Wednesday, February 29, 2012

Standard Chartered's Peter Sands identifies systemic risk

In discussing his bank's financial results, a Telegraph article reports that Peter Sands observed
that he was worried that international regulators were fixated on preventing another collapse like Lehman Brothers and not looking at the risks created by the expansion of central bank balance sheets.
Please re-read the highlighted text because Mr. Sands has identified the largest systemic risk in the financial system.

Just like structured finance securities and bank balance sheets are 'black boxes', so too is a central bank's balance sheet.

While a central bank can always fund its balance sheet by printing more money, there is a risk from the expansion in the central bank balance sheets that the public loses confidence.

As Morgan Stanley said (hat tip Zero Hedge):

What happens when the public loses confidence in central bank liabilities? 
A: A run on the fiat money systemIn response to the seismic shift in private sector risk-aversion the financial crisis brought about, central banks have deployed their balance sheets to cushion the blow to the economy.
Actually, the private sector is no longer willing to buy opaque products including structured finance securities and bank liabilities that are not guaranteed.

The central banks are using their balance sheet to fill this hole.

Should the central banks want to stop using their balance sheets, they should require the end of opacity in the financial system.
They have done so by taking the unwanted risk off the private sector balance sheet and replacing it with safe as well as liquid assets: central banks’ own liabilities
This is, in essence, a confidence trick. It works for as long as the private sector is willing to hold these liabilities – i.e., for as long as they are considered safe, which in turn depends on them being considered safe by everyone else. 
A central bank will, of course, never default on its liabilities – they can, after all, create unlimited amounts of it. 
But the ‘safety’ property also depends on whether this asset is seen as a store of value, i.e., likely to maintain its real value – its value in terms of goods and services. 
So, while there is no technical limit to the expansion of central bank balance sheets, there is a limit nonetheless: the public’s confidence in the real value of such liabilities – and government liabilities more generally. The more such liabilities are created, the more we approach this point. 
How would such a loss of confidence unfold?  
If the supply of central bank liabilities – call it ‘liquidity’ – exceeds the public’s liquidity preference, then the latter will seek to substitute away from it. The public will then buy goods and real assets. The result is self-fulfilling inflation – inflation will rise essentially because the public has lost confidence in the ability of central bank liabilities to maintain their real value. 
 We are probably very far from such an outcome – far enough that it can be considered a tail risk. Yet, the risk in question is nothing less than a wholesale run on the fiat money system.

ECB's bazooka has not stopped money collapse in Greece, Italy, Portugal and Spain

In his column, Ambrose Evans-Pritchard discusses the ECB's Long Term Refinancing Operation and notes that it has not stopped the collapse of M1 deposits in Greece, Italy, Portugal and Spain.

Readers know that the collapse in deposits in these countries is related to the run on the banks going on in these countries.

Specifically, there is a run on the banks going on because not only are there questions about the solvency of the banks, but there are also questions about the ability of the sovereign to make good on its bank deposit guarantee.

As for deposit growth in the North, particularly Germany, this is not surprising because the deposits have to go somewhere.  The alternative is a mattress.

So the Draghi Bazooka II will be just under €530bn: Goldilocks, if you like that kind of liquidity. Not too high, not too low. Instant thoughts: 
This is about €330bn of new money once you strip out roll-overs of shorter maturities. The last one in December was a net €200bn, so it is a nice shot in the arm for French, Italian, and Spanish banks, and their sovereigns. 
They can borrow at 1pc for three years to buy Club Med bonds at over 5pc, the Sarko "carry trade". It is certainly a game-changer for the South, heading off the near-certain disaster that was unfolding before Mario Draghi took over the European Central Bank.
While it will boost the income of the Club Med banks, it is not clear that it will restore them to solvency.

As this blog has said repeatedly, it is time to adopt the Swedish model under which Wall Street/the Banks rescue Main Street.  Banks need to recognize all their losses and provide ultra transparency to prove it.

Combining this with the Draghi Bazooka then puts the banks on the path to restoring their book capital and providing the funds the local economies need to grow.
But be careful. It is in essence a Martingale play, a doubling up of a very risky strategy. Prof Charles Wyplosz from Geneva University said the ECB is taking a trillion-euro bet. 
The weakest banks in the weakest countries are gobbling up ever more sovereign debt, concentrating systemic risk. If it all goes wrong, the ECB itself will be in grave trouble with ever expanding junk collateral. 
The ECB action is leading to structural subordination of all other creditors, degrading the bonds of weaker banks – some of which will soon be reduced to junk status. The Draghi LTRO reduces the likelihood of defaults, but increases the losses should it happen.
As previously discussed, the unsecured debt and interbank lending markets are frozen.  As a result, the ECB funds are replacing the unsecured debt and interbank loans as they mature.

Should these markets remain frozen, subordination is a moot point as they will no longer have any exposure in the banking system.
It is double-edged, and whether it ultimately works will depend on the monetary transmission channels. The data from January showed that the eurozone’s broad M3 money supply has recovered slightly, but narrow M1 is flat and lending to business is still deep in the doldrums. 
It is not yet enough to save the South. 
What few economists picked up – because there are almost no monetarists left – was the monetary break-down by country. Simon Ward from Henderson Global said the collapse of real M1 deposits is continuing at terrifying speeds in Europe’s arc of depression. The vortex is actually getting worse
The six-month fall was 12.9pc in Greece, 9.2pc in Ireland, 9pc in Portugal, 8pc in Italy, and 1.5pc in Spain (there are special technical reasons for the Spain’s better profile). On an annual basis these rates would be twice as high. These are 1931-1932 rates of decline. Indeed they are worse than the worst year of the Great Depression. 
Meanwhile, real M1 deposits are recovering in the North. The gap is widening again.

ECB's cheap money preserves zombie banks

In a Telegraph article, Harry Wilson looks at the impact of the ECB's Long Term Refinancing Program and concludes that it kicks the problem of banks recognizing their losses on toxic assets into the future.

Actually, it is not the ECB's funding that kicks the problem into the future, but rather the choice by the Eurozone policymakers and financial regulators of implementing the Japanese model for handling a bank solvency based financial crisis.

What Mr. Wilson discovered is that unless financial regulators require banks to recognize their losses, they will not do so.  Why should they given the impact of these losses on their bonuses?

Under the Japanese model, not only are the Eurozone financial regulators not requiring the recognition of losses, but they are actively blessing banks hiding their losses on and off their balance sheets (see RBS's Stephen Hester's confession).
Last year a well-known senior former investment banker travelled around southern Europe’s troubled banks offering them a simple trade. 
He knew their balance sheets were stuffed with billions of euros of toxic loans. He also knew the banks could neither afford to finance these assets any longer, nor had enough capital to recognise the full-scale of the losses they would have to take to sell them. 
Meeting with the banks he offered to buy not the odd loan here and there, but their entire toxic portfolios. The catch: well he wouldn’t offer them the face value of the loans, not even close, but he’d pay enough that it would be at a level where the bank could take a manageable loss. 
Everything was going well until December when the ECB launched the first three-year long-term refinancing operation, or LTRO, which saw eurozone lenders borrow €489bn (£414bn) from the central bank at a 1pc interest rate. 
Almost immediately the banker’s calls stopped being returned and meetings were cancelled. 
Buoyed by the ECB’s cheap money, the impetus for the previously cash-strapped banks to offload their toxic assets was removed and they were now in a position to adopt a wait and see approach. 
I do not expect many people to feel too sorry for the banker, but what his story demonstrates is the profound effect the ECB’s LTRO borrowing programme, which today has lent a further €530bn to eurozone banks, has had on the recipients behaviour. 
Losses that might have been recognised sooner will now be taken later. Problems that were on the cusp of being dealt with have been bought off for at least the next three years.... 
Across Europe hundreds of banks open their doors every day only because of Mr Draghi’s intervention. These lenders may look like banks, call themselves banks, and, to their customers, feel like banks, but they are in reality wards of the ECB, going through the motions of banking.
These banks can make little impact on the real economy, and their main purpose in life is merely to survive and maintain the status-quo. They cannot afford to make loans and be the agents of Europe’s economic recovery as they remain too bloated with toxic debt and are, to all intents and purposes, insolvent.
Actually, Mr. Wilson is wrong here.  As shown by the US Savings and Loans in the late 1980s, banks that are for all intents and purposes insolvent can continue to make loans.  Call it gambling on redemption.  In the case of the Savings and Loans, they invested heavily in commercial real estate and junk bonds and had a significant impact on the economy.
In Italy, Spain, Portugal and many other European countries, small and medium-size lenders, and many larger banks too, have tens of trillions of toxic debt still on their balance sheets. 
The ECB loans have bought time to begin fixing these problems, but it is not a cure in and of itself. 
Unpalatable as it may be, the European banking system’s toxic debt burden will not begin to be solved until lenders are forced to make the scale of writedowns that banks in Britain and the US have done over the last four years.
Actually, as Stephen Hester confessed, the banks in Britain have not been require to take the write-downs necessary to solve the problem.
Be under no doubts, the European banking system remains broken at its core. The LTRO is merely the full body plaster cast hiding the cadaver inside.

Is Sir Mervyn King about to champion ultra transparency? [update]

As a Telegraph article says, Sir Mervyn King 'loses his cool' when it comes to talking about what should have happened with the banks as a result of the financial crisis.

My only question is will Sir Mervyn King now step forward and lead the charge to require banks to provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details?

Given what he told the Treasury Select Committee he wants, requiring ultra transparency is the most direct and fastest way to achieve it as it brings market discipline to the banking system.  Unlike politicians, markets are not influenced by lobbyists, but rather by the actual risk and performance of the banks.
Sir Mervyn King, Governor of the Bank of England, made a remarkable statement in front of the Treasury Select Committee this morning. I’ll include his whole quote below, but let me sum it up. 
Andrew Large, a Labour MP on the committee, accused the Governor of being “relaxed” about the current economic situation, which provoked a surprisingly angry reaction from the Governor. 
First, he said he is far from “complacent” .... Then he launched into a fierce attack on the banks, the weakness of politicians in the face of the forceful bank lobby, and the Labour Government.... 
Politicians did back down in the face of the bank lobby when it came to regulating the banks.

However, that was only after these same politicians had been advised by their nation's financial regulators to adopt the Japanese model for handling a bank solvency led financial crisis.

The regulatory blessing of hiding losses on and off the banks' balance sheets gives the banks tremendous negotiating leverage that bankers are uniquely qualified to take advantage of.

Had the Swedish model for handling a bank solvency led financial crisis been adopted, politicians would not have backed down in the face of the bank lobby.
Sir Mervyn opened by claiming the banks should have been recapitalised far more than they were (in all it was close to £100bn). In the case of RBS, that would have probably meant full nationalisation. 
Readers know that between deposit guarantees and access to liquidity through a central bank banks can continue to operate indefinitely and therefore there is no reason for governments to ever recapitalize a bank.

Readers also know that banks are the safety valve between the excesses in the financial markets and the real economy.  Banks perform this safety valve function by absorbing the losses on the excesses in the financial markets today and rebuilding their book capital through the retention of future earnings and equity issuance.

Finally, readers know that banks must be required 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 confirm that the banks have recognized all their losses and that the banks are not gambling on redemption in their efforts to rebuild their book capital.
Then he claimed Labour had been feeble in its attempts to ensure the banks lent to small businesses, something he claimed to have had concerns about from the start of the financial crisis. 
Gathering a head of steam, he proceeded to turn his guns on the way banks are currently behaving – suggesting they are even trying to profit at taxpayers’ expense.
Why exactly does he find the banks' behavior shocking?

The UK government adopted the Japanese model for handling a bank solvency lead financial crisis.  Having made bank book capital a sacred number, the government then had to bailout the banks on terms that were favorable to the banks.

Having benefitted so much from the bailout at taxpayer expense, why should he be surprised that the banks expect to continue to profit at taxpayer expense?
He claimed they are proving an obstacle to the Chancellor’s efforts to establish a “credit easing” programme to help lending to small business. 
The banks, he said, want to hand over to the taxpayer the dud loans that will make losses while keeping the profitable ones for themselves. 
This behavior is no different than what banks had been engaged in leading up to the financial crisis.  Then, the banks simply put the dud loans into opaque, toxic structured finance securities.
Having slammed the self-interested banks, he turned his ire on Labour’s years in power and, seemingly, Alistair Darling. In Labour's years, he suggested, banks more or less set public policy. The government negotiated with them and then adopted their proposals, he claimed. In all, it was quite a remarkable tirade. 
Again, by adopting the Japanese model, the government choose to let banks set public policy.
Here’s the quote: 
“I’ve consistently and publicly been dissatisfied with what has been done. I said to the previous government that the scale of the recapitalisation of the banks was inadequate and their actions in making sure banks lend to SMEs was also inadequate. I made that very clear. 
“In terms of asking banks to put together pieces of paper that are claims on SME loans, I will tell you exactly what would happen. The pieces of paper given to us [taxpayers] would be the worst of the loans, not the good ones. And I’ll tell you why. Because in discussing with the present Government a scheme to lend to SMEs, the banks were unhappy about the idea of a scheme in which the Government would participate in all SME lending. 
“Why? Because they didn’t want to share the fruits of the most profitable loans to small businesses. We’d [the taxpayer again] end up being left with the bad ones. That’s why we’ve [the Bank] been very clear on this with Government.
“I’m not relaxed about it at all. I’m the person who put forward proposals for how this might be done. They are not proposals that banks find in favour. I’m disappointed that the government you supported before [Labour] was unwilling to take on the banks on this issue. 
“They negotiated with the banks, and if the banks didn’t like it, that was what came out. That doesn’t seem to be a very strong public policy. So, I’m far from relaxed or complacent, Mr Large. I am actually rather concerned about it. I want to see something that makes sense economically, not something which is just a gesture. 
“Unless there’s an element that tries to prevent the banks picking and choosing which SME loans they share with Government, and which not, there is a risk of adverse selection and taxpayer gets a bad deal.”
Sir Mervyn King's issues with the banks could be cured by abandoning the Japanese model and adopting the Swedish model for handling a bank solvency led financial crisis.

Requiring banks to recognize their losses and provide ultra transparency to prove it would dramatically change the financial system for the better.

Economic models versus financial system reality

Since your humble blogger began talking about the need for transparency/disclosure in the financial system almost two decades ago, I keep finding out that transparency/disclosure is an idea that is easy to understand at a purely theoretical level, but is very hard to understand at the implementation level.

Cathy O'Neil provides a wonderful example on her Naked Capitalism post: economists don't understand the financial system.
What I felt then and what I still feel is that these super influential economists are so high on their clean, simple economic models of the world (about the only variables of which are GDP, stimulus, and tax rates) that they focus on the model to the exclusion of the secondary issues. 
Sometimes you get important results this way: simplifying models can be really useful. But sometimes it’s really truly misleading to do so, and I believe this is one of those cases. 
I’m left thinking that they (the economists) are so entranced with their simplified world view that still don’t understand what actually fucked up the world in 2007 and 2008, namely the CDO market’s implosion. 
Message to Krugman: this is not exactly like other financial crises, because it’s partly caused by complexity, and nobody seems to have the balls to fix it. The problem is that the financial system has been allowed to get so complicated and so rigged in favor of the people with information, that normal people, including homeowners, credit card users, politicians, and regulators have been left in the dark, and many of the little guys are still stuck in ludicrous contracts left over from the outrageous securitizations that took place in the CDO market. 
Apparently I am not the only one who wonders how the policies that have been adopted to deal with a crisis that started with opaque, toxic securities has never explicitly deal with the opaque, toxic securities or opacity in the system.
What is especially enraging is how these same economists are still the experts that people turn to to help figure out how to get out of this mess, when they don’t actually understand the mess itself.
A point that the Queen of England made when she asked how the economics profession managed not to warn of the crisis in advance.

Confession:  it has always been a sore point with your humble blogger that he predicted the financial crisis and laid out what had to be done to moderate its impact and, since the beginning of the financial crisis, has not been turned to for help in getting us out of the mess.
Why else would a large audience be willing to pay $25 a piece to hear them talk about this? Why else would Obama be considering Larry Summers to lead the World Bank? 
As an aside: please, Mr. President, do not let Summers lead the World Bank. He does not understand the system well enough to lead it. And he is too arrogant to admit what he doesn’t know.
Doesn't this apply to the economists in general?

After all, when you did not predict the financial crisis isn't that a sign that you do not understand the system.

It most clearly is a sign of arrogance that after not predicting the financial crisis economists feel free to pontificate on how to solve the problem created by the financial crisis.  Hello, what insight do you have exactly?
I can introduce you to a bunch of people that may be less imposing but are more informed, more ethical, and wiser. Give me a call any time and we can chat and form a short list of candidates.
Hopefully Cathy, I am on the short list.

Why did I say that transparency/disclosure is easy to understand at the theoretical level, but very hard to understand at the implementation level?

As Yves Smith discussed in her book, ECONNED.
The scientific pretenses of economics got a considerable boost in 1953, with the publication of what is arguably the most influential work in the economics literature, a paper by Kenneth Arrow and Gérard Debreu (both later Nobel Prize winners), the so-called Arrow-Debreu theorem. 
Many see this proof as confirmation of Adam Smith’s invisible hand. It demonstrates what Walras sought through his successive auction process of tâtonnement, that there is a set of prices at which all goods can be bought and sold at a particular point in time. Recall that the shorthand for this outcome is that “markets clear,” or that there is a “market clearing price,” leaving no buyers with unfilled orders or vendors with unsold goods. 
However, the conditions of the Arrow-Debreu theorem are highly restrictive. For instance, Arrow and Debreu assume perfectly competitive markets (all buyers and sellers have perfect information, no buyer or seller is big enough to influence prices), and separate markets for different locations (butter in Chicago is a different market than butter in Sydney). So far, this isn’t all that unusual a set of requirements in econ-land.... 
this paper is celebrated as one of the crowning achievements of economics.
The idea of perfect information and hence perfect transparency/disclosure is an assumption that underpins economics.

If you look at the Nobel prizes that have been awarded, you will find a couple of them have been awarded that call into question this assumption of perfect  information by looking in the area of transparency/disclosure.

Specifically, Joseph Stiglitz for his work on information asymmetry and Robert Akerlof for his work on accounting control fraud.  The fact that both of these are of interest to financial market participants highlights the simple fact that there is not perfect transparency/disclosure (or as I like to call it ultra transparency) in the financial markets.

If banks were required to provide ultra transparency and disclose their current asset, liability and off-balance sheet exposure details, it would be very difficult for management to engage in accounting control fraud.  Accounting control fraud requires that banks be able to take on greater risk without market participants being able to see the increase in risk and adjusting the pricing of their exposures to reflect this higher risk.

If structured finance securities were required to provide information on the underlying assets as observable events with these assets occur, it would be very difficult for Wall Street to profit from an information asymmetry.  Information asymmetry requires that Wall Street owns the servicers of the underlying assets so that it has tomorrow's news today and disclosure of observable events on the underlying assets is delayed to market participants.

These are just a couple of examples that illustrate the gap between theory and implementation.

More importantly, it makes one ask why do economists stop by awarding Nobel prizes for illustrating the gap between theory and implementation on transparency/disclosure and not offer it up as a solution to a financial crisis that featured opaque, toxic securities?

Tuesday, February 28, 2012

Bank of England's Chris Salmon: Three principals for successful financial sector reform

The Bank of England's Chris Salmon, Executive Director of Banking Services and Chief Cashier, gave a speech titled:  Three principals for successful financial sector reform.

Principal one:

First, in general it is better to manage the costs of change by having a long-transition period to achieve the preferred outcome, than it is to water down the reform so that change can be implemented more quickly... 
There is one area the Bank has tended to be less persuaded by the benefits of transition periods:  transparency.   
The costs of producing information are obviously much less than those associated with
changing balance sheet structures, and lack of transparency was an important factor in the run up to and during the crisis. 
To give a specific example where a relatively speedy move to greater transparency may help, the FPC has recommended that banks publish leverage ratios from the start of 2013, ahead of the Basel III timetables. These would act as a backstop to capital ratios, which are affected by the risk weights applied to bank assets.   
In making this recommendation the FPC drew on market intelligence which suggested that the
opacity of the methods used to calculate risk weights has dented confidence in the published data.  
Manipulating the calculation of risk weighted assets is one of two reasons that bank capital ratios are meaningless.

The primary reason that bank capital ratios are meaningless is that the Japanese model for handling a bank solvency crisis was adopted at the beginning of the financial crisis and regulators have blessed banks hiding losses on and off their balance sheets (see RBS's Stephen Hester's confession).  As a result, bank book capital has no relation to reality.
The Bank hears multiple arguments against producing data like leverage ratios, ranging from the idea that investors will have difficulty interpreting the data, so disclosure could be destabilising, to the suggestion that investors could calculate simple ratios like this themselves, so they add little value.  And sometimes both arguments are put forward at the same time!
The 'investors are stupid and would have difficulty interpreting the data, so disclosure would be destabilizing' is one of the favorite arguments put forth for retaining opacity by the Wall Street Opacity Protection Team.
In the Bank’s view investors need to be presented with a range of information, which allows them to build their own picture of a firm. Some of these may be less sophisticated investors than others, but if we are to reduce the dependence on ratings agencies, more data, must in general be a good thing.
At the high end of the 'range of information', Mr. Salmon appears to recognize the need for ultra transparency and having the banks disclose on an on-going basis their current asset, liability and off-balance sheet exposure information.

In his own words, there are investors who are "sophisticated" and this disclosure would "allow them to build their own picture of a firm".

An example of these sophisticated investors would be banking competitors who currently have a tendency to freeze the interbank lending market because they do not have the data to build their own picture of a firm and assess its risks and the probability of repayment.

Financial innovation and the financial infrastructure [update]

As part of its series on financial innovation, the Economist magazine carried an article in which it discussed the role of financial infrastructure.
FAILURE IN THE financial crisis had many fathers. There were failures of regulators, bankers, shareholders, borrowers and economists. But two in particular were closely tied to the way financial innovations work. One was a failure of plumbing—the infrastructure of the markets and the back offices of financial firms. The other was a failure of the imagination. 
Actually, the failure of the plumbing and the failure of imagination are linked.  It is the back office that has the information that is needed so that risk can be assessed.

As Yves Smith observed on Naked Capitalism, nobody on Wall Street was compensated for creating transparent, low margin products.  To the extent that the back office lags financial innovation, it creates the opportunity for opaque products to be developed and sold.
Infrastructure often lags when an innovation takes off. Remember how markets move over time from being customised to becoming more standardised. When products are standardised and demand is high, finance’s manufacturing, sales and distribution channels can pump out a vast supply....
Looked at from the perspective of the back office, products move from customized, where it is tracked in an excel spreadsheet, to standardized, where it is tracked in a relational database.

In an ideal world, as the product moves from customized to standardized and sales volume takes off, the relational database is there at the moment of standardization to support the growth.

In the real world, the relational database for tracking all the product information, like terms, trails the growth in volume because it must be designed and built.  As a result, significant growth occurs and is supported by the customized spreadsheet.
[Some] argue that having a bigger haystack of data makes it harder to find the really important needles. Others want a lot more information. 
Given 21st century information technology, it is better to error on the side of providing a lot more information.  Unless all market participants know in advance what the really important needles are in the haystack, it is better to take the whole haystack and let the market participants subsequently discard what they think are the unimportant needles.

Each market participant can easily find what they think are the important needles using modern database technology.  For example, they can drilldown into the data.
No national regulator can see all of the financial system: an American regulator can see the CDS exposures of American banks to French banks, for instance, but is not allowed to see the counterparty risks of the French lenders in turn.... 
Given concerns about financial contagion, this is wholly unacceptable.

This is a problem that is easily solved by requiring each bank to provide ultra transparency and disclose on an on-going basis its current asset, liability and off-balance sheet exposure details.

Then all market participants, not just the national regulator, could see not just the CDS exposures of American banks to French banks, but also the counterparty risks of the French lender in turn.
“Margining and technical policy and back-office monitoring of positions against collateral are unsexy but it is the stuff to be focused on,” says Mohamed Norat of the IMF. 
This is particularly true when it comes to innovations that pledge to transfer or reduce risk. 
Many of the instruments and techniques that were most lauded before the crisis were designed to package risk and shift it away from people who did not want it towards those who did. 
More transparency might have made it clear that risk was simply being concentrated somewhere else, or was not really leaving banks’ balance-sheets at all. 
Or, more transparency might have allowed the market participants who supposedly wanted the risk the information they needed so that they could accurately assess and price the risk.
This weakness in infrastructure compounded a behavioural one. Finance is at its most dangerous when it is perceived to be safe. One element in the financial crisis was a failure to understand the risks inherent in various products until it was too late... 
Investors do not necessarily think through all the risks embedded in these new instruments (for example, that a national housing bust would render the tranching within CDOs useless) and buy them enthusiastically. When those risks materialise, there is a destabilising flight to safety. 
“The standard argument for financial innovation is that there are gains from trade, but that model crumbles if you suppose that people do not fully understand the risks,” says Mr Shleifer.... 
Why was there a failure to properly assess the risks in various products?  Because as Yves Smith said it was the intention of Wall Street from the get go to innovate opaque products that hid the risk.
This analysis rings true of much of finance: people are liable to forget about the risks of products that have already blown up as well as misjudge those that have been newly created. 
The euro zone’s debt crisis has shown that risks even in long-established instruments like government bonds can be underestimated. 
These are problems with the practice of risk management and not just a consequence of financial innovation.
But innovations are particularly susceptible to the problem of self-delusion. If they go wrong early enough, they are unlikely to get off the ground. But once they reach a sufficient scale without a big blow-up, nobody believes that they might be flawed.
Given Wall Street's incentives, it is a bad assumption to believe that because a product has not had problems that all the risks of the product are known and that it will not have problems in the future.

In a Naked Capitalism post, Satyajit Das reviews the Economist magazine's series on financial innovation.  He observes

There is no acknowledgement [in the series] that much of what is called financial innovation is economic rent extraction, exploiting lack of transparency as well as information and knowledge asymmetries. 
There is no discussion of the destructive bonus culture which encourages certain behaviours in financial institutions. Thomas Philippon and Ariel Reshef have estimated that around 30-50% of the extra pay bankers received compared to similar professionals is attributable to economic rents. 
In a January 2009 speech, Lord Adair Turner, chairman of UK’s Financial Services Authority, observed that: “Much of the structuring and trading activity involved in the complex version of securitized credit was not required to deliver credit intermediation efficiently, but achieved an economic rent extraction made possible by the opacity of margins and the asymmetry of information and knowledge between…users of financial services and producers…financial innovation which delivers no fundamental economic benefit, can for a time flourish and earn for the individuals and institutions which innovated very large returns.” 
The unpalatable reality that few, self interested industry participants and their cheerleaders are prepared to admit is that much of what passes for financial innovation is specifically designed to conceal risk, obfuscate investors and reduce transparency
The process is entirely deliberate. Efficiency and transparency is not consistent with the high profit margins on Wall Street and the City. Financial products need to be opaque and priced inefficiently to produce excessive profits. The Report does not canvas this issue.
Mr. Das has nicely summarized why financial regulators must error on the side of too much transparency.

Europe's banks are addicted to ECB's money

Der Spiegel carried an interesting article that identifies the lack of trust in the financial system as the cause of many of the symptoms, like frozen interbank lending markets and bank runs, that exist today.  It observes that while the ECB can provide enough money to replace the normal money markets, this does not address the issue of restoring trust.

The article confirms what your humble blogger has been saying since the beginning of the financial crisis.

The only way to restore trust in banks or structured finance securities is if they provide ultra transparency.  For banks, this means disclosing on an on-going basis their current asset, liability and off-balance sheet exposure details.  For structured finance securities, this means disclosing on an observable event basis what is happening with the underlying collateral.

It is only with this disclosure that market participants have the information they need to independently assess the risk of the banks or structured finance securities.  Based on this analysis, market participants can adjust the amount and price of their exposure and make buy, hold, sell decisions based on the prices shown to them by Wall Street.
For Kleanthis Papadopoulos, chairman of Greece's TT Hellenic Postbank, the situation is not looking good. "I can't give any new credits," he admits soberly. 
Many Greeks are withdrawing their euros from the country's banks. To make matters worse, insurance companies and other financial institutions have long since stopped giving any money to Greek banks. As a result, the country is simply running out of cash...
Greeks say that anyone intending to withdraw several thousand euros in cash from their bank would be well advised to warn them in advance.
For months, this blog has been documenting the run on the Greek banks.
This dearth of money will prompt the European Central Bank (ECB) to once again open its seemingly bottomless coffers this week and grant generous loans....
The fact is that so long as a central bank is willing to provide liquidity, banks can remain in business.

What drives the run on the Greek banks is not just questions about their solvency, but also questions about whether the government can perform on its deposit guarantee.  The Eurozone could have ended the bank run by backstopping the deposit guarantee.
When asked how long such a policy could be successfully pursued, ECB President Mario Draghi said that it was only "temporary." In his view, the financial system faces an emergency situation -- and therefore requires emergency aid. 
But when does an emergency become business as usual? And how big is the danger that Europe's banks will simply forget how to stand on their own two feet if they are continuously being propped up?

It's been years since the banks were last able to easily access money. 
"Before the Lehman Brothers collapse, liquidity was simply there," says Stefan Best, an analyst at the rating agency Standard & Poor's. At the time, banks readily lent each other billions at low interest rates -- overnight as well as for longer periods. It was an era of widespread trust.
Please re-read the highlighted text and recall that before deposit insurance the sign of a bank that could stand on its own two feet was a bank that provided ultra transparency!

The issue is not just that banks are addicted to central bank funding and government bailouts, but that there is no policy in place that restores trust.  Without trust, there is no possibility of ending bank reliance on central bank funding and government bailouts and replacing this funding with money from the markets.
There was such an abundance of money that banks became less and less reliant on customer deposits. 
[Until] the 1990s, banks primarily recapitalized using funds that individuals and companies had squirreled away on their accounts. In 1997, the gap between deposits and loans granted within the euro zone was only €44 billion. 
During the 10 years that followed, this disparity increased to €1.3 trillion.  
The banks easily plugged the hole using funds that they acquired on the financial markets....
A hole that the ECB has to fill if financial markets are unwilling to lend to banks.
The fact that this situation changed dramatically is thanks to managers like Richard Fuld and Georg Funke, the former CEOs of the US investment bank Lehman Brothers and Germany's Hypo Real Estate (HRE) respectively. 
They invested money which they borrowed short-term at low interest rates in risky and protracted mortgage deals. As long as the profits continued to flow, nobody asked about the risks.
Actually, market participants relied on the regulators since the regulators had ultra transparency into the banks exposure details (think bank examiners) and the market participants did not.

More importantly, market participants assumed that the regulators knew how to assess this exposure detail and understand its implication for the risks the firms were taking.

Finally, market participants assumed that the regulators would convey their assessment of risk to the market in a timely manner or take steps to keep the risk the banks were taking in line with regulatory pronouncements.  After all, who can forget Alan Greenspan's comments on how financial innovation had made the banks less risky.
But after the collapse of Lehman Brothers and HRE in the fall of 2008, the financial industry's trust was shattered.
Trust was shattered not only in the banks, but in the regulators!  Subsequent actions by the regulators, like the stress tests, have only confirmed why the regulators' assessment should not be trusted (recall that European banks have failed within weeks of the last two stress tests).

Market participants have reacted by going on a "buyer's strike" until such time as they are provided with ultra transparency so they can independently assess the risk of each bank for themselves.
The interbank lending market dried up...
Predictably because the data was not available to assess the risk of making the loans.

Under the Japanese model for handling a bank solvency based financial crisis, regulators blessed banks hiding losses on and off their balance sheets.  Each bank knows what it is hiding and as a result is reluctant to lend to another bank.
[Central] bankers ... became paramedics who eagerly rushed to the aid of ailing banks with each new crisis -- continuously increasing the dosage in the meantime. 
Today, euro-zone banks owe the ECB some €796 billion. 
"The ECB's cash injections have significantly reduced the danger of refinancing bottlenecks and a credit crunch," says Stefan Best, the Standard & Poor's analyst. 
But how long can this policy of almost free money continue to work?
In Japan, they have been pursuing this policy of almost free money for 2+ decades.
ECB President Draghi is hoping that the situation will resolve itself on its own. 
Since the beginning of the year, he says, the banks have again been increasingly borrowing via their normal financing channels....
There is no reason to believe that the situation will resolve itself on its own.  The lesson of the financial crisis is the need for market participants to do their own homework (a point that US Treasury Secretary Hank Paulson made).

Without ultra transparency, it is impossible to do the homework.

Citing an increase in borrowing via normal financing channels is a bit misleading given the dependence of the financial system on life support programs like the ECB's Long Term Refinancing Operation.  Perhaps access to these financing channels is simply investors reasoning that the ECB will provide funds in the future to repay them at maturity.
With the latest round of three-year loans granted by the ECB, the central bank is charging a rock-bottom interest rate of just 1.0 percent. Critics argue that this is like distributing free heroin to junkies. 
"If the ECB continues in this vein, we'll soon be able to shut down the normal money markets," says Hans-Werner Sinn, head of Germany's influential Ifo economic think tank.
The normal money markets have been shut down since the start of the financial crisis.  The only way to reopen them is requiring ultra transparency.
There is a long list of possible risks and side effects. 
Draghi's cheap money is also keeping financial institutions afloat that simply don't earn enough to cover their financing costs. 
The ECB's money is even paving the way for deals that in reality are too risky.  However, the price for such risks is blurred when a central bank continuously maintains artificially low interest rates. 
By definition, central banks maintaining artificially low interest rates (think zero interest rate policies) distorts the pricing of risk.

Central banks hope that this mis-pricing of risk leads to economic activity.

This is a case of hope triumphing over experience.  As shown by Japan which has followed artificially low interest rate policies, their GDP was lower in 2010 than it was in 1995 (Wikipedia - Economy of Japan).
Draghi's prescription for the crisis is also "a recipe for a new speculative bubble," says Uwe Burkert, head of credit analysis at Landesbank Baden-Württemberg, a state-owned regional German bank. 
In Germany, for instance, rates on real-estate financing loans are about as low as they have ever been. In its most recent monthly report, the German central bank, the Bundesbank, noted a "marked price reaction on the housing markets."...
Interest rate expert Uwe Burkert points to an additional risk that concerns the general public: Interest payments on life insurance policies are already declining from year to year. 
"The ongoing low interest rates are insidiously eating away at people's pensions," he argues. Since money is no longer circulating normally, the entire economic system is going off the rails....
Apparently Uwe Burkert was channeling his inner Walter Bagehot and seeing interest rates below 2% as causing a problem with the entire economic system.

It is important to note that the low interest rate policies in the Eurozone that are feeding a real estate bubble in Germany (and Sweden too) are still higher than in the US, UK or Japan.
In any case, Draghi is convinced that it's all been worth it. He's also convinced that it's now time to stop. "We have done enough," he told the FAZ, adding that, in future, the focus would be on "tightening the requirements again." 
But there are many bankers who suspect that he won't find it that easy to slip out of the role of Europe's bankroller. Indeed, it will be difficult to wean the banks off cheap and generous loans from the ECB.
In fact, a number of banks would again find themselves in trouble if that happened, because investors are even more loath to lend them money after years of dependency on the ECB. 
In many regions, the economy would simply run out of money -- as is the case in Greece.
For TT Hellenic Postbank chairman Kleanthis Papadopoulos, the situation in his country is clear. "Greek banks are dependent on the ECB for their funding," he says.
As I have said since the beginning of the financial crisis, there is only one way to exit all of the central bank  funding programs and government bailouts and that is to provide ultra transparency.

With ultra transparency comes adoption of a Swedish model for handling a bank solvency based financial crisis, because, even if the regulators do not require the banks to recognize the losses on and off their balance sheets, the market will. 

Monday, February 27, 2012

HSBC confirms need for banks to provide ultra transparency

In its review of HSBC's financial results, the Telegraph focused on the dramatic increase in funds HSBC has parked at central banks.

Why given the demand for funds from banks looking to borrow in the interbank lending market?

As the review noted, HSBC was right not to lend it to its weaker rivals at the risk of not getting it back.

Readers know that banks are in the business of making credit judgements.  There is always some chance that a loan will not be repaid.

The reason that the interbank loan market froze and banks like HSBC are not lending is that they do not have access to the information that is needed to assess the risk of not being repaid.

Specifically, banks do not have access to ultra transparency from the borrowing bank so that they can evaluate the borrowing bank's asset, liability and off-balance sheet exposure detail to assess the probability of repayment.

One of the most eye-catching of HSBC’s 2011 figures was how much money it has on deposit at central banks. The figure’s shot up from $57.4bn (£36.3bn) to almost $130bn – a sure sign of risk aversion, if ever. 
Before the crisis in 2007, that number was $22bn. 
But chief executive Stuart Gulliver is rightly loth to lend depositors’ cash to weaker rivals at the risk of not getting it back, while noting wryly that: “The only people you want to lend it don’t need to borrow it.” 
Such prudence hits net interest income but explains why HSBC has coped with a crisis that has decked profligate competitors, not least Royal Bank of Scotland and Lloyds Banking Group.

G-20 answers how large are the losses hidden in Eurozone financial system

Regular readers know that under the Japanese model for handling a bank solvency based financial crisis banks, with regulatory approval, hide the true extent of their on and off balance sheet losses (see RBS's Stephen Hester confession).

Naturally, your humble blogger is curious as to just how big the losses are that are being hidden.

The G-20 provided an estimate for the Eurozone sovereign debt related losses.  From an article in the Telegraph, the figure appears to be about $1.5 trillion.

This also happens to be the amount of money the G-20 is requiring the Eurozone to put into its financial firewall before non-Eurozone countries would be willing to provide any financial support.

There is a logic behind the G-20s request for $1.5 trillion.

Remember, each member of the G-20 has also adopted the Japanese model.  As a result, they have some knowledge of the size of the losses that their own banking system is hiding.  It is a simple matter to take these losses and scale them assuming that the Eurozone is hiding similar losses.

Then, having estimated the size of the losses hiding in the Eurozone, it makes sense to require the Eurozone to cover these losses before providing any financial support.  Otherwise, the G-20 countries would be covering the Eurozone losses.
In an interview with Sky News, Mr Osborne said: "We are prepared to consider IMF resources but only once we see colour of eurozone money and we have not seen this. 
"While at this G20 conference there are a lot of things to discuss, I don't think you're going to see any extra resources committed here because eurozone countries have not committed additional resources themselves, and I think that quid pro quo will be clearly established here in Mexico City." 
Pressure to mount a large enough financial firewall to head off eurozone sovereign debt concerns has been mounting this weekend, after America, Brazil, and the Organisation for Economic Cooperation and Development all pushed for a funding increase. 
Angel Gurria, the head of the OECD, set the tone at the conference on Saturday, calling for about $1.5 trillion in "firewall" funds aimed at restoring confidence in European countries' debt....
Guido Mantega, the finance minister of Brazil, said "there is a very strongly shared opinion that first, the European countries should strengthen their firewall."... 
US Treasury Secretary Timothy Geithner said: "I hope we´re going to see, and expect we´ll see, continued efforts by Europeans to put in place a stronger and more credible firewall."

ECB's unlimited loans are no panacea for banks

A Bloomberg article discusses how the ECB's Long Term Refinancing Operation (LTRO) temporarily ends concerns over Eurozone banks failing for lack of liquidity, but it does nothing to address the underlying problem of the bad debt on and off their balance sheets.

Regular readers know that your humble blogger sees the LTRO as a useful program to have in place to support my version of the Swedish model for handling a bank solvency based financial crisis (aka, Wall Street rescues Main Street blueprint).

Under the Wall Street rescues Main Street blueprint, the Eurozone banks would be required to recognize the losses on the bad debt on and off their balance sheets.  They would also be required to provide ultra transparence and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details so that market participants could verify the losses were recognized.

Over the weekend, the G-20 asked the EU to enhance its firewall against financial contagion.  As this blog has repeatedly said, the best way to enhance the firewall is to realize that bank book capital is there to absorb losses and not something to be protected as banks have the capacity to generate book capital in the future through retention of earnings and stock issuance.

This is a very important point and needs to be repeated.  Under the Wall Street rescues Main Street blueprint, existing bank capital and future earnings and stock issuance are the primary contributors to the firewall between the excesses in the financial system and the real economy.

It is only under the failed Japanese model for handling a bank solvency based financial crisis that governments are called on to use their creditworthiness to bailout the banks or erect a firewall against financial contagion.

European Central Bank President Mario Draghi’s success in quelling a bond-market rout across the euro region’s periphery masks a failure by the region’s banks to bolster their capital. 
The ECB will offer a second round of unlimited three-year funds on Feb. 29. Firms will seek 470 billion euros ($629 billion), approaching the 489 billion euro take-up by 500 banks at the first long-term refinancing operation on Dec. 21, the median estimate of 28 analysts surveyed by Bloomberg show. 
“The worry is it may act to keep afloat institutions that aren’t exactly viable,” said Stewart Robertson, chief European economist at Aviva Investors in London, which manages more than $425 billion. “This buys time for banks, but does it really provide them with an incentive to sort out their books? The worry is it doesn’t.” 
This is the reason that a Swedish model like the Wall Street rescues Main Street blueprint must be explicitly adopted.
The Frankfurt-based central bank is flooding the market with cheap money to head off a credit crunch, boost lending to companies and consumers, and spur demand for unsecured bank debt.... 
“Providing money so cheaply, for so long, against what is now effectively any collateral whatever, leaves the ECB in a position no central bank would choose to be in,” UBS AG analysts led by London-based Alastair Ryan said in a Feb. 22 note to clients. “It cannot control the credit risk coming onto its books, or at least onto the books of its national central banks. Worse, the success of its interventions risks encouraging politicians to avoid making necessary but difficult decisions.”...
Specifically that the banks their country hosts be required to recognize their losses and disclose their current exposure details.
“This will ease credit flows but won’t stop the great deleveraging,” Huw van Steenis, an analyst at Morgan Stanley in London, wrote in a note to clients. “LTRO is important but not a panacea. While the LTRO should materially ease the euro zone deleveraging process, credit conditions appear likely to remain fairly tight in Spain, Italy and central and eastern Europe.”...
After all, banks are still deleveraging in order to achieve the 9% Tier I capital ratio that bank regulators are requiring.

Of course, if the Swedish model is adopted, regulators would have to abandon the capital ratio target in the near term so there are no impediments to losses being realized -- over the long term, regulators could require banks to achieve the capital ratio target.

A benefit of abandoning the 9% Tier I capital ratio in the near term is it would end the credit crunch regulators precipitated as a result of adopting this target in the first place.

Sunday, February 26, 2012

Mortgage plan seeks single securities platform

The Financial Times wrote an article about the push by the Federal Housing Finance Agency (FHFA) to create a data warehouse for mortgage backed securities.

Regular readers know that your humble blogger has been advocating for the creation of this data warehouse since before the financial crisis (full disclosure:  I have a US patent that may cover this data warehouse; however, patent or no patent, a data warehouse is needed if a new model for mortgage backed securities is to emerge that doesn't have the problems that exist with the current model).
The US may create a public utility to process all mortgage securitisations in the future after the main regulator of housing finance said it wants to invest in a single platform. 
In a strategic plan published on Tuesday, the Federal Housing Finance Agency said that it aims to build a single securitisation platform for Fannie Mae and Freddie Mac, the two housing finance agencies that guarantee and bundle most US mortgages. 
The plan points to a revolutionary future for the $8,500bn US mortgage-backed securities market, in which all public and private issuers use a single platform to process and track payments from mortgage borrowers through to MBS investors, and Fannie and Freddie may no longer exist.
The platform should track and provide reports on the mortgages on an observable event basis.  An observable event for a mortgage includes, but is not limited to, a payment, delinquency, default, bankruptcy of borrower, or modification.

By tracking and reporting on an observable event basis, users of the data always have current information on the performance of the underlying mortgages.

Fortunately, observable event based data is obtainable from the mortgage servicers because this is the way their loan databases are designed -- they already track and report observable events for each mortgage.
“Right now, Fannie and Freddie each have their own proprietary systems,” said Edward DeMarco, acting director of the FHFA. He said it made little sense for taxpayers to keep investing in two different platforms when they could instead build a single system that could be used regardless of whether Congress keeps Fannie and Freddie or scraps them. 
“It’s about building out an infrastructure for the secondary mortgage market but doing so in a way that is not dependent on any particular policy path,” said Mr DeMarco. In the medium-term, such an infrastructure could mean a single agency MBS, instead of different Fannie and Freddie securities....
The role of the state-backed US mortgage originators has come under the microscope. 
Politicians across the spectrum in the US want to scale back the government’s role in guaranteeing mortgages but Congress has not yet decided whether to keep Fannie and Freddie or scrap them. ... 
“We want to gradually shift some of the mortgage credit risk that Fannie and Freddie are taking on today back to the private market,” said Mr DeMarco....
The data warehouse is the key to bringing back the private market for mortgage backed securities.  With observable event based reporting, market participants can actually independently value these securities.  This is the first step in making an investment decision.

IceCap Asset Management discusses Japanese model and resulting monetary policy

IceCap Asset Management wrote a very interesting investment letter in which it discusses the Japanese model for handling a bank solvency driven financial crisis and the resulting monetary policy (h/t ZeroHedge).

Today, future economic historians are lucky enough to both see and experience what will happen as Europe (lead by Germany), Japan, Great Britain and the United States fully engage in the biggest, coordinated, money printing experiment in the history of the Universe. 
In its simplest form, only three scenarios are possible: 
1) Money printing has absolutely no impact on prices rising or falling
2) Money printing results in a return to the 1922 German experience
3) Money printing results in a return to the modern day Japan experience

No worries though - the very competent hands of today ’s central bankers, on the surface at least, appear quite confident that their money printing games will successfully engineer a very serene road to prosperity. The mere mention of the probability of scenarios 2 or 3 occurring are casually dismissed as easily as an offering of a third espresso. 
However, what should make you a little concerned is that central bankers in both 1922 Germany and 1990 Japan came to the very same conclusion before they commenced their devastating money printing strategies. 
Any investment manager worth their salt these days will tell you that the probability of scenario 1 occurring is lower than the real odds of England winning the next World Cup. 
The elimination of scenario 1, naturally leaves us with a tug of war between a hyper-inflationary World or a deflationary World. Both outcomes are certainly extreme, yet what else could you expect when we have the World’s biggest central banks implementing extreme monetary policies in the form of money printing?...

The 1922 German hyperinflation experience was undoubtedly propelled by printing massive amounts of money. Yet, the Japanese money printing experience has had no impact whatsoever on inflation. 
Here we are in 2012, and the World’s four main central banks (USA, Britain, Europe and Japan) continue to print gobs of money. Will the outcome be 1922 Germany or 1990 Japan? 
An important point to understand is whether the printed money actually flows through to the economy. In the 1922 German case – yes, it definitely did. The printed money circulated in the economy causing the German Mark to plummet against other currencies which resulted in extreme inflation. 
Today, trillions of Dollars, Yen, Euros and Pounds are being printed – yet this new money is certainly not being distributed into the economy. Instead, big banks everywhere are hoarding the newly minted cash for a rainy day. In economic parlance, this is referred to as a “liquidity trap” meaning there is plenty of cash available, however the cash remains trapped and is not being used. This makes today’s situation, perilously closer to the Japanese experience. 
Chart 1 ... shows the amount of money not being distributed into the economy by the very big American banks. Once this money is eventually released (via loans) into the economy, the cost of things could rise very quickly – similar to 1922 Germany. 
We (and many, many others) have been very critical of the American, European and British central banks. We freely admit that these people all have very good intentions – they truly do want the World’s economy to return to normal.
So is that why they adopted the Japanese model for handling a bank solvency based financial crisis and engage in misrepresentation about the condition of the banks?  Is that why they adopt extreme policies that negatively impact the vast majority of their society?
Yet in our opinion, it is their analysis of the problem that is leading them to make a very big mistake.
Your humble blogger agrees with this observation whole heartedly.

There are two problems with their analysis.

First, they assume that banks cannot operate with negative book capital!  This is absolutely not true.

Second, they assume that the economy cannot 'recover' from all the excesses in the financial system being recognized.  Iceland, which followed the success of Sweden, has shown that this is not true.
 The central banks fully believe that the World is currently suffering from what they would call – an aggregate demand problem. They believe growth is slow around the World because people and companies are not spending as much money as they normally would. 
To many of the big banks, stock brokers and mutual fund sales people, this “aggregate demand problem” sounds no different than any other economic slow down – it’s a part of a normal business cycle. And during a normal business cycle, the solution to encourage people and companies to spend more money has always been 1) lower interest rates and 2) increased government spending. And if the situation becomes untenable as it is today, you can add 3) money printing to the list. 
The reason this combination isn’t working today is due to the flawed belief that all of this extra money sloshing around in the economy will naturally entice people and companies to spend their hard earned (and borrowed) money again. 
As this blog has documented, zero interest rate policies actually create a headwind to spending.  Both retirees and savers reduce demand to make up for the loss in income on their savings.
With trillions in freshly printed money, sub 2% growth, widening government deficits and continued bailouts to banks, it has become crystal clear that the central banks’ money printing strategies are not working. 
The reason it isn’t working is simply due to the fact that all of this free money being provided to the banks, is not being distributed back into the economy. US and European banks are hoarding this free money and as a result - the transfer mechanism is broken.

The reason for hoarding free money has to do with the banks' solvency problem.  Since all banks are hiding losses on and off their balance sheets, the interbank loan market is frozen as it is impossible for banks to determine which banks are solvent and which are not.

At the same time, zero interest rate policies are suppressing aggregate demand and with the reduction in aggregate demand comes a reduction in the demand for new loans.

Finally, banks have the risk free option to make money on the free money they have been given by keeping it in an interest earning account at the central bank.

Saturday, February 25, 2012

Is there any truth to bank earnings presentations when banks use 'Alice in Wonderland' accounting?

In a Telegraph article, RBS chief Stephen Hester confessed that bank regulators have blessed RBS hiding losses on and off its balance sheet and only recognizing these losses as RBS generates the earnings to absorb them (an example of the Japanese model for handling a bank solvency based financial crisis).

One result of this is what Mr. Hester refers to as 'Alice in Wonderland' accounting.

The RBS chief admitted that since its £45bn bailout in 2008, the lender had taken losses when it could "afford" to and used profits to "finesse" its results. 
"We have to finesse it with our own profits as we go through. Each year we have, in a sense, a budget for making losses for clean-up – and the better or worse our profits are, the better or worse that budget is and the faster or slower that we can go," said Mr Hester, adding that the bank had "never" had sufficient capital to recognise all its losses upfront.
The question is, with regulator blessed 'Alice in Wonderland' accounting, is there any truth to bank earnings presentations?

In a column in the Guardian, Rob Taylor looks for an answer by asserting "the truth is in Lloyd's latest results presentation....somewhere".

This is the fourth year we have watched banks claim improvements in their core areas – and then turn round and tell us there is still garbage inside their businesses that needs to be written off. 
This just happens to coincide with the start of the financial crisis and the regulatory blessing of and bank adoption of Alice in Wonderland accounting.
For the layman, operating profits are key indicators of the health of a business. As long as a company has the income to cover one-off losses – or sufficient capital tucked away to absorb these losses – the business can, in theory, continue to run another year and make more money.  
Of course, chief executives and boards don't like to have to tell shareholders they need to write down high levels of legal liabilities and restructuring charges, let alone do so for several years in a row. 
The strategy for most new chief executives is to fully audit and find the rubbish lurking in their businesses – then clear it off their books as soon as possible. 
This strategy runs counter to the Japanese model of delaying recognition of the losses until the bank has the capacity to absorb them through earnings.

Under the Japanese model, loss recognition is balanced against the fact that management doesn't like reporting write downs and restructuring charges for several years in a row.  The result is that banks report earnings while they are still hiding additional losses.
In the case of Horta-Osório, he announced early in his tenure that he would write-off PPI repayments and the restructuring charges one assumes were necessary for his longer-term growth strategy. 
RBS's chief executive, Steven Hester, has had several years to find the bad bits and rid his bank of its financial liabilities. 
Of course, banks will have to write down some sort of unanticipated expense most years. But let's just hope that Hester and Horta-Osório have finally got these big charges out of the way.
There is no reason for market participants to trust the bank's financial statements since they reflect Alice in Wonderland accounting and may or may not be hiding significant additional losses. This has directly contributed to the interbank lending market freezing as each bank knows what it is hiding through Alice in Wonderland accounting and assumes that other banks are also hiding losses.

Without ultra transparency under which banks disclose their current asset, liability and off balance sheet exposure details, there is no way of knowing if the banks have gotten the big charges out of the way.

Finally, so long as regulators pursue the Japanese model for handling a bank solvency based financial crisis and bless Alice in Wonderland accounting, regulators will be undermining confidence in the financial markets.

Since the 1930s, confidence in the financial markets has come from the idea that market participants are able to access all the useful, relevant information in an appropriate, timely manner and independently assess this information prior to making their investment decisions.

When regulators deliberately bless the withholding of all the useful, relevant information in an appropriate, timely manner, they undermine confidence (and this is before the question of is it legal is raised -- see IndyMac and its regulator, OTS)

Friday, February 24, 2012

Hedge Fund Manager Paul Singer renews call for transparency

Approximately one year ago, this blog carried a post on hege fund manager Paul Singer, who like your humble blogger was publicly recognized as predicting the financial crisis.

At that time, Mr. Singer was critical of the Dodd-Frank Act for its failure to bring transparency to the financial system and its reliance on regulators to effectively monitor the Too Big to Fail banks.

Mr. Singer is back with a letter to investors in his Elliott Management funds which once again sounds themes that are very familiar to regular readers.

In a NY Times Dealbook article on the letter, Mr. Singer observes:

A great deal of stupidity has chipped away at the massive advantages of Western civilization, which could terminally decline if it remains on the current path. But these problems can be solved — and swiftly ....
This observation confirms the long term economic impact of the Japanese model for handling a bank solvency based financial crisis (preserve bank capital and only recognize losses as banks generate earnings to absorb them).  The US, UK and EU policies since the beginning of the financial crisis reflect this model.

As shown by Japan, the impact of the Japanese model and its supporting fiscal and monetary policies is long term economic decline.  In Japan's case, its economy has shrunk over the last 15 years.

This observation also supports the idea that adopting the Swedish model for handling a bank solvency based financial crisis and requiring banks to recognize all of their losses today will bring a quick end to the global financial crisis.
Mr. Singer is generous with his ire, directing it at the United States,  the European Union and Japan, and offering a critical assessment of the sorry state of affairs in the world marketplace. 
Here is a current snapshot of the U.S., Europe and Japan: the financial sector is overleveraged and opaque. Fiscal, tax, and regulatory policies are unsound and not oriented toward growth and efficiency. On a long-term balance sheet basis, these countries are insolvent, with no hope of paying presently promised benefits regardless of the level of growth achieved or tax rates charges. Monetary policy is extreme and experimental. None of these assertions is refutable...
The financial sector is opaque and, with the blessing of regulators, hiding losses.
He goes a step further, too, arguing that “the epoch of investor confidence in money backed by nothing is coming to an end.” 
As he often has in recent letters, Mr. Singer spends pages railing against the Federal Reserve for buying bonds, printing cash and keeping interest rates at or near zero percent. 
“This policy is arrant idiocy and is likely to ultimately lead to serious inflation, a risk that governments continue to ignore at their peril,” he writes.
Whether it leads to serious inflation or not, Mr. Singer joins Bill Gross, Charles Schwab and Walter Bagehot in thinking that the zero bound for monetary policy is at an interest rate greater than zero and more like Mr. Bagehot 2%.

Mr. Singer spells out a clear casualty of pursuing a zero interest rate monetary policy:  investor confidence in money backed by nothing.
The peril he spells out for Europe, meanwhile, is much more immediate. He points out the circle of codependency between the nations and their banks: the nations support the banks to keep them from falling prey to markets, but the banks support the nations, too, by buying their debt. 
In the next global trading crisis, characterized (as it may well be) by the cascading transmission of losses from one opaque, overleveraged institution to another, the survival of any given commercial or investment bank (or group of such institutions) is likely to depend more on the perception of the creditworthiness of the sovereigns which stand behind them (and the sovereigns’ willingness to actually do so) than on any analysis of the fundamentals of the afflicted institutions....
By adopting the Japanese model, nations have to stand behind their banks to inject capital should a bank's book value fall.  As a result, there is a circle of codependency between banks and sovereign.

Under the Japanese model with its emphasis on protecting the level of capital at the banks, opacity is a policy requirement.  For example, regulators have given RBS's Stephen Hester permission to hide the losses on and off the RBS balance sheet and only recognize them as RBS has earnings to absorb them.

If the Swedish model were adopted, nations would only stand behind the bank depositors.  This breaks the circle of codependency.

Under the Swedish model with its emphasis on protecting Main Street and requiring banks to recognize the losses on and off their balance sheet, transparency is a policy requirement.  If banks disclose their current asset, liability and off balance sheet exposure details, market participants could see that all their losses have been recognized.
Back home, a bevy of regulation in the wake of the financial crisis has done little to shelter the system from risk, address leverage or puncture the veil of secrecy at large financial institutions, he writes. 
The argument is context to his real point, however, about impending  regulation of hedge funds: “It is worse than pointless.”...
“We wonder if the Securities and Exchange Commission, the regulatory body tasked with policing hedge funds in the U.S., has the sophistication and resources to sniff out issues related to the myriad of complicated trades, strategies and securities that these firms manage,” he writes, before throwing some salt on a particularly sensitive wound at the agency. “Hopefully this new crop of regulators will be more astute than those who ignored a 15-page detailed analysis of the Madoff fraud that was handed to them on a platter years before his unmasking.”
If every financial institution over a certain size were required to provide ultra transparency, the regulators could enlist the resources of the market to help them understand each firm and the risks it poses to the system.

For example, JP Morgan could help the regulators in their analysis of Citi and BofA.  Likewise, these firms could help in the analysis of JP Morgan.