Bank of England's Paul Tucker wants regulators to set margin requirements

The Bank of England's Paul Tucker called for regulators to have the ability to set margin requirements on transactions in the shadow banking system.  Reuters reports that Mr. Tucker would like this ability to cool down the markets when they overheat.

In theory, regulators need to have a complete toolkit for taking away the punch bowl so the party doesn't get out of hand.

In practice, as demonstrated in the late 1990s by the US Fed, regulators are not going to use this authority.

Readers might recall in the late 1990s, the equity markets were experiencing a bubble.  A bubble whose magnitude could have been greatly diminished by the Fed.  

The Fed had and still has the right to change stock margin requirements under Regulation T.  Had the Fed raised stock margin requirements, as Mr. Tucker points out, it would have cooled down the market.

However, the Fed did not raise stock market requirements.  It did not for several reasons including 1) it is hard to recognize a bubble and hence the event that would trigger the need for raising margin requirements and 2) the believe that it could clean up the mess after the equity bubble popped.

Supervisors should have powers to demand more collateral on financial transactions in order to cool down overheated markets, Bank of England Deputy Governor Paul Tucker said on Friday. 

He and other regulators from across the world are looking at how to rein in the multi-trillion dollar "shadow-banking" sector which handles credit and leverage outside traditional banking....

The best way to rein in the "shadow-banking" system is by making it transparent.

This is easily accomplished by requiring ultra transparency.

"The authorities should be able to step in and set minimum haircut or margin levels for the collateralised financing markets, or segments of them," Tucker told a European Commission conference on regulating shadow banks.... 

The European Commission will propose EU-wide shadow bank regulation next year after a global regulatory body, the Financial Stability Board (FSB), completes work on policy recommendations for world leaders by November when G20 leaders meet. 

The FSB, of which Tucker is a member, said in an interim report on securities lending and repos on Friday there was a lack of transparency, potential risks from firesales of collateral assets, and insufficient rigour in collateral valuation and management practices.

Adopting ultra transparency addresses all of these issues.

For example, the potential for a fire sale of collateral is greatly reduced when the holder of the collateral can independently assess the risk of the borrower.  Based on this independent assessment, the holder of the collateral will require bigger haircuts well before regulators would think to step in.

Is a federal banking system necessary for the EU?

In his column, the Telegraph's Jeremy Warner looks at the possibility of a federal banking system for the EU and concludes that it is a political impossibility.

Regular readers know that your humble blogger doesn't think that a federal banking system is necessary for the EU but rather that the EU should adopt two elements of a federal banking system.

First, a common deposit insurance mechanism.

Specifically, I think that the EU should dedicate 100% of the remaining funds in the European Financial Stability Fund and the European Stability Mechanism to backstopping the sovereign deposit guarantees.

As I predicted, so long as there is concern over the ability of the sovereign to perform on its deposit guarantee, there will be an on-going bank run from these countries.  The huge credit building up at the German central bank with the central banks of the 'Club-Med' countries is confirmation that this prediction was accurate.


Reinforcing the deposit guarantee is important as it will stop the run on the banks going on in the EU countries with shaky sovereign financing.

Second, ultra transparency as a common disclosure requirement.

By requiring every bank in the EU to disclose on an on-going basis its current asset, liability and off-balance sheet exposure details, it brings all the banks under common supervision.  Common supervision provided by the market.

This supervision by the market is important as it is not subject to gaming for the benefit of individual countries.

The latest crackpot idea for shoring up Europe's monetary union, much discussed at last week's spring meeting of the International Monetary Fund and now widely promoted by eurocrats, is the establishment of a federal banking system, with a single framework for regulation, bailouts, deposit insurance, supervision and resolution.... 

If Irish, or indeed Spanish banks, had been regarded as a mutual ward of all eurozone nations, neither economy would today be in quite the same mess as it is, where the sovereign has effectively been overwhelmed by the hubristic expansionism of its banks. 

So why do I say that the formation of a federal banking system in euroland is another crackpot idea? It's because as things stand, there is virtually no chance of it happening. 

To the contrary, all the pressures right now seem to be the other way around, towards disintegration of the eurozone banking system rather than further integration. It is as if in progressively retreating behind national borders, finance is subconsciously preparing for the eventual break-up of the euro back into its constituent sovereign currencies....

Full mutualisation of banking assets and liabilities under a federal banking system would plainly take us some way further towards a lasting solution, but nowhere in the eurozone is such a framework thought remotely acceptable. 

This is because national banking systems are still seen as an important conduit for the economic and industrial policies of individual sovereign governments. No one is going to surrender these levers to the "greater good" intentions of some unaccountable eurocrat. 

In France, the major banks are so much a creature of government that they might as well be regarded as one and the same thing. In Germany, too, the banking system is unashamedly used for the pursuit of perceived industrial advantage.

Spanish banks: set aside reserves, mark down loans, repeat

Rather than recognize all their losses at once, Spanish banks are stuck in a cycle of setting aside reserves to cover losses in one area, marking down the related loans and then repeating for a different area.

Each cycle reminds market participants that there are still losses hidden on and off the banks' balance sheets.

Each cycle confirms why the 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.  Without this data, investors will never believe that the banks have recognized all the hidden losses.

As the Economist magazine observed

In February the Spanish government hoped at last to put an end to worries about lenders’ health when it asked them to set aside billions in provisions and to raise more capital. It also pushed for mergers to reduce capacity and improve margins in an overcrowded market. 

These measures provide some comfort. Spain’s central bank says that since the middle of 2008, banks have set aside €112 billion ($148 billion) against loan losses. 

This year it asked them to set aside another €54 billion in provisions and new capital (although this double-counted some write-downs that had already taken place). 

With these plump cushions, Spain’s banks can shrug off losses amounting to about half of their loans to property developers.... 

As a result of the write-downs, regulators have achieved one objective. Few investors now fret about property-development loans blowing up Spanish banks. The worry now is about all the other loans on banks’ balance-sheets, against which there are almost no provisions...

Take residential mortgages, which have so far held up remarkably well. Less than 3% of residential mortgages have started to wobble, a surprise in a country where unemployment is close to 25%. 

Spanish officials argue that mortgage losses are so low because the loans were mostly issued to creditworthy borrowers with low loan-to-value ratios and no incentive to walk away from their debts.... 

Investors will take some convincing. “People just do not believe the numbers,” says one analyst. “There has been a lot of ‘extending and pretending’ or renegotiation of mortgages.”

Former Fed Governor Kevin Warsh says ramped up disclosure needed for banks

In her NY Times column, Gretchen Morgenson asks former Fed Governor Kevin Warsh about the policies being pursued to reform the financial system, particularly the big banks.  To address the big bank problem, he said

their disclosures must be subject to new and ramped-up transparency requirements so investors can differentiate strength from weakness.

Your humble blogger welcomes Mr. Warsh in his call for ultra transparency.

Regular readers know that the only way that investors can differentiate strength from weakness in the banks is if each bank discloses on an on-going basis its current asset, liability and off-balance sheet exposure details.  With this data, investors can independently assess each bank.

Absent ultra transparency, investors do not have the data needed to properly assess the banks.  As the Bank of England's Andrew Haldane says, bank disclosure leaves them resembling 'black boxes'.

Big banks are bigger than ever, and they exert enormous power over regulators and lawmakers. Increasingly, smaller institutions can’t compete. 

So it was refreshing last week to hear Kevin M. Warsh, a former Fed governor, speak candidly and critically about the government backing that continues to support our largest banks. Equally refreshing were his prescriptions for eliminating the too-big-to-fail problem. 

“We cannot have a durable, competitive, dynamic banking system that facilitates economic growth if policy protects the franchises of oligopolies atop the financial sector,” Mr. Warsh told an audience at the Stanford Law School on Wednesday night. “Those ‘interconnected’ firms that find themselves dependent on implicit government support do not serve our economy’s interest.”.... 

Put simply, Mr. Warsh does not believe that higher capital standards for banks and greater regulatory scrutiny will be enough to prevent future taxpayer-financed bailouts. 

“At core, I’m worried that the Dodd-Frank Act doubles down on regulators, gives up on markets and outsources capital requirements to an international standards group in Basel, Switzerland,” he said in an interview last week. 

Please re-read the highlighted text as it as Mr. Warsh confirms what your humble blogger has been saying about 1) regulators as a source of financial instability because they are a single point of failure, 2) the meaninglessness of capital standards, and 3) the need to let the market help in preventing the next financial crisis.

Importantly, none of these responses have moved us closer to “ridding the United States financial system of large, quasi-public utilities atop the sector,” he said. 

Mr. Warsh does not prescribe breaking up giant institutions. Rather, he says their disclosures must be subject to new and ramped-up transparency requirements so investors can differentiate strength from weakness....

I have also never argued for breaking up the giant institutions.  Like Mr. Warsh, I realize that with ultra transparency, market discipline will be brought to the banking sector.

As a result, not only will investors distinguish between strong and weak institutions, but they will also price their exposures to all banks based on the riskiness of each bank.  This will put pressure on banks to become less risky.

 “Still, disclosure practices by the largest financial firms remain lacking, and the periodic reporting overseen by the Securities and Exchange Commission tends to obfuscate as much as inform.”

Regulators must require clearer and more expansive disclosures so that the financial statements and associated risks of large and complex companies can be assessed, Mr. Warsh said. 

If investors had more detailed information from these institutions, they would very likely sell their shares and debt if they took too many risks. This would hold the managers of these institutions accountable for reckless behavior by making them pay more to fund their businesses.

Please re-read the highlighted text because it repeats the arguments I have been making since the beginning of the financial crisis.

Confirming the regulatory race to the bottom, the EU says it will match least restrictive regulation

As if further evidence was needed for why the financial system should not be dependent on its regulators for insuring stability, Bloomberg reports that the EU is ready to match least restrictive financial regulations adopted by any other country.

The statement was specifically made about bank capital ratio requirements, but is indicative of the mindset  across all financial regulation.

Banks (SX7P) in the European Union may win a partial reprieve from Basel capital and liquidity rules if lenders in other regions such as the U.S. are allowed to escape the full force of the measures.

EU lawmakers are weighing safeguards to prevent lenders in the region from being left at a competitive disadvantage when a global accord by the Basel Committee on Banking Supervision is implemented, according to a document obtained by Bloomberg News....

The European Banking Authority and the European Commission, the 27-nation region’s executive arm, should be empowered to “take appropriate measures in order to adjust to the level of global competition,” according to the document by Othmar Karas, the lawmaker guiding the adoption of the law through the European Parliament. 

The Basel committee said on April 3 that the U.S. and China are among eight nations lagging behind in their implementation of its rules. The U.S. still hasn’t fully put in place an earlier round of changes agreed on by the Basel group in 2004.

The London-based EBA should “regularly assess” how well other nations apply the requirements, Karas proposed in the document. 

The report “strongly indicates that there is a lack of confidence that all regimes will ultimately commit to internationally agreed rules if these are seen to conflict with domestic priorities or individual national characteristics,” Richard Reid, research director for the International Centre for Financial Regulation in London, said in an e-mail. 

The proposals are “yet another sign of how difficult it is going to be in practice to get a uniform global implementation of rules on banks’ capital and liquidity,” Reid said.

Capital and liquidity standards are subject to being undermined by the "competitive disadvantage' argument.  Ultra transparency is not.

In fact, adoption of ultra transparency puts every country and bank that does not adopt ultra transparency at a disadvantage.  Adopting ultra transparency is a sign that the banks in the country can stand on their own two feet.

As a result, they should pay less to raise everything from deposits to unsecured debt to equity.  A lower cost of funds should translate directly into higher profits.

Bottom line:  ultra transparency results in a regulatory race to the top as regulators scramble to protect their banks by adopting ultra transparency.

Confirming ineffectiveness of bank capital ratios, France and UK argue over question of how much

First, I apologize for the lack of posts over the last several days.  I encountered unexpected technical difficulties while traveling.

Reuters reports that France and the UK are disagreeing over the level of capital that banks will need to hold in the future.  France wants lower levels and the UK wants higher levels.

This argument is much like arguing about the arrangement of deck chairs on the Titanic after it hit the iceberg.  Bank book capital levels are so highly manipulated that the OECD sees them as meaningless.

The argument does highlight one weakness of relying on regulators.  That weakness is the natural bias to engage in a race to the bottom.

Large international financial institutions are fully capable of moving their operations to the country with the weakest banking regulations.

Britain clashed with France on Wednesday over demands that London be allowed force banks to top up capital beyond new EU levels, diplomats said, in a long-running dispute threatening to undermine a central plank of European financial reform. 

The European Union is attempting to translate higher capital standards set by the Basel Committee of regulators and central bankers into EU law by the end of this year, a move to make it costlier for banks to engage in high-risk lending or investing....

And, much more importantly, to show that regulators can create a credit crunch at a time when the global economy is trying to recover from a deep recession.

Britain argues it is entitled to take extra steps to make banks safer, to protect the interests of taxpayers who could be called on to bail them out if they face collapse. 

But France is concerned that international banks based in London could cut lending elsewhere in Europe if they have to beef up capital.

These positions highlight why it is difficult to agree on global regulations on issues like capital standards.

Some diplomats suspect the dispute is fuelled by concern that deposits and other business might flow to British banks were they to be better capitalized than French and German rivals and thus safer in the eyes of investors....

The diplomats highlight how easy it is for the banks to play the regulators off against each other.  

Clarifying the precise rules on capital, almost five years after the start of the financial crisis that toppled some lenders and hit many countries hard, would remove some uncertainty for banks, already nervous about lending as Europe slides into recession. 

The new European capital regime will also influence how stringently Washington interprets the global Basel standards on Wall Street.

"It is a very political question," said one French diplomat.... 

One diplomat complained about countries trying to carve out exceptions that best suit them. "They have made a Swiss cheese out of it," he said.

Finally, having already made Swiss cheese out of the bank capital regulation shows yet again how meaningless bank capital ratios are outside of a convention filled with economists who failed to predict the financial crisis.

Regular readers know, that ultra transparency does not suffer from the same short-comings as bank capital.  It is easy to agree on a global standard of what constitutes ultra transparency:  disclosure on an on-going basis of each bank's asset, liability and off-balance sheet exposure details.

Spanish banks avoid writing down toxic loans to reach capital requirements

What happens when regulatory forbearance meets higher capital requirements?  Bank capital ratios become completely meaningless.

The latest example of this is a CNBC report that Spanish banks are not writing down their bad debt in order to report higher capital ratios.

The proposed solution is the adoption of the Swedish model and the recognition today of the losses on the banks' balance sheets.  In proposing the solution, the speakers clearly indicate that the market can deal with bank continuing in operation that have negative book capital levels.

Spanish banks like BBVA are meeting regulators’ capital ratio targets by avoiding writing down toxic property loans, Anthony Fry, chairman of Espirito Santo Investment Bank U.K, told CNBC. 

Spain’s second-biggest bank BBVA released earnings on Wednesday which showed it had achieved a core capital ratio of 10.7 percent without tapping public money, as its profit fell 13 percent in the first quarter. 

“We are back in a slightly ‘smoke and mirrors’ situation, as these banks are strengthening their capital ratios as required but finding it extremely hard to do the write-offs they need to, because those write-offs have a direct impact on their capital ratios,” Fry told CNBC’s ‘Squawk Box Europe’ on Wednesday.... 

Moorad Choudhry, treasurer of RBS’s corporate banking division, said Spanish banks were yet to “reap out” the country’s real estate crash. 

“These banks have still got on their balance sheets, valued at par, property loans whose real value is probably less than 30 cents on the euro. So I think the Spanish banking sector hasn’t reaped out in full this real estate crash. That’s why we should be a little more concerned about Spanish banks,” he toldCNBC. 

Espirito's Fry said worse capital ratios and a "more realistic" appreciation of the value of the underlying assets would be preferable. 

“I think it is a real problem within the euro zone that some of the capital ratios required are actually unrealistically high for the state of the current markets,” he added. 

RBS' Stephen Hester explains why governments should never invest in or bail out banks

In a speech at the Manchester Business School, RBS's Stephen Hester explained why governments should never invest in or bailout banks.  In doing so, directly undermines governments ongoing implementation of the Japanese model for handling a bank solvency led financial crisis.

As reported by the Guardian, Mr. Hester observed,

he had "underestimated how intense, critical and long lasting" the spotlight would be on the bailed-out bank and implied that the £45bn of taxpayer cash poured into the bank to save it from collapse was now hindering its return to financial health.: 

"Governments are not good long term owners of complex international businesses. The ownership can cause political controversy of itself, and create pressures that hinder the progress of the subject company."

In short, the bank should have been left to work through its troubles without a government investment.  An investment that was not needed given that banks in a modern financial system can continue to operate even when they have negative book capital levels because they have both deposit insurance and access to unlimited liquidity from the central bank.

As Mr. Hester points out,

There were two years of "heavy lifting, significant clean up costs and vulnerability to outside events" left at RBS, he said. Hester is three years into a five year recovery plan and said his belief that the company can be turned around "has been tested but remains intact". He added that the day when RBS can resume paying shareholder dividends and drive up its share price was "steadily approaching".

The bottom line is that had the government adopted the Swedish model and forced RBS to recognize its losses on day one, it would be well on its way to rebuilding its book capital levels to a point where it could begin paying dividends again without having tied up scarce sovereign resources.

Goldman faces 'full discovery' on Abacus deal

Bloomberg reports that ACA Financial Guaranty Corp's lawsuit with Goldman over the Abacus deal has now moved to full discovery.

Like the 1930s Pecora Commission, it ought to be fascinating to see what full discovery turns up on how Wall Street operates.

Goldman Sachs Group Inc. (GS) must face fraud claims brought by ACA Financial Guaranty Corp. over a mortgage-based investment that led to a settlement with the U.S. Securities and Exchange Commission. 

ACA Financial sued Goldman Sachs in New York State Supreme Court in January 2011, accusing the company of fraudulent inducement, fraudulent concealment and unjust enrichment in connection with a collateralized debt obligation known as Abacus. 

Justice Barbara Kapnick threw out the unjust enrichment claim in an order dated yesterday, saying that the plaintiffs failed to establish that Goldman Sachs wrongly benefited at ACA Financial’s expense. Kapnick let stand two fraud claims in the complaint. 

“Justice Kapnick vindicated ACA’s position, and rejected all of Goldman’s arguments opposing ACA’s fraud claims,” Marc Kasowitz, a lawyer for New York-based ACA, said in an e-mailed statement. “Full discovery in this case will now proceed.” 

ACA seeks $120 million in compensation and punitive damages for the fraud claims, according to the statement.... 

Goldman Sachs agreed in July 2010 to pay $550 million, the largest penalty ever assessed by the SEC against a Wall Street firm, to settle allegations against it involving the Abacus deal.

Real issue for banker bonuses is not how large or when paid, but are they merited based on risk taken

The Bank of England's Andrew Haldane has once again focused attention on bankers bonuses with his call to defer payment and increase the claw-back period of these bonuses to 10 years.  This increase to 10 years is an attempt to end a mismatch between end of year bonuses and multi-year risks.

In making this proposal, Mr. Haldane shows that the real issue for banker bonuses is 'are they merited given the risk that was taken to earn them'.

Regular readers know that your humble blogger does not think that regulators should involve themselves in the mechanics of banker bonus payments.  The mechanics should be related to each firm's business strategy and are more appropriately set by the Board of Directors and approved by the shareholders.

I prefer that the regulators focus instead on making sure that both the Board of Directors and the shareholders have access to the information that is necessary to independently confirm that the bonus was merited given the risk that was taken to earn them.

The foundation for this is requiring banks to provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details.

According to a Telegraph article,

Andrew Haldane, executive director for financial stability and a member of the Financial Policy Committee, said "while bank performance has fallen off a cliff, executive pay remains close to pre-crisis Himalayan heights". 

He argued in a speech given in Berlin that bonus deferral, or claw-back periods, should be extended to 10 years or more on an internationally co-ordinated basis, from three or four years at present, to make bankers responsible and accountable for their decisions for longer. 

"The risk cycle might last perhaps 20 years. This duration mismatch means it is more likely than not that risk and reward may get out of kilter in the financial sector," he said...

He said the way bankers were paid should be reconsidered, broadening the instruments used beyond cash and shares. 

"The focus to date has been on non-cash distributions, often in equity. But paying in equity appears in some pre-crisis cases to have exacerbated risk-taking incentives, acting as a disincentive to raising new equity and encouraging gambles for resurrection," he said.

ECB's Draghi confesses that monetary policies can only buy time

The ECB's Mario Draghi ended the myth that monetary policy can do anything to bring the current bank solvency led financial crisis to an end.

He then goes on to say who can bring an end to the current financial crisis:  the governments and the banks.

The governments can do this by abandoning the Japanese model for handling a bank solvency led financial crisis and adopting the Swedish model.  Under the Japanese model, governments have played for time while praying for a miracle to bailout the global economy.

Under the Swedish model for handling a bank solvency led financial crisis, Wall Street (the banks) rescue Main Street.  The banks do this by absorbing the losses on the excesses in the financial system and not imposing the drag from these losses on the real economy.

According to the ECB's Draghi

the LTRO operations had succeeded in "buying time" for policymakers to solve the long-running sovereign debt crisis. 

"The LTROs have been quite timely and all in all successful and if the only thing we managed was to buy time, then that is an extraordinary success," he said. 

"Buying time is not a minor achievement." 

Nevertheless, the ECB could only do so much and "the ball is entirely, squarely in the court of governments and banks, and they have to use this time," he insisted.

With break-up of austerity front, dealing with excess debt finally becomes an idea whose time has come

With the rebellion of the European voters against austerity, dealing with the excess debt in the financial system has finally emerged as the idea whose time has come.

The question is 'how to deal with this excess debt'?

The answer is 'by adopting the Swedish model and having Wall Street rescue Main Street'.  As laid out in my blueprint, this involves:

• Requiring the banks to recognize all the losses on private and sovereign debt hidden on and off their balance sheets;

• Requiring the banks to provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposures to show that all losses have been recognized;

• Supporting the banks while they repair their balance sheet through retention of future earnings by guaranteeing their deposits and unsecured debt (for weaker sovereigns, their guarantee should be backstopped by entities like the EFSF, ESM or IMF); and

• Providing the banks with unlimited access to central bank funding to the extent they have good collateral. 

Taking these actions will produce a number of positive benefits including:

• Banks absorb the losses on the excesses in the financial system and modify loans to reflect the borrower's ability to service the debt (this restarts the economy by lifting the burden on the real economy of carrying the excess debt);

• Market participants exert discipline on the banks' risk taking by rewarding low risk banks and penalizing high risk banks; and

• Regulators piggyback off the ability of the market participants to analyze the disclosed information and step in as necessary to maintain financial stability.

Experts say economic recovery requires fresh tactics

According to a Reuters article, experts are calling for addressing the excesses in the financial system.  In particular, they are looking at the issue of too much debt.

Readers know that the Japanese model for handling a bank solvency led financial crisis adopted by the EU, UK and US at the beginning of the current crisis postpones indefinitely dealing with debt in excess of the borrower's capacity to pay.

By calling for fresh tactics, the experts are calling for dropping the Japanese model and adopting the Swedish model for handling a bank solvency led financial crisis.

Under the Swedish model, the issue of too much debt is explicitly addressed.  Banks are required to recognize the losses on the excesses in the financial system.  What this means in practice is that banks absorb the losses on the debt in excess of the borrower's capacity to pay.

The amount of money thrown at rescuing the world economy since the Great Recession began is truly staggering, probably more than $14 trillion, and the financial spigots are still open....

But can all this money restore growth to robust levels anytime soon?

No.  This blog has covered numerous reasons why the Japanese model and its related policies (like zero interest rates and bailouts) does not work.

Government officials and economists point to the same problem: too much debt. 

Rescue funds and central bank stimulus measures are just keeping the world economy afloat until the hard and painful work of repairing balance sheets gets done. 

"The real solution has to do with the fiscal and structural reforms that address the real causes of this crisis, particularly in Europe, but also elsewhere," said Tharman Shanmugaratnam, Singapore's finance minister and head of the IMF's steering committee. 

"The firewall is absolutely essential, but by itself it is not sufficient, and the real solutions require attention."

Before balance sheets can be repaired, the size of the repair must be known.

Under the Japanese model, financial regulators are blessing banks hiding losses on and off their balance sheets.  As a result, no one knows how big of a repair is needed.

Under the Swedish model, banks would stop hiding losses and instead recognize these losses.  Then, banks would use future retained earnings to repair their balance sheets and rebuild their book capital levels.

Goldman urges offering transparency to restore confidence and restart ABS

According to a Financial News article, Goldman sees the revival of the securitization market as key to ending the credit crunch in the EU.  In order to revive securitization, Goldman urges offering transparency that is sufficient to restore investor confidence.

Regular readers know that it is only transparency offered by observable event based reporting that is adequate to restore investor confidence.

With observable event based reporting, any observable event with the collateral backing a structured finance security is reported to investors on the business day after it has occurred.  This way investors always have current collateral performance information and can know what they own.

An observable event would include, but not be limited to, a payment, delinquency, default, modification, substitution/buyback or bankruptcy filing.

A revival in the much-maligned securitisation market remains key to solving the financing dilemma in Europe's corporate sector, according to analysts at Goldman Sachs... 

The market for asset-backed securities seized up after the financial crisis as investors reeled from losses tied to toxic products including collateralised debt obligations. 

New regulations are forcing global banks to hold more high-quality capital on their balance sheets against riskier assets, including residential mortgage-loans. 

In a research note this morning, Goldman Sachs said that asset-backed securitisation, or ABS, would go a long way to solving European corporates’ financing quandary. ABS involves a bank taking an asset - such as its residential mortgage loans - off its balance sheet and creating a security backed by those assets that is then sold to investors. 

The bank said: “A rebound in securitisation activity could make it easier for the euro area private sector to digest bank deleveraging. For this to happen, however, there needs to be an increase in appetite among investors for ABS." 

But Goldman Sachs's analysts said the reputation of the securitisation market was still a problem for investors. 

They wrote: “One reasons for the lacklustre growth in ABS issuance can be traced back to the bad experience investors had during the credit bubble. More transparency may therefore be needed in order to restore sufficient confidence in this asset class.” 

Goldman Sachs has itself felt the ire of investors stung by the ABS markets. In April 2010, the US Securities and Exchange Commission filed a civil suit against the bank for alleged wrongdoing in a sale of collateralised debt obligation called Abacus 2007 AC-1. 

The regulator said that the bank omitted to tell investors that its client, hedge fund manager John Paulson of Paulson & Co, was betting that the sub-prime securities underpinning the CDO would default. 

Ninety-nine percent of the portfolio has since been downgraded and investors are alleged to have lost more than $1bn, according to the SEC. The suit was settled for $550m in 2010....

The Abacus deal shows why investors are on a buyers' strike and won't return to the ABS market without the current information on the underlying collateral performance that can only be provided by observable event based reporting.

Without this information, investors are unable to assess the risk of an ABS deal.  As a result, buying an ABS deal is blindly betting.

The Abacus deal showed that when investors blindly bet against Wall Street they are likely to lose a significant amount of money.

The bank said in its note that "a further retrenchment in bank lending would pose a significant downside risk to economic growth in the euro area".

MF Global bond offerings make case for requiring ultra transparency

In his Bloomberg column, William Cohan looks at the reasons that investors in MF Global bonds felt duped.

Had MF Global been required to provide ultra transparency and disclose on an on-going basis its current asset, liability and off-balance sheet exposure details, each of the ways that investors might have been duped would have gone away.

On July 28 and again on Aug. 3, MF Global raised $325 million by selling bonds -- the first a 3.375 percent convertible-note offering, due 2018; the other a 6.25 percent senior note offering, due 2016.... 

Not surprisingly, in addition to all the other lawsuits that MF Global executives and board of directors are facing, one brought by the buyers of these notes is wending its way through federal court in the Southern District of New York. 

The plaintiffs make a compelling argument that they were duped by the public statements of Jon Corzine, MF Global’s former chief executive officer, and the company’s Securities and Exchange Commission filings.

Had their been ultra transparency, the investors would not have had to rely on MF Global's representations.  They would have had the information they needed to verify the facts for themselves.

The class-action complaint claims that MF Global’s collapse was caused by management’s “wholesale disregard for its purported risk management and internal controls as MF Global sought to transform itself from broker-dealer to a full service investment bank at all costs.”... 

the plaintiffs cite the statements MF Global made in its 2011 Form 10-K about its abundant liquidity as evidence that the company was intentionally misleading investors. 

“Our policy requires us to have sufficient liquidity to satisfy all of our expected cash needs for at least one year without access to the capital markets,” reads the form. “To manage our liquidity risk, we have established a liquidity policy designed to ensure that we maintain access to sufficient, readily available liquid assets and committed liquidity facilities.” 

The plaintiffs argue these statements were false. “MF Global was suffering from severe liquidity pressures” -- as quickly became evident -- “based on its exposure to the European debt crisis through its enormous holdings of European sovereign debt,” according to the complaint. “MF Global was materially undercapitalized.”

With ultra transparency, it would have been easy for the investors to see if MF Global was experiencing severe liquidity pressures.

Further, the plaintiffs claim, whereas the offering documents for the bonds claimed that the use of proceeds would be partly for “general corporate purposes” -- a typical catch- all -- MF Global management knew that large chunks of the $650 million were “desperately needed to provide required liquidity and working capital given the then-deterioration in value of MF Global’s $6.4 billion holdings of European sovereign debt.”...

Again, with ultra transparency, investors could have determined with the market value of MF Global's $6.4 billion holdings of European sovereign debt was and seen that most of the proceeds would be used to plug the hole between the cost of these securities and the then current market value.

And few tears should be shed for sophisticated investors who miscalculate the risks of owning securities in companies that are highly leveraged and have new management intent on changing business plans. (By last summer, it was certainly no secret that Corzine intended to change the way MF Global conducted its business by making big bets with other people’s money. He said as much publicly on several occasions.)

It is one thing for investors to miscalculate risk when they have access to all the useful, relevant information in an appropriate, timely manner under ultra transparency and quite another when the true condition of the firm is hidden by opaque reporting practices.

Still, the level of deception by MF Global’s executives and board members demands that they be held personally accountable for the losses suffered by these bondholders -- just as they should be held personally liable for the losses suffered by MF’s customers. 

It seems to me, demanding this level of accountability -- which, of course, their lawyers will say is unjustified -- is the only way Wall Street executives will begin to take seriously their fiduciary duties to their customers, counterparties and creditors. 

At the moment, though, that is just a columnist’s fantasy. No MF Global executives have been held accountable for their actions, more than six months after the firm’s collapse and billions of dollars of other people’s money have been lost. 

Come to think of it, no one else on Wall Street has been held accountable for blowing up our economy, either. How can this still be the case?

Ultra transparency brings accountability to Wall Street.  With this information, market participants are able to exert discipline on Wall Street.  Particularly when their is a gap between what they represent as the condition of their firm and what is the actual condition.

Social model is developed countries' solution, not the problem

In a Bloomberg column, Paul Fourier, a leader of one of France's largest labor union groups, explained why Wall Street rescues Main Street (aka, the Swedish model) and not Main Street rescues Wall Street (aka, the Japanese model) is the best solution for handling a bank solvency led financial crisis.

His arguments will resonate with regular readers as they focus on the moral imperative when handling a bank solvency led financial crisis to inflict minimum damage on the real economy and its poorest citizens.

In the wake of the financial crisis, Europe’s leaders are calling the continent’s social model into question -- it is “done,” according to European Central Bank President Mario Draghi. 

That’s a travesty. 

The crisis is, above all, financial. Yet governments aren’t addressing the malfunctions that caused this problem. Instead, they are forcing ordinary people to pay and attacking the social systems that support them.

This is the direct result of having adopted the Japanese model with its emphasis on protecting bank book capital levels.

Take the example of Greece. The country is being pushed to accept an austerity plan of unprecedented severity, predicated on reducing public spending and slashing salaries, pensions and social systems in the most brutal way. This has forced the country into an economic, social and political crisis that will last for many years. 

Ireland, Spain, Portugal and Italy are also being pushed to accept an austerity plan of unprecedented severity.

Please note that it is not just the EU peripheral countries as the US is not immune to a similar austerity plan as there is now talk of making significant cuts in the social benefit programs like Social Security and Medicare.

These policies are initiated not by Greeks but by European Union officials in Brussels, at the European Central Bank in Frankfurt, or in London....

Labor unions in the European Trade Union Confederation ... believe austerity is pushing Europe -- and many industrialized countries outside the region -- into a recession, unemployment and poverty. Democracy, both political and social, has to be restored....

 It is a very important point that austerity is being forced on countries by unelected technocrats.  By their policy choice, these technocrats are forcing the real economy to absorb the losses on the excesses in the financial system rather than the banks.

Priority has to be given to growth and employment, rather than pleasing the markets. 

We need new economic, social and monetary policies. We need to move toward a new distribution of wealth that favors income derived from labor over capital; wages and productive investments over financial investments and dividends....  

More of the wealth that companies produce should be used to increase salaries (together with social-security payments), and to pay for training as well as research and development. Doing so would help companies to innovate and strengthen their position in the market. 

Above all, we need to maintain employment in the public services, the quality of which benefits companies as well as individuals. Cutting public spending can only be done to the detriment of the very things that underpin the growth of large industrialized economies: excellence in education, an effective health system and quality public services. To undermine these strengths is to misunderstand the challenges that we face today.

Social-protection systems based on solidarity between the generations, between men and women, rich and poor, have to endure in their current form. To attack them is to cast onto the mercy of the marketplace our ability to maintain our health, to safeguard our pensions and to raise our children in good conditions. Invariably, this produces two-speed protections and weakens the poorest.... 

Leaders on Europe’s political right are refusing to question the economic model they have been supporting for decades. The financial crisis has shown that this model, based on deregulation, privatization and reduction of the state’s role, is exhausted, if not bankrupt. 

Either by error or ideological stubbornness, Europe’s current leaders are imposing the heaviest burden of reform on those who are least protected.

As oppose to on the banks which in a modern financial system are designed to absorb the heaviest burden in the form of recognizing the losses on the excesses in the financial system.

Fed creates council of outside economists to study US bank stress tests

In its search to enhance the credibility of its fundamentally flawed stress tests, the Fed has created a council of outside economists to evaluate the models used by the Fed in its stress tests.

According to a Bloomberg article,

The Federal Reserve created an advisory council of economists to help evaluate the models used in so-called stress tests judging how banks would perform in a poor economy. 

The Model Validation Council will provide the Fed “expert and independent advice on its process to rigorously assess the models used in stress tests of banking institutions,” the central bank said in a statement today in Washington. “The council is intended to improve the quality of the Federal Reserve’s model assessment program and to strengthen the confidence in the integrity and independence of the program.”

U.S. regulators, empowered by the Dodd-Frank Act and criticized for not averting the crisis in mortgage finance, have redesigned their approach to bank supervision, focusing more on systemic risk. They seek to prevent a repeat of the financial crisis that led to the collapse of Lehman Brothers Holdings Inc. in the largest bankruptcy in U.S. history. 

The central bank last month released the results of stress tests showing that 15 out of 19 banks would be able to maintain capital levels above a regulatory minimum in an “extremely adverse” economic scenario, even while continuing to pay dividends and repurchasing stock. ... 

The committee will be led by Francis X. Diebold, an economics professor at the University of Pennsylvania. The panel will also include Peter Christoffersen, of the University of Toronto; Mark Flannery, from the University of Florida; Philippe Jorion, from the University of California at Irvine; Chester Spatt, from Carnegie Mellon University; and Allan Timmermann, from the University of California at San Diego.

Based on a quick Google search (please let me know if I am wrong!), predicting the current financial crisis was not a requirement for appointment to the Model Validation Council.

Your humble blogger can understand why this was not a requirement as there were less than a handful of economists who publicly predicted the crisis.

However, why would anyone think it adds credibility to have economists who did not predict the current financial crisis reviewing models that are supposed to prevent the next crisis?

On its way to embracing observable event based reporting, ECB increasing scrutiny of ABS collateral

In a significant step towards embracing requiring observable event based reporting, Reuters reports that the ECB is increasing its scrutiny of ABS collateral by requiring banks to notify it one month in advance of making any changes in the underlying collateral for deals that are pledged to the ECB.

The European Central Bank is to increase its scrutiny of the asset-backed securities banks exchange for ECB loans, by demanding they inform it of even the slightest changes to the make up of the tricky-to-value assets....

Please re-read the highlighted text because once the ECB started down the path of wanting information on the slightest change to the underlying collateral there is no logical stopping point prior to requiring observable event based reporting as a condition of eligibility for an ABS security to be pledged as security for a loan.

Regular readers know that under observable event based reporting, all observable events involving the underlying collateral are reported before the start of the next business day.  An observable event includes, but is not limited to, a payment, a delinquency, a default, a borrower filing for bankruptcy, a modification of the terms on the collateral and a substitution of new collateral for existing collateral.

Observable event based reporting is needed if the ECB or any investor is going to be able to know what they own.

Decisions made at its mid-month meeting this week, details of which were published on Friday, showed the bank was further upping its scrutiny of ABS collateral with immediate effect. 

The changes mean borrowers will have to tell the ECB if they swap any of the assets that make up a securitisation, even if the shuffling does not trigger any change in its overall rating. 

"Counterparties (borrowers from ECB)... are to inform the Eurosystem: (i) one month beforehand of any planned modification to an ABS that it has submitted as collateral," ...
"And (ii) upon submission of an ABS, of any modification made to that ABS in the six months prior to its submission, if the ABS is "own-used". 

The latest figures from the ECB showed that asset-backed securities made up 21 percent of all collateral used by banks taking loans from it in 2010. 

Irish Department of Finance shows how regulators' need to speak with one voice stymies difference of opinion

In a must read piece in the Irish Independent, the Irish Department of Finance shows how the need to talk with one voice in official public statements resulted in dismissing and ignoring warnings by an official on the growing risk of a property crash.

This is very important because it is an example of how regulators add instability to the financial system.

Regular readers know that market participants are dependent on the regulators because they have access to current bank exposure level details.  The other market participants don't have this data and instead receive disclosure that leaves the bank resembling a 'black box'.

For market participants to properly adjust their exposures based on the risk of each bank, the regulators must both correctly assess this risk and communicate this risk to the market participants.

Clearly, the need to talk with one voice in official public statements means that differences of opinion on risk are stifled by a permanent barrier that is part of the DNA of financial regulators.

As shown by this example, the official would have had to convince all of her superiors at the Department of Finance in order to have her opinion included in the official public statements.

One of the advantages of requiring banks to provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details is it ends reliance on the regulators to properly assess and communicate the risk of each bank.

The Sunday Independent today reveals how a catalogue of stark warnings by a Department of Finance official on the risk of a property crash were systematically ignored and dismissed by senior civil servants in the preparation of official public statements. 

In one revealing email, the whistleblower official warned in 2006, at the height of the boom, of "increased residential mortgage defaults thereby exposing the banking sector". 

But instead of being acknowledged as a prescient forecaster of impending economic woes, assistant principal officer Marie Mackle was told that such language was "inappropriate" for a public ministerial speech and "positively alarmist". 

"I've paid the price for being an internal whistleblower," Ms Mackle wrote in 2011 in a memo in which she says she has been left "progressively alienated and isolated". 

But had her dire warnings, from 2005 to 2007, been brought to public attention, it is believed much of the current mortgage crisis could have been averted. 

Ms Mackle's hundreds of emails, briefing notes and speeches will feature prominently in an inquiry into the banking collapse to be held by the Dail's Public Accounts Committee (PAC). 

Yesterday PAC chairman John McGuinness said the revelations contained in Ms Mackle's documents were "absolutely shocking". 

He said: "The public and every member in Leinster House will be appalled and deeply shocked to know that such warnings within the Department of Finance were not shared with them.....

Ms Mackle prepared a detailed file for various bodies, including PAC, Transparency Ireland and the Nyberg Commission, which examined the banking crash.... 

The documents reveal, that between January 2005 and early 2007, Ms Mackle repeatedly attempted to include references to the risks from over-reliance on the property market in official departmental statements, as well as speeches by the then Finance Minister Brian Cowen and in replies to parliamentary questions tabled by Opposition TDs. 

It is documented how senior officials repeatedly removed, erased and dismissed such warnings in favour of more optimistic language. 

A number of those senior civil servants implicated still occupy key positions in the Department of Finance and the Department of Public Expenditure and Reform.... 

Another senior official, Derek Moran,... ordered Ms Mackle to formulate a response highlighting the positive aspects of the property market. 

"Go back to them and say this. . . the large increase in new housing supply will restore equilibrium to the market. . . There is a broad consensus amongst commentators that the most likely outcome for the housing market is a 'soft landing'. Government continues to run a prudent, stability-orientated budgetary policy. . ." Mr Moran wrote.

 Also in 2006, Ms Mackle attempted to warn in a speech that Mr Cowen gave to a builders' conference in early 2006 that the never-ending spiral in house prices increased the risk of "default on residential mortgages thereby exposing the banking sector".

Her warning was dismissed and Ms Mackle was told: "Marie, this type of material is not appropriate or suitable for a ministerial speech. It is positively alarmist in tone in some areas." 

In documents she sent to the Nyberg Commission, Ms Mackle said she had paid the price for trying to speak up. 

"As matters stand currently, I am completely ostracised and my work is ignored," she said.

As the highlighted examples show, there are significant internal barriers that silence a dissenting opinion in a financial regulator.  Barriers that insure that the next financial crisis will not be prevented.

This alone makes the case for requiring the banks to provide ultra transparency.

HSBC chairman: Financial Policy Committee likely to harm lending

In a Telegraph article, HSBC's chairman Douglas Flint warns that the Bank of England's new Financial Policy Committee (FPC) is likely to harm lending.  Specifically, he thinks it could limit the ability to borrow from banks and increase the borrower's costs.

Is this a feature or a bug?

Its a feature if you think that restraining lending would have prevented the credit crisis.  Its a bug if you think that rationing credit will keep the economy from operating at its full potential.

Mr Flint said that the new committee - chaired by Bank Governor Sir Mervyn King - is likely to reduce capital in the financial system and, as a result, harm business lending. In an outspoken speech, Mr Flint said the committee’s pending statutory powers “could easily materially impact access to credit and its pricing.”... 

His comments come three weeks after Peter Sands, chief executive of Standard Chartered, blasted the new financial oversight committee’s approach as “extremely interventionist and extraordinarily blinkered.” Mr Sands said he was “dismayed” by the FPC’s call for extensive powers to control the UK’s financial system.... 

Mr Flint noted that the FPC is beginning “to articulate how it wishes to exercise its statutory powers” including sectoral capital requirements – where banks would have to post more money against companies in specific risky sectors – and possibly a time varying liquidity tool. 

“I see this as a significant new risk for you all to get to understand, as a change in sectoral capital risks could easily materially impact access to credit and its pricing,” he warned.... 

The FPC, which has been meeting ahead of its powers hitting the statute book, was designed in response to the 2008 financial crisis, and intended to monitor the economy of the UK, looking at macro-economic and financial issues.

Readers know that I prefer not to have to rely on regulators to restrict credit.  I prefer that the market participants have access to all the useful, relevant information they need in an appropriate, timely manner so they can make a fully informed investment decision.

If this type of data is available, then market participants can exert discipline on the banks so that credit is properly priced throughout the credit cycle. 

Lesson from Ireland: Property prices 'could take decades to recover'

The Irish Independent ran an interesting article in which the new Irish central bank deputy governor warns that property prices could take decades to recover from the crash.  A crash in prices that is still continuing.

HOUSE prices could take decades to recover from the property crash even if the economy starts growing, the new deputy governor of the Central Bank of Ireland [Stefan Gerlach] warned last night. 

Experience of booms and property crashes in other countries suggests the economic recovery here will be slow and house prices will recover even more slowly, he said....

Ireland had experienced a classic housing boom. House prices here rose faster and higher than in most booms but the bubble and burst is in line with the pattern seen around the world, he said. 

It means experience elsewhere could help forecast the likely trend here over the coming years. 

That evidence points to a sustained housing slump, because credit-fuelled booms are typically worse than other booms and the combination of a housing crash with a financial crisis is especially damaging....

A study comparing crashes in the likes of Scandinavia with in Korea and Japan revealed the wider economy recovered much faster than house prices, where they recovered at all. 

"While gross domestic product (GDP) in this sample of countries typically recovered to peak levels within six years, the recovery in house prices was much delayed," Mr Gerlach said.
"In the Nordic countries, the recovery took between 10 and 22 years, house prices have not yet recovered to pre-crisis levels in Korea and continue to decline in Japan. 

What is fascinating about this study is it shows that countries that pursue the Swedish model for handling a bank solvency led financial crisis see house prices recover to pre-crisis levels.

Under the Swedish model, banks are required to recognize the losses on the excesses in the financial system.  As a result, real estate prices decline initially to a market clearing level and then increase with growth in the economy.

Countries that pursue the Japanese model for handling a bank solvency led financial crisis don't see house prices recover to pre-crisis levels.  In fact, in Japan they continue to decline.

"Overall these graphs suggest that economic activity in Ireland will recover only gradually, and that it may take a long time before house prices return to their level in 2007," he said.

Financial firewalls: a tool for bankers to secure their next round of bonuses

In a Bloomberg article, Treasury Secretary Geithner urges Europe to be aggressive and creative in dealing with the ongoing financial crisis.

“The success of the next phase of the crisis response will hinge on Europe’s willingness and ability, together with theEuropean Central Bank, to apply its tools and processes creatively, flexibly and aggressively to support countries as they implement reforms and stay ahead of markets,” Geithner said. 

While cautioning Europe to stay vigilant, Geithner was less pessimistic than when he warned the IMF in September to intensify its efforts to avoid the “threat of cascading default, bank runs and catastrophic risk.”

Naturally, at the top of the list of creative tools for staying ahead of the threat of cascading default, bank runs and catastrophic risk are financial firewalls.

There are two sets of firewalls.  First, the Europeans have pledged almost $1 trillion to the combined European Financial Stability Fund (EFSF) and the European Stability Mechanism (ESM) firewall.  Second, the IMF recently received $430 million more to shore up its resources.

As Liam Halligan observed in his Telegraph column

The very size of the “bazooka” is supposed to reassure global markets any contagion will be contained. That’s the theory behind financial firewalls – that they’ll never actually be needed. 

Such reasoning is defendable but only if the breathing space provided is used to press ahead with genuine structural solutions to the issues that necessitated the firewall in the first place.

Mr. Halligan goes on to define the problem for which genuine structural solutions are needed and then discusses what genuine structural solutions must occur so that the firewalls are not actually needed.

Europe’s almost entirely unrestructured banking sector remains bombed-out, sitting on trillions of euros of undeclared losses. Member states continue to bail out their busted banks using “virtually printed money”, the banks in turn using such bail-outs to buy member states’ sovereign debts. 

This is unsustainable — so, by definition, will not be sustained. These IMF and eurozone firewalls may allow the party to continue a while longer. But the ultimate hangover will be even worse. 

What the eurozone desperately needs, as this column has argued ad nauseam, is for its banks to be forced, under threat to executives of custodial sentence, to fess-up to the massive losses on their balance sheets. 

The worst of those losses must be written off, resulting in bank restructurings, with salvageable loans placed in a state-sponsored “bad bank” in the hope some value can be recovered. 

Doing this will cause a lot of pain and yet more debt will hit some nations’ balance sheets. But there really is no alternative. We’re well, well beyond the point where any eurozone solution will be palatable. The harsh medicine of write-downs and debt restructurings should be implemented behind the various firewalls, while they can still be erected. 

None of this will happen, of course. 

Why can't the banks disclose the losses on and off their balance sheets?

Because the EU, like the UK and US, has adopted the Japanese model for handling a bank solvency led financial crisis.  Under this model, the book capital level of banks is protected and, by definition, losses are not disclosed.

In fact, losses are only recognized to the extent that the bank has earnings in excess of the amount needed to pay banker bonuses and dividends.

The existence of financial firewalls provides cover for the bankers to continue taking their bonuses.  The financial firewall is suppose to eliminate the risk of contagion and if all is well at the bank then why shouldn't the bankers get their bonuses.