Tuesday, January 31, 2012

Paul Volcker asks how are we going to restore trust in government and financial regulators?

Earlier today your humble blogger asked how are we going to restore trust in the banking system.  While I am unaware of a direct connection, Paul Volcker came out later and broadened the question to how are we going to restore trust in government and the financial regulators.

As reported in a Bloomberg article,

Together they have 120 years experience in financial markets. John Bogle, 82, popularized index investing. Paul Volcker, 84, broke the back of 15 percent inflation as Federal Reserve chairman in the 1980s. 
Today, they shared the same stage in New York and this view: confidence in the U.S. financial system is broken.
Regular readers know that the only way to restore confidence in the US financial system is to require banks to provide ultra transparency and disclose their current asset, liability and off-balance sheet exposures.  This lets market participants independently assess what the banks are doing.
Bogle, the founder of mutual fund company Vanguard Group Inc. who has spent his career advocating a low-cost approach to personal investing and railing against conflicts of interest in his industry, said he would grade the U.S. financial system a ‘D’. 
Volcker, who has urged Congress to ban proprietary trading by commercial banks, said banks are lobbying to undermine financial regulation aimed at making the industry more stable. 
“There’s no question that confidence in government is shaky,” Volcker, who’s a towering 6 foot 7 inches (201 centimeters) tall, said in New York today at The John C. Bogle Legacy Forum hosted by Bloomberg Link.  
Washington is “filled up with law firms that cover whole city blocks. Lobbying firms. And it’s all living off the influence of the government.” 
The so-called Volcker rule seeks to stop regulated banks that receive support from the government from making risky bets with their own money. Wall Street firms including Goldman Sachs Group Inc. (GS) have argued the limitations could harm capital markets by reducing the role of banks. The Dodd-Frank Act, the regulatory overhaul enacted in 2010, requires that the rule be in place by July 21.
Apparently Mr. Volcker also recognizes how Wall Street's Opacity Protection Team operates.

How are we ever going to re-establish trust in the banking system?

At the beginning of the financial crisis in a speech at the London School of Economics, the Queen of England asked how if everything was going so well, the economics profession managed to miss the signs that we were headed for a global financial crisis.

If she were to be invited back, I suspect that she might be tempted to ask, given everything that the governments have done since the beginning of the credit crisis, how are we ever going to re-establish trust in the banking system?

Regular readers know that my solution is to require banks to provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details.  With this disclosure, market participants can independently assess the risk of each bank and trusting in their assessment adjust the amount and price of their exposure to each bank.

Given the number of economists that I have talked to who have rejected ultra transparency, which happens to be a necessary condition if the invisible hand is to operate properly and buyers are going to know what they are buying when it comes to investing in banks, I am interested in what they propose that should restore trust.

To date, economists have recommended and governments have implemented a number of methods to restore trust that have failed including

  • Stress Tests.  Financial regulators are engaging in an annual ritual of subjecting financial institutions to stress tests.  As this blog has documented, these tests are absolutely worthless for restoring trust and confidence in the banking system.  For example, in Europe, within weeks of the announcement of the results for the last two stress tests, a bank that passed the stress test has imploded.  
  • Higher Capital Ratios.  In what is admittedly an over-simplification, higher capital ratios are suppose to signal to the market that banks are safe and can be trusted because they have more loss absorbing capacity.  If this were remotely true, then the EU interbank lending and unsecured debt markets should not have frozen while banks are increasing their capital to meet the 9% Tier I capital requirement.

ECB life-line necessary because no one knows which EU banks are solvent

I am surprised by much that has been written about the ECB life-line, otherwise known as the long term refinancing operation or LTRO, that shows a lack of understanding of this life-line.

LTRO was implemented for a very simple reason:  no market participant can figure out which of the EU banks are solvent and which are not.  Included in the market participants who cannot answer this question are banks and private sector investors.

LTRO was necessary because without it the EU banking system was going to implode due to a lack of liquidity as market participants wanted to be repaid on their existing exposures and were unwilling to rollover into new exposures.  As this blog has documented and the ECB's Mario Draghi confirmed, both interbank lending and unsecured bank debt markets are frozen.

LTRO is all about substituting funds from the ECB for funds from the credit markets.

Since it is all about substitution of one funding source for another funding source, we are talking about a program that effects the right hand side of the bank balance sheet and not the left.  LTRO is not about stimulating loan growth or sovereign debt purchases.  It is about fund the loans and sovereign debt that already exist on the balance sheet.

The primary driver for lending and sovereign debt purchases is compliance with the 9% Tier I capital ratio requirement.  As predicted on this blog, this compliance is causing a credit crunch in the EU as banks shrink their balance sheets.

Monday, January 30, 2012

Should RBS lead bank disclosure practices by being the first large bank to provide ultra transparency?

Jeremy Warner wrote an interesting Telegraph column in which he observed that the focus on Stephen Hester's bonus takes attention away from the real issue of when, if ever, is the UK taxpayer going to see a return on and of its investment in RBS.

He observes that

Investors have taken the view that virtually all European focused banks, RBS included, have become essentially "uninvestable" and show few signs of changing their minds. Who can blame them? RBS continues to be a massive leveraged play – which in this environment is a complete no no – extreme regulatory and business uncertainty hangs like a pall over the entire sector, the total size of banking exposures remains largely unknown given the increasingly questionable nature of much financial hedging, and as can be seen from the row about Mr Hester's bonus, RBS remains a political football, to be booted around in a way quite unsuited to normal commercial endeavour. 
To cap it all, regulators have demanded that European banks raise an additional €150bn in new capital. There's a veritable tsunami of banking capital already slated to hit the market. RBS would be lost in the rush. 
The other point worth bearing in mind about RBS is this. The £45bn of capital provided by the taxpayer merely stabilised the position. It didn't pay for the full horror of the legacy losses, which are still coming through. More and more of them keep cropping up all the time, the latest being the likely total writeoff on Greek sovereign debt (so far, RBS has provided for a 50pc haircut).
He then asks what to do with RBS.

Regular readers know that my solution for RBS would be to have it become the first large financial firm to provide ultra transparency and discloses on an on-going basis its current asset, liability and off-balance sheet exposure details.

With this type of disclosure, RBS would become investable again as market participants could assess the risk of RBS and would know what they were buying.

RBS is actually the ideal bank to adopt ultra transparency first because the UK government is already its leading shareholder.  Market participants know that even if recognition of all the losses hidden on and off the balance sheet causes RBS' book capital to fall below zero, the UK government will not close the bank.

Rather, the UK government will hold onto its shares while RBS rebuilds its book capital through retention of future earnings.

Voluntarily or involuntarily, Greek banks move towards recognizing their losses

It appears that the ability of Greek banks to continue hiding their on and off balance sheet losses is coming to an end.

As reported by Kathimerini (hat/tip ZeroHedge), Greek bank customers with or without jobs may now be able to have their debts written down to what they can afford.

Effectively, this greatly reduces the ability of Greek banks to continue hiding losses.

The question becomes how to retain confidence in a banking system with negative book capital?

Regular readers know the solution proposed on this blog.

  • In the case of Greece, deposit insurance needs to be backstopped not just by the Greek government, but also by the European Financial Stability Fund.  If depositors believe they can get their money out when they want to, they will leave it in the banks even if they have negative book capital (don't take my word for it, this is what US depositors did with Savings and Loans in the late 1980s).
  • The European Central Bank needs to reiterate that it will accept all of the good collateral that the Greek banks might have.  This signals to depositors that the Greek banks have the liquidity necessary to in fact give them their money back.
  • The Greek banks need to provide ultra transparency and disclose their current asset, liability and off-balance sheet exposure details.  This allows market participants to assess their risk and assure themselves that no additional losses are being hidden.
  • The Greek banks need to continue to originate loans to creditworthy customers to support economic growth in Greece.  These loans can be funded in a variety of ways - covered bonds, deposits or sale.
  • Finally, the Greek banks should retain their future earnings to rebuild their book capital base.
In what could turn out to be a significant ruling for Greeks suffering from the economic crisis, a court in Hania, Crete, has become the first in the country to order that the majority of the debt owed to banks by someone still in full employment be wiped out. 
Sunday’s Kathimerini understands that the Justice of the Peace Court in Hania based its decision on a 2010 law that allows judges to give protection to people struggling to meet their financial commitments. Until now, the legislation has only been used to give debt relief to unemployed people or those with no substantial income. 
However, in the Hania case, the court ruled in favor of a full-time civil servant. The divorced woman, who has three children, asked to be given protection after her banks refused to offer her new terms for combined loans of 112,000 euros. The unnamed woman explained that she did not have any assets she could sell to pay off her debt. 
In its ruling, the court deemed that the woman, who has moved in with her parents, needs 350 euros a month to cover her own costs but that the rest of her earnings could be distributed equally among the three banks she owes money to. The judge deemed that this process should last for four years, meaning the woman would pay back some 30,000 euros and the remaining 82,000 would be written off....
[T]he decision in Hania may lead to a new wave of appeals by Greeks who still have jobs but are unable to repay their loans.

Banks fight to exempt half of swap books from transparency

A Bloomberg article reported on how large US banks are lobbying to exempt their swap books from Dodd-Frank Act capital and margin requirements as well as transparency.

Using a classic lobbying strategy, Wall Street's Opacity Protection Team is making the level playing field argument and saying that they would be at a competitive disadvantage if their Edge Act foreign subsidiaries were subject to capital and margin requirements as well as transparency.

The regulators response should be that the regulators are setting the 'gold standard' and they expect every other country to modify their regulations to meet it as oppose to US regulators adopting existing regulations from other countries that have been shown to be inadequate.

This lobbying also highlights the extremes that Wall Street's Opacity Protection Team will go to head off transparency.

Specifically, the Opacity Protection Team is arguing that US regulators don't need to see the banks' swap books held offshore, but can instead rely on the foreign regulators to review these books.

While I don't think that macro-prudential regulators are going to be successful, at a minimum, they need to have access to all the useful, relevant information for each bank.  Not having access to information on half of each bank's swap book would directly undermine the macro-prudential regulators.

Regular readers know that I would throw away most of the Dodd-Frank Act and substitute ultra transparency instead.  At the end of the day, ultra transparency requires far less regulation to mandate and it produces far better regulatory outcomes.

More than half of the derivatives- trading business of Goldman Sachs Group Inc. (GS), Morgan Stanley and three other large banks could fall largely outside the Dodd- Frank Act if they succeed in lobbying regulators to exempt their overseas operations, government records show....
Banking lobbyists have been gaining traction with their argument that a combination of U.S. supervision of their holding companies and foreign supervision of their operations abroad is sufficient to oversee risk to the financial system. 
While the banks haven’t publicized how much of their swaps business is overseas, they file quarterly statements to the Federal Reserve. A Bloomberg News analysis of the filings shows that Goldman Sachs had 62 percent of its $134 billion in fair- value derivatives assets and liabilities in non-U.S. branches or subsidiaries for international banking as of Sept. 30, while 77 percent of Morgan Stanley (MS)’s $101 billion was in non-U.S. operations. 
If overseas operations aren’t subject to U.S. rules or equivalent regulation by other nations, it could impede the goal of preventing another credit crisis, Darrell Duffie, professor at Stanford University’s Graduate School of Business, said in a telephone interview. 
“Not only is that neglectful from a viewpoint of systemic risk as it sits today, but it’s also an incitement to move the risk abroad,” Duffie said.... 
The provision raised the stakes for banks because their swaps business is global. In 2008, Sally Davies, a Fed adviser, said that between 55 percent and 75 percent of U.S. banks’ notional derivatives exposure was with non-U.S. residents.
For example, New York-based Goldman Sachs’s largest counterparty for credit derivatives on the eve of the credit crisis in June 2008 was Deutsche Bank AG (DB)’s London branch; its third-largest interest-rate derivatives counterparty was JPMorgan’s London branch; and its largest counterparty for currency products was Royal Bank of Scotland Plc’s London branch, according to a 2010 report from the Financial Crisis Inquiry Commission, a U.S. panel that investigated the crisis. 
Selling over-the-counter derivatives is among the most lucrative business for financial companies, with U.S. bank holding companies reporting $14 billion in trading revenue in the third quarter of 2011, according to the OCC. The five banks control 95 percent of cash and derivatives trading for U.S. bank holding companies, which had $326 trillion in notional derivatives as of Sept. 30, the agency said....

Derivatives, including swaps, are financial contracts tied to interest rates, commodities or events, such as the default of a company. The values of overseas derivatives held by individual banks that were calculated for this story include assets and liabilities for foreign branches and subsidiaries, including so- called Edge corporations. 
Edge corporations, formed under the 1919 Edge Act on international banking, are bank subsidiaries for which Congress granted greater leeway to compete overseas. Citibank Overseas Investment Corp., J.P.Morgan International Finance Limited and Bankamerica International Financial Corp. are among Edge subsidiaries that have interest rate and equity derivatives and could benefit from an exemption.

The banks don’t report the holdings of Edge corporations in their standard quarterly filings. 
According to documents obtained through a public records request to the Fed, Citibank’s Edge corporation had a combined $7.8 billion in fair-value derivatives as trading assets and liabilities in the first quarter of 2011, while JPMorgan’s had $88 billion. 
Banks are seeking to have Edge corporations and other international affiliates exempted from Dodd-Frank rules when they have contracts with non-U.S. companies, Sullivan & Cromwell said in a letter on June 29. The exemption should also cover the subsidiaries’ swaps with foreign-based affiliates of other U.S. companies because the trades don’t have a direct and significant effect on U.S. commerce, the law firm said in its letter. Under the requested exemption, two U.S. companies could trade swaps outside of Dodd-Frank rules so long as their overseas affiliates engaged in the transaction. 
The combination of U.S. banking supervision at the parent company level and foreign regulation of overseas operations is sufficient to protect the U.S. financial system, according to the Sullivan & Cromwell lawyers.

U.S. and European Union regulators have said they want to bridge international gaps to avoid disparities that helped undermine oversight of American International Group Inc. (AIG) in 2007 and 2008 and contributed to a $180 billion taxpayer bailout. The insurer booked many of its swaps in Europe, where regulators in 2007 decided that U.S. authorities should have oversight. That transatlantic split “excluded any comprehensive examination and regulation” of AIG’s credit-default swaps, the U.S. Congressional Oversight Panel said in a June 2010 report.

Knowledge lies at the heart of western capitalism

Hernando de Soto wrote an interesting column in the Financial Times in which he argues that capitalism does not need to be re-invented but rather rediscovered.  Specifically, he argues that we are dealing with a knowledge crisis where the symptom is the ongoing financial crisis.

The idea of a knowledge crisis should immediately resonate with regular readers as your humble blogger has been discussing how information in the form of utter transparency is what is needed to solve the financial crisis.
The world economy is made up of many tiny parts that are useful only when we combine them into more complex wholes. The higher the value of these aggregations, the more economic growth. Humanity’s achievements – from the 120 ingredients of my clock to the countless financial deals and developments that produced the internet and flight navigation systems – all result from joining people and things to each other. 
That’s why western capitalism has triumphed for the past 150 years: it gave us the best knowledge to explore economic combinations. Capitalism does not need to be re-thought or re-invented; it simply has to be re-discovered. 
The reason credit and capital have contracted for the past five years in the US and Europe is that the knowledge required to identify and join parts profitably has been unwittingly destroyed. 
The connections between mortgage loans and liquid securities, between non-performing financial derivatives and the organisations that hold them; the non-standardised, scattered records that obscure who holds risks; and the off-balance-sheet accounting that obscures many companies’ health: these all make it harder to trust and hence combine. 
Until this knowledge system is repaired, neither US nor European capitalism will recover. 
This is a point that has been made repeatedly on this blog.
Reformers and policymakers must recognise that they are not dealing with a financial crisis but with a knowledge crisis.  
Capitalism lives in two worlds: there is a visible one of palm trees and Panamanian ships, but it is the other – made up of the property information cocooned in laws and records – that allows us to organise and understand fragments of reality and join them creatively.
The world of organised knowledge and joining began in earnest in the mid-19th century, when reformers in Europe and the US concluded that the segmented, undirected knowledge left by the old regimes could not cure the recessions that beset early capitalism. 
They faced what was known as “the knowledge problem”, the inability to select and store dispersed information about economic things. 
Those reformers created “property memory systems” to map – in rule-bound, certified and publicly accessible registries, titles and accounts – all the relevant knowledge available on assets, whether intangible (stocks, patents, promissory notes) or tangible (land, buildings, machines). 
Knowing who owned – and owed – what and where, and fixing that information in public records, made it possible for investors to locate suppliers, infer value, take risks and combine such simple things – to borrow a famous example – as graphite from Sri Lanka and wood from Oregon into pencils. 
Reformers also helped to solve “the binding problem,” finding the information needed for parts to fit together .... The logic behind the property documentation is the DNA of capitalism. 
Modern recording systems evolved from data warehouses certifying isolated assets, into factories of facts for facilitating the knowledge entrepreneurs need to combine assets, skills, technologies and finance into more complex and valuable products. 
Thus, real estate documentation no longer just says that Smith owns the house on the hill but also describes that house as the address at which mortgages can be foreclosed; debts, rates and taxes collected; deliveries made; and from which utilities services can be controlled and bills collected. 
This knowledge allowed western economies to grow more since the second world war than in the previous 2,000 years without big credit contractions. 
Until 2008, when we began to learn that memory systems had stopped telling the truth – through off-balance-sheet accounting; debts buried in footnotes or the ledgers of “special purpose entities”; financing raised by “bundling” mortgages into securities not recorded in traditional public registries; and nations masking debt as income by swapping it from one currency to another. 
No wonder institutions and investors have lost confidence in the system. 
The brilliance of western capitalism lies not in providing a formula for wealth creation but in its property memory systems, which are the result of examining, selecting and validating information about who owns land, labour, credit, capital and technology, how they are connected and how they can be profitably recombined. 
For the past 15 years, the records of western capitalism have been debased, leaving governments without the facts to spot what needs to be fixed and for businesses to know where their risks are. 
To regain its vitality, western capitalism must bring under the rule of law and public memory hundreds of trillions of dollars now swirling mindlessly out of control in the obscure world of financial innovation. That task requires major political leadership.

Sunday, January 29, 2012

Wouldn't investors in mortgage backed securities want to have accurate data on the underlying loans?

Since before the credit crisis began, your humble blogger has been promoting the creation of a database that would have for every structured finance deal its terms and the performance data for each asset backing the deal.

This is the information that investors need if they are going to be able to independently value these deals.

In her NY Times column on the newly created Mortgage Task Force, aka the Residential Mortgage-Backed Securities Working Group, Gretchen Morgenson confirms this.

Consider the most recent complaint filed by the Assured Guaranty Corporation, an insurer of mortgage securities, against Bear Stearns, the defunct brokerage firm; EMC, Bear’s mortgage origination and servicing unit; and JPMorgan Chase, which bought Bear in March 2008. 
Filed in November, the complaint shows what kinds of revealing material can be dug up by determined investigators. 
The complaint contends that Bear Stearns knew it was stuffing its mortgage-backed securities with crummy loans
It cites an e-mail written by a former EMC analyst in the unit that dealt with these instruments. 
“I have been toying with the idea of writing a book about our experiences,” the analyst wrote. “Think of all of the crap that went on and how nobody outside of the company would believe us ... the fact that data was constantly changing and we sold loans without the data being correct — wouldn’t investors who bought the MBS’s want to know that?” 
Indeed they would.

The 'Lost Generation' versus bank bailouts

Regular readers of this blog know that I tend to focus on how to fix the global financial system.  Today, I am going to focus on why I think this is important.

The Guardian ran an article discussing how as a result of our on-going financial crisis, youth, referring to people who have graduated from high school and college, unemployment is surging globally.  In Spain, it has reach 50%.

This is a level of unemployment that is significantly beyond what is reasonable for any country.

I don't need to tell the Spanish government that this is a problem that needs to be addressed immediately.  They know it.

However, the Spanish government thinks that its hands are tied by the need to bailout the Spanish banking system for all the bad debt that is hidden on and off its balance sheet.

The question is how to free up the funds dedicated to bailing out the financial system to addressing the youth unemployment problem.

Regular readers know the answer is that the Spanish government's hands are not tied by the need to bailout their banking system.  While retaining a functioning financial system, the banks can absorb the losses today and recapitalized themselves by retaining future earnings.

It is the fact that the banks can recapitalize themselves from future earnings that frees up the Spanish government to spend money on its youth unemployment problem.  The same is true for other countries.

Saturday, January 28, 2012

At last a politician who dares to admit we need full disclosure

The Telegraph's Liam Halligan is out with another terrific column on the need for banks to fully disclose all of their exposure details.

He does a great job of tying together many of the issues that have been talked about on this blog including the blueprint for saving the financial system and ultra transparency.
I want to record that, while campaigning in Florida last Monday, Romney made an extremely significant statement on the causes of the world's ongoing financial angst. 
His words showed more honesty and insight on this subject than anything I've heard, from any senior politician, on either side of the Atlantic. Barely reported amid the primary razzmatazz, Romney's analysis should be seen by a broader audience. This time next year, he could be running the most powerful country on Earth. 
The biggest financial problem the West faces isn't low growth, or unemployment. The issue isn't, as some would have it, that over-indebted governments are "cutting too far and too fast". They're barely cutting spending, if at all. But let's leave that for another week. 
The most significant financial problem, in both Europe and the US, is that the banking system remains gridlocked, with banks doing everything possible to conceal tens of billions of euros, sterling and dollars of losses.
All those non-performing loans, and toxic debts, many of them linked to the housing sector, haven't gone away. We don't know their precise scale, of course, because the banks still won't publish full sets of accounts, including their "off balance sheet vehicles". And, disgracefully, governments and regulators won't force them. 
So banks are petrified of lending to each other, as they know very little about each others' solvency. Investors, too, are worried about recapitalising banks, or even holding bank shares in most cases, as they don't know what they're buying. 
The result is that inter-bank lending – the wholesale market for loans – has seized up. This, in turn, has led to a drought of finance for solvent households and firms. So, investment suffers, housing markets suffer, and economic life stagnates. With the credit channel "blocked", the wheels of Western finance have stopped turning and commercial stasis has ensued. 
That's why growth is so slow, with some countries now re-entering recession – because insolvent banks, pretending they're still viable, are hoarding cash in a desperate bid to survive. 
Meanwhile, legitimate demands for credit, not least from firms wanting to maintain or expand their operations, are denied or granted only at usurious rates. Ergo, the West isn't recovering and unemployment is rising – and the core of the problem is a group of opaque, moribund banks. 
Attempts to keep these banks afloat, extending the lives of what are commercially "dead" institutions, have hammered sovereign balance sheets. 
Several of the most advanced nations on Earth are now only keeping their government debt markets afloat by ordering central banks to "print" electronic credits, then buying back blocks of their own paper. 
During the past two decades, Western governments have borrowed and spent irresponsibly. Cleaning-up after the banks, though, has pushed several financially stable nations to the brink of insolvency and, if we're honest, beyond. 
In western Europe, of course, this evil brew is even more ghastly – given the policy incoherence, and conflicting incentives, imposed by the economic madness that is the euro. 
Breaking this deadlock and restoring growth and stability isn't about "big bazookas" or "quantitative easing". These "solutions" merely buy time, albeit at untold cost to our children and grandchildren. 
Above all, though, QE and the other "special measures" have allowed badly-run banks to keep pretending they can avoid facing-up to their massive investment errors, while allowing politicians to dodge the really tough decisions. 
Given the powerful interests it serves, no wonder QE is set to continue. "Bank transparency" – genuine transparency, such as the one FDR imposed to break the Great Depression, or as Sweden used to escape its banking mess in the 1990s – has been the "third rail" of the West's response to subprime. 
Many politicians know it's ultimately needed, but they've refrained from discussing it for fear of enduring an almighty shock. 
The power of the banking lobby, its campaign dollars, and concerns about being seen to provoke a crash, have meant our leaders keep avoiding the central issue – that is that many of our banks are insolvent and need to write off their losses and close.... 
"Full disclosure" must happen, if we're to free ourselves from this torpor and get the Western world back on an even financial keel. 
"We're just so overleveraged," said Romney, during a routine campaign stop in Florida. "There's so much debt in our society, and some of the institutions that hold it aren't willing to write it off and say they made a mistake ... and that we need to write those losses down and start over. 
"They keep on trying to harangue and pretend what they have on their books is still what it's worth," Romney continued. "The banks are scared to death that if they write all these loans off, they're going to go broke … So they just pretend all of this is going to get paid someday so they don't have to write it off and potentially go out of business … This is now cascading through our system and in some respects government are trying to just hold things in place, hoping things get better ..." 
"My own view," Romney concluded, "is that you recognise the distress, you take the loss and let people reset. Banks that are prudent will be able to restart, those that aren't will go out of business". 
I don't particularly want Mitt Romney to be President. Were he to win the White House, he may even backtrack on these Florida words. Yet this is a man with perhaps more financial acumen than anyone who has ever got close to becoming President. And in arguing for "full disclosure", Romney is totally correct. He is also far from alone. A growing number of policy experts now talk along these lines. 
America's SEC, in fact, just issued "guidance" that US banks should provide "detailed information" about their European debt exposure so investors can make more informed decisions about which banks should survive. 
"Guidance", though, isn't a requirement, more an attempt by compromised regulators to fend-off an idea whose time has come. 
Last week saw much backslapping at Davos, as eurozone politicians, and their banking chums, pushed Germany closer to full-scale money-printing. Predictably, banking stocks rallied. 
The bankers should know, though, that the logic of "full disclosure" is irresistible, the historic evidence clear. Romney's outburst may have been unconscious, perhaps even unintended. But he has tipped the first political domino in a process that will ultimately prevail.

Friday, January 27, 2012

Bank of England and HM Treasury agree on covert operations to save banks

HM Treasury and the Bank of England have agreed on a Memorandum of Understanding under which the BoE will conduct covert operations if requested to do so by the Treasury.

Clearly, the areas of the UK government that supervise the financial system believe that the invisible hand works best when there are secrets.

This directly contradicts Econ 101 where students are taught that a necessary requirement for the invisible hand to work properly is that buyers know what they are buying.  How could a buyer of a bank's securities have all the useful, relevant information so that they could assess the riskiness of the bank and know what they are buying if the bank is part of a covert operation?

With ultra transparency, market participants can assess the risk of each bank.  As a result, market participants will demand a higher rate of return from the riskier banks.

Some banks will see this increase in their funding costs and respond by lowering their risks.

Other banks will ignore the increase in their funding costs and increase their risks.  As these banks increase their risk, an interesting thing happens to the ownership of their securities.  Each owner decreases the amount of exposure towards that level that the owner can afford to lose if the bank goes under.  

I think of this as simple asset allocation towards low risk securities and away from high risk securities.  Market participants see failure as a real possibility and adjust their exposure accordingly.  This is the essence of market discipline -- something banks have not been exposed to for decades.

If in fact a bank subsequently fails, there is no pressure on regulators to bail it out as the issue of contagion has already been addressed (investors are only exposed to what they can afford to lose).

Hence, there is no need for a secret operation and this includes when the central bank acts as a lender of last resort.  Please note how the long term refinancing operation undertaken by the ECB has completely eliminated any stigma from borrowing from any central bank.

How is the market better off for the government misrepresenting the financial condition of a bank and conducting covert programs?  It isn't.

The reason the interbank loan market in Europe is frozen like a rock is that no one knows which banks are solvent and which are not.  All the secret government programs have done nothing to answer this question.

If you want to maintain an inherently unstable financial system with regulators contributing directly to financial instability, you don't have disclosure and you allow governments to conduct secret bailouts.

Where the Chancellor directs the Bank to conduct a support operation, either to the financial system as a whole or to one or more individual firms, the Bank will act as the Treasury’s agent. 
The Bank will set up a Special Purpose Vehicle (SPV), separate from the Bank’s balance sheet, to effect the support operation. 
The Bank and the Vehicle will be indemnified by the Treasury. 
Where the Treasury has determined that the operation needs to be carried out covertly, the Bank will execute the operation in a way which best ensures that the existence of the operation does not become public.

Eurozone banks face question of what to do with ECB provided liquidity

The Wall Street Journal published an article discussing what Eurozone banks are going to do with the ECB provided liquidity.

The article confirms what your humble blogger has said previously.  Specifically, that the money is not going to be used to fund new loans because of the pursuit of the 9% Tier I capital ratio, but rather hoarded.
After receiving nearly half a trillion euros in cheap loans from the European Central Bank last month, the Continent's banks face a dilemma: to invest the money in lucrative but potentially risky government bonds or hoard the cash at a loss. 
The choice reflects the uncertainty surrounding Europe's financial system at a time when dark clouds continue to hover over the euro-zone economy and its common currency. Regardless of whether banks use the money to buy bonds or simply stash it at the central bank for safekeeping, consumers and businesses are unlikely to see much of the funds pumped back into the economy in the form of loans. 
The ECB in December extended about €489 billion ($640.88 billion) in three-year loans to hundreds of banks that operate in the euro zone. The loan program was primarily designed to fend off a potential cash crunch. European banks face hundreds of billions of euros of debt coming due this year and, with funding markets shut to all but the strongest institutions, some banks faced the prospect of serious liquidity problems.
Bankers and government officials gathered in Davos, Switzerland, this week for the World Economic Forum are virtually unanimous that the ECB's loans have eliminated such fears, at least for now. And the ECB is poised at the end of February to offer banks another chance to take out the loans. Bankers and analysts expect them to borrow hundreds of billions more. 
The ECB loan program provides "a very significant degree of breathing space to banks," said Adair Turner, chairman of the U.K.'s Financial Services Authority, in an interview here. 
But bank executives say lenders are taking radically different views on how to use the money.
Some are squirreling it away. In at least some cases, that means parking the funds back at the ECB in a facility that houses bank deposits overnight.
Thanks to the ECB loans, the banking industry is "awash with liquidity, although I have to admit that most of that liquidity goes back to the ECB overnight," said Francisco Gonzalez, chairman of Spanish lender Banco Bilbao Vizcaya Argentaria SA. 
That sentiment, echoed privately by other senior European bank executives in Davos this week, also is apparent in the amounts housed in the ECB's overnight deposit facility....
The downside is that leaving the money in the deposit facility is a money-losing proposition. The ECB pays a paltry 0.25% interest rate—less than the 1% that banks were charged to borrow from the ECB in the first place. 
But it offers banks the comfort of knowing their funds are safe. Industry experts said this week that such safety is more valuable in the current environment, especially for lenders in troubled countries such as Italy, Spain and Portugal. "'Survival first' will have to be the mantra for most banks in peripheral European countries," analysts at RBC Capital Markets wrote. 
"Those [banks] with liquidity are parking it with central banks. Those without liquidity are borrowing from central banks," said Peter Sands, chief executive of U.K. bank Standard Chartered PLC, which didn't borrow funds from the ECB. "So instead of being the lender of last resort in times of crisis, central banks have become the central actor."
This way the ECB takes on the credit risk of the borrowing bank which the lending bank is not able to determine because of opacity.
Other bankers and investors said several lenders are using the funds to snap up large quantities of government bonds in stressed countries. The theory: The banks could pocket a tidy profit thanks to high interest rates on the government bonds. 
That, in turn, could defuse governments' financial problems and simultaneously help repair banks' balance sheets by boosting their profits.... 
But it exposes banks to the risk of drops in the price of the bonds, particularly if the European crisis takes a turn for the worse....
Even if banks are using the funds to buy government debt, that won't necessarily provide permanent relief to cash-strapped European governments. "Without greater demand from nonbank investors, the level of supply absorption may not be sustainable," said Guy Mandy, a European rates strategist at Nomura, on an investor call Thursday. 
Some bank executives said they are loath to publicly confirm they are using ECB funds to buy government bonds for fear of public criticism that they are using central banks' money for a quick buck rather than to help kick-start the European economy by lending the funds to customers. 
Some bank executives said the ECB money will eventually trickle down into loans to businesses and individuals. 
"The cost of funding is going down very rapidly. That will put more money in the margins of the banking system, which is good because in order to give credit you need strong banks," said BBVA's Mr. Gonzalez. "We are in the process of filtering that money down to the real economy."
Actually, you do not need "strong banks" to provide credit.  As shown by the US Savings and Loans in the late 1980s, insolvent banks can provide credit.  In addition, there is the entire structured finance industry and shadow banking system to provide credit. 

Thursday, January 26, 2012

$175 billion in incurred, but not allocated losses for RMBS securities show transparency needed

R&R Consulting issued a press release in which it discussed how realized losses on private label residential mortgage-backed securities are likely to rise by $300 billion.  Of this $300 billion, $175 billion has already been incurred, but not yet properly allocated.

The existence of incurred, but not yet properly allocated losses is a major problem.

For example, until the losses are properly allocated, junior tranches of the RMBS securities continue to receive cash distributions that they would not be entitled to if the losses were allocated as incurred.

Regular readers know that your humble blogger has been pushing since before the financial crisis for a master database that would have all of the underlying asset performance data on an observable event basis for each transaction.

If this database existed, losses would be allocated as they are incurred and each tranche of a deal would get the cash it was entitled to.
On the securities performing at December 2011, a universe of approximately $1.42 trillion, R&R estimate the amount of additional losses likely to materialize is $300 billion, with one-third concentrated in ten arranger names, including Countrywide, Morgan Stanley and JP Morgan. About 17,000 tranches, or 34% of the universe analyzed by R&R, may lose up to 83% of their remaining principal. 
In addition, R&R estimates that approximately $175 billion of losses already incurred on the loans have not yet been allocated to the bonds in the related transactions. Failure to allocate realized loan losses could distort the valuation of related RMBS tranches.... 
In the course of conducting valuations on RMBS, the R&R analytics team discovered widespread, serious, repeated data discrepancies. Ann Rutledge, a founding principal, asked the team to measure the magnitude of the discrepancy on the RMBS universe. 
To do this, R&R subtracted cumulative losses allocated to the tranches from unallocated, expected losses, calculated as the sum of defaults, bankruptcies, foreclosures and REOs minus recoveries. “The results were very disturbing: $175 billion of unallocated current losses and $300 billion of imminent losses,” Rutledge said. 
Rutledge commented that she was not clear why these losses are being held in limbo instead of being properly allocated, since the data used by R&R in the calculations were included in the servicer reports. She cautioned, “Investors should be concerned about receiving inaccurate bond performance information and paying unnecessary fees.” 
The implication for bond holders in RMBS is significant with respect to both estimates.  
Subordinated securities in the RMBS with probable future losses ought to be written down by such losses but instead may be continuing to receive interest owed to more senior tranches. It could also mean that servicers are earning fees against loans that have already been liquidated, which also reduces the amount of cash to pay senior bond holders.  
For example, in one month, servicers could generate $75 million or more in inappropriate fees against the $175 billion in unallocated losses. 
Rutledge also noted that R&R has observed a steady increase in amount of limbo losses, raising the prospect that a significant amount of funds are still being misallocated for bond investors. 
“The system for MBS is still fundamentally broken,” she said. “All the loose ends need to be identified and knit together into a well-functioning system before investors can feel comfortable investing in RMBS once more.”

And the only way that is going to happen is if there is a master database for all structured finance securities.

Eurozone banks hoarding ECB cash spells end to 'zombie companies'

A Bloomberg article reports on the ongoing Eurozone credit crunch as banks continue hoarding the EBC cash while trying to reach the 9% Tier I capital requirement.

Specifically, the article looks at how the credit crunch is increasing Europe's default rate.

In particular, the default rate will increase for firms that have little or no equity value but have enough value so that senior lenders like the banks can be repaid.

At the same time, banks have an incentive to continue using extend and pretend on the loans to zombie companies where they would have to recognize a loss on the loan and the resulting reduction to Tier I capital.

Corporate defaults may almost double in Europe as companies struggle to refinance debt and banks hoard cash borrowed from the European Central Bank or use it to buy government bonds.
Europe’s default rate may soar to 8.4 percent or more, from 4.8 percent at the end of 2011 as the recession bites and company financing dries up, according to Standard & Poor’s. ... 
“It’s very challenging for anyone to raise money from lenders right now,” said Andrew Cleland-Bogle, a Frankfurt- based director at corporate finance specialist DC Advisory Partners. “Combine that with increased bank capital requirements and you can see that although banks are getting money they’re very selective when it comes to lending it. 2012 is going to be a very, very tough year.” 
Speculative-grade companies have to refinance about 230 billion euros ($300 billion) through 2015, according to S&P. At the same time, banks and loan funds that provided the initial funding are scrambling for capital or reaching the end of their reinvestment periods and may be unwilling to extend loans....
Note the use of the word 'may' in the highlighted sentence.
“There are a lot of zombie companies that are trapped by their debts and have no way out,” Bryan said. “The recovery isn’t really happening and there’s a high probability we’re going into a double-dip recession. For all that the banks kicked the can down the road once, the realization is dawning that they can’t just do that again.” 
A very big assumption that banks cannot kick the can down the road again particularly now that they have guaranteed access to funding through the ECB.
Companies bought by leveraged buyout firms during the boom years in the middle of the last decade are particularly vulnerable to the dearth of funding because their debt levels are higher than investors are willing to accept, said Edward Eyerman, head of leveraged finance atFitch Ratings in London. And because banks and collateralized debt obligations are also leveraged, the problem is amplified, he said. 
“For companies that have five times leverage, are in cyclical industries, exposed to anemic economies and have near- term maturities, it’s questionable how much equity value is underneath the debt,” Eyerman said. “When these highly leveraged borrowers get into trouble, the focus on what’s the right capital structure for a company within its industry to perform effectively competes with the demands of banks and CLOs to preserve the senior debt.”...
Lower-rated borrowers that have a large part of their business in the nations hardest hit by the sovereign debt crisis, and which haven’t refinanced loans coming due this year and next, will “face particular difficulties,” he said.

The European Banking Authority, which found a 115 billion- euro capital shortfall in its most recent stress tests on lenders, has given banks until June to find the cash or face nationalization. 
Struggling to raise the money, lenders are choosing to reduce risk-weighted assets instead. European banks, which currently have total assets of about 26.5 trillion euros, will probably reduce their balance sheets by 5.1 trillion euros in the next three to five years, according to Alberto Gallo, a strategist at Royal Bank of Scotland Group Plc (RBS) in London. 
“Given the large shortfall in equity capital and persistent sovereign risk, we think it will be difficult for European banks to start transferring their liquidity to the broader economy,” Gallo said.

Big Data and the Mother of All Financial Databases

The NY Times reports that at Davos discussions have focused on big data.  Specifically, how big data is going to transform the way decisions are made and the industry operates.

The financial industry is no exception and would be particularly true if ultra transparency was adopted and your humble blogger's Mother of All Financial Databases was constructed.

Today’s topic de jour: data. Lots of data. 
What makes the data discussion different than in previous years is that it is being discussed in high-profile nontechnology meetings too. This is clearly evident at this year’s annual World Economic Forum. 
Meetings here this week include: “From data to decisions: How are new approaches to data intelligence transforming decision-making?” “Data deluge and citizen science.” “Incidents from digital crime to massive incidents of data theft are increasing significantly, with major political, social and economic implications.” “How is big data being used to uncover individual and collective human dynamics?” 
The discussions are not confined to technology attendees either. Chancellors, bankers and educators meeting at the conference are being asked to discuss what the forum calls a growing data deluge and how to manage it. 
2012 report released by the World Economic Forum, titled, “Big Data, Big Impact: New Possibilities for International Development,” outlines some of the possibilities data can bring around the globe to business and education. It also warns of its potential privacy implications.
Please note that I designed a prototype of the Mother of All Financial databases where protecting borrower privacy was a major feature.  Specifically, the database complies with the privacy as laid out under HIPAA - the gold standard for privacy in the US; it is based off of EU financial privacy laws.
The report says data is a new economic asset class, which touches all aspects of society, regardless of income or location. 
“Big data represents one of these seismic economic shifts that happens every 10 years,” said Zach Bogue, co-founder of a stealth data investment fund called Data Collective, who was attending Davos. “In some sense, this data has always existed, but until now the bandwidth, storage capability and compute power haven’t existed to harness it.” 
Yet as there is talk of data, the discussion of privacy is not far behind....

At the World Economic Forum, the discussion is also focusing on one of the toughest regulation challenges in regards to data collection: How to manage a balancing act between governments overseeing data collection and its actions stifling innovation. More importantly, regulators hope to figure out a global solution to data collection.
When it comes to finance, governments should require ultra transparency and let the market develop the Mother of all Financial Databases consistent with protecting borrower privacy.
As the World Economic Forum reports says: ”Concerted action is needed by governments, development organizations and companies to ensure that this data helps the individuals and communities who create it.”

Bernanke confirms why economists must disclose three critical assumptions behind their recommendations

Regular readers know that your humble blogger focuses on solutions to the financial crisis.  As a result, I seldom write on monetary or fiscal policy.  However, when I do write on monetary or fiscal policy, the ideas in the posts are typically provocative and subsequently become accepted.

In the last 24 hours, I was asked by a reader (hat/tip Bart E.) to apply my economic paper disclosure requirement to Fed Policy -- Zero Interest Rate Policies and Quantitative Easing -- and I came across an interesting post on NakedCapitalism which asked the simple question "Is QE/ZIRP killing Demand?"  I answered yes to this question over a year ago in a post.  

Regular readers know that I prefer a simple disclosure be attached to all economic papers:
The following are the three most important assumptions on which this paper is based.  If they are not correct, accepting or applying any aspect of this paper, including its recommendations, is likely to cause significant economic damage.
Now, imagine that this was applied to the zero interest rate and quantitative easing policies being pursued by central banks around the world.

What would the critical assumptions look like?  As reported on a Forbes' blog,
In his post-FOMC press conference, Fed Chairman Ben Bernanke recognized his zero-interest rate policy hurts savers.  Clearly Mr. Bernanke realizes that his recommended policy has the capacity for inflicting harm.
But what assumptions is he making that would justify inflicting harm?

Bernanke made it crystal clear that his intention is to make people spend, practically telling savers to get out there and invest [in longer term and riskier assets].
First, he assumes that in the aftermath of a credit bubble monetary policy can actually make people spend or change their investment behavior to accept greater risk.

This is a very interesting assumptions given what happened leading up to the financial crisis in 2008.  Then, investors responded to the Fed's low interest rate policy by chasing yield.  Specifically, they purchased opaque, toxic structured finance products produced by Wall Street.

We know how chasing yield worked out for investors.

Does Mr. Bernanke now assume that these same investors have amnesia and have forgotten how much money they can lose chasing yield?

This assumption is also very interesting in light of the Japanese experience.  Japan also experience a credit bubble bursting that rendered its largest financial institutions insolvent (the market value of their assets was less than the book value of their liabilities).

Japan's central bank rolled out zero interest rate policies and quantitative easing.  

This has been going on now for 2+ decades and savers are trying to save and investors are still shying away from risk.  What has not happened is that savers and investors have not decided because they cannot receive a return on their savings or investments that they should stop saving or investing and instead spend.

Why exactly should US savers and investors behave differently?

The Chairman was put on the spot with several questions regarding the effectiveness of his policies.  Asked about the destruction of savings given ultra-low interest rates, Bernanke admitted he understood savers were getting a real bad deal.  Essentially, Bernanke said the anemic recovery necessitated low interest rates to strengthen.  Low rates are used to stimulate investment, according to Bernanke, and that “has a cost on savers.”
Second, he assumes that ultra low interest rates will stimulate investment.

I have a confession.  I do not have a PhD in economics.  I have a Masters in Management (another way of saying MBA).

In b-school they teach that interest rates factor into the decision by business to invest well after the question of "is there demand" has been answered.  If there is no demand or prospect for demand, no further analysis is needed and no investment takes place.

[In b-school they also teach the idea of discounting cash flows and the rule of 72 - the time it takes to double your money.  This rule is interesting as it gives a sense for the lack of importance low interest rates has in the investment decision.  At 6%, it takes 12 years to double your money.  At 4%, it takes 18 years.  Simply put, low rates do not change a marginal or high risk investment into a good investment or one that should be undertaken.]

So now we know why Mr. Bernanke is pleading with savers to spend.  Without spending, there is no demand and without demand businesses will not invest.

This raises an interesting question?  What will it take to encourage savers to spend again given that Japan has shown that 2+ decades of zero return doesn't do the trick?

A good place to start might be to look at Walter Bagehot's 1870s observation about what rate savers need.
John Bull can stand many things, but he cannot stand two percent.
[For those who do not know who Walter Bagehot is, he was a businessman and editor-in-chief for the Economist magazine who quite literally wrote the book on what modern central bank's should and should not do.]

The economic experience of each country that has pursued zero interest rate policies would appear to confirm that Mr. Bagehot is right.  Below two percent, John Bull cannot stand it and demand declines.
In other words, Bernanke told people to stop saving and start investing.  When the economy is really bad, he explained, returns are going to be low and savers will get meager returns.  
Keeping your money in supposedly safe Treasury bills and CDs won’t help reactivate the economy, according to the Chairman’s view of the economy, and neither will keeping dollars under a mattress.
So apparently Mr. Bernanke assumes that people should behave exactly how his economic model says they should behave or conversely that people are behaving irrationally if their behavior does not conform to the model's prediction.

Instead, people appear to be following Mark Twain's investment advice:  worrying about the return of their money rather than the return on their money.  In following this investment advice, they are not reactivating the economy.

Mr. Bernanke is clearly frustrated that people are following Mark Twain's investment advice and not his economic model [which apparently assumes that retirees will rush out and spend the savings they need to live off of for the rest of their life because interest rates are zero and not instead cut back on consumption to make their savings go as far as possible].

Perhaps the Queen of England and I are the only ones to notice a simple fact: economic models failed leading into the financial crisis and have failed in their predictions since the start of the crisis.

The important point here is that policy is being driven off of assumptions in economic models that do not work.

As they say at Davos, now is time for a Great Transformation.  We need to start setting policy based on what people actually do and not off failed economic models.