Thursday, May 31, 2012

NY Times' Peter Eavis Part III: Shockingly, US banks are less than transparent on EU exposures

According to a New York Times Dealbook article by Peter Eavis, US banks have been less than forthcoming about their true exposure to the EU.

Call this yet another reason that the banks need to 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 information, it is impossible for investors to assess the risk to these banks.

United States banks received a regulatory memo this year asking them to make clearer their public disclosures about their exposure to Europe’s troubled countries. Not all the banks bothered to comply fully, however. And this could backfire on them if financial conditions in Europe deteriorate further.
In January, the Securities and Exchange Commission requested that banks’ financial filings contain specific descriptions of loans and trading positions relating to Europe. But some large financial firms did not follow all the S.E.C.’s suggestions in their first-quarter reports. 
The agency’s memo was “guidance” and therefore not an edict that banks must adopt. Even so, with European leaders struggling to find solutions to the region’s problems, investors may not appreciate that banks chose to comply only in part.
Of course by not complying the banks send a loud message that says "WE HAVE SOMETHING TO HIDE!!!!"
One of the S.E.C.’s chief aims was to expand banks’ European disclosures so that outsiders can see what’s really packed inside them. 
The problem was that a bank might say it had total Italian trading positions of $3 billion, for example, but that might actually be a net figure that included hard-to-see offsetting items. 
Without such offsets, the “gross” Italian trading total may in fact be a lot higher. In its January memo, the agency made a point of asking banks to disclose gross figures, and then to highlight any offsetting items. 
The fear is that, in a crisis, a bank might not be able to collect all the offsets, so its true exposure may not be its net exposure.
Some banks nevertheless stuck with less transparent approaches. 
Please recall the Wall Street Opacity Protection Team.  Unless forced to provide more disclosure, Wall Street always provides the bare minimum.
One is Morgan Stanley, whose share price was pulverized last fall when investors worried about its exposure to Europe. In its first-quarter filing, the Wall Street firm’s disclosed an item called “net counterparty exposure,” a term that includes collateralized short-term loans and derivatives that don’t trade on exchanges.....
“Net counterparty exposure” is the largest component of Morgan Stanley’s troubled Europe exposure. But it could be bigger on a gross basis. A footnote to the item says it takes into consideration an undisclosed amount of collateral, the cash or assets that clients post with Morgan Stanley. 
However, if banks choose to include collateral as an offset, the S.E.C. asked them to quantify that collateral in a footnote. Morgan Stanley didn’t do that....
Bank of America also chose not to provide a gross total for all its Europe exposures. For example, the total for a $1.7 billion item called “securities/other investments” is reduced by an undisclosed amount of hedges and short positions, which are trades intended to go up in value if the underlying securities go down. 
“We believe that our disclosure is consistent with the guidance provided by the S.E.C.,” said Jerome F. Dubrowski, a Bank of America spokesman. “Each company will do this a little differently, but we believe this disclosure meets the criteria established by the S.E.C. If we are asked to provide additional information, we will of course comply.” 
The banks argue that offsetting items like collateral and hedges should not be ignored because they provide dependable protection. In certain stress situations, they will. 
But hedges may not work if European banks get into trouble. They may not be able to honor any payments they owe on trades American banks have made as a hedge. Morgan Stanley recognizes this danger. It doesn’t count hedges struck with banks in troubled countries in its overall total for European hedges. 
Another situation that could overwhelm banks’ strongest defenses is a dissolution of the euro
For instance, many of the banks’ hedges are credit default swaps whose prospective payouts would be in euros. What would happen to the value of a swap if its payout currency disappeared, or fractured into new currencies? ...
Even collateral, assets the banks already hold, may turn out to be worth a lot less than they had hoped for. Collateral often comes in the form of cash euros or European government bonds. 
For instance, one place banks receive and supply substantial amounts of collateral is at clearinghouses, entities that handle claims underlying trades. Indeed, the reason French exposure is high for Goldman Sachs and Morgan Stanley is that they both use a Paris-based clearinghouse for trades in secured short-term loans. But it’s common practice for collateral at European clearinghouses to take the form of cash euros or European government bonds. 
When asked whether this leaves them with vulnerable euro-based collateral, banks say they can swap such collateral into assets in other currencies. 
If things get worse in Europe, some banks may be pressed to include more countries – particularly France — in their troubled Europe disclosures. Bank of America, Goldman and JPMorgan all leave France out of those tables, though they reveal limited data about France in other places in their filings. The problem with the skimpier disclosures is that they don’t show how hedged any of those three banks are against French exposures. 
Perhaps it’s time for the S.E.C. to send another memo?
Yes, this time saying that the banks need to provide ultra transparency so all market participants have access to the information they need to truly assess the riskiness of each bank.

Spain's bank job accelerates towards bank run

According to a Telegraph article, almost 100 billion euros was pulled from the Spanish banking system in the first three months of the year.  Of that amount, over 65 billion euros was pulled out in March alone.

Given the credibility destroying response of the government to Bankia, there is no reason to believe that the pace of deposits leaving the Spanish banking system is not continuing to accelerate.

I know I have said this before and I will say it again, but it is still not too late to adopt the Swedish model with ultra transparency and restore confidence in the banking system.

Almost €100bn (£80.2bn) of cash was pulled out of Spain in the first three months of the year by private and corporate investors fleeing the advancing financial and political crisis. 
The Bank of Spain said €66.2bn was withdrawn in March alone – the fastest rate since records began in 1990 – taking the total to €97bn for the first quarter. 
Experts warned that the chaotic state-rescue of Bankia is likely to have speeded up the capital flight, compounding the already critical instability of the banks. 
Foreign investors have also rapidly withdrawn their support for Spanish government funding. According to figures from Barclays Capital, foreigners accounted for just 30pc of the holders of Spanish sovereign debt in March, down from 40pc at the same time last year.

Bankia risk dragging Spain and EU into vortex

As reported by Bloomberg,

Bankia group risks dragging the rest of Spain into its vortex. 
As Spain’s third-biggest bank asks Prime Minister Mariano Rajoy’s government for 19 billion euros ($24 billion), international investors are tallying the potential cost for the rest of the industry and betting he won’t be able to foot the bill.... 
“The problem for Spain is that they can’t simply finance all this by issuing debt,” said Edward Thomas, who helps manage $6 billion as head of fixed-income investment at Quantum Global Wealth Management in Zug, Switzerland. “It’s a perfect storm for Spain, with more banks now being sucked in.” 
Spain needs to bail out lenders still reeling from the collapse of the real-estate boom while its own access to funding increasingly depends on domestic banks being kept afloat by the European Central Bank’s refinancing operations....
Given that Spain cannot foot the bill, it seems prudent to make the banks foot the bill for their recapitalization instead.

According to the IIF, after recognizing all the losses hidden on and off the bank balance sheets, the Spanish banks should be able to generate sufficient capital to rebuild their book capital in less than 4 years.
Spain is facing a credibility problem because of doubts generated by Bankia about “the size of that hole in the banking system,” said Andrew Bosomworth, a money manager at Pacific Investment Management Co., in a Bloomberg Television interview on May 29. 
“They know what to do. I think it’s the consequences of doing it -- how do the markets react if Spain applies for official external finance,” said Bosomworth, adding that experience of bailouts for Greece, Ireland and Portugal had been like a “kiss of death.”
Spain does know what to do.  It simply needs to require the banks to provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details.  The markets can calculate the size of the hole in the financial system that the banks will have to refill with future retained earnings.

For the near term, it will undoubtedly be the 'kiss of death' for cash bonuses for bankers.
External auditors are due to publish a stress test on Spanish banks in June, followed by a more detailed report that will make clear how much additional capital banks may need.... 
Like the third party stress tests in Ireland and Greece, no one will believe the results.  In the absence of providing ultra transparency, there is no credibility to anything the government says or pays for.

Market participants have to discount the results because without ultra transparency so the market participants can confirm the results, it has to be assumed that there is something to hide.

ECB's Draghi calls for EU bank reform

As reported by the Wall Street Journal, the ECB's Mario Draghi's call for EU bank reform gets closer to but does not fully adopt your humble blogger's blueprint for saving the financial system.
In testimony to European Parliament, Mr. Draghi criticized the efforts by national regulators to get a handle on the state of their countries' banks, an error that he said makes it far more expensive to recapitalize struggling financial institutions. 
When regulators are faced with banks needing more capital, they "underestimate the problem and then come out with a second or third or fourth assessment," he said, citing Franco-Belgian bank Dexia SA and Spain's Bankia. 
"That's the worst possible way of doing things. Everybody ends up doing the right thing but at a high cost and price," he said.... 
Your humble blogger could not agree more that how national regulators are handling their financial institutions is the 'worst possible way of doing things'.

I have written extensively on how the only way to end the 'worst possible way of doing things' is to require the banks to provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details.

So long as national financial regulators have an information monopoly on all the useful, relevant information on the financial institutions hosted by their country, market participants, including financial regulators in other countries, are dependent on these regulators to both properly assess the information and communicate the results of this assessment.

Clearly, there are a number of institutional hurdles that make it virtually impossible to both assess and communicate the results.

I have talked about several of these hurdles including:  if the assessment is done correctly, the bank's successfully challenges the assessment to more senior regulators (regulators only speak with one voice); if the assessment is right and the senior regulators support it, the senior regulators still have to deal with politicians who they might not be able to convince (after all, when real estate prices are increasing, everything looks okay); if the assessment is right, senior regulators still have to overcome concerns about the safety and soundness of the financial system before they would publicly disclose the assessment to the other market participants.
Mr. Draghi called for a banking union entailing a euro zone-level fund for resolving failed banks, a euro zone-level deposit insurance guarantee system, and banking sector supervision that is more centralized on a European level. 
Under your humble blogger's blueprint, resolving failed banks remains with the host country.  However, the blueprint has a much different definition of failed banks than Mr. Draghi is using.

The blueprint explicitly recognizes that in a modern financial system with deposit guarantees and access to central bank funding, banks can operate and support the real economy for years even when they have negative book capital levels.

What distinguishes a failing bank from a non-failing bank is the non-failing bank has a franchise that allows it to generate and retain earnings to rebuild its book capital levels.

It is only the banks that after recognizing all the losses currently hidden on and off their balance sheet that cannot generate earnings that need to be resolved.
The euro-zone's permanent rescue fund, the European Stability Mechanism, could be used to recapitalize banks, he suggested. Under its charter, the ESM is only allowed to lend to governments. That makes it difficult for many governments to recapitalize banks without putting unbearable stress on their own public finances, an issue that is particularly acute in Spain. 
The blueprint explicitly recognizes that a modern banking system does not require bailouts as the banks can generate earnings in the future to rebuild the book capital decline that results from recognizes all the losses on and off their balance sheets today.

As a result, the ESM is freed up to be used to backstop the government's deposit guarantee.
Mr. Draghi's calls for more European integration are "spot on," said Philip Whyte of the London-based think tank Centre for European Reform. "It's a totally dysfunctional currency union. You need reforms to make a more fiscally-centralized union," he said....
The blueprint explicitly recognizes that information is the key to the new model for bank supervision.

With ultra transparency, no longer are each nation's financial regulators dependent on the other nations' financial regulators to assess and communicate what is going on in the banks and bank subsidiaries hosted in their countries.

With ultra transparency, each nation's financial regulators have access to all the information.  They can both independently assess this information themselves and tap the market's ability to assess this information.  As a result, each nation's financial regulators can exert discipline on all the other nation's financial regulators when it comes to bank supervision.

JP Morgan's trading loss highlights another reason for requiring ultra transparency

According to a Bloomberg article, JP Morgan valued the credit default swaps involved in its trading losses differently across its organization.

One of the benefits 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 that it eliminates valuation differences.

These difference will be caught in one of two places.

First, when the positions are disclosed.

Second, as part of their independent assessment of the disclosed data, market participants are likely to catch both internal differences in valuation as well as where internal and external valuations differ.

The JPMorgan Chase & Co. (JPM) unit responsible for at least $2 billion in losses on credit derivatives was valuing some of its trades at prices that differed from those of its investment bank, according to people familiar with the matter. 
The discrepancy between prices used by the chief investment office and JPMorgan’s credit-swaps dealer, the biggest in the U.S., may have obscured by hundreds of millions of dollars the magnitude of the loss before it was disclosed May 10, said one of the people, who asked not to be identified because they aren’t authorized to discuss the matter.
“I’ve never run into anything like that,” said Sanford C. Bernstein & Co.’s Brad Hintz in New York, ranked by Institutional Investor magazine as the top analyst covering brokerage firms. “That’s why you have a centralized accounting group that’s comparing marks” between different parts of the bank “to make sure you don’t have any outliers,” said the former chief financial officer of Lehman Brothers Holdings Inc....
Jennifer Zuccarelli, a spokeswoman for New York-based JPMorgan, declined to comment on whether the CIO and investment bank were using different prices. 
“All components of the synthetic credit portfolio in the chief investment office were mark-to-market,” she said.... 
Because JPMorgan had amassed such large positions, even a small change in how the prices were marked may have generated a big difference in the value of the trades, one of the people said.

“It would not be normal to book it at levels that were better than the dealer desk,” said Peter Tchir, founder of New York-based hedge fund TF Market Advisors. “That would strike me as a very big issue.”
The only way to truly prevent this from occurring in the future is to require ultra transparency.

Since ECB will only lend to solvent banks and all EU banks are insolvent, its time to run

According to a Bloomberg article, ECB President Mario Draghi says that the ECB will continue to lend to only solvent banks.  Since every bank in the EU is insolvent, by definition, the ECB is done lending.

Regular readers know that Mr. Draghi's statement is in direct contradiction to the rules for central bankers laid out by Walter Bagehot in the 1870s and discussed on this blog.

Rule number one for central bankers is that in times of crisis they are suppose to lend freely against good collateral at high interest rates.  This rule says absolutely nothing about whether the bank that is borrowing the money is solvent or not.

In fact, by writing the rule the way he does, Mr. Bagehot shows that he understands that bank solvency can change over time as it is defined as the current value of the bank's assets minus the book value of its liabilities.

In times of financial panic, assets tend to be valued at substantially less than they would be in more normal times.  As a result, a bank that is solvent in normal markets could be insolvent in a financial panic.

U.C. Berkeley Professor J. Bradford DeLong confirmed my reading of Mr. Bagehot in his article This Time, It Is Not Different.

As for the statement that all EU banks are insolvent, there are a number of different pieces of information that confirm this observation.

First, one need look no further than the latest EU stress test that showed that both the Netherlands bank Dexia and the Spanish bank Bankia passed.  Both has subsequently been nationalized.  In short, everyone knows that passing the stress tests does not equate to a bank being solvent.

Second, we have policymakers taking actions to bailout the banks.  For example, the Greek bailout was designed so that the money from the EU would flow directly to the banks.  A clear sign that the policymakers don't think the banks are solvent.

Third, we know that under regulatory forbearance the banks are hiding losses on and off their balance sheets (please note, if a bank were not hiding losses, it would provide ultra transparency to let market participants confirm this point and show that it can stand on its own two feet).  What this means is that the banks themselves cannot tell who is solvent and who is not.  As a result, the interbank lending market has frozen.

Fourth, we know that banks are still interconnected.  Are German banks really solvent if the insolvent Greek, Spanish and Italian banks trigger insolvency in the French banks too?

Given that Mr. Draghi says the ECB is only going to support solvent banks, then it is pretty clear what the prudent course of action is for EU depositors.  Run to their bank and withdraw their money before the system collapses.

Perhaps the ECB and Mr. Draghi would like to rethink their position...

European Central Bank President Mario Draghi said policy makers will keep focusing their crisis support on solvent euro area banks as he reiterated it’s not the ECB’s job to fix the cause of the region’s turmoil. 
“The ECB will continue lending to solvent banks and will keep the liquidity lines active and alive with solvent banks,” Draghi told a European Union Parliament committee in Brussels today....
 So much for lending to any bank in the EU.
When pressed on whether the ECB can step up action to tame financial turmoil and help cap widening bond spreads, Draghi said that “it’s not our duty, it’s not in our mandate” to “fill the vacuum left by the lack of action by national governments on the fiscal front,” on “the structural front, and on the governance front.”

Draghi signaled the ECB is in no rush to introduce a third three-year loan program as the turmoil hasn’t arrived at “the same levels reached in November 2011,” when such aid was first mooted. While the ECB’s lending can help improve bank liquidity, it cannot address risk aversion and capital shortages in the banking sector, he said. 
Apart from funding “there are two other issues that are now hampering credit flow, one is risk aversion” and “the second is lack of capital,” Draghi said. “We cannot do much about the two other reasons about the slowing in credit.”
Keep in mind, Mr. Bagehot says that central bankers should never, ever look at a bank's capital position.

Central banks are senior secured lenders who haircut any collateral they take prior to extending a loan.  As a result, the only issue the central bank should focus on is correctly valuing the collateral.

This is a point Paul Volcker made several years ago when he said that central banks should evaluate the collateral pass the point of no return.  Central banks should assume that the bank will default.
Draghi hinted that he is in favor of using the permanent bailout fund, the European Stability Mechanism, to be used to inject capital into banks. 
“People are actually working on finding ways that the ESM could be used to recapitalize banks,” he said. “ The issue is not so much the use of ESM money to recapitalize banks but whether this could be done directly without having to go to governments.”...
A far more effective way to use the ESM is as a backstop to deposit guarantees.
He said one of the lessons drawn from the Bankia (BKIA) group’s need for a 19 billion euros capital injection is that “further centralization of banking supervision is needed,” as national governments and supervisors tend “to first underestimate the importance of the problem, then come out with a first assessment, then a second, then a third, then a fourth” and “all countries have done the same thing.” 
This is “the worst possible way of doing things” as even though in the end they do the “right thing, but at the highest possible cost and price,” he said. He also urged governments to “err on the high side” when recapitalizing banks.
Actually, the lesson is that banks should 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 information, the market will assess the banks and determine the extent of the problems.

The ability to use the market's assessment of the problem saves the government from destroying its credibility when it consistently underestimates the true extent of the problem.

Finally, in a modern banking system with deposit guarantees and access to central bank funding, there is no reason for a government to step in and recapitalize a bank.  The banks are perfectly capable of rebuilding their book capital levels through retention of future earnings.

It is only when a central bank stops lending based on a bank's current solvency status that a modern banking system collapses.

Wednesday, May 30, 2012

Argument for National Safety Board for Financial Crashes really is case for ultra transparency

In his Bloomberg column, Simon Johnson puts forward why he thinks we need a National Safety Board to investigate financial crashes.  While doing so, he highlights the need for ultra transparency throughout the financial system.

There are growing concerns that the regulatory bodies overseeing the financial sector are incapable of understanding, preventing or even properly investigating excessive risk taking that threatens to ruin the economy.
All of these reasons suggest that regulators should not have the information monopoly they have on all financial institutions' useful, relevant data in an appropriate, timely manner.

Instead, this data should be made available to all market participants.  The way to do this is to require  banks to provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details.
This issue was raised before the 2008 financial crisis and received more attention during the debate that led to the 2010 Dodd-Frank financial-reform law....
In light of the $2 billion-and-counting trading losses at JPMorgan Chase & Co., the issue is back on the table.
Previously discussed on this blog is the simple fact that bank regulators do not approve or disapprove of the individual positions.  They see this as interfering in the allocation of capital across the economy.

Rather, regulators try to estimate the potential for losses from these positions and try to ensure that the bank has adequate book capital levels to absorb the losses.
If anything, the key points have been sharpened both by what we know and don’t know about JPMorgan’s losses. ...
The JPMorgan trading losses of 2012 are much more specific and focused. We know that something went badly wrong in a high- profile trading unit, staffed with people who were considered to be the best in the business. We know that Jamie Dimon, the chief executive officer, approved in general what was happening, yet appears not to have been informed about key decisions. 
We don’t know the exact nature of the initial mistake or mistakes. We don’t know the details of reporting within the JPMorgan management structure. And we also don’t know what Dimon knew and when he knew it..... 

Because JP Morgan's current disclosure practices leave it resembling a 'black box', we know that we don't have the position data that Jamie Dimon wanted so he could understand what was going on.

We know that without this data, market participants cannot assess the risk these trades pose to JP Morgan.  As a result, we know that market participants cannot properly assess the risk of JP Morgan or exert market discipline.

It is in the public interest to have a proper, independent investigation of the losses at JPMorgan. But here we run into a number of practical and political difficulties. 
First, the obvious parties to conduct an investigation are also the regulators and supervisors of JPMorgan -- and thus face a potential conflict of interest. Would the Securities and Exchange Commission, the Commodity Futures Trading Commission, the Office of the Comptroller of the Currency or the Federal Reserve really want to uncover and explain what they previously overlooked? 
The Federal Bureau of Investigation has launched a probe, but its focus is presumably on whether to bring charges, rather than to figure out how to make the financial system safer. The Office of Financial Research, established by Dodd-Frank to monitor financial risk in the larger picture, so far has had no discernible effect.

Second, Dimon has the best possible political connections, including at the White House, where one of his former executives, Bill Daley, was until recently the chief of staff. Dimon also sits on the board of the Federal Reserve Bank of New York, a supervisor of large banks and the source of expertise on financial markets within the Federal Reserve system....
Your humble blogger has a preference to focus on what could have been done to prevent the losses in the first place.

Please note how JP Morgan is not disclosing the position level data related to the CDS trade because of its concern that the market will trade against it.  If the market could have seen what JP Morgan was buying when it initially started buying, this concern would have stopped JP Morgan from putting on the position in the first place.

Bottom line:  ultra transparency would have prevented the loss.

EU still searching for way to stop bank run contagion caused by redenomination risk

The EU is scrambling to find a way to stop the risk of bank runs across the peripheral countries if Greece is forced back onto the drachma.

Regular readers know that your humble blogger has suggested an easy solution:  adoption of the Swedish model with ultra transparency.

Under this solution, the banks will absorb the losses on the debt in excess of the borrower's capacity to repay.  If this were done, then Greece would not be forced onto the drachma and the risk of bank run contagion resulting from forced redenomination would go away.

As reported by Reuters, the EU is pursuing alternatives endorsed by bankers that don't require the banks to recognize the losses hidden on and off their balance sheets.

As the euro zone ponders a possible Greek exit, policymakers have not yet built a shield robust enough to prevent a bank run in one country sending others in the bloc deeper into crisis.... 
But a wave of withdrawals by depositors - either for fear that their government is too weak to stand behind its banks or that their country will exit the euro and switch their savings into a vastly devalued national currency - would represent a whole different scale of crisis. 
Such pressure on Ireland's banking system prompted a national bailout by the International Monetary Fund and European Union. 
Now investors are worried about the contagion effect a Greek exit from the euro zone could have on savers in other countries. 
"Preventing bank runs in Italy, Spain and Portugal should be the top priority," said Berenberg Bank economist Holger Schmieding. "Policymakers need to make sure that the potential Greek precedent of a forced conversion of domestic euro deposits into a weak new currency would not spark a run on banks ... elsewhere."
Bank runs in these other countries are already taking place.  
The ECB is pressing the euro zone to set up a fund that would prevent this dangerous ripple effect, a message reinforced by ECB policymaker Joerg Asmussen last week. 
"The recapitalization of a troubled bank by its government may lead to a deterioration of the government's fiscal position," Asmussen said. "The deteriorating fiscal position in turn further weakens banks' balance sheets, through their holdings of sovereign bonds. 
"This feedback loop has to be stopped ... A European bank resolution authority and a European deposit insurance scheme are two elements that could be used to address the nexus between sovereigns and banks."
Adopting the Swedish model with ultra transparency stops the feedback loop.

As regular readers know, in a modern financial system with deposit guarantees and access to central bank funding, banks can operate and support the real economy for years with negative book capital levels.

In fact, a modern financial system is designed so that bank book capital is suppose to act as a safety valve between the excesses in the financial system and the real economy.  Banks do this by absorbing the losses on the excess debt in the financial system today and rebuilding their book capital levels through retention of future earnings.

There is no reason in a modern banking system for governments to recapitalize the banks.  As the IIF pointed out, the banks in Spain should generate enough earnings over the next 4 years to absorb all the losses that the IIF forecast.

Finally, I agree with the call for a European deposit insurance scheme.  It is part of my blueprint for saving the financial system.
Any pan-euro zone deposit guarantee scheme would need to be large in order to stem ebbing confidence. 
The typical national guarantee in Europe now covers the first 100,000 euros on deposit, something that would do little to reassure corporate investors with millions. 
It was the decision by companies in Ireland to withdraw deposits that accelerated its banking crisis....
Under my blueprint, the combination of the European Financial Stability Fund and the European Stability Mechanism is more than adequate as the only banks that need to be restructured or closed are those banks that do not have a viable franchise.  Where viable reflects the capacity to rebuild their book capital levels through retained earnings.
In the absence of a resolution fund or insurance scheme to deal with a bank collapsing, many investors expect the ECB would act to head off a bank run or a similar systemic threat.... 
In the case of Greece, the belief is that the ECB would act again to contain a bank run, said Clemens Fuest, a professor at Oxford University and a member of the academic advisory board of the German Federal Ministry of Finance. 
"The expectation seems to be that the ECB will prevent it by providing whatever liquidity is needed," he said, adding that this could either be from the ECB directly or as emergency funding from the Bank of Greece with the ECB's backing....
It is comments like this that reflect how little academics understand about a modern banking system and deposit guarantees.

In a modern banking system with deposit guarantees, depositors do not care about the current level of bank book capital or whether the bank is currently solvent or not.  All depositors care about is that the guarantee will be honored.

There are two reasons the guarantee might not be honored.  First, the sovereign does not have the financial capability.  Second, deposits are subjected to forcibly exchanged from a stronger currency into a weaker currency.

In the presence of either of these reasons, there are bank runs.

What the ECB can and does do is provide liquidity to the banks so that depositors can withdraw their funds.  
The banking environment has steadily deteriorated, according to statistics from the Bank for International Settlements, which chart the flight of capital from the euro zone's weakest members. 
Figures from December last year show a sharp decline in deposits from abroad held in banks in Greece from $160 billion in late 2009 to less than $80 billion. 
Ireland's bank deposits from abroad fell from $905 billion to $471 billion over that time and a similarly sharp fall was seen in Portugal. 
Households and companies have almost 11 trillion euros on deposit with banks in the euro zone, with over 3 trillion in Germany alone, according to ECB statistics....
Further confirming the on-going bank run from the EU periphery countries to the core countries.
Draghi is pressing governments rather than the ECB to take the decisive action and delivered a stark message last Thursday, saying: "We have reached a point in which the process of European integration needs a courageous leap of political imagination in order to survive."
The courageous leap of political imagination is to adopt the Swedish model with ultra transparency.

Banks shrink from counterparty risk as EU financial crisis gathers steam

Both Reuters and the Wall Street Journal had articles (see here and here) on how banks, including Chinese banks, are reducing their exposure to other banks because they cannot assess the risk of the other banks.

Regular readers know that in the absence of ultra transparency where banks disclose on an on-going basis their current asset, liability and off-balance sheet exposure details that the interbank lending market is prone to freezing.

This is further confirmation of that fact.

From Reuters,

Alarmed by Europe's latest debt crisis and its unpredictable outcome, banks are getting increasingly picky about who they do business with for fear of taking on risky exposures to rivals who could be about to be whipsawed by bad debts. 
Greece's slow-motion crash towards default, coupled with the poor health of banks in Spain, have left banks wondering if any of their fellow institutions will end up holding catastrophic losses and will be unable to meet their obligations.
Only the requirement that banks provide ultra transparency fully addresses this issue.  It is only with this data that can assess whether any of their fellow institutions will end up holding catastrophic losses and will be unable to meet their obligations.
All banks then are becoming increasingly cautious about their dealings with counterparties perceived to be in the firing line - making it harder for those firms to do their everyday business, throwing grit into the cogs of the financial system and ultimately crimping prospects for economic recovery. 
"Banks are particularly wary of counterparties at the moment and no compliance officer is going to take on exposure to a counterparty just because historically they have a strong track record," said Christopher Wheeler, an analyst at Mediobanca.
Being wary translates into a freezing of the credit market and a disruption of the real economy.

This disruption to the real economy was completely preventable.  It has been well known since the beginning of the credit crisis, which also saw the interbank lending market freeze because banks could not tell who was solvent and who was not, that the solution was to require ultra transparency.

The fact that policymakers and financial regulators have not made ultra transparency a requirement is an example of the efforts of Wall Street's Opacity Protection Team as well as regulators gambling with financial stability to protect their information monopoly.
In the fast-moving banking sector, failures can happen quickly. Just ask anyone involved with MF Global, which collapsed overnight in October last year after clients and trading partners pulled back amid rumours of a trading loss in the European sovereign debt crisis. 
Three years previously, Lehman Brothers became the largest bankruptcy in U.S. history, after it was brought to its knees by a combination of losses, nervous clients and credit rating downgrades. 
Failures like those can leave massive losses splattered across the financial system, reason enough for compliance officers to rein in risky exposures to their peers. 
For any bank, loss of trust is potentially fatal and can catch it in a pincer movement where it rapidly finds it harder to borrow money, while being asked to put up more costly security in its daily trading. 
There are signs in the market this is already happening. 
"Banks are being very cautious over who they do business with. They are avoiding counterparties they perceive to be risky ... and this attitude will become more extreme if market conditions deteriorate further," said Wheeler.
An added problem is that many of the markets in which investment banks participate are virtually invisible to regulators.
The problem is not that the markets are invisible to regulators.  The problem is that each bank's positions are not visible to their banking fellows.  Without this data, the other banks cannot make an assessment of each bank's riskiness.

From the Wall Street Journal,
Some of China's biggest banks have cut off a handful of their European counterparts from borrowing and derivatives trading as they seek to reduce their exposure to the simmering crisis on the Continent, people familiar with the matter said....

The moves by the Chinese banks, which occurred late last year and early this year, aren't believed to have had a significant impact on the funding or trading positions of their European counterparts, analysts say, given the still-limited role played by the Chinese in global funding markets and derivatives trading.... 
Many analysts view the Chinese banks' pullback from the European counterparties as a sign of improvement in how they manage risks posed by banks they do business with.
At the height of global financial crisis in 2008, some Chinese banks, including Bank of China, got burned because they failed to unwind their exposure to now-defunct Lehman Brothers Holdings Inc. fast enough.
"The Lehman bankruptcy was a wake-up call to many of us," said a senior Chinese banking executive based in Beijing. "Now we monitor the risks posed by our counterparties all the time, and it's the responsibility of our financial institutions and risk-management departments to adjust the amount of credit extended to our counterparties accordingly."
The European financial crisis has intensified in recent weeks because of fears that Greece will withdraw from the euro. European banks have been largely cut off from public funding markets and are reluctant to lend to one another, though most are under no immediate financial pressure because of the huge loan program implemented late last year and early this year by the European Central Bank.
Big Chinese banks started reviewing the credit profiles of their European counterparts in the second half of last year, with Bank of China—the most international of all Chinese banks—being one of the first to cut back on trading with and counterparty exposure to European banks.
Since late last year, the bank has suspended purchasing derivatives including credit-default swaps—or insurance-like financial contracts—from European banks including Société Générale and Crédit Agricole. ....
In addition, Bank of China also stopped trading certain foreign-exchange derivatives with UBS and BNP Paribas. ... 
Even as they have vowed to further liberalize the domestic financial markets, Chinese regulators have fretted that foreign banks could be a new source of risk to the domestic financial system.
"Risks associated with foreign banks shouldn't be overlooked," Shang Fulin, chairman of the China Banking Regulatory Commission, said in February.

Tuesday, May 29, 2012

Confirmation that transparency reduces relevance of rating firms

A Bloomberg article confirms that the more transparency provided to market participants, the less relevant the rating firms are.

The response to the Moody’s Investors Service downgrade of the biggest Nordic banks was rising bond and share prices. 
The reaction is the latest sign that investors are paying less attention to the views of rating companies and relying more on their own analysis to determine whether to buy or sell.
“We can see for ourselves just how strong the Swedish banks are so we don’t place much weight on what rating agencies tell us,” Nicklas Granath, a partner at Stockholm-based asset manager Norron AB, who helps manage about $200 million, said in an interview. “More and more the market is likely to take the same approach.” 
Even though Sweden doesn't require the banks to provide ultra transparency, it has a history of requiring the banks to recognize the losses hidden on and off their balance sheets.
As European policy makers try to reduce the dominance of rating companies in financial markets, investors are showing greater willingness to ignore Moody’s, Standard & Poor’s and Fitch Ratings.... 
“The Nordic banks are in general very solid and have currently no issues in funding,” said Espen Furnes, an Oslo- based fund manager at Storebrand Asset Management, which oversees $72 billion. “Moody’s is knocking down open doors with this. In these volatile markets the rating agencies are definitely behind the curve and, strangely enough, could be at risk of being considered irrelevant by the market during times when they actually do have something critical to say.”...
Keep in mind that the rating firms' business model is currently built around the idea of access to proprietary information.  Prior to their ratings being changed, banks have a chance to present the facts that they feel merits a higher rating.  Facts that are not always available to all market participants.
In Denmark, banks have started firing Moody’s after winning assurances from some of the country’s biggest investors that the opinions of ratings companies hold limited value.... 
Swedish banks, still among the best-rated in Europe, are now signaling they may rethink their cooperation with the rating company.
Cooperation that results in the rating firms having an informational advantage compared to other market participants.
“It is hard for” rating companies “to keep track and when you come close to them it is quite apparent they have difficulty following everything that is happening elsewhere,” [Swedbank Chief Financial Officer Goran] Bronner said. “The key is more transparency and then the market can decide.”
In particular, ultra transparency under which the banks disclose on an on-going basis their current asset, liability and off-balance sheet exposure details.  With ultra transparency, the market participants have access to all the information they need to independently assess the risk of each bank.

Former Bankia executive gets 14 million euro payoff

The Guardian reports that a former Bankia executive is going to receive a 14 million euro payoff.

While I have nothing against bankers being well paid when their institutions provide ultra transparency and everyone can see the risks taken, ...

A former senior executive at bailed-out Spanish bank Bankia is to receive a €14m (£11.2m) payoff in a move that will cause controversy beyond the country's borders if Europe is asked to help rescue Spain's banks. 
As the government seeks to raise the €19bn needed by Bankia, the news that Aurelio Izquierdo would walk away with such a large payoff raised questions about what Spain's troubled banks have been doing with their money....
News of the payoffs came amid growing uproar over the multimillion euro deals handed out to executives at Spain's cajas, or savings banks, during the boom years when they helped inflate a housing bubble that burst four years ago. 
Many have since been forced out of the banks they ruined, taking millions more euros in payoffs.
Showing that bankers get paid regardless of performance.
The toxic real estate assets they left behind are at the root of growing worries that Spanish banks will need a European-funded bailout on top of the Bankia rescue.... 
Bankia said on Tuesday that bailout money would not be used for the multimillion euro executive payoffs as the sums were already accounted for. In Izquierdo's case, they said, the money was owed by one of the seven cajas that merged to form Bankia, and which remain shareholders, rather than by the new bank. 
Izquierdo was the number two at Bancaja, the second largest of the cajas that were merged two years ago....

Bancaja brought large amounts of toxic real estate to the merger. Bankia's parent company BFA now recognises €40bn of such assets. 
Bancaja operated in eastern Valencia, a coastal region that became a byword for both voracious construction and political corruption. 
With control of individual cajas in the hands of local politicians, their presidents were largely political appointees. 
study by economists Luis Garicano and Vicente Cuñat in 2009 found a close relationship between political caja bosses and bad loans. These increased by 50% where the president was a politician with no banking experience.... 
Yet another reason for requiring ultra transparency so that market discipline can restrain risk taking.

Regulations adopted since financial crisis inhibit recovery

In his Telegraph column, Jeremy Warner provides a terrific description of the financial regulations adopted since the beginning of the financial crisis.

In this description, he confirms your humble blogger's observation that the regulations are a response to the financial crisis that treat symptoms without looking at the root cause.  Since the regulations only treat symptoms, they often contradict each other and/or inhibit recovery of the real economy.

As if the [corporate debt] refinancing problem wasn't already challenging enough, into it all stumbles the European commissioner for internal markets, Michel Barnier, to prove the old saw that there is no mess quite so bad that official intervention won't make even worse.... 
After a crisis of the magnitude we've just seen, it's perfectly right and proper, and certainly very human, to want to take immediate steps to fix the system, so as to ensure that this kind of nonsense can never happen again. 
However, you cannot count on luck if you want to fix the system and make sure this doesn't happen again.  You actually have to look not at the symptoms, but the root causes.

If policymakers had looked at the root causes of the financial crisis, they would have seen that the bankers  reintroduced opacity into the financial system.

They did this in many ways.

For example, rather than offer ultra transparency that was the sign of a bank that could stand on its own two feet, banks complied with minimalists disclosure requirements and turn themselves into 'black boxes'.

For example, they created structured finance securities that gave Wall Street an informational advantage over the investors as Wall Street had access to reports on the underlying collateral performance well before investors.
There is also something to be said for striking while the iron is hot. Leave things too long, and the political will to act melts away.
Actually, by investigating the cause(s) of the financial crisis, the political will to regulate remains.  This was shown in the aftermath of the Great Depression when the Pecora Commission paved the way for the regulations implemented by the FDR Administration 3+ years after the start of the financial crisis.
Even so, it's not clear that right now, with the crisis self evidently approaching some kind of fresh denouement, is the time to be buttressing the system against the once in a hundred year event of the present maelstrom. Nor in any case can the sort of extreme regulatory overkill we are seeing at the moment ever be seen as appropriate.
As I have been saying since the start of the financial crisis, the right regulation can both resolve the current problems with the financial system and buttress the financial system against the once in a hundred year event.

The right regulation was to adopt ultra transparency and shine a light into every opaque corner of the financial system.

Adopting ultra transparency leads directly to adoption of the Swedish model.  This leads to banks recognizing the losses on all the excess debt in the financial system.  In turn, this removes the burden of servicing this debt from the real economy and the restoration of growth.

Adopting ultra transparency also leads directly to market discipline being applied to the financial system.  With this disclosure, investors can actually assess the risk of banks and structured finance securities.  This leads directly to an ability to value these securities and make investment decisions (buy, hold, sell) based on the prices being shown by Wall Street.
As far as I know, Mr Barnier is well intentioned enough. He wants to protect us all from the calamities of the past. But in attempting to regulate away all future risk, he also threatens to undermine growth and further reduce already wanting European competitiveness. 
To be fair, it's not all Mr Barnier's fault. He's only part of a posse of international regulators riding furiously off in the wrong direction long after the horse has bolted.
A direct result of not investigating the causes of the financial crisis.
If even a fraction of the time spent on trying to protect us against a crisis that's already happened was devoted to finding a way out of it, then we might actually be getting somewhere. As it is, almost every part of the reform agenda is making matters worse, not better.
Please re-read the highlight text as it summarizes both why ultra transparency needs to be adopted and why most of Dodd-Frank (the Consumer Financial Protection Bureau and Volcker Rule being exceptions) should be repealed.
In its analysis of the refinancing challenge, S&P concedes that it might just about be possible for the banking system to cope with the wave of corporate debt maturities, assuming no further deepening of the eurozone crisis. But providing the $13 trillon to $16 trillion of new money to spur growth is going to be a much bigger ask, especially in Europe. 
"Much will depend on the continued ability of banking system regulators to pilot a path through the minefield that lies ahead", S&P observes. 
Well that appears to be that, then. Abandon all hope, for at the moment these very same regulators seem to be blundering their way forward as if entirely unaware of what lies beneath their feet. Ever more onerous capital and liquidity requirements have steepened the refinancing challenge, even with highly supportive central bank funding on hand. 
European banks, still grappling with high leverage and a worsening sovereign debt crisis, are particularly badly affected. Because of the escalating European banking crisis, they face intense pressure to meet new capital and liquidity requirements more quickly. With new equity virtually impossible to raise, this has only further exaggerated the de-leveraging problem. Enforced recapitalisation from governments which are themselves insolvent scarcely helps matters.
The financial regulator driven credit crunch I previously discussed.
In the US, there is at least a highly developed corporate bond market to act as an alternative to bank funding.
The reason is that non-financial corporations have to provide disclosure that provides all market participants with acces to all the useful, relevant information in an appropriate, timely manner.
That's not the case in Europe, where to the contrary, the regulatory agenda seems determined to put as many obstacles in the way of a viable bond market as possible. 
Standard & Poor's calculates that if corporate issuers in Europe were to tap the bond market for 50pc of their new funding requirements (up from 15pc historically), it would imply net new yearly issuance of $210bn to $260bn. In only two years in the last decade has net new European issuance exceeded $100bn. 
You might think this a significant growth opportunity, but Mr Barnier's new solvency directive threatens to snuff that one out too, by requiring that only the most credit worthy and liquid bonds count for capital purposes. 
The new solvency requirements virtually outlaw bundling together corporate loans and issuing them as asset backed securities, or rather, they prevent financial institutions from providing a viable source of demand for such bonds. Instead, finance is pushed by regulation ever more aggressively into sovereign bonds, even though many of them are now less than credit worthy.
As I previously said, most of the regulations that have occurred since the beginning of the financial crisis should be dropped.

Today, bank capital is completely meaningless (by extension, so are bank capital requirements).  Regulators are practicing forbearance and as Spain has shown banks have a virtually unlimited number of ways to practice 'extend and pretend' on zombie borrowers.

 Mr. Warner identifies one of several problems with the new solvency requirements.

A much better approach would be to adopt ultra transparency.  This will end the financial regulators' information monopoly and bring market discipline to the banking system for the first time in almost 80 years.

My bet is that market participants will reward firms that have a strong, liquid balance sheet.
Europe desperately needs growth, but it seems determined to stifle the credit needed to provide it. How stupid can you get?

Despite what the government says, more Spanish banks need to recognize their losses

In his Telegraph column, Alistair Osborne asks how is Spain going to cope with the 270 billion euros of losses analysts predict are in its banking system when Spain is struggling trying to figure out how to deal with Bankia.

Regular readers know that the source of capital for rebuilding bank book capital levels is retention of future earnings.  The IIF estimated that it would take less than 4 years of earnings to rebuild the bank book capital levels after recognizing losses of this order of magnitude.

By way of comparison, the financial crisis has been going for 4+ years already with no apparent end in sight.

The answer to Mr. Osborne's question is that Spain is going to deal with all the losses in its banking system by adopting the Swedish model with ultra transparency.

As a result, the losses are going to be recognized today.  The burden of excess debt is going to be removed from the real economy as debtors are going to have their loans written down to levels they can afford.

Over the next several years, Spain's banks will rebuild their capital levels through retention of their earnings and by issuing bonuses in stock.  At the same time, market participants will assess the banks using the information disclosed under ultra transparency and exert discipline on the banks so that they do not take excessive risks.

How long can Mariano Rajoy keep this up? You know, the old matador routine. Swooshing his cape and declaring: “There will be no rescue of the Spanish banks.”...
If the Spanish government adopts the Swedish model with ultra transparency, the answer is forever! 
You’d hardly expect Spain’s PM to say anything else. But no-one believes him, judging by yesterday’s trampling in the bond markets.... 
The reasons? For starters, Madrid’s botched bail-out of Bankia, that paella of seven cajas, or savings banks. In just a fortnight, Bankia has gone from requiring €4.5bn (£3.6bn) of emergency funding to €23.5bn. Go figure, as they say. 
In addition, there is the simple fact that the PM is being advised by former and current bankers.  As everyone knows, 100% of the advice offered by these individuals is self-serving.

The question the PM must ask is there any overlap between what is best for Spain and this self-serving advice.  When it comes to the government bailing out the banks by injecting funds, the answer is there is no overlap between what is best for Spain and the bankers' self-interest.
Then, there’s all Rajoy’s mixed messages, in one breath ruling out a foreign bail-out for Spain’s banks, the next backing a eurozone rescue fund for lenders that bypasses national governments. “Lots of people are in favour of that, and I certainly am,” was his take on that. 
And this is before you consider the big picture. That, on Centre of European Policy Studies figures, Spain’s banks face potential write-offs of €270bn, once they finally 'fess up to the true horrors of a property bust. That’s roughly a quarter of Spanish GDP.
In that context, the leaks over Spain’s preferred fix for Bankia were especially telling. Until now, the state-backed FROB (Fund for Orderly Bank Restructuring) had been raising money in the debt markets and transferring it to any troubled bank. 
But there are two problems now. First, that the FROB only has €5.4bn, including €1bn already committed. Second, as Rajoy admits: “With a risk premium at 500 [basis] points, it is very difficult to raise finances.” 
So, Madrid is considering injecting newly-issued bonds directly into Bankia’s parent, Banco Financiero y de Ahorros. Bankia could then use them as collateral to borrow from the ECB. 
Rajoy may see it differently but that looks uncannily like a foreign rescue by the backdoor. What choice has he got, though? 
Whatever he says, Rajoy knows Spain can’t afford to bail out its banks – not amid a double-dip recession and with the jobless rate near 25pc.
Fortunately, Spain's banks can afford to rebuild their own capital levels without the government stepping in.  They can do this by simply retaining future earnings.

Keep in mind that it does not matter whether the banks need 4 years or 10 years to rebuild their capital.  In a modern financial system with deposit guarantees and access to central bank funding, banks can continue to operate and support the real economy while they are rebuilding their capital levels. 

Did Bankia's depositors buying bonds require Spain to bailout bank?

Bloomberg carried an interesting article in which it presents the argument that Spain was on the hook for bailing out Bankia because its depositors were significant investors in its bonds.

This argument reflect one true and one fase assumption:

  • True:  Spain has a moral obligation to protect investors; and
  • False:  Maintaining positive book capital levels is necessary to prevent bank runs.
Spain has a moral obligation to protect investors that results from its information monopoly.  

If banks were required to provide ultra transparency and disclose on an ongoing basis their current asset, liability and off balance sheet exposure details, market participants would not be dependent on the government's assessment of the bank's solvency.  There would be no moral obligation as investors could use this disclosure and independently assess the solvency of the bank's for themselves.

However, since investors, unlike regulators, do not have access to ultra transparency, they are dependent on the the regulators to accurately assess this information and to report their findings.  This dependency creates the moral obligation.

Bank book capital is an accounting construct.  In a modern financial system with deposit guarantees and access to central bank funding, it can be positive or negative without effecting the bank's ability to operate and provide loans to the real economy.

As a result, there is no reason for governments to bailout the banks today.  The banks can simply rebuild their book capital levels through retention of future earnings.
Spain’s hands are tied with the rescue of Bankia (BKIA) because alternatives to injecting cash or government debt, such as forcing bond investors to bear the cost, risk hurting ordinary depositors.
Actually, the alternative of requiring the bank to recognize all of the losses hidden on and off its balance sheet today and provide ultra transparency does not risk hurting ordinary depositors.

Ordinary depositors are protected by deposit guarantees.  These guarantees are strengthened by the government not investing.  These guarantees are strengthened by the losses being recognized as the losses do not become a burden that crushes the real economy.
Bankia is among Spanish lenders that sold 22.4 billion euros ($28.2 billion) of preferred stock to individual investors through retail branches, according to data compiled by CNMV, the financial markets supervisor. 
In a so-called bail in, these investors would be wiped out before holders of more senior bonds, which tend to be banks and institutions.... 
“The sale of preferred stock to depositors means that almost the only option for the government now is injecting capital,” said Arturo Bris, a professor of finance at IMD business school in Laussanne, Switzerland. “A writedown of preferred shares placed with depositors would cause a social problem. It’s not really a feasible alternative.”...
The option of letting the bank rebuild its book capital level through retention of future earnings is still feasible.  It would avoid the social problem.
A taxpayer-funded bailout of Bankia would foist losses on a wider portion of society than making individual bondholders, many of them depositors, lose money....
A taxpayer-funded bailout would place the burden of the excess debt squarely on the real economy.  Everywhere this has been tried the result has been a long term economic decline.  As a result, this is not a viable option.
Fernando Herrero, the secretary general of ADICAE, a Madrid-based association of clients of financial institutions, estimated that about 1 million Spanish households bought banks’ preferred shares, some of which have been converted to common equity or subordinated convertible bonds.

“The instruments were marketed as very liquid and as safe as a deposit,” said Herrero, who described issuing the risky securities to individual investors as an “original sin.”
The bank was able to get away with this marketing because of the government's information monopoly.

If the bank had to provide ultra transparency, investors could have assessed the riskiness of the bank for themselves.  Since investors could not assess the risk of the bank, they had to trust what the government said about the bank.

Iceland shows that debt forgiveness under Swedish model leads to best recovery

Bloomberg ran an excellent article on Iceland confirming that adopting the Swedish model for handling a bank solvency led financial crisis results in recovery (as oppose to the Japanese model which results in prolonged economic decline).

Regular readers know that under the Swedish model banks absorb the losses on the excesses in the financial system today.  These excesses are the total of all the debt that excedes the borrower's capacity to repay.

By writing off all of this debt today, the banks protect the real economy.
Icelanders who pelted parliament with rocks in 2009 demanding their leaders and bankers answer for the country’s economic and financial collapse are reaping the benefits of their anger. 
Since the end of 2008, the island’s banks have forgiven loans equivalent to 13 percent of gross domestic product, easing the debt burdens of more than a quarter of the population, according to a report published this month by the Icelandic Financial Services Association. 
“You could safely say that Iceland holds the world record in household debt relief,” said Lars Christensen, chief emerging markets economist at Danske Bank A/S in Copenhagen. 
“Iceland followed the textbook example of what is required in a crisis. Any economist would agree with that.”
While your humble blogger agrees that Iceland is doing what is required in a crisis, I see very little evidence that 'any' economist would agree beyond Patrick Honohan and Joseph Stiglitz.
The island’s steps to resurrect itself since 2008, when its banks defaulted on $85 billion, are proving effective. 
Iceland’s economy will this year outgrow the euro area and the developed world on average, the Organization for Economic Cooperation and Development estimates. It costs about the same to insure against an Icelandic default as it does to guard against a credit event in Belgium
Most polls now show Icelanders don’t want to join the European Union, where the debt crisis is in its third year. 
Remember, the EU chose the Japanese model with its focus on protecting bank book capital levels.  As a result, the bad debt is still in the banking system and the real economy is spiraling down under the weight of the excess debt.
The island’s households were helped by an agreement between the government and the banks, which are still partly controlled by the state, to forgive debt exceeding 110 percent of home values. On top of that, a Supreme Court ruling in June 2010 found loans indexed to foreign currencies were illegal, meaning households no longer need to cover krona losses.

“The lesson to be learned from Iceland’s crisis is that if other countries think it’s necessary to write down debts, they should look at how successful the 110 percent agreement was here,” said Thorolfur Matthiasson, an economics professor at the University of Iceland in Reykjavik, in an interview. “It’s the broadest agreement that’s been undertaken.”  
Without the relief, homeowners would have buckled under the weight of their loans after the ratio of debt to incomes surged to 240 percent in 2008, Matthiasson said....
Please re-read the highlighted text as it confirms why the real economy must be protected from the excesses in the financial system.
Iceland’s approach to dealing with the meltdown has put the needs of its population ahead of the markets at every turn.
Once it became clear back in October 2008 that the island’s banks were beyond saving, the government stepped in, ring-fenced the domestic accounts, and left international creditors in the lurch. The central bank imposed capital controls to halt the ensuing sell-off of the krona and new state-controlled banks were created from the remnants of the lenders that failed. 
Activists say the banks should go even further in their debt relief. Andrea J. Olafsdottir, chairman of the Icelandic Homes Coalition, said she doubts the numbers provided by the banks are reliable. 
“There are indications that some of the financial institutions in question haven’t lost a penny with the measures that they’ve undertaken,” she said. 
According to Kristjan Kristjansson, a spokesman for Landsbankinn hf, the amount written off by the banks is probably larger than the 196.4 billion kronur ($1.6 billion) that the Financial Services Association estimates, since that figure only includes debt relief required by the courts or the government....
This demonstrates one of the reasons 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 could confirm that loans had been written down.
According to Christensen at Danske Bank, “the bottom line is that if households are insolvent, then the banks just have to go along with it, regardless of the interests of the banks.”
The real bottom line is the banks have to go along with absorbing the losses on the excesses in the financial system regardless of the interests of the bankers.

Monday, May 28, 2012

Following the lead of the US, UK and EU, Spain jeopardizes financial system and real economy by lying

In a must read Bloomberg article, the problems with pursuing the Japanese model for handling a bank solvency led financial crisis are laid bare.  At the top of the list is lying about the true condition of the banking system.

Spanish banks are masking their full exposure to soured property loans while they continue to prop up insolvent “zombie” developers, leading to credit-rating downgrades and plummeting share prices. 
Spain is trying to clean up its banks, requiring lenders to set aside more for possible losses on loans deemed performing to developers likeMetrovacesa SA (MVC), which hasn’t completed a project in more than a year and has none under way. 
While that represents about 30 billion euros ($38 billion) of increased provisions, it’s not enough because many of the loans said to be performing aren’t, said Mikel Echavarren, chairman of Irea, a Madrid-based finance company specializing in real estate. 
“Spain has engaged in a policy of delay and pray,” Echavarren said in an interview. “The problem hasn’t been quantified by anyone because there is huge pressure not to tell the truth.”
Please re-read the highlighted text as it confirms why banks must be required to provide ultra transparence and disclose their current asset, liability and off-balance sheet exposure details.

Without requiring ultra transparency, banks, their financial regulators and their host governments will lie about the condition of the banks by allowing them to engage in 'extend and pretend' practices....

There is a significant cost to the real economy from this practice.
Many Spanish banks are avoiding property sales so they don’t have to make “mark to market” valuations. Instead, they’re giving developers new loans to pay debt coming due to prevent defaults, said Ruben Manso, an economist at Mansolivar & IAX and a former Bank of Spain inspector. 
“The larger banks have been selling bits and pieces and can absorb the losses,” Manso said. “Smaller savings banks are acting in bad faith in their refusal to allow transactions and saying they can’t mark to market because there isn’t one.”...
In an environment of regulatory forbearance, banks have a number of ways of avoiding recognition of the losses on and off their balance sheets.
“The Irish property market had to collapse like the Spanish one because the economy was collapsing,” Kelly said. “Spain is looking like a re-run.” 
More than half of Spain’s 67,000 developers can be categorized as “zombies,” according R.R. de Acuna & Asociados, a real-estate consulting firm. They have combined debt of 180 billion euros that will lead to 104 billion euros of losses that hasn’t been fully provisioned for, Acuna estimates. 
“They aren’t officially bankrupt because they have been refinanced time and time again,” Fernando Rodriguez de Acuna Martinez, a partner at the company, said by telephone. “Their assets are worth much less than their liabilities, they struggle to repay loans and they haven’t revaluated them to reflect today’s prices.”
Confirming why all the strategies that failed in Ireland will also fail in Spain.
The Bank of Spain allows loans that are refinanced before turning delinquent and interest-only loans to be considered “normal” or “performing” on banks’ books, according to Manso. 
“You won’t find that data anywhere,” Manso said. “There has been a lot of cheating going on where banks have lent developers new money, classed as new lending, so they can pay off their original loans.” That’s masking delinquency, he said.
This is an example of what banks can do when there is regulatory forbearance and banks are not required to provide ultra transparency.
Refinancing the current and future zombie developers will cost 30 billion euros over the next two years, according to Acuna. The depreciation of those developer assets from 2012 onwards will generate a further 20 billion euros of losses in that time, he said. 
The Bank of Spain doesn’t publish data on the amount of restructured developer loans or interest-only paying loans that are classed as normal. The bank closely monitors refinancing to ensure that arrears aren’t being hidden, said a spokeswoman for the Bank of Spain who declined to be identified.
Please re-read the highlighted text as this is a partial estimate of the cost to the real economy from not forcing the banks to recognize their losses.
[Echavarren] forecasts that the larger Spanish banks with income from international operations will be able to pay for domestic real-estate losses within two years. The rest can’t take such a hit and will have to be nationalized, he said.
Confirming again that the government should not bailout the banks but should instead allow the banks to rebuild their book equity through retention of future earnings.
“We cannot continue to jeopardize the whole financial system by not telling the truth,” Echavarren said.