this way over the short term. 
The Committee therefore recommended that banks should take any opportunity they had to strengthen their levels of capital and liquidity so as to increase their capacity to absorb flexibly any future shocks, without constraining lending to the wider economy. This could include raising long-term funding whenever possible and ensuring that discretionary distributions reflected any reduction in profits. 
The Committee also advised the FSA to encourage banks, via its supervisory dialogue, to manage their balance sheets in such a way that would not exacerbate market or economic fragility. For example, at the present time, some actions taken to raise capital or liquidity ratios could potentially worsen the feedback loop between the financial sector and the wider economy and so should be avoided.

Tuesday, September 27, 2011

Under the Geithner Plan for Europe, Who gets the losses?

As US Treasury Secretary Tim Geithner attempts to export his plan for creating the European equivalent of a leveraged TARP to buy sovereign debt and recapitalize the banking system, the question arises:  Who gets the losses.

Under the current Geithner Plan, the ECB would lend money to the European Financial Stability Fund (EFSF).  If the ECB is following the advice of Walter Bagehot, it would lend money to the EFSF only against good collateral.

Said slightly differently, the ECB would not take on any risk of loss on its loans to the EFSF.  This limits the potential for the EFSF to absorb losses to the 400+ euros that the EU countries invest in the EFSF.

Any losses above this level would have to be absorbed by the ECB.  Were this to occur, the ECB would need to be recapitalized by the EU countries which may or may not be able to afford their share of the recapitalization.

Under the Geithner Plan, the EFSF would recapitalize the banks.  This suggests that the banks realize the losses on the assets on their balance sheets first.  By recognizing the losses first, the bank's equity is reduced.

If the bank's equity drops to zero, then the bank's unsecured bond holders should absorb losses.  In 2009, the decision was made that the unsecured bond holders would not absorb losses.  Naturally, this created the problem we now refer to as 'moral hazard'.  Ending moral hazard would require the unsecured bond holders to absorb losses.

If the bank's equity drops to zero and the unsecured bond holders are written down to zero, we reach the point where governments would need to step in to protect the insured depositors.  Who is responsible for these losses?  The EFSF or the host countries?

Remember, absorbing these losses does not leave the bank with any capital.  Presumably, the EFSF would be called on to add capital.

All of this assumes that the bank's assets (including sovereign debt, real estate loans and toxic structured finance securities) are really going to be written to market value.

I make this assumption because if the Geithner Plan does not involve writing all the assets to market value, then how are market participants to know if the banks are solvent or not.  If market participants do not know if a bank is solvent or not, then why implement the Geithner Plan because it does not fix the problem?

If Europe's banks are really going to write their assets to market value, are the banks in the US and the UK still solvent?

As I have said since before the credit crisis began, the only way to address the solvency issue is to start with disclosure.  It is only when everyone has the facts that a solution which really ends the solvency crisis can be found.

Monday, September 26, 2011

Bankers splinter on remedy for European debt

As predicted under the FDR Framework, without the appropriate disclosure, bankers splinter on what the appropriate remedy for the European debt crisis is.

A Bloomberg article reports,
Wall Street leaders, urging coordinated action from world governments to solve the European sovereign-debt crisis, struggled themselves during four days of meetings in Washington to agree on what’s needed to end it. 
The chiefs of firms including JPMorgan Chase & Co.Goldman Sachs Group Inc.Deutsche Bank AG and Societe Generale SA met for three hours at the National Archives on Sept. 23. They differed on which government and private solutions may restore confidence in European debt and banks, and on some elements of regulation, said two participants who spoke on condition of anonymity because the meeting wasn’t public.
Since all the solutions that have been tried since the solvency crisis began on August 9, 2007, have failed - we would not be worrying about solvency now if they had worked - it is not surprising the bankers were skeptical that variations of these solutions would work now.

As Winston Churchill said of the US, they always find the right solution, they just have to try everything else first.

In the case of restoring confidence, the only idea that has not been tried is the roadmap based on the FDR Framework which requires disclosure of all the useful, relevant information in an appropriate, timely manner.

Bankers are unlikely to voluntarily choose the roadmap, because it eliminates their ability to profit from opacity or take proprietary trading positions.
... Bank-stock indexes in Europe and the U.S. have dropped more than 30 percent this year and borrowing costs for European lenders have climbed amid concern that Greece and other European countries may default. The level of disagreement between bankers and government officials who gathered for the annual IMF meeting was matched only by their shared sense that the stakes have rarely been higher.... 
Discussion of European governments’ options, including how to use their 440 billion-euro ($596 billion) rescue fund, dominated the policy meetings. Most European parliaments, including Germany’s, still haven’t voted on a July 21 plan to endow the fund with more powers, including the ability to buy bonds and inject money into banks.

U.S. Treasury Secretary Timothy F. Geithner urged governments to unite with the European Central Bank to increase the firepower of the fund, known as the European Financial Stability Facility. 
Having experience with leveraging up TARP in the US, think PPIP, Geithner is exporting the Geithner Plan to Europe.

For better or worse, Europe does not seem eager to embrace the Geithner Plan given that it did not work in the US.  For example, PPIP was suppose to restore a normal market for private label RMBS.  Clearly, it did not do this as the Fed could not sell a trivial amount of RMBS paper without causing the price on RMBS paper to decline by 20%.
The Institute of International Finance, an organization of more than 400 financial companies worldwide, holds its annual meetings in parallel with the IMF’s. In normal times, the private-sector bankers use the weekend to mingle with one another, and with government ministers and central bankers, trying to win business and get policy insight.,,, 
A classic opportunity for lobbying.
Yet in private discussions, bankers said the environment was exceptional. A senior European banker said he sees policy makers’ decisions as being as momentous as those in the 1930s. A senior U.S. bank executive said he’s more worried than he was at any point during the financial crisis of 2008 and 2009.
It is not surprising the level of concern as the limits of fiscal and monetary policy are quickly being reached as this marks the end of pushing addressing the solvency crisis into the future.

To address solvency in the 1930s, policy makers adopted disclosure. Will policy makers repeat a successful strategy now?
... Schaeuble, the German finance minister, addressed the same room hours later with a contrasting message: “We won’t come to grips with economies deleveraging by having governments and central banks throwing -- literally -- even more money at the problem,” he said. 
Regular readers know this is true.  What is needed is disclosure so that market participants know if the money that is being literally thrown everywhere is in fact addressing the solvency crisis.

Saturday, September 24, 2011

Europe's Super TARP

Another weekend, another grand bank bailout scheme.

Based on what has been reported, Europe is apparently going to set up a super TARP with 1.5 trillion euros.  The funds are going to be spent to ring-fence Ireland, Greece and Portugal debt and to recapitalize the European banks.

As always, the critical question is:  where did the figure come from?

Apparently European banks were not as well capitalized as the recent stress tests suggested.

However, the idea that the European banks that passed the stress tests need a significant capital injection:

  • Completely discredits the national bank regulators and anyone else involved in the stress tests.  Who would trust anything they have to say now?
  • Says that the size of the equity injections are a reflection of "Kentucky Windage" - make believe.  After all, it is one thing to represent that the banks need to raise a few billion euros of additional capital, it is entirely another to say that the banks actually need upwards of a trillion euros of additional capital.
  • Clearly, this will not restore confidence in the markets.  Remember, in a leveraged financial system there is never enough equity in the face of fears of contagion from a meltdown of sovereign debt and real estate debt.  The situation can be much worse than is being presented - if in doubt, look at the Irish experience.
If the Europeans ever want to solve their problem, they will turn to the FDR Framework based roadmap.  Until that time, they are simply wasting taxpayer money.

Friday, September 23, 2011

Thank you George Osborne, UK Chancellor effectively gives Europe six weeks to adopt FDR Framework based roadmap

A Telegraph article reports that UK Chancellor George Osborne has effectively committed European policy makers to adopting the roadmap based on the FDR Framework.

As many observers have noted, Europe is fast approaching the limits of what can be done with fiscal and monetary policy.

In addition, there is massive bailout fatigue as bailouts have not restored confidence.  This was completely predictable because without disclosure market participants do not know if the recipient of the bailout has been restored to solvency.

By calling on the European leaders to solve the crisis in the next six weeks, Mr. Osborne is pressuring these leaders to adopt the roadmap (disclosure, analysis, solution, implementation) as it will prevent a disorderly outcome.
Speaking at the IMF meeting on Friday, UK Chancellor George Osborne ratcheted up the pressure on European leaders to solve the crisis by calling on them to bolster the European bail-out fund and declaring they have just six weeks to find solutions. 
"Patience is running out in the international community... More needs to be done to avoid a disorderly outcome," he said, before referring to the next G20 meeting in Cannes on November 3 and 4. "The eurozone has six weeks to resolve its political crisis."

Thursday, September 22, 2011

When will bailouts end? When Europe implements the FDR Framework based roadmap!

In his Telegraph column, Andrew Lilico asks the question of when will the bailouts end.  He summarizes the bailouts that have occurred since the start of the solvency crisis in 2007 as follows:

Setting aside the bailouts of late 2007 and early 2008 and just starting when it got serious, we have the bailouts of Fannie Mae and Freddie Mac in early September 2008, which triggered the collapse of just about everything (most notoriously Lehman Brothers), and the bailouts of Autumn 2008. Then we had the bailouts of Spring 2009. The US version of quantitative easing involved the Fed buying up loads of the loss-making collateralised mortgage obligations that triggered the bust, so the bailouts continued through 2009. Then from early 2010 we started re-branding our banking sector bailouts as "sovereign debt bailouts", as if changing the name would make it any less so that these were bailouts of banks. So we had the "Greek" bailouts of the European and US banking sectors of Spring 2010. Then the "Irish" bailout of the European, US, and UK banking sectors of Autumn 2010. Then the "Portuguese" bailout Spring 2011. Then the "Greece II" bailout of Summer 2011. All banking sector bailouts. All good money thrown after bad.
As predicted under the FDR Framework, all of these bailouts were predestined to fail because they were not accompanied by the necessary disclosure so that market participants could assess if the bailout returned the recipient to solvency.

The answer to his question is the bailouts will end with the adoption of the FDR Framework based roadmap.   The roadmap involves four basic steps:  disclosure of each bank's current asset and liability-level data; analysis of this data by both market participants and regulators; review of alternative solutions by market participants and regulators; and execution of selected solution to solvency crisis.

Why zero interest rate policies cause deleveraging

As I was traveling to Minneapolis today, I had a very interesting conversation -thanks Ted - about the Fed's various zero interest rate policies including quantitative easing and Operation Twist.

The key point that came out of the conversation is that interest rates below 2% provide an incentive for households and businesses to pay down their debt.

The incentive is that by paying off their debt they can earn a substantially higher risk-free rate of return than is available elsewhere. 

This is true for households even after refinancing at today's low interest rates.

As for companies, Ted said that his firm surveys CFOs and that interest rates at this level have essentially no impact on the decision to invest to expand as oppose to making the necessary capital investments to maintain existing capacity.

What zero  interest rate policies have effectively done in this financial crisis is changed the association of risk-free from applying to government securities to applying to the debt owed by individuals and companies.

This suggests that continuing low interest rate policies is in fact counter-productive.

Wednesday, September 21, 2011

Worried about solvency, Lloyd's of London pulls deposits out of European banks

A Bloomberg article reports that Lloyd's of London is pulling its deposits out of European banks over solvency concerns.  This is further confirmation of the on-going run on the European banks.

By withdrawing its deposits, Lloyd's is also confirming that assurances of solvency without disclosure by regulators and banks is insufficient.

As the FDR Framework predicts, it is going to take disclosure of each bank's current asset and liability-level data to restore confidence.  It is only when market participants can assess a bank's solvency using granular information that confidence in the bank returns.
Lloyd’s of London, concerned European governments may be unable to support lenders in a worsening debt crisis, has pulled deposits in some peripheral economies as the European Central Bank provided dollars to one euro-area institution. 
“There are a lot of banks who, because of the uncertainty around Europe, the market has stopped using to place deposits with,” Luke Savage, finance director of the world’s oldest insurance market, said today in a phone interview. “If you’re worried the government itself might be at risk, then you’re certainly worried the banks could be taken down with them.” 
European banks and their regulators are trying to reassure investors and customers that lenders have enough capital to withstand a default by Greece and slowing economic growth caused by governments’ austerity measures.  
Siemens AG (SIE), European’s biggest engineering company, withdrew short-term deposits from Societe Generale SA, France’s second-largest bank, in July, a person with knowledge of the matter said yesterday. 
Lloyd’s, which holds about a third of its 2.5 billion pounds ($3.9 billion) of central assets in cash, has stopped depositing money with some banks in Europe’s peripheral economies, Savage said, declining to name the countries or institutions. 
“We have a very conservatively positioned balance sheet,” Savage said. Lloyd’s also holds about a third of its assets in mainly U.S. and U.K. government bonds and a third in corporate bonds, he said....

Did the IMF endorse the FDR Framework's roadmap for addressing Europe's solvency crisis?

In his Telegraph column, Jeremy Warner analyzes not only what the IMF said in its twice yearly Global Financial Stability Report but what its message to European policymakers was.

Independent of this report, I posted a roadmap based on the FDR Framework for addressing Europe's solvency crisis.

It is clear from what the IMF said and its message to European policymakers that it would support European policymakers adopting the roadmap and addressing Europe's solvency crisis.

Most International Monetary Fund reports are necessarily the result of compromise and negotiation. Rarely is the IMF allowed by its nation shareholders to tell it exactly as it sees it. 
So the warning in the IMF's latest "Global Financial Stability Report" that European Union banks face a possible capital shortfall of €200bn to €300bn as a result of the eurozone sovereign debt crisis comes as quite an eye opener. 
European governments will have fought this assessment tooth and nail, for not only does it seem to add fuel to what is already a raging panic around the solvency of the European banking system, it also provides some indication of quite how much more public money is going to be required for recapitalisation. 
In the absence of asset and liability-level disclosure as recommended under the FDR Framework, it is necessarily public money that is needed for recapitalization.

After all, what private investors would take on the risk of losing their investment in a financial institution where they do not have the data necessary to evaluate if the financial institution will be solvent after their investment?
Banks were stress tested by European banking regulators against bad debt risk less than three months ago, and with a few notable exceptions, were found to be broadly sound....
But these stress test results did not restore market confidence as, for example, the assumptions used in the test were immediately criticized.  One of the criticisms was that the test did not adequately cover the possibility of one or more sovereign defaults/restructurings.

Regular readers know that by definition stress tests do not restore market confidence.  Stress tests are run by regulators.  The source of market confidence is market participants using granular level data from the banks to run their own stress tests.  It is the results of these stress tests that market participants believe.
The IMF is at pains to stress that the €200-300bn cited is an estimate of the increased sovereign credit risk in the EU banking system, not of the extra capital needed by banks as such. None the less, it is the IMF's best guess at the size of capital at risk. This is, if you like, the IMF's assessment of the unrealised losses in the European banking system as a result of the sovereign debt crisis. 
Of course, some of this risk may already have been written off or provided for. The point is that we just don't know, as there is no transparency in the system or commonly applied method of accounting for such assets.  
Since before the financial crisis began on August 9, 2007, I have been advocating for transparency in the global financial system.  This includes both the regulated banking system and the shadow banking system.

The reason I have done so is with transparency (disclosure of all the useful, relevant information in an appropriate, timely manner) we could know.

There is no reason given the availability of 21st century information technology that it should be a mystery if a bank has written off or provided for a sovereign credit.
Small wonder that many European banks can no longer access private funding markets.
Who would want to put funds into a bank if they cannot assess the risk of loss?  This assessment can either be done by the market participant or by using trusted independent third parties.
Small wonder too that European governments are so alarmed at this assessment, statement of the bleedin' obvious though it might be. Another round of bank bailouts so soon after the last one is anathma to most Europeans, worse, in some respects than the idea of bailing out sovereign nations directly. 
Yet if this crisis is ever to be resolved, the IMF is surely right in asserting that recapitalisation of the banks is one of the first things that needs to happen.
But not until after there is transparency so that the market can assess whether the recapitalizations actually restored solvency or not. 
Most people will find the idea that more than four years after the banking crisis began, the banking system continues to require squillions of public money almost beyond belief. 
It was reasonable to assume that the balance sheet problems of most banks had been "cured". Plainly they have not. Indeed the process seems barely to have begun....
Actually, assuming that the bank balance sheet problems had been "cured" is just repeating the assumption that bank balance sheets were not risky prior to the beginning of the financial crisis in 2007.

Just because global financial regulators have been saying the problem has been fixed does not mean it has been fixed.
As the IMF Stability Report warns, "Time is running out to address existing vulnerabilities. The set of policy choices that are both economically viable and politically feasible is shrinking as the crisis shifts into a new, more political phase"....
Which is where the roadmap based on the FDR Framework comes in.  It is economically viable as it limits the amount of government money needed to address solvency in the European banks and sovereigns.  It is politically feasible because it addresses the solvency crisis in a way that will result in a credible solution.

The IMF embraces the FDR Framework disclosure requirements

As reported in a Telegraph article about the IMF's twice yearly Global Financial Stability Report, the IMF embraces the FDR Framework disclosure requirements as what is needed for answering the question which European banks are solvent and which European banks are not.

The FDR Framework requires disclosure of each financial institution's current asset and liability-level data.
It estimated that the eurozone debt crisis has directly cost banks in the European Union €200bn since Greece's debt crisis erupted. Of this, €60bn comes from sovereign debt in Greece, €20bn from Ireland and Portugal, and €120bn from Belgium, Spain and Italy. 
The IMF estimated that there was a further €100bn in additional costs linked to the banks of those six countries. 
"This estimate does not measure the capital needs of banks, which would require a full assessment of bank balance sheets and income positions. Rather, it seeks to approximate the increase in sovereign credit risk experienced by banks over the past two years," the global lender said. 
The fund said that while the numbers are "based on market assessments of credit risk, which may reflect a degree of overshooting, the underlying problems that they highlight are real".

The FDR Framework provides a roadmap for addressing the European solvency crisis

Both Ed Harrison on Credit Writedowns (cross-posted on NakedCapitalism) and Larry Summers in a Financial Times column (cross-posted on a Reuters blog) called for a "credible solution" for Europe's solvency crisis.

Fortunately, the FDR Framework provides a credible roadmap for addressing the European solvency crisis.  

It addresses the solvency crisis by requiring banks to disclose all their current asset and liability details to all market participants thereby engaging the market's analytical abilities to determine who is solvent and who is insolvent.  Subsequently, policymakers can work with the market to develop a solution for the insolvent banks and sovereigns and then implementing the solution.

Going through these steps takes time.

Fortunately, by disclosing the facts now and engaging the market's analytical abilities, the roadmap eliminates uncertainty as to who is solvent and who is insolvent and buys a significant amount of time for addressing the issue.

Right now, markets are guessing about who is solvent and who is insolvent  and, if insolvent, by how much and in the process guessing if there are adequate resources to protect depositors from losses.  This has spurred the ongoing runs on the European banks and sovereigns (see here).

With the uncertainty of who is solvent eliminated, markets can see if there are adequate resources, from the host European country or from vehicles like the European Financial Stability Fund, to protect the depositors from losses.  If there are, the ongoing runs will stop so long as the market thinks the solvency issue is being addressed.

Eliminating the uncertainty over who is solvent also eliminates the fear of contagion.  Part of assessing solvency is looking at each bank's exposures and the potential impact of a restructuring on these exposures.

Eliminating the uncertainty over who is solvent also eliminates financial instability caused by brinksmanship in sovereign debt restructuring.  For example, Greece could not use a threat of default and the uncertain consequences of contagion as leverage for additional funds.  Similarly, Germany might be much more willing to help Greece if it were well known to the German public that their banks would be insolvent if Greece was not supported.

What remains to be determined is how to handle the insolvent financial institutions and sovereigns.  Market participants can help in the determination of which of these can regain its solvency on its own, which of these will need to access private capital and which of these will need to be restructured.

Regular readers recall that under the FDR Framework, governments are responsible for ensuring that market participants have access to all the useful, relevant information in an appropriate, timely manner.  Market participants are given an incentive to use this data to assess the risk and reward of an investment because they are responsible for any gains or losses on the investment.

Let's look at how this translates into a roadmap for addressing the European solvency crisis:
  • First, European policymakers and regulators must make a statement describing the current condition of each of the 90 banks that were stress tested.  Regulators should not simply restate the results of the stress tests, but rather state here is the bank's current condition accompanied by disclosure of the hard facts sufficient to support this statement of condition.  For an example of what this statement should look like, policymakers and regulators might want to refer to the recent disclosure by Societe Generale in its bid to win back market confidence.
    • The reason for issuing this statement is to anchor the market to the current facts about the European banks.  This replaces what is happening now where market participant's assumptions are not constrained by these facts.  In a leveraged financial system, when fear of contagion takes over, it always justifies a pre-emptive run on the banks as there is never enough equity in the system.
  • Second, European policymakers and regulators must promise to provide market participants what the Chairman of BNP Paribas called 'utter transparency'.  This involves creating a data warehouse with each bank's current asset and liability-level data.  When finished, this data will be kept current and will be made available at no cost to all market participants.
    • The reason for building the data warehouse is that over the three to four years it will take to build it provides the credibility for the policymakers' and regulators' statements about the condition of each bank.  Market participants know this granular data would not be released if it were going to show that these statements of condition were untrue.
This roadmap has several advantages.
  • It recognizes the need to reassure the markets now by ending uncertainty about the condition of each bank and sovereign.
  • It engages the market's analytical capabilities for thinking through how to address bank and sovereign solvency starting from a common point of reference.  This is critically important because it is this activity that allows market participants to accept the solution that emerges as ending the solvency crisis.
  • It restores confidence going forward because market participants have access to the granular level information they need to assess the risk and reward of investing in each country's banks and the sovereign.
Professor Summers observed,
At every stage from the first signs of trouble in Greece to the spread of problems to Portugal and Ireland, to the recognition of Greece’s inability to pay its debts in full, to the rise of debt spreads in Spain and Italy, the authorities have ... done just enough beyond euro-orthodoxy to avoid an imminent collapse, but never enough to establish a sound foundation for a resumption of confidence....
The roadmap based on the FDR Framework establishes a sound foundation for the resumption of confidence in both the European banks and sovereigns.
The process has taken its toll on policymakers’ credibility.  As I warned European friends quite some time ago, authorities who assert in the face of all evidence that Greece can service on time 100 percent of its debts will have little credibility when they later assert that the fundamentals are sound in Spain and Italy, even if their view is a reasonable one.  
After the spectacle of stress tests that treat assets where credit default swaps exceed 500 basis points as riskless, how can markets do otherwise than to ignore regulators assertions about the solvency of certain key financial institutions. 
Thank you Larry for warning the European financial community about the potential to lose credibility.  This is particularly true when policymakers engage in stress tests and partial recapitalizations without meeting the disclosure standards under the FDR Framework.

I presented a similar warning to the global financial community prior to the onset of the financial crisis (see December 2007 and February 2008).  In doing so, I also outlined the reason the crisis was about to occur and the solution to resolving it which is reflected in the roadmap based on the FDR Framework.

The roadmap increases the policymakers' credibility.  It engages the market participants in the determination of who is solvent and who is not.  More importantly, it engages the market participants in the determination of how to handle those key financial institutions that are not solvent.

In the future after the data warehouse is operating, it eliminates any need for regulators publishing the results of a stress test again and the potential for loss of credibility.
A continuation of the grudging incrementalism of the last two years risks catastrophe, as what was a task of defining the parameters of too big to fail becomes a challenge of figuring out what to do when key insolvent debtors are too large to save.  
By taking the bold step of following the roadmap based on the FDR Framework, European policymakers will firmly address the issue.

Market participants know that to end the solvency crisis requires their involvement from knowing what the facts are to their using these facts to analyze alternative solutions to their input to policymakers in the selection of a the solution that ends the problem.

As Mr. Harrison said,

It was only when the US banks were partially recapitalised in 2009 after the stress tests that the panic ended. And even so, partial recapitalisation means nagging doubts about the health of some institutions like Bank of America persist. If the US economy double dips, you should expect those doubts to increase and the doubts to spread to other institutions.
Simply bailing out financial institutions and sovereigns without the accompanying disclosure required under the FDR Framework does not tell market participants if they are solvent or not and therefore does not end the crisis.

Tuesday, September 20, 2011

European regulators signaling that banks need more capital, but how much more is the question

According to an article in the Independent, European regulators are gearing up to provide more capital to their banks.

Regular readers know that providing more capital without disclosure fails to answer the question of which banks are solvent and which are not.  Like the bailouts of 2009, it leaves open the very real possibility of the markets concluding the banks are still insolvent.

By restarting the downward spiral of relying on public backstops, this recapitalization of the banks only serves to make the sovereign solvency crisis worse.
European Competition Commissioner Joaquin Almunia has admitted that more European banks may need to be recapitalised. 
As the debt crisis deepens and banks in France and Germany exposed to countries like Italy, he said: "The worsening of the sovereign debt crisis, its impact on a fragile banking system and the continuing tensions in funding markets, all point to the possible need for further recapitalisation of banks on top of the nine that failed the stress tests earlier this year," Mr Almunia said. 
The Commission is now expected to extend rules put in place at the time of the financial crisis of 2008 that will enable Governments to provide state aid to their banks after 2011, if necessary. 
"Of course, banks should first try to finance themselves on the markets, and take all possible measures like the sale of subsidiaries and limitation of dividends, before they turn to the use of public backstops, which should be used as a last resort," he added. 
"I would have preferred to go back to normal rules sooner and this was indeed my intention until the summer."
“But the situation we are facing these days calls for an extension of the existing state aid crisis regime." 

Disclosure under FDR Framework moving closer to being Volcker Rule enforcement mechanism

In an earlier post on the Volcker Rule, your humble blogger pointed out how the FDR Framework would approach the Volcker Rule and its enforcement:
[T]here is a simple regulation [regulators] could put in place that would guarantee compliance with the Volcker Rule and eliminate proprietary trading under any name by the large Wall Street firms. 
The regulators should require that the Wall Street firms disclose to all market participants at the end of each business day each and every position in their trading and investment portfolios.
As Warren Buffett would be happy to point out, this simple regulation would dramatically squash the potential profitability of proprietary trading under any name.
According to the NY Times' Dealbook article on the UBS trading scandal, it appears that regulators are leaning to adopting this approach.

As discussed in the article, the regulators are looking at creating a data warehouse to capture the trading position data.   Your humble blogger would be happy to assist in setting up and running this data warehouse.
The Delta One desks operate in a gray area, where the line is sometimes blurred between proprietary trading and client activities like market making. A bank, for example, can buy securities from one customer with the intent of selling them to another client. But if the bank holds the assets too long or lets the stake grow too large, it may look more like a proprietary trade.
“You’re never going to be able to craft a rule that permits legitimate market-making activities that our economy desperately needs while at the same time prohibiting proprietary positions,” said Mr. Seiberg of MF Global. “That’s because one man’s market making is another man’s prop trading.
Regulators are looking to make the boundaries clearer. After working on a draft of the Volcker Rule for weeks, they now agree on some of the thorniest provisions, including the definition of market making, according to a person with knowledge of the discussions.
But they are still debating how to enforce the regulation. While some are pushing for Wall Street to police itself in proprietary trading activity, the Federal Deposit Insurance Corporation and other policy makers want a tougher crackdown. The agencies could leave open the possibility of a compromise plan for banks to detail their positions to data warehouses, where regulators could keep an eye on the trading. They have also discussed whether to hold executives liable should a bank skirt the rules.
Under the proposal, the definition of market making, at least for now, largely tracks the metric laid out in an earlier report by the Financial Stability Oversight Council, according to the person close to the discussions. For example, positions held for less than 60 days would draw scrutiny, as regulators ensure that the trades are either bona fide hedges or market-making deals.
It is a tough rule to get just right. Make the regulation too broad and it could prove ineffective at keeping banks from taking on too much risk. Make it too specific, and it could crimp legitimate businesses that bolster the economy.
“The challenge for regulators is to thread that needle,” said Donald N. Lamson, a lawyer at Shearman & Sterling and a former Treasury Department official who helped write the Volcker Rule. “You have to draw a line somewhere.”
Actually, the regulators do not have to draw a line anywhere.  By requiring disclosure and sharing this data with all market participants, market discipline plus the fact that it will be harder to make money from proprietary trading when all market participants know their positions will draw the line for the regulators.

Monday, September 19, 2011

Having exhausted monetary and fiscal policy it is time to turn to regulatory policy to restore confidence

As predicted under the FDR Framework, fiscal and monetary policy have not restored confidence in either the capital markets or the economy.

Since the beginning of the solvency crisis, we have tried both fiscal stimulus and austerity (see Greece and Ireland).  Neither has restored confidence nor should they as they are tools for adjusting aggregate demand in the economy at one point in time and not for addressing solvency.

Since the beginning of the solvency crisis, we have tried policies including zero interest rate policies and quantitative easing.  None of these policies has restored confidence nor should they as they are tools for adjusting aggregate demand and not for addressing solvency.

This failure to restore confidence is not surprising, because it is regulatory policy that is the source of confidence and the tool for addressing solvency.

It is the ongoing failure of regulatory policy that is causing the solvency crisis to continue.  It is the ongoing failure of regulatory policy that undermines confidence and stymies expansionary fiscal and monetary policy.

Why has regulatory policy failed?  It has failed because the key to ending a solvency crisis is answering the question of who is solvent and who is insolvent.  This question is the starting point for determining how to address the insolvent banks and sovereigns.

In their defense, the global financial regulators would say that they have adopted policies to answer the question of who is solvent and who is insolvent.  They have engaged in bank recapitalization and stress tests.

These policies were predestined to fail in the absence of the ability of market participants to Trust but Verify.

Why should market participants trust the regulators given their pre- and post- solvency crisis track record?  Before the solvency crisis, the regulators failed to fulfill their number one responsibility of preventing the crisis from occurring in the first place.  Since the beginning of the solvency crisis, regulators have run stress tests that have been discredited shortly after the results were announced.

As predicted under the FDR Framework, it is only by providing market participants with access to each bank's current asset and liability-level data and each structured finance security's current loan-level performance data that the question of who is solvent and who is insolvent can be answered.
  • It is only when market participants have this data that they can value the structured finance securities.  
  • It is only when market participants can value the structured finance securities and all the assets on each bank's balance sheet that they can determine which banks are solvent and which are not.
The reason that market participants must analyze this granular level data for themselves is that it is the only way for them to trust their valuation.  It is this trust in their own valuations that is the source of confidence in both the capital markets and the economy.
  • It is only after doing this analysis that market participants have assessed the risk of an investment in the banking system and are willing to be responsible for all gains or losses on any new investments they make in bank related securities.  
  • It is only when market participants have the confidence to invest in the banking system that they have confidence to invest in the economy.
Until market participants have access to current asset and liability-level data or are promised that they will get this level of disclosure, confidence will continue to deteriorate as the market participants assume that policy makers and regulators must have something to hide.

If market participants cannot have confidence in their banking system, it is impossible for them to have confidence in their economies.

Sunday, September 18, 2011

FDR Framework 101

A Bloomberg article reports that
European banks are “grossly under- capitalized” and the debt crisis is more serious for the region than the 2008 meltdown as governments are constrained by fiscal pressures, former U.K. Prime Minister Gordon Brown said. 
“In 2008, governments could intervene to sort out the problems of banks,” Brown said at the World Economic Forum in the Chinese port city of Dalian today. “In 2011, banks have problems, but so too do governments.” 
Investor skittishness over Europe’s sovereign debt crisis raised lenders’ funding costs and caused a rout in the region’s banking stocks this month. European Central Bank President Jean- Claude Trichet pressed euro-area governments late yesterday to take decisive action to restore confidence after the ECB extended an emergency lifeline to lenders. 
Brown said that while the ECB is part of the short-term solution, it needs additional assistance. 
The European Financial Stabilization Mechanism, which is run by the European Union’s 27-nation executive arm, is “not enough,” Brown said. “Substantially more resources” are required, including from the International Monetary Fund and lenders including China, he said....
“European banks as a whole are grossly under- capitalized,” Brown said. “We’ve now got the interplay between banks that are not properly capitalized and sovereign debt problems that have arisen partly because we’ve socialized or accepted responsibility for the banks’ liabilities.”
With this background in mind, a quick review of the FDR Framework and how it could restore confidence and help to address the bank and country solvency problems in Europe is useful.

The FDR Framework gets its name from both the President, Franklin Delano Roosevelt, whose administration introduced the philosophy of disclosure to the capital markets and from the framework's focus on financial disclosure requirements.

FDR introduced disclosure of all the useful, relevant information in an appropriate, timely manner to accomplish two linked goals.  First, to restore confidence in the markets.  Second, to keep the government out of making investment recommendations.  Disclosure achieves both of these goals because it allows market participants to analyze the information disclosed for themselves to assess the risk and reward of any investment.

There was one part of the financial system that disclosure could not be introduced to:  banking.  Simply put, without access to 21st century information technology, it is not possible to disclose to all market participants each bank's current asset and liability-level data (all the useful, relevant information) in an appropriate, timely manner.

Instead, his administration set up a system where the government both regulated and supervised the banks.  Included in bank supervision was the idea of bank examiners having access to and looking at the current asset and liability-level data 24/7/365.

Unfortunately, the lack of disclosure also meant that the market participants were dependent on the bank regulators to properly analyze the risk of each bank and convey it to the market.

Besides the historically opaque banks, there was another source of opacity in the financial system.  That source was Wall Street and the products it developed.  As Yves Smith observed on NakedCapitalism, no one on Wall Street was paid for developing low margin, transparent products.

Examples of opaque products Wall Street developed include structured finance securities and exchange traded funds.  While both are conceptually simple, that was before Wall Street engineered opacity into the information needed to value these products.  Neither of these products provide investors with all the useful, relevant information on the underlying "assets" in an appropriate, timely manner so that investors can value the product.

The FDR Framework is the backbone for a financial system based on using 21st century information technology both to facilitate disclosure and the analysis of the disclosure.

Under this framework, governments are responsible for ensuring that every market participants can access all the useful, relevant information in an appropriate, timely manner.  This includes current asset and liability-level data for banks.

Under this framework, market participants have an incentive to assess each investment using the disclosed information because, under the principle of caveat emptor, they are responsible for any gains or losses on the investment.

Previously, this blog discussed how using the FDR Framework, policymakers and regulators in Europe could restore confidence and address the issue of bank and sovereign solvency.  This involves two steps.

Step one is for the policymakers and regulators to issue a statement that describes what the actual condition of each bank is providing as needed the hard facts to back up the analysis (this is something that Societe Generale did recently in a bid to restore confidence).

Step two is for the policymakers and regulators to promise and implement utter transparency (set up a data warehouse where all market participants can access the current asset and liability-level data for each bank).

Setting up this data warehouse is critically important, because market participants will put far more faith in the analysis if they see that the data is going to be released that confirms or debunks the analysis.  The market is likely to give the analysis the benefit of the doubt because not releasing the data suggest there is something to hide.