Bank regulators trigger credit crunch that central banks to try to head off

In a classic case of regulators acting as a source of financial instability, the Eurozone bank regulators decided that Eurozone banks should prove their solvency by achieving a 9% Tier 1 ratio.

Eurozone banks, seeing that any common equity offering would be highly dilutive, responded by shedding assets (the denominator in the ratio).  Assets shed included sovereign debt from countries experience financial difficulties and loans.

Most of this has been achieved by allowing the assets to mature and not rolling them over.  After all, when everyone is a seller, the question is who is the buyer.  The rapid increase in the interest rate that troubled sovereigns have to pay to issue debt is a sign of how few buyers there are.

Another way that banks have reduced their assets is by slowing down the pace at which they originate and book new loans.  Unfortunately, this has a significant impact on the real economy -- namely, a credit crunch.

Oh, by the way, all this activity by the banks does nothing to prove that they are solvent.  The bad assets on the bank's books are still there.

Why?  Since the beginning of the solvency crisis, financial regulators have allowed banks to engage in a wide variety of practices that kept the banks from having to mark down the assets -- examples of these practices include securities being marked to model as well as extend and pretend being applied to loans.

Selling these assets today would cause the bank to incur losses.  These losses would make it harder to achieve the 9% Tier I capital ratio.

In a preverse way, by requiring Eurozone banks to achieve a 9% Tier I capital ratio, regulators have actually made the banks riskier.  The assets that the banks are busily selling, not rolling over will tend to be their better performing assets.

Truly, there is nothing good coming out of the 9% Tier I capital ratio policy.

As the Guardian reports, the global central banks have responded to try to head off the problems caused by this policy.

Central banks from around the world have announced emergency measures to boost liquidity in the global economy and prevent the financial system from freezing up. 

In a clear sign that policymakers fear the downturn in the eurozone risks spiralling into a fresh credit crunch – where banks stop lending to each other – they announced "co-ordinated central bank action to address pressures in global money markets". 

The Bank of England joined the Federal Reserve, the Bank of Japan, the ECB, the Bank of Canada and the Swiss National Bank in taking the measures ....  cut the price of emergency dollar loans to cash-strapped banks by 0.5 percentage points, and extend the scheme until February 2013. 

They will also establish "temporary bilateral liquidity swap arrangements" between one central bank and another, allowing liquidity to be provided at short notice in any currency "should market conditions so warrant"....

The central bankers fear that if financial institutions rein in credit, it will hit ordinary consumers and businesses, and threaten a double-dip recession in the world economy. 

"The purpose of these actions is to ease strains in financial markets and thereby mitigate the effects of such strains on the supply of credit to households and businesses and so help foster economic activity," they said in a joint statement. 

Separately, the ECB, which has come under intense pressure in recent weeks over its role in the deteriorating eurozone crisis, said it would now be able to provide liquidity to struggling banks in yen, sterling, Swiss francs and Canadian dollars if necessary. 

Central banks have become increasingly nervous in recent days as declining confidence in the health of the euro, and of many major banks in the single currency zone, has pushed up the cost of funding for banks whose balance sheets have already been ravaged by the credit crunch and the recession. 

Central banks respond to solvency crisis with more liquidity

Just like 2008, the global central banks have once again responded to a solvency crisis with massive quantities of liquidity.

In 2008, their response was to the interbank lending market freezing over because banks would not lend to each other because they could not determine if the borrower was solvent or not.

Today, their response was to the interbank lending market freezing over because once again banks are refusing to lend to each other because they cannot tell if the borrower is solvent or not.

I wonder if this time the central bankers will put pressure on the policymakers to require banks to disclose on an on-going basis their current asset, liability and off-balance sheet exposure details so that solvency can be assessed.

UK homeowners reduce mortgages by most since at least 1970

A Telegraph article reports that UK homeowners paid back their mortgages by the most since at least 1970.

Regular readers understand that this reflects the low interest rate policies being pursued by the global central banks.

When individuals compare investment options, they see that paying down their mortgage offers a much higher return at much lower risk than any alternative.  This is particularly true outside of the US where there is recourse to the borrower until the mortgage has been paid off.

Home owners paid back £9.15bn more than they took out from their mortgage in the three months to the end of June, the figures showed. This was the most consumers have ever paid back in a three-month period since at least 1970, when the Bank of England started collecting data. 

Until the financial crisis families have – with a few exceptions – regularly remortgaged their homes and used the money to fund holidays, new cars, school fees or other big purchases. 

Housing equity withdrawal, as it is technically called, is one of the most important drivers of the economy because the money unlocked from property then ends up boosting consumer spending. 

During the housing boom of the 1980s and also over the last ten years, billions of pounds were taken out each month and then pumped back into the high street economy. 

However, with house prices hardly budging in the last three years, with the exception of central London, there has been little incentive for home owners to remortgage their properties. Even those that might have wanted to have struggled to find a bank willing to undertake the transaction. 

Housing equity withdrawal has been in negative territory for 13 consecutive quarters. 

Since June 2008, a total £92.9bn has now been paid back by home owners, a vast sum that has failed to enter the consumer economy, explaining why so many high street shops, restaurants and travel companies have been feeling the pinch. 

Economists pointed out that while the record figure was bad for the economy, the money was being used to pay back mortgages – a sensible move for many indebted families on an individual level, a sign of how nervous they were about the future.... 

Howard Archer at IHS Global Insight, said: "... extremely low savings interest rates have made it much more attractive for many people to use any spare funds that they have to reduce their mortgages. In particular, many people may be using the extra money that is resulting from their very low mortgage interest payments to reduce the balance that they still owe on their houses."

So individuals are taking advantage of the reduction in their monthly payments from refinancing their mortgages to pay down their mortgage debt faster. 

Wall Street's Opacity Protection Team meets Judge Rakoff [update]

In a MarketWatch article, A new era of Wall Street transparency, U.S. District Judge Jed Rakoff takes on Wall Street's Opacity Protection Team.

“In any case like this that touches on the transparency of financial markets whose gyrations have so depressed our economy and debilitated our lives, there is an overriding public interest in knowing the truth. In much of the world, propaganda reigns, and truth is confined to secretive, fearful whispers,” the judge wrote. 

“Even in our nation, apologists for suppressing or obscuring the truth may always be found.

Judge Rakoff calls out Wall Street's Opacity Protection Team.

But the SEC, of all agencies, has a duty, inherent in its statutory mission, to see that the truth emerges; and if fails to do so, this Court must not, in the name of deference or convenience, grant judicial enforcement to the agency’s contrivances.”

It is the SEC that was set up to ensure that market participants have access to all the useful, relevant information in an appropriate, timely manner so that the risk of any investment can be fully assessed prior to making the investment decision.

The SEC defended the settlement it reached with the bank....

In defending its actions, the SEC confirms the late Mark Pittman's observation that the regulators are members of Wall Street's Opacity Protection Team.

“The court’s criticism that the settlement does not require an ‘admission’ to wrongful conduct disregards the fact that obtaining disgorgement, monetary penalties, and mandatory business reforms may significantly outweigh the absence of an admission when that relief is obtained promptly and without the risks, delay, and resources required at trial....”

The SEC focuses on what is essentially a cost of doing business for a Wall Street firm.  It ignores the fact that the SEC had reached prior settlements with the bank that included mandatory business reforms that, if implemented, would have prevented the sale of the security which gave rise to the proposed settlement.

Rakoff’s ruling is likely to have far-reaching ramifications on Wall Street and at the SEC. 

The consent judgment settlement reached between Citi and the regulatory body, in which Citi had the ability to neither admit to any wrongdoing nor deny the allegations held against it, was a common one that the SEC typically reached with firms that it accused of wrongdoing.... 

The fact that this type of settlement is commonly used by the SEC does not mean that it is a good practice.

In fact, using it frequently makes this type of settlement look like the equivalent of a parking ticket.  As everyone knows, parking tickets are at best a nuisance and do not change people's behavior.

If Rakoff’s ruling proves to be popular in the public sphere, then it is possible that other judges might start scrutinizing settlements between the SEC and Wall Street firms more closely, and the SEC would also be compelled to be stricter in its discipline of firms who flout rules.

I can only hope that the ruling is extremely popular in the public sphere.

This ruling shows the degree of regulatory capture that has occurred at the SEC.  The SEC needs to be compelled to be stricter in its discipline of firms who flout its rules.

As Adam Sorensen of Time magazine notes: 

“Rakoff’s ruling is one small dose of exactly what Wall Street’s critics have been hankering for. 

The conflict ... is basically over whether securitization fraud cases will get swept under the rug. 

And you’d be hard pressed to find a realistic outcome more appealing to protesters hoisting ‘Jail the Banksters’ signs in Zuccotti Park than a public fraud trial for a major Wall Street institution and a rebuke to what Occupiers see as an overly sympathetic federal government. 

Judge Rakoff just gave them both of those things.”

That being said, it is still unlikely that the facts of the Citi fraud case will be uncovered, even though a trial date of July 16, 2012 has been set.

Of course, Citi will just agree to pay a bigger fine for its parking ticket.  There is precedence for paying a bigger fine and that is why SEC settlements are simply a cost of doing business as opposed to being a tool to bring about changes in the conduct of business.

In 2009, the SEC sued Bank of America (NYSE:BAC) , claiming that the bank had lied to shareholders about bonuses paid out to Merrill Lynch executives when it sought approval to acquire the troubled firm. The agency reached a $33 million settlement, which Rakoff first rejected. However, the judge later relented and approved a $150 million settlement in February 2010, even though he said the agreement was “half-baked justice at best.” 

If history is to repeat itself, what will probably happen is that the SEC will increase the penalty Citi has to pay — perhaps an amount closer to the $550 million Goldman coughed up — and Rakoff will approve the new settlement. 

Then again, populist anger toward big banks has grown since the SEC-Bank of America settlement last year, as exemplified by the nationwide Occupy movement, and perhaps Rakoff, augmented by the pro-transparency public sentiment and a growing public profile as a take-no-nonsense judge, will insist on holding the SEC and Citi accountable to the public this time around.

Clearly, this is what it is going to take if Wall Street's Opacity Protection Team is ever going to be defeated.

Update
Jesse Eisinger wrote an article in ProPublica that also addressed how Wall Street views fines from regulators.

I asked Richard Kramer, who used to work as a technology analyst at Goldman Sachs until he got fed up with how it did business and now runs his own firm, Arete Research, what was going wrong. He sees it as part of the business model. 

“There have been repeated fines and malfeasance at literally all the investment banks, but it doesn’t seem to affect their behavior much,” he said. “So I have to conclude it is part of strategy as simple cost/benefit analysis, that fines and legal costs are a small price to pay for the profits.”

Always nice to get confirmation of my analysis and the need for transparency as the solution.

MF Global highlights need for disclosing asset, liability and off-balance sheet exposure details

A Bloomberg article discusses the role played by the Board of Directors and complicated disclosure in MF Global's demise.

Regular readers know that market participants need financial firms to disclose on an on-going basis their current asset, liability and off-balance sheet exposures if the market participants are going to be able to assess the risk of the financial firm.

Rather than offer ultra transparency, the article describes how MF Global's disclosure failed to lift any of the opacity surrounding the trades.

MF Global’s regulatory filings don’t give dollar amounts for the gross purchases of European sovereign debt or for the hedges. Instead, the investments are shown as percentages of a bigger base of assets, leaving investors to calculate the numbers themselves. Those assets are reported on a market-value basis. 

The firm in filings and an October investor presentation disclosed the net amount at risk from its European bonds after hedges. Neither the presentation nor regulatory filings explained that the hedges matured before the bonds and thus would have to periodically be renewed....

MF Global disclosed in a May 20 filing that its net holdings among the five European countries consisted of $6.3 billion in debt at the end of March that had an average maturity of April 2012. 

The company said in the Aug. 3 filing that its European sovereign portfolio had risen to $6.4 billion of debt with an average maturity of October 2012. 

In both instances, MF Global said the figures were “net of hedging transactions the company has undertaken to mitigate issuer risk.” 

While reporting its net holdings had increased 2 percent, MF Global had expanded its bets to $11.5 billion as of June 30 from $7.64 billion as of March 31, according to data contained in the SEC filings. The firm didn’t quantify its holdings at the end of 2010. 

The firm’s hedges, known as reverse repurchase agreements, jumped to $4.93 billion at June 30 from $1.08 billion as of March 31, the data show. 

Revenue from the European sovereign trades was about $47 million during the fiscal fourth quarter ended March 31, or 16 percent of net revenue, and $38 million, or 12 percent, in the following quarter, according to an October investor presentation.

This lack of useful disclosure meant that MF Global's management was not constrained by market discipline -- market discipline would have taken the form of investors reducing their exposure to the firm and increasing the cost of funds to the firm as MF Global increased its risk.

Instead, MF Global was dependent on its Board of Directors.

Although the trades didn’t require pre-approval by the board, directors (MF) later questioned Corzine’s investment, according to a person familiar with the discussions. 

After challenging the size of the bets and the concentration on a small number of countries, the board set dollar limits on the amount of sovereign debt its chairman could buy. 

Corzine came back to the board at least once to get the ceiling raised. 

At multiple meetings, Corzine reassured directors that the trades would work out, said the person, who asked not to be identified because the discussions were private. 

Corzine said the European countries he selected wouldn’t default before the bonds matured, and that the market was mis-pricing the debt, according to the person. Underpinning Corzine’s view was the euro zone’s European Financial Stability Facility, which could backstop government short-term debt through June 30, 2013. 

Some risk managers and traders at MF Global shared the directors’ concerns, according to a former employee with knowledge of the matter. The risk-management department began asking for daily prices of credit-default swaps on sovereign debt to keep track of how the market viewed the underlying bonds, a second person said. 

The demise of MF Global, which was spun off from fund manager Man Group Plc in 2007, shows how Corzine’s stature made it hard for the board or underlings to oppose him, even as the crisis in Europe deepened. 

Directors believed that rejecting the trades would have been an affront to the veteran trader and would have been tantamount to firing him, said the person familiar with the board’s deliberations. 

The trades could have been rejected had there been market discipline.  Investors selling the stock as MF Global's risk increased would have been the equivalent of firing Corzine.

“This was a board that could not possibly have been more expert in exposure to risk, a board with at least as much, if not more, expertise than the CEO,” said Jeffrey Sonnenfeld, senior associate dean at the Yale University School of Management in New Haven, Connecticut, and founder of a nonprofit educational and research institute focused on CEO leadership and corporate governance. “This was an example of people not having the courage to stand up to the CEO.”

The failure to stand up to the CEO would not have been a problem if there had been ultra transparency as that would have permitted the market to exert market discipline on the CEO.

Run on the Greek banks accelerates prior to new government's arrival

A Bloomberg article describes the on-going deposit run on the Greek banks.

Greek political instability spurred an acceleration of bank withdrawals, with the decline stemmed by the appointment of a new government this month. 

Greek banks saw an outflow in deposits of about 13 billion euros to 14 billion euros ($18.7 billion) in the two months to the end of October, said George Provopoulos, the head of the central bank and a member of the European Central Bank Governing Council. Deposits totaled 183.2 billion euros at the end of September. 

“One could say these two, two and a half months have been the worst for deposits since the start of the crisis,” Provopoulos told lawmakers in Athens today. He said the decline continued in early November and has since stabilized. 

The comments indicate that as much as 8.6 billion euros moved out of the Greek banking system in October alone, since the central bank had reported a 5.4 billion-euro outflow in September. The September figure was the biggest one-month decline since Greece joined the euro as doubts surfaced about the country’s ability to meet the terms of an EU-led bailout. 

Prime Minister Lucas Papademos, a former vice president of the European Central Bank and former head of the Greek central bank, was sworn in on Nov. 11, after former Prime Minister George Papandreou’s bid to hold a referendum on the second financing package angered EU leaders, leading to a freeze on payments and throwing markets into disarray.

How Paulson gave hedge funds advance word

Bloomberg has another terrific article on the problem with regulators having a monopoly on the useful, relevant information for financial institutions.

In this case, the article discusses a meeting between then US Treasury Secretary Hank Paulson and a group of hedge fund managers.  At the meeting, Paulson discussed Fannie Mae, Freddie Mac and the possibility that the government might put them into receivership.

The reason that I highlighted the article are the following paragraphs

Morgan Stanley and BlackRock Inc. both helped the Federal Reserve and OCC prepare the reports on Fannie Mae and Freddie Mac that Paulson told the New York Times would instill confidence the morning of [July 21, 2008 when he and hedge fund managers attended] the Eton Park meeting.

Paulson learned by mid-August that the Federal Reserve had found the GSEs “unsafe and unsound,” he told the Financial Crisis Inquiry Commission, which was appointed by President Barack Obama and Congress to probe the causes of the financial collapse. 

“We’d been prepared for bad news, but the extent of the problems was startling,” he wrote in “On the Brink.”

The Federal Reserve and the OCC had Morgan Stanley and BlackRock Inc. prepare reports on Fannie Mae and Freddie Mac with the intent of instilling confidence in the market.

Why exactly are the Federal Reserve and OCC having reports written to instill market confidence?

This blog has repeatedly said that the only way to instill market confidence is to disclose all the useful, relevant information in an appropriate, timely manner.  Market confidence flows from market participants being able to use this information to independently assess the risk of an exposure.

The fact that the Federal Reserve and OCC were in a position to consider having these reports written is a function of the fact that the regulators' monopoly on all the useful, relevant information meant that there was inadequate disclosure to market participants.

Like all financial institutions, Fannie Mae and Freddie Mac should be required to disclose on an on-going basis their current asset, liability and off-balance sheet exposure details.

Mr. Paulson confirms that there was a regulatory failure to properly assess the information from Fannie Mae and Freddie Mac on which the regulators have a monopoly.

This is another problem that would be resolved with ultra transparency.  The market participants could help the regulator by providing them with their assessments.

Wall Street's Opacity Protection Team and Mark Pittman

In a wonderful tribute to Mark Pittman, Bob Ivry wrote a Bloomberg article describing the triumph of a single person (backed by the Bloomberg news organization) over the Federal Reserve.

Mark was not a random reporter to me.  He was someone I had dined and exchanged ideas with (either by phone or email).

Several weeks prior to his death, we had our last telephone conversation.  The focus of the conversation was Wall Street's Opacity Protection Team.

I was pointing out all the different ways that Wall Street was preventing transparency from occurring in the structured finance market (regular readers know that disclosure of the current underlying collateral performance is necessary if investors are going to know what they own and be able to value it).

Mark pointed out that the Opacity Protection Team extended well beyond Wall Street and included its regulators.

He talked about where he was in the pursuit of the Fed's bailout data and how the Fed lent new meaning to the term significant, well-financed resistance to disclosure.

He concluded our conversation by observing that with only the two of us pursuing disclosure Wall Street's Opacity Protection Team would win.

Mark, I am glad that Bloomberg News carried your quest to the finish line.  I suspect I am going to need the 99% to carry my quest for disclosure to the finish line.

One legacy of the release of the Federal Reserve’s bailout data was the triumph of a single person over the most powerful bank in the world. 

Bloomberg News’s Mark Pittman, a hulking former cop reporter from Kansas with equal love for spreadsheets and beer chasers, filed a Freedom of Information Act request with the Fed in May 2008. He asked for details of the emergency-lending programs that were then just under way. It’s the taxpayers’ money, Pittman argued. They ought to know where it’s going. 

The Fed resisted, and along with a group of the biggest U.S. banks called Clearing House Association LLC, waged a legal battle that in March 2011 reached the U.S. Supreme Court, which refused to rule against lower courts that ordered the release. 

Pittman wasn’t around to celebrate....

Pittman had a favorite joke he’d tell about the bailouts, which he believed were futile because by preserving the status quo they presumed that, without incentive to change, things would be different next time. Bankers would be prudent, regulators would be firm and the public good would be served. 

It went like this: A guy borrows money from a loan shark. When he doesn’t pay up, two goons visit him one evening at home, where he’s eating dinner with his wife. 

“Give me one more day,” the guy tells the debt collectors. “I have a dog that talks, and tomorrow I’m going to make a bunch of money from my talking dog.” 

The goons accept this, vowing to return for the money the next evening. 

After they leave, the guy’s wife looks at him like he’s nuts. 

“What will you do when they come back?” she asks her husband. 

The guy shrugs and says, “Maybe tomorrow the dog will talk.”

Regulatory discretion and lying about the financial condition of banks

The financial regulators, including the Fed, have proved once again that the cover-up is worse than the initial problem.

The number one responsibility of financial regulators is to ensure the safety and soundness of the financial system.  The financial crisis showed a significant failure of regulatory supervision in performing this responsibility.

In two must read articles, the NY Times and Bloomberg have documented how the financial regulators used regulatory discretion to cover-up this failure with the results being that banks lied about their financial condition to the market.  

• The NY Times article by Gretchen Morgenson and Louise Story reveals that the Office of Thrift Supervision oversaw IndyMac mis-stating its capital.

• The Bloomberg article by Bob Ivry reveals that the Fed provided the banking industry with secret below market price loans at the same time bank executives were representing how healthy they were to the financial markets.

Regular readers know that trust in our financial system is built on disclosure.  Specifically, it is built on the idea that market participants will have access to all the useful, relevant information in an appropriate, timely manner.

This information, which auditors certify as accurate, is used by market participants to independently assess the risk of an investment and to adjust the amount and price of any exposure.

Here we have specific examples where regulators blessed mis-representations that were substituted for the useful, relevant information.  Doing so directly undermined trust and confidence in the financial system.

In fact, given the regulators' willingness to bless mis-represent of the financial condition of the banks in 2008-2009, how do we know that anything banks say about their financial condition today is true?

Regulators were provided with discretion when it comes to the timing of when they close a financial institution.  As this blog has repeatedly observed, so long as a bank's deposits are insured and the central bank is willing to lend against good collateral, an insolvent bank can remain open indefinitely.

Regulators were not provided with discretion when it comes to disclosing the true financial condition of the banks.  

The introduction of deposit insurance and increased regulatory oversight following the Great Depression did not change that fact that disclosure of all the accounts fit to print was still the sign of a bank that could stand on its own two feet.  

If we are ever going to restore trust and confidence in the financial system, we must require that all banks provide ultra transparency.  The banks must disclose on an on-going basis their current asset, liability and off-balance sheet exposure details.

Until this is done, there is no reason to believe that the financial disclosures being made by the banks represent anything other than some rosy scenario dreamt up by the financial regulators.

Secret Fed bank loans make definitive case for requiring the financial system be based on ultra transparency

Bob Ivry wrote a must read article for Bloomberg on how secret Fed loans during 2008-2009 gave banks an undisclosed $13 billion boost to income.  As Mr. Ivry observes, 'a fresh narrative of the financial crisis emerges' when actions by the Fed, like the loans, are examined.

In fact, the narrative that emerges is my narrative on an opacity driven solvency crisis where the only way to fix the financial system is to require ultra transparency from all market participants, including banks and the Federal Reserve.

These loans illustrate everything that is wrong with the current financial system including:

• The opacity of banks.  This blog has frequently cited Bank of England's Andy Haldane referring to banks as 'black boxes'.
• As documented by the Financial Crisis Inquiry Committee, the crisis began with banks asking the question of which banks are solvent and which are not.  Clearly, there was inadequate disclosure.  The fact that the Fed could make secret loans confirms this inadequacy and the need for banks to disclose on an on-going basis their current asset, liability and off-balance sheet exposure details.
• The reason that banks were asking about solvency was the exposure of banks to opaque, toxic securities -- CDOs, sub-prime mortgage backed securities.  Clearly, ultra transparency needs to be applied to these securities too.

• The relationship between banks and their regulators.  
• In a NY Times article, Gretchen Morgenson and Louise Story covered how the Office of Thrift Supervision advised IndyMac to misrepresent its capital to market participants.  How is offering secret loans to the banks any different than advising the banks to misrepresent their capital to market participants?
• The Nyberg Report on the Irish Financial Crisis showed how even when a member of the regulatory body saw that something was wrong, the regulatory bureaucracy pushed to suppress this finding.  Contributing to this result was both political pressure on the regulator and lobbying from the banks.

• The dependence of market participants on the regulators because of the regulators' information monopoly.
• Unlike every other market participant, banks are not a black box to financial regulators as they have access to all the useful, relevant information.  This includes access to the bank's current asset, liability and off-balance sheet exposure details.  The result of this access is that market participants rely on the regulators to properly assess the risk of the bank and to communicate this risk to the market.
• The moral obligation to bailout investors after each round of stress tests where the banks are deemed to be solvent.

I could go on, but the more the facts behind what caused the financial crisis and how the crisis was handled come out, the stronger is the case for requiring ultra transparency.

The Federal Reserve and the big banks fought for more than two years to keep details of the largest bailout in U.S. history a secret. Now, the rest of the world can see what it was missing. 

The Fed didn’t tell anyone which banks were in trouble so deep they required a combined $1.2 trillion on Dec. 5, 2008, their single neediest day. 

Bankers didn’t mention that they took tens of billions of dollars in emergency loans at the same time they were assuring investors their firms were healthy. 

And no one calculated until now that banks reaped an estimated $13 billion of income by taking advantage of the Fed’s below-market rates, Bloomberg Markets magazine reports in its January issue. 

Saved by the bailout, bankers lobbied against government regulations, a job made easier by the Fed, which never disclosed the details of the rescue to lawmakers even as Congress doled out more money and debated new rules aimed at preventing the next collapse. 

A fresh narrative of the financial crisis of 2007 to 2009 emerges from 29,000 pages of Fed documents obtained under the Freedom of Information Act and central bank records of more than 21,000 transactions 

While Fed officials say that almost all of the loans were repaid and there have been no losses, details suggest taxpayers paid a price beyond dollars as the secret funding helped preserve a broken status quo and enabled the biggest banks to grow even bigger....

The size of the bailout came to light after Bloomberg LP, the parent of Bloomberg News, won a court case against the Fed and a group of the biggest U.S. banks called Clearing House Association LLC to force lending details into the open. 

The Fed, headed by Chairman Ben S. Bernanke, argued that revealing borrower details would create a stigma -- investors and counterparties would shun firms that used the central bank as lender of last resort -- and that needy institutions would be reluctant to borrow in the next crisis....

Here we have the major bank regulator in the US arguing for opacity.  Chairman Bernanke takes the position that market participants should not know the true condition of the banks because if they did the market participants might properly assess the risk of the banks and adjust the amount and price of their exposure accordingly.

Think of how absurd a position that is for the Chairman of the Federal Reserve to be arguing.  Particularly one who is a scholar of the Great Depression and the introduction by FDR of a financial system based on transparency.

There is only one way to prevent any Fed Chairman from ever being in a position for making this argument again and that is requiring ultra transparency.

Had ultra transparency existed for the structured finance securities, CDOs like Abacus could never have been sold.

Had ultra transparency existed for banks, market discipline would have restricted casino banking activities to what a bank could have afforded to lose.  If the bank insisted on taking more risk than this, its cost of funds would have gone up and its access to funds down as investors adjusted their exposure to reflect the risk of the bank.

Had ultra transparency existed for the Fed, it would never have violated Walter Bagehot's advice to lend against good collateral at high rates of interest.  There would not have been a $13 billion gift from the Fed to the banks.

Bankers didn’t disclose the extent of their borrowing. 

On Nov. 26, 2008, then-Bank of America (BAC) Corp. Chief Executive Officer Kenneth D. Lewis wrote to shareholders that he headed “one of the strongest and most stable major banks in the world.” He didn’t say that his Charlotte, North Carolina-based firm owed the central bank $86 billion that day....

Is this a fundamental misrepresentation similar to the advice of the Office of Thrift Supervision to IndyMac on its capital?

With ultra transparency, regulators are permanently blocked from inadvertently supporting misrepresentations to the financial markets.  Market participants could have seen that BofA was borrowing from the Fed and that IndyMac did not have adequate capital.

The Fed has been lending money to banks through its so- called discount window since just after its founding in 1913. Starting in August 2007, when confidence in banks began to wane, it created a variety of ways to bolster the financial system with cash or easily traded securities. 

By the end of 2008, the central bank had established or expanded 11 lending facilities catering to banks, securities firms and corporations that couldn’t get short-term loans from their usual sources.

“Supporting financial-market stability in times of extreme market stress is a core function of central banks,” says William B. English, director of the Fed’s Division of Monetary Affairs. “Our lending programs served to prevent a collapse of the financial system and to keep credit flowing to American families and businesses.”...

As regular readers know, restoring and maintaining confidence in banks comes from providing market participants with access to ultra transparency so that the market participants can independently analyze each bank.

None of the lending programs engaged in by the Fed restored confidence.  This is supported by the fact that the Fed announced that its late 2011 round of stress tests is designed to restore confidence.

As previously discussed on this blog, all the Fed's latest stress tests will do is create a moral obligation for the Fed to bailout investors.  After all, investors cannot be expected to incur losses on a bank that is reported as solvent under the Fed's stress tests subsequently blows up ... look at the need to bailout the investors in Dexia after the latest round of European stress tests found it adequately capitalized.

While the emergency response prevented financial collapse, the Fed shouldn’t have allowed conditions to get to that point, says Joshua Rosner, a banking analyst with Graham Fisher & Co. in New York who predicted problems from lax mortgage underwriting as far back as 2001. 

The Fed, the primary supervisor for large financial companies, should have been more vigilant as the housing bubble formed, and the scale of its lending shows the “supervision of the banks prior to the crisis was far worse than we had imagined,” Rosner says.

Ultra transparency is needed so that the failure of bank supervision no longer puts the financial system at risk.

With ultra transparency, market participants are no longer reliant on the regulators to properly assess the risk of the banks.  Market participants can assess the risk for themselves.

“I believe that the Fed should have independence in conducting highly technical monetary policy, but when they are putting taxpayer resources at risk, we need transparency and accountability,” says Alabama Senator Richard Shelby, the top Republican on the Senate Banking Committee....

So Senator Shelby when can I expect a call from your staff to discuss legislation bringing ultra transparency to the financial markets before December 31, 2011?

“Some might claim that the Fed was picking winners and losers, but what the Fed was doing was exercising its professional regulatory discretion,” says John Dearie, a former speechwriter at the New York Fed who’s now executive vice president for policy at the Financial Services Forum, a Washington-based group consisting of the CEOs of 20 of the world’s biggest financial firms. “The Fed clearly felt it had what it needed within the requirements of the law to continue to lend to Bear and Wachovia.”

Ultra transparency ends regulatory discretion of picking winners and losers.  That is the job of the market.

On May 4, 2010, Geithner visited Kaufman in his Capitol Hill office .... At the meeting with Kaufman, Geithner argued that the issue of limiting bank size was too complex for Congress and that people who know the markets should handle these decisions, Kaufman says....

Provide ultra transparency and banks will come under enormous pressure from the market to reduce their risk and shrink their asset base.  It will also be harder for them to run their casino banking business because everyone can see their proprietary positions ... a trader's worse nightmare because of the potential to be front run when buying or selling.

Dean Baker, co-director of the Center for Economic and Policy Research in Washington, says banks “were either in bad shape or taking advantage of the Fed giving them a good deal. The former contradicts their public statements. The latter -- getting loans at below-market rates during a financial crisis -- is quite a gift.”...

Regardless of which one, requiring ultra transparency eliminates this from occurring again in the future.

Canadian bank regulator shows why regulators' information monopoly must be ended

A Reuter's article reports on the push by global financial regulators to get every bank to calculate capital in the same way.

There is a simpler solution.  Require each bank on an on-going basis to disclose its current asset, liabilities and off-balance sheet exposure details.  Market participants will calculate each bank's capital ratios instead in a highly consistent manner.

Global regulators must step up supervision of how so-called Basel III bank standards are implemented in order to ensure a level playing field among lenders, the head of Canada's banking watchdog said on Wednesday. 

Julie Dickson, who heads the Office of the Superintendent of Financial Institutions (OSFI), said the regulator has been emphasizing internationally that capital rules must be accompanied by "intensive supervision" to be effective and that there was an effort underway to increase scrutiny. 

"It's been agreed that we're going to try to assess whether global banks, if given the same portfolio, would come up with the same capital," she told the Senate Standing Committee on Banking, Trade and Commerce. 

"That's going to be very difficult to do, but it's on the radar screen and a huge amount of effort will go into that in the coming months." 

Dickson said she has told Canadian banks that they should be prepared to meet the new standards, which toughen rules on how much capital and liquidity they must hold, by the first quarter of 2013 rather than 2019 as laid out by the agreement. 

"Canadian banks are currently well-positioned to meet or exceed this expectation," she said.
But she acknowledged that there were questions as to whether or how quickly some other countries would implement the rules, due the weak economic outlook in Europe and the United States. 

She said that was why Basel III has a very long transition period, but she added: "We're very, very focused on this. We want other countries to implement because that's how you get a level playing field." 

The spreading European sovereign debt crisis has wrought havoc with the region's banks, and Dickson noted that markets were concerned that Europe's plan for a 106 billion euro ($141 billion) recapitalization of its banks may not be enough. 

"The market is speaking to some extent, so there are some concerns about the European banking system," she told reporters after her testimony. 

"The IMF had talked about to 200 to 300 billion euros, and I think the market is wondering whether (106 billion) is sufficient," said Dickson, who chairs a supervisory committee on the G20's Financial Stability Board. 

Dickson said she had not done the work herself to determine the European plan's sufficiency, but added: "At the end of the day, it's the market opinion that matters."

So, let's end the regulators' monopoly on all the useful, relevant information and require banks to provide ultra transparency.  The market can use this data to make a fully informed opinion.

European Banking Authority warns on bank funding...ultra transparency emerges as only solution

A Reuter's article reports on how the European Banking Authority (EBA) is growing increasingly concerned over the fact that the inter-bank funding market is frozen and Eurozone banks need to rollover almost $1 trillion in debt.

The EBA is looking at all the solutions tried in 2008-09 to unfreeze the market -- for example, state guarantees, stress tests, higher capital ratios -- and has concluded that these are not working.

The solutions are not working because banks simply do not trust each other or the sovereigns that stand behind them (this is not confined to the Eurozone as a collapse of the Eurozone banks will wreak havoc in the UK and US too).

Why don't banks trust each other?

Because banks are unable to evaluate the solvency of other banks.  As the Bank of England's Andy Haldane would say because each bank is a 'black box'.

Four years ago, I said predicted a solvency crisis driven by opacity in the financial marketplace.  One area of opacity is bank balance sheets.

Regular readers know that in order to assess the risk of a bank, market participants, including the bank's competitors, need access to the bank's current asset, liability and off-balance sheet exposure details on an on-going basis.

It is the ability to independently analyze this data that restores and maintains trust in the banks.

Until this data is made available, as I predicted, the financial system and the real economy will continue on a downward spiral.

Europe's finance chiefs try again next week to end a deadlock over bank funding, after the industry regulator warned time is running out to revive confidence across the troubled euro zone. 

Over breakfast on Wednesday, European Union finance ministers will seek agreement over state-backed guarantees in a bid to unblock wholesale funding markets. With 700 billion euros ($933 billion) of bank debt needing to roll over next year, the need is pressing. 

One solution touted, a pooling of state-backed guarantees, has effectively been abandoned, while another, individual national guarantees, is seen as unlikely to help banks in euro zone countries whose government bonds are being given a wide berth. 

The European Central Bank (ECB) may end up having to step in with a band-aid solution of two-to-three year liquidity lines to banks. 

The European Banking Authority (EBA) has drafted a three-pronged package to shore up confidence in banks: a 106 billion euro recapitalisation by mid-2012, writedowns on exposures to stressed sovereign debt and the funding guarantees. 

But EBA Chairman Andrea Enria signalled this week his increasing frustration with the deadlocked political process, including how to leverage the EU's new bailout fund, the EFSF. 

"The fact that so far only the EBA's measures to strengthen bank capital have been publicly put forward is for us a source of real concern," Enria said in a speech. "We believe that further delays to having all the elements in place are severely affecting the effectiveness of the whole package."... 

But the EBA package is already in danger of being left behind by the deepening euro zone crisis, making it harder for banks to find enough quality collateral to back loans and which is often in the form of government bonds. 

"With the sovereign debt crisis moving to the bigger euro zone countries, there is no longer any confidence in collateral, and the only way to get banks lending to each other again is to restore trust and confidence in sovereign debt used for collateral," said Godfried de Vidts, director of European Affairs at brokerage ICAP. 

So far the EBA is sticking with its timetable to publish by the end of November how much capital each bank must raise, but it and bankers now worry more about funding than capital. 

"We are in a bad spot," Stefano Marsaglia, chairman of Barclays Capital's financial institutions group, said at a Thomson Reuters IFR Bank Capital conference on Thursday. "The problem for banks is very much a funding problem, it's not so much a capital problem." 

The EBA has told banks they need to raise about 106 billion euros to repair their balance sheets, but that amount could rise as the watchdog may take a tougher line on what qualifies as capital and losses on sovereign bonds.... 

Banks are expected to mostly meet shortfalls by selling assets and loans, retaining earnings and cutting dividends or pay, and the amount of capital needing to be raised could be less than 30 billion euros, analysts have estimated.  

Regulators and national governments ... have become increasingly concerned that aggressive "deleveraging" to lift capital ratios will squeeze credit and hurt economic growth. 

Of course they are worried, as it appears that their policies have triggered a mini-credit crisis in the Eurozone.

To try to alleviate this de-leveraging, regulators are proposing a new way for banks to raise capital.

Banks will be given details of how they can plug their capital with debt that converts into equity, or "contingent capital" instruments dubbed CoCos. 

Contingent capital will be accepted if it meets "strict and harmonised" criteria, the EBA has said. It plans to issue a common European "term sheet" to make that clear. 

That is desperately needed, as uncertainty about how regulators view key aspects such as the point where bonds have to convert into equity -- probably when core Tier 1 capital drops to about 7 percent -- have held back issuance. 

But with some investors steering clear of investing in bank shares and most types of debt, market confidence will need to improve first.

Who would invest in contingent capital that converts to equity if they cannot assess the risk of the underlying bank?

Without ultra transparency, there is no real market for contingent capital.

The only way to improve market confidence is by providing ultra transparency.

UK investor M&G said where it has exposure to financials it is "very conservative" and senior in the capital structure. "That is unlikely to change soon. It is difficult to quantify banks' exposure to the periphery but the sector needs better disclosure, more liquidity and less reliance on interbank funding," said M&G fund manager Stefan Isaacs.

Investors, including banks making loans to each other, are on a buyers' strike until ultra transparency is provided.

The rising fear in bank stock prices signal conditions ripe for financial panic

A Wall Street Journal column discusses the relationship between investors' concerns with bank balance sheets and increased volatility in bank stock prices.

Regular readers know that the only way to restore and maintain investor confidence is to require banks to disclose on an on-going basis their current asset, liability and off-balance sheet exposure details.  With this data, investors can independently assess the risk of each bank.

There are emerging signs in the stock market that the U.S. economy is about to face financial headwinds that may lead to another credit crisis and recession next year. The recent volatility in bank stocks is a signal that U.S. banks, large and small, are not as healthy as many analysts assume. 

Banking is a game of confidence. 

So if the investing public is uncertain about the health of bank balance sheets, its uncertainty can turn into fear, setting the stage for a banking panic.

That is the problem with current reporting that leaves bank balance sheets opaque and the banks themselves little more than black boxes to investors.

This dynamic has played out twice before over the past 85 years—in the Great Depression and the panic of 2008-09—with devastating consequences for the broader economy. 

Over the past three months, investor uncertainty about the soundness of bank balance sheets, manifested in the daily volatility of stock prices, is back up to levels seen historically only in advance of these two great crises.

There is no reason for this uncertainty.  After the panic of 2008-09, regulators could have required banks to provide ultra transparency (disclose on an on-going basis their current asset, liability and off-balance sheet exposure details).

The volatility of bank stock prices from one day to the next depends on investor perceptions of the riskiness of the assets held by banks. 

In tranquil times, when investors feel that bank portfolios are reasonably safe and not excessively leveraged, daily volatility is low. 

When investors are uncertain about the soundness of bank balance sheets and about the adequacy of bank capital, then daily volatility rises in bank stock prices to double or triple their normal levels.

When uncertainty turns to panic, as it did in 1929-33 and again in 2008-09, the volatility in the daily movements of bank stock prices can shoot up to seven or eight times their normal levels. 

When this occurs, the damage radiates quickly from the banks to the broader economy...

So by not requiring ultra transparency, financial regulators have been gambling with the stability of the financial system and the real economy.

From mid-August through last week, bank volatility has been over 3%. The market for bank stocks is now sending a bright red warning signal that conditions are ripe for another potentially disastrous financial panic.

This extraordinary volatility is not limited to the stocks of large banks but extends to small and midsize banks as well. 

For example, the volatilities of the daily stock returns of indices of regional and smaller bank stocks have also been hovering around 3% since mid-August, including the KBW Regional Bank Index (KRX), S&P's bank index (BIX), the Nasdaq bank stock index (IXBK), and the ABA Community Bank index (ABAQ). 

What can be done?

Simple, require banks to disclose on an on-going basis their current asset, liability and off-balance sheet exposure details.

Bond vigilantes should stress out US banks

A Wall Street Journal Heard on the Street column by David Reilly looks at the contortions the Fed is going through to try to restore investor confidence in banks.

Regular readers know that the only way to restore investor confidence in the banks is to require the banks to disclose on an on-going basis their current asset, liability and off-balance sheet exposure details.  With this data, market participants can independently assess the risk of the banks and adjust both the amount and price of their exposures.

Instead of requiring ultra transparency, the Fed is focusing on stress tests and adopting the moral obligation to bailout investors in any bank that passes the test.  It is the moral obligation that keeps the bond vigilantes at bay.

If banks were required to provide ultra transparency, the bond vigilantes would move the banks' cost of funds to levels that reflect the risk of each bank.

Banks are notoriously complex.

Made more so by the opacity that surrounds their financial disclosure.  The Bank of England's Andy Haldane refers to banks as 'black boxes'.

But in one respect, they are pretty simple; like other companies, banks depend on access to a raw material to build products and need to purchase it at a price that allows them to generate a profit. 

For banks, that raw material is money. Whether banks can persuade credit investors to provide it comes down to confidence and capital. And as the European crisis shows, doubts on either can mean suppliers charge too high a price or simply walk away. 

That is worth remembering as the Federal Reserve prepares for another round of "stress tests" to determine whether some big U.S. firms can return capital to shareholders.... 

In doing so, the Fed will again grapple with the question of how much capital is enough. That is particularly tricky because the Fed wants banks to hold enough capital to absorb losses but also doesn't want to constrain lending and, thereby, economic growth.

As this blog has repeatedly discussed, bank capital is a meaningless, highly manipulated number.  The Fed should never look at it again.

However, because the Fed focuses on bank capital, it causes itself all sorts of problems.

And the Fed faces an added dilemma. It has decided the economy is so fragile that extraordinary monetary-policy actions are appropriate and even more may be needed. That in itself argues against banks doing anything other than stockpiling capital. 

For their part, banks argue that holding too much capital hampers credit creation. They also worry that holding more capital makes it tough to generate higher returns on equity, affecting valuations. ... 

So let's see what the Fed gets for its focus on bank capital.  It provides an incentive to banks to stop lending.

In the Eurozone where banks are being asked to achieve a 9% Tier I capital ratio, banks are dumping sovereign bonds in addition to reducing lending.  In effect, the European regulators have created a credit crisis by their focus on bank capital.

Hopefully, the Fed will learn from the European experience.

Yet any doubt about capital sufficiency means banks can lose access to funding. That, too, can have adverse economic consequences. 

In a note Friday, analysts at Morgan Stanley argued that "bank funding is as big a brake on bank lending as bank capital." Banks that can't raise funds have to shrink their balance sheets.

Who would lend to a bank when they cannot evaluate the risk of the bank?

Dexia showed that a bank can have a high Tier I capital ratio and still need to be nationalized.

The only way to restore and maintain investor confidence is by requiring banks to provide ultra transparency on an on-going basis.

So it is good the Fed's coming stress tests look stressful. ... 

But the lack of investor confidence in banks justifies a harsh approach. Of the six biggest banks, none are trading above book value, and only Wells trades above tangible book. 

Given this, the Fed needs to be mindful of credit investors. Granted, the Fed has been able to print money without bond vigilantes exacting revenge. But the vigilantes are present in bank credit markets, as Europe's institutions know. 

Even U.S. banks are feeling some heat. The price of insuring against default at the biggest institutions, for example, has jumped. ... 

Clearly, the bond vigilantes are on the prowl. The Fed shouldn't do anything that spurs them to further action.

Measuring financial contagion - Simon Johnson on banks disclosing their 'exact exposures'

In his NY Times Economix column, Simon Johnson discusses the need for banks to disclose their 'exact exposures' so that market participants can assess and exert market discipline on the banks.

Regular readers are very familiar with the argument Professor Johnson makes as it touches on many of the central themes addressed in detail on this blog.  In particular,

• Bank runs -- when market participants do not know which banks are solvent and which are not and there are questions about the strength of the sovereign's deposit guarantee;

• The cost of opacity -- in the form of bank bailouts and losses on opaque structured finance securities;

• How regulators create financial instability by preserving their monopoly on all the useful, relevant information on financial institutions -- market participants are dependent on the regulators to properly assess this information and convey it;

• Moral hazard in the form of an obligation to bailout investors from potential losses after regulators use their information monopoly to conduct stress tests and say the bank is solvent;

• The need to require banks to disclose on an on-going basis their current asset, liability and off-balance sheet exposure details;

• If market participants are unable to understand a bank's disclosed data, this is a diagnostic tool that tells the regulators the bank must reduce its complexity until market participants can understand its disclosed data;

• How the risk of financial contagion is virtually eliminated as market participants will adjust their exposures based on the risk of each bank; and

• The return of market discipline -- it will put pressure on banks to reduce their risks as high risk banks will find they face high funding costs.

Gotta give the guy credit for recognizing a good idea!

People see one bank failure and fear the consequences – hence, panics and runs on the bank. 

Anyone who thinks that we solved this problem with forward-thinking central banks or fiscal interventions has not been paying close attention – either to the United States or to Europe – over the last three years. 

We really need transparency on the exact exposures of banks. To whom have they lent and on what basis? 

Just telling supervisors does not help us at all, because sharing information only behind closed doors is just another potential mechanism for regulatory capture. 

For large financial institutions – those with more than $100 billion in total assets – everything should be out in the open. 

If you want to operate in relative secrecy, stay small. 

The costs of today’s opaqueness are huge, creating the basis for the plea, “Save us or you’ll lose the world.” 

And if the published information is too complex for outsiders to understand, big banks must be forced to simplify their operations until they become sufficiently transparent. Potential contagion risks must be measurable and apparent to the marketplace, including to independent analysts who have access only to public information. 

Needless to say, if any institution poses major contagion risks, as measured on this basis, it should be forced to become safer. 

Richard W. Fisher, president of the Federal Reserve Bank of Dallas, spoke recently about what he called the “pernicious problem” of too-big-to-fail financial institutions, “in a culture held hostage by concerns for ‘contagion,’ ‘systemic risk’ and ‘unique solutions’”: 

“Invariably, these behemoth institutions use their size, scale and complexity to cow politicians and regulators into believing the world will be placed in peril should they attempt to discipline them. They argue that disciplining them will be a trip wire for financial contagion, market disruption and economic disorder. Yet failing to discipline them only delays the inevitable – a bursting of a bubble and a financial panic that places the economy in peril.” 

You can only discipline a big troubled bank if you understand and can measure the consequences of its failure.

Regulators as source of financial instability: the failure to forecast the Great Recession

The Federal Reserve Bank of New York published an interesting post on the failure of economic forecasts since 2007.

At its heart is the idea that no one predicted the Great Recession and therefore that the failure of the Federal Reserve System to do so was excusable.

The idea that no one predicted the Great Recession is not true.  The idea that no one has accurately predicted what has happened since the beginning of the Great Recession is also not true.

One of the reasons my blog attracts readers is that I have predicted both.

Prior to the beginning of the Great Recession, I observed that if opacity in the financial system was not addressed, we would have a crisis.  Once the crisis began, I added the observation that we would continue in a downward spiral with no logical stopping point until opacity in the financial system was addressed.

Unfortunately (I say unfortunately because of the suffering that occurred to everyone outside of Wall Street/Washington), these two predictions have turned out to be very accurate.

In his post, Simon Potter does try to qualify who he includes in the group that failed to predict the Great Recession and its aftermath.  He observes that the economics profession failed - which by definition includes everyone with a PhD currently working in the Federal Reserve System.

A casual observer might conclude if they failed, we should immediately remove anyone who is a trained economist from a position where they can have any impact on the economy... say beginning with the chairman of the Federal Reserve.

Having worked for the Federal Reserve in DC in the area responsible for the analysis supporting monetary policy, I do not think this is the right solution.

Consistent with this blog's focus on disclosure, the right solution is that the Fed should be turned into the single most transparent financial market participant.

Everything the Fed does should be subject to disclosure.

This should apply to everything from the individual bank examination reports to every financial transaction involving the Fed up to and including telecasting the FOMC meetings as they are happening.

You simply cannot root out opacity in the financial system if you let a major financial institution regulator, the lender of last resort and the monetary authority operate in an opaque environment.

Looking through our briefing materials and other sources such as New York Fed staff reports reveals that the Bank’s economic research staff, like most other economists, were behind the curve as the financial crisis developed, even though many of our economists made important contributions to the understanding of the crisis. Three main failures in our real-time forecasting stand out: 

1. Misunderstanding of the housing boom. Staff analysis of the increase in house prices did not find convincing evidence of overvaluation (see, for example, McCarthy and Peach [2004] and Himmelberg, Mayer, and Sinai [2005]). Thus, we downplayed the risk of a substantial fall in house prices. A robust approach would have put the bar much lower than convincing evidence.
2. A lack of analysis of the rapid growth of new forms of mortgage finance. Here the reliance on the assumption of efficient markets appears to have dulled our awareness of many of the risks building in financial markets in 2005-07. However, a March 2008 New York Fed staff reportby Ashcraft and Schuermann provided a detailed analysis of how incentives were misaligned throughout the securitization process of subprime mortgages—meaning that the market was not functioning efficiently.
3. Insufficient weight given to the powerful adverse feedback loops between the financial system and the real economy. Despite a good understanding of the risk of a financial crisis from mid-2007 onward, we were unable to fully connect the dots to real activity until 2008. Eventually, by building on the insights of Adrian and Shin (2008), we gained a better grasp of the power of these feedback loops.

However, the biggest failure was the complacency resulting from the apparent ease of maintaining financial and economic stability during the Great Moderation. Perhaps most important, as noted by some analysts as early as the 1990s, these adverse consequences of the Great Moderation were most likely to arise from the actions, judgments, and decisions of financial market participants: 

Longer stretches of economic growth imply greater leverage and complacency and thus, greater financial problems when recessions do occur.
--William Dudley and Edward McKelvey³

A modest proposal to save Spain from repeating the Irish mistakes in handling its banking crisis

A Bloomberg article reveals that Spain's newly elected government is seeking proposals for how to clean up its banking system.  This includes asking two academics for advice on setting up a bad bank to acquire the troubled real estate assets from its banking system.

Allow me to offer a modest proposal:  Before taking any action, require every Spanish bank to disclose on an on-going basis its current asset, liability and off-balance sheet details.

Since handling the banking crisis successfully requires that market participants think the crisis was handled, start the process of resolving the banking crisis by including the market participants.

Requiring that each bank provides ultra transparency does this.

With this data, market participants can independently assess each bank and value its assets.  This is the critical step if market participants are going to believe that the solution to the banking crisis actually solved the problem.

There is no way around doing this.  Like the Irish government, the Spanish government has already represented that the scope of the problem is less severe that the problem actually is.

To get around this, Ireland engaged a third party, BlackRock Solutions, to value the assets in its banking system.  Market participants confirmed the need for ultra transparency by effectively not believing the results and continuing their run on the Irish banks.

There are other benefits to ultra transparency including, but not limited to:

First, since each asset is being continually valued by the market, there is no reason for the banks not to work diligently to get the bad asset off their balance sheet.  Market participants are already anticipating the losses on the bad assets so there is no benefit to not addressing them.

Second, it eliminates the need for the Spanish government to recapitalize its banks.  So long as the Spanish government and European Financial Stability Fund guarantee the deposits and the guarantee is trusted, depositors will keep their money in the Spanish banks even if they are technically insolvent (market value of their assets exceeds the book value of their liabilities).

Three, it allows the banks to resume lending.  One of the biggest barriers to lending is nobody knows what the value of real estate pledged as collateral is.  By disclosing all the details on bank exposures, the market can determine a clearing price for real estate (that is what markets do after all).  With a 'market price', lenders can be comfortable taking real estate as collateral again.

Spanish Prime Minister-elect Mariano Rajoy has asked for at least two papers from academics on how to create a so-called bad bank, according to two people with knowledge of the matter. 

Both proposals outline mechanisms for a state-backed agency to buy soured assets such as real estate from banks at a discount, said the people, who declined be named because the process isn’t public. 

According to one of the proposals, Spain needs external financing of about 100 billion euros ($133 billion) to absorb the cost of transferring assets to the bad bank and should seek it from the European Financial Stability Fund or the International Monetary Fund, one of the people said. Both options call for valuations of real estate to be made by independent appraisers, the people said. 

The People’s Party, which won the Nov. 20 general elections in Spain by a landslide, has pledged a “cleanup and restructuring” of the country’s banking system to help restore the supply of credit in an economy where lending is shrinking at its fastest pace on record. 

Spanish banks, burdened with 176 billion euros of what the Bank of Spain terms “troubled” assets linked to real estate, are fighting to preserve profit as lending slumps and their cost of financing surges. 

Rajoy hasn’t been specific about how he’ll make banks deal with real estate on their books. 

His electoral program said his government would make it easier to “actively manage” the industry’s impaired assets so that they can be sold off....

Still, Faes, a Madrid-based research institute that is linked to the PP and chaired by former Prime Minister Jose Maria Aznar, favors creating a bad bank, Jaime Garcia-Legaz, secretary general of the organization, said in an interview on Oct. 24. 

Luis de Guindos, a former deputy finance minister under Aznar, said in an interview he wants to “eliminate all doubts” about valuation of real estate on the balance sheets of banks.

As Ireland has shown, the only way to do this is by providing ultra transparency to the market.  Not letting market participants have access to the data to assess the valuation fo real estate for themselves tell the market participants that there is something to hide.

The 52 percent of the more than 300 billion euros of assets linked to developers that the Bank of Spain deems to be “troubled” dwarfs other risky assets held by the industry such as the combined 13 billion euros banks own of Greek, Italian, Portuguese and Irish sovereign debt. 

Banks may face more than 60 billion euros of losses they haven’t covered with reserves as the economy risks tipping back into a recession, Banco Bilbao Vizcaya Argentaria SA (BBVA)’s research department said in a Nov. 8 report.