Wednesday, August 29, 2012

States review requiring insurers to hold more capital against riskier mortgage bonds

The Wall Street Journal reports that state insurance regulators are examining requiring insurers to hold more capital against riskier mortgage backed securities.

In a White Paper recently released by the National Association of Insurance Commissioners (NAIC), in its concluding remarks the NAIC observed:

There are two ways to implement change in the way the RMBS market performs. Government can enact laws and regulations requiring the reporting of certain data and insist on a level of transparency that sellers of RMBS must meet, or the private sector can recognize the market is not working well and an alliance of buyers, regulators and the public can insist on greater transparency and effective disclosure of sufficient information to allow RMBS investors and regulators to have greater confidence in the market. 

If a private sector solution is developed, insurance regulators could influence its success by providing greater credence to assets ... [that] provide collateral performance disclosure on a more frequent basis. 

Regulators might want to give greater credence, perhaps in the way of reduced capital requirements, to insurers who invest in assets with greater transparency both through more frequent disclosure....  Improving transparency would be a good thing for insurers, regulators and the capital markets.... 

From an insurance regulatory perspective, the goal is to improve the knowledge insurers have regarding their RMBS holdings. The true value of RMBS holdings should be readily available to insurance regulators charged with monitoring solvency.

The goal to improve the knowledge insurers have regarding their RMBS holdings is simply a restatement of the European Capital Requirement Directive Article 122a's 'know what you own' requirement for commercial and investment banks.

From the White Paper, disclosure which allows the insurers to know what they own has two elements.
  • First, a structured finance security would report on an observable event basis any activity like a payment or delinquency that occurs with the underlying collateral before the beginning of the next business day.  This is a change from the current once-per-month or less frequent reporting.
  • Second, the disclosure would include all data fields tracked by the originators and servicers while protecting borrower privacy consistent with HIPAA patient privacy standards.  This is a change from the current focus on data templates that don't include all non-borrower privacy protected data fields.  After all, why exclude any non-borrower privacy protected data field that the experts, the originators and servicers, confirm is useful and relevant by spending money to track?
There are two reasons that the NAIC white paper has effectively set the global disclosure standard for structured finance.  
  • First, the market depends on the capacity of insurance companies as buyers.  Deals that don't provide sufficient disclosure will not be economically attractive for insurance companies to buy due to the amount of capital they need to hold against the security.
  • Second, setting capital standards for insurance companies based on disclosure effects the entire buy-side.  Non-insurance company portfolio managers have an incentive to adopt these standards as it reduces their risk of an adverse finding should litigation occur related to losses on these securities.
From the Wall Street Journal article,
State insurance regulators are considering changes that would require U.S. insurers to hold more capital against some of the riskier mortgage bonds they have been scooping up lately as high-yielding investments. 
The moves under discussion could increase by billions of dollars the total amount industrywide that insurers including American International Group Inc., MetLife Inc. and others must hold to protect policyholders, estimate some analysts. 
The changes could be implemented later this year by the National Association of Insurance Commissioners, an organization of state officials that sets solvency standards. 
The shift, currently under study by an NAIC task force, would make it costlier for insurers to hold certain bonds backed by subprime mortgages and other risky home loans....
More importantly, the shift would set the global standard for disclosure for all asset backed securities ranging from covered bonds to mortgage-backed securities.

If the security has observable event based reporting, insurers and any other market participant could know how the underlying collateral was currently performing.  With access to this information, the insurers could make investment decisions.

If the security doesn't have observable event based reporting, insurers don't know how the underlying collateral is currently performing.  Without current performance information, insurers are blindly betting on the value of the security.

It makes sense that the regulators would require insurers to hold less capital against an investment where they had access to all the useful, relevant information in an appropriate, timely manner and more capital against a blind bet.
Many insurers "are looking for ways to enhance yield" and mortgage-bond yields are very attractive relative to other assets, says John Melvin, global head of insurance fixed income portfolio management at Goldman Sachs Asset Management. He adds that the regulatory capital treatment is "important" in insurers' decision to buy these securities. 
Set the capital requirements high enough and insurers cannot buy bonds where they are blindly betting.

Regulator's reputation for requiring banks to recognize losses allows Swedish banks to borrow for less

In a financial marketplace where the lack of disclosure makes all banks 'black boxes', Swedish banks are able to borrow at attractive rates because of their regulator's reputation for forcing the banks to recognize their losses.

One of the advantages enjoyed by Swedish banks is the reputation of their regulator.

In the 1990s, rather than bailout the banks, the regulator forced the banks to recognize all of their losses.  Those that could were given the time to rebuild their book capital levels.  Those that couldn't, were closed.

Regular readers recognized this as the Swedish model for dealing with a bank solvency led financial crisis.

Implementing the Swedish model allowed the regulator to establish a reputation.  Now, the banks are able to raise money at attractive rates because of this reputation as market participants believe (which they must because without ultra transparency it cannot be verified) that if there were losses hidden on and off the Swedish bank balance sheets the regulator would force the losses to be recognized.

From a Bloomberg article,

Sweden’s financial regulator said the country’s banks can increase lending to households and businesses even as the industry adopts some of the world’s strictest regulatory standards. 
“Swedish banks have adapted well to the new regulation, they are well-capitalized and have access to funding, which means they have the ability to continue increasing their lending to households and companies,” Magnus Karlsson, an analyst at the Swedish Financial Supervisory Authority in Stockholm, said in a phone interview yesterday.... 
Nordea Bank AB (NDA)SEB AB (SEBA), Swedbank AB (SWEDA) and Svenska Handelsbanken AB (SHBA) need to set aside 10 percent of their risk- weighted assets in core Tier 1 capital from January, with the ratio rising to 12 percent two years later. That compares with Basel’s 7 percent goal for 2019. Sweden’s banks, which credit default swaps show are among Europe’s safest, are able to fund themselves at better rates than many of their peers, lowering the cost of passing on credit to borrowers.... 
In Sweden, credit growth has stabilized from rates as high as 13 percent before the crisis, after stricter mortgage lending rules capping loans at 85 percent of a property’s value were introduced in 2010, the FSA said. Banks should stick to current lending rates to avoid imbalances, Karlsson said. 
Swedish bank shares outperformed a European benchmark index for financial stocks today. Nordea rose 0.6 percent to 61.70 kronor as of 10:38 a.m. in Stockholm. SEB gained 0.9 percent, Handelsbanken and Swedbank rose about 0.1 percent, compared with a 0.5 percent loss in the 38-member Bloomberg index of European financial companies. 
At the end of last year, Swedbank and Handelsbanken were the two best-capitalized lenders in Europe under Basel II in a Riksbank ranking of 24 of the region’s largest banks, including Deutsche Bank AG (DBK)BNP Paribas SA (BNP) and Barclays Plc. (BARC) SEB was No. 4 and Nordea was seventh.

William White: Ultra easy monetary policy and the law of unintended consequences

In a must read article, economist William White evaluates
the desirability of ultra easy monetary policy by weighing up the balance of the desirable short run effects and the undesirable longer run effects – the unintended consequences.... 
He finds
There are limits to what central banks can do. 
One reason for believing this is that monetary stimulus, operating through traditional (“flow”) channels, might now be less effective in stimulating aggregate demand than previously. 
Further, cumulative (“stock”) effects provide negative feedback mechanisms that over time also weaken both supply and demand. 
It is also the case that ultra easy monetary policies can eventually threaten the health of financial institutions and the functioning of financial markets, threaten the “independence” of central banks, and can encourage imprudent behavior on the part of governments. 
None of these unintended consequences is desirable. 
Mr. White's article is the economist's version of why central banks must observe Walter Bagehot's rule that interest rates must not be lowered below 2%.

For those who do not know:  Mr. White is one of the handful of economists that the economic profession hauls out to say there were some economists who predicted the financial crisis (without Mr. White and his colleagues at the Bank for International Settlements, the number of economists that predicted the financial crisis would have been countable on one or two fingers);  and Mr. Bagehot was the individual who in the 1870s wrote the book, Lombard Street, on modern central banking.

Mr. White makes one observation in particular that I would like to draw regular readers' attention to.
The unexpected beginning of the financial and economic crisis, and its unexpected resistance to policy measures taken to date, leads to a simple conclusion. The variety of economic models used by modern academics and by policymakers give few insights as to how the economy really works.
Please re-read the highlighted text again and then a third time as it is a highly respected economist answering the Queen's Question by saying although economists claim to have some insight into how the economy really works, in reality they have no clue.

The clear conclusion from Mr. White's observation that the economic models currently in use give few insights as to how the economy really works is that there is no reason to believe that any solution based on these models is likely to fix the problem with the financial system.

Tuesday, August 28, 2012

Deposit flight from Spanish banks reaches new highs

As previously discussed and predicted by your humble blogger, deposit flight from the Spanish banking system continues to accelerate so long as the threat of deposits being converted to a less valuable currency hangs over depositors' heads.

The Telegraph reports that the Spanish banking system lost deposits equivalent to 7% of GDP or 74 billion euros last month.

Halting this deposit flight requires two policy changes.

First, the Spanish government must force the Spanish banks to absorb the losses on the excess debt in the Spanish financial system.  With the burden of the bad debt taken off of the Spanish economy, like Iceland's, the economy can resume growing and the possibility of needing to leave the EU recedes.

Second, the EU must use the bailout funds to backstop the Spanish deposit guarantee.  This increases the Spanish banks' access to central bank funding in euros and further reduces the threat of an involuntary conversion of deposit accounts to a less valuable currency.

Data from the European Central Bank shows that outflows from Spanish commercial banks reached €74bn (£59bn) in July, twice the previous monthly record. This brings the total deposit loss over the past year to 10.9pc, replicating the pattern seen in Greece as the crisis spread. 
It is unclear how much of the deposit loss is capital flight, either to German banks or other safe-haven assets such as London property. The Bank of Spain said the fall is distorted by the July effect of tax payments and by the expiry of securitised funds. 
Julian Callow from Barclays Capital said the deposit loss is €65bn even when adjusted for the season: “This is highly significant. Deposit outflows are clearly picking up and the balance sheet of the Spanish banking system is contracting.” 
Economy secretary Fernando Jimenez Latorre said Spain is in the eye of the storm right now with the “worst falls” in economic output yet to come in the second half of the year. 
Meanwhile, the Spanish statistics office said the economic slump has been deeper than feared, with lower output through 2010 and 2011. The economy slid back into double-dip recession in the third quarter of last year, three months earlier than thought.
Further evidence that the real economy of Spain is unable to carry the burden of the excess debt in the Spanish financial system.   

Bloomberg editors call for disclosure of Libor related data

In an editorial, Bloomberg editors call for full public disclosure of each bank's actual borrowing data so that it can be determined exactly who manipulated Libor and by how much.  

In making this call, the Bloomberg editors are also telling the Wheatley Review that full public disclosure of each bank's current actual borrowing data is needed going forward to ensure the integrity of Libor.

Regular readers know that the Bloomberg editors are endorsing the recommendations concerning Libor put forward by your humble blogger.  Naturally, with the support of the Bloomberg editors, I hope these recommendations come to pass.

The global investigation into the manipulation of Libor has so far done a good job of exposing how bankers corrupted one of the world’s most important financial indicators. 
Now authorities need to take a giant step further: Make banks release the data needed to determine how much damage was done and who should bear the most responsibility....
Please re-read the highlighted text as the Bloomberg editors are calling for disclosure.
Investigators are focusing on two kinds of manipulation. In one, bankers submitted false data to push Libor in a direction that would benefit their own traders. In the other, bankers intentionally lowered the reported rates, which are published daily, to make their institutions’ financial positions look better than they really were.... 
How long the lying went on, and how systematic it was, matters a lot. 
If, for example, underreporting caused Libor to be artificially depressed by 0.1 percentage point for only a few months, payments on more than $300 trillion in mortgages, corporate bonds and derivatives tied to the benchmark might have fallen short by about $75 billion or so. If the problem lasted a few years, the shortfall could be close to $1 trillion....
How much Libor was off, then, could be a trillion-dollar question.....  
An article in the Financial Times indicated that manipulation of Libor goes back to the early 1990s.  As a practical matter, the data disclosed should go back to when Libor was first calculated.

Regular readers know that Libor was designed to be opaque and allow bankers to hide bad behavior behind the opacity.  The question is 'when' did this bad behavior in the form of manipulating Libor start.
To give a more complete picture of the misbehavior, and to establish what share of the compensation burden each Libor- reporting bank should bear, researchers need access to better data on actual borrowing costs.   
If they could get records of observable transactions, they could produce an independent estimate of how much the banks’ Libor quotes were off on any given day. 
It is only with all the observable transactions that market participants have the information they need to independently assess what went on.
Such an authoritative benchmark would have many benefits: Plaintiffs, for example, could use it to reach settlements with banks, avoiding legal wrangling that could weigh on the financial sector for years.
Good data, though, are hard to find. 
This observation is true throughout the financial system with its many opaque areas.  The reason that good data are hard to find is because Wall Street's Opacity Protection Team does not want this data to be made available and the regulators have failed to require that this data be made available.

Wall Street profits from opacity.  In the case of Libor, Wall Street increased it profits from manipulating the rate in its favor.  Had current transaction data been available, Wall Street couldn't have engaged in this manipulation.
The Fed hasn’t made information from its wire-transfer system public. 
The Libor panel banks, for their part, closely guard information on the interest rates they pay on actual short-term loans. This is an odd habit, given that they are supposedly publishing their borrowing rates in great detail every day for the purpose of calculating Libor. If they’re not lying, there should be no news in the transactions.
The Bloomberg editors are right that in the case where the banks were not lying there is no news.  However, that case is likely to be shown as the exception rather than the rule.
It’s up to the authorities investigating Libor to break the information blockade. 
In the U.S., for example, the Office of Financial Research, set up by the Dodd-Frank financial reform act, has the subpoena power needed to get the data and the brain power required to crunch the numbers. Ideally, it would also make the data public, so independent academics and journalists could check its work. 
If the data is not made public, there is no reason for market participants to trust the findings of the Office of Financial Research or any other government regulator.

Market participants are fully aware that the financial regulators' analytical ability is questionable.
Shedding light on the extent of Libor manipulation is essential to restoring the market’s integrity. The point of justice, after all, isn’t only to punish the guilty. It’s also to establish the truth, so we can draw the right conclusions, fix what needs fixing and move on.
Hence the reason that current borrowing data needs to be disclosed on an ongoing basis if confidence in the integrity of Libor is to be maintained.

Monday, August 27, 2012

Dexia demonstrates bank bailouts are far from over

Surprise, surprise ... it appears that despite assurances by the financial regulators, Dexia is coming back for an additional bailout.

Anyone who is familiar with the bank bailout experience of Ireland and Spain knows the bailout loop:  regulators declare bank solvent; market analyzes bank and concludes it is insolvent; regulators ask for and get a taxpayer funded bailout for bank; regulators declare bank solvent; market analyzes bank and concludes it is insolvent; regulators ask for and get a taxpayer funded bailout for bank...

The point where the bailout loop stops is when the government can no longer afford the next bailout.

This point was reached in Iceland at the beginning of the financial crisis.  As a result, they required their banks to absorb the losses on the excess debt in the financial system.  Currently, they have one of the best performing economies in Europe.

This point was reached in Ireland, but the EU stepped up to provide the cash for the next bailout.  As a result, Ireland's economy is deprived of the opportunity to grow as the capital generated by the economy is primarily used for debt service.

This point has been reached in Spain, but no decision has been made whether the EU will step in to provide the cash for the next bailout.  Will the Spanish government deprive its society of growing economy and ask for an EU bailout or will the Spanish government protect its society and require the banks to absorb the losses on the excess debt?

Regular readers know that modern banking systems are designed so that they do not need government funded bailouts.  Banks can absorb the losses on the excess debt in the financial system and continue to support the real economy.

The reason that banks can operate with negative book capital levels is that through deposit guarantees taxpayers are the "silent" equity partner of the banks.  In guaranteeing the deposits, the taxpayer provides the equity for the bank to continue to operate without the taxpayer having to invest $1 in the bank.

The past few months have been good for Belgium. Like France, the country has benefitted from being part of the euro zone’s so-called “soft core,” becoming a sort of second-best safe haven for investors keen to escape risky states such as Spain or Italy, but unwilling to accept the super-low interest rates offered by the likes of Germany.... 
Yet in a sobering report Friday, Credit Suisse research analyst Michelle Bradley, did some number crunching on one risk still facing public finances: taxpayers’ exposure to Dexia, the banking group that all but collapsed last autumn. 
In fact, Dexia has already needed two bailouts in recent years. In 2008, Belgium, France and Luxembourg stepped in with a capital injection and debt guarantees. Last October, the same trio were called on again as the bank was cut off from funding. The Belgian government acquired the domestic retail unit of the bank for €4 billion, pledged to cover 60.5% of up to €90 billion in bank debt guarantees, and ended up with several other potential liabilities to the group. 
Ms. Bradley tots up Belgium’s total potential exposure (contingent liabilities) as follows:
-          €12.2 billion from its share of the outstanding 2008 guarantees
-          €33.0 billion from its share of the €55 billion in debt guarantees pledged as part of the 2011 rescue and that have been approved by the European Commission. Of those €55 billion, €49.1 billion has been used.
-          An additional €21.0 billion if the full €90 billion in guarantees is approved by the Commission.
-          On top of this, she calculates an exposure of €4.3 billion from a collateral deal the now-nationalized Belgian unit struck with its former Luxembourg subsidiary, plus a €2 billion guarantee to the group’s municipal-bond agency. 
The grand total: a maximum total contingent liability of €72.5 billion. That’s 20% of Belgium’s economic output.
Of course, the odds of the government having to absorb such huge losses from Dexia are minimal. The government acquired assets that offset some liabilities when it nationalized the domestic retail unit of the bank. And it would likely lay claim to some of the €411.1 billion in assets Dexia says it owned as of June 30..... 
Ms. Bradley says the main risk is that the government will have to find new taxpayer money to recapitalize Dexia  if market conditions deteriorate. After all, the bank reported a hefty loss in the first half of 2012, it has significant exposure to Spain and Italy and its Tier one capital ratio on June 30 was a fairly low 6.6%, according to its earnings report. 
“Our concern is that should market conditions deteriorate then it is possible that Dexia will need a further capital injection. In an environment when the market is stressed this would already imply higher yield levels for Belgium. Should Belgium have to raise additional funds to support Dexia this puts additional pressure on Belgium’s debt to GDP ratio and its yield levels,” she says.

Next on the financial front: a new and improved Libor

I apologize to my regular readers for the limited number of posts recently, but I have been working on my response to the Wheatley Review on how to improve Libor.

As discussed in the Wall Street Journal, rolling out a new and improved mechanism for setting Libor is on the regulatory fast track.

My response focuses on how to credibly fix Libor and restore market confidence.  So naturally, it is based on requiring the banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

This disclosure cures multiple problems.

First, it unfreezes and keeps unfrozen the interbank lending market.

This market is currently frozen as a result of banks being 'black boxes'.  As a result of the lack of adequate disclosure, banks with money to lend cannot assess the risk of banks looking to borrow.  Fortunately, the banks with money to lend have an alternative as they can invest their money in government securities rather than blindly betting on the borrowing banks.

By requiring the banks to provide ultra transparency, banks with money to lend can access all the useful, relevant information in an appropriate, timely manner to independently assess the risk of a borrowing bank.  With this assessment, the lending bank can adjust both the amount and price of their exposures to the borrowing banks.  The result is that the interest rate on interbank loans truly reflects the  true cost to the bank of borrowing unsecured debt.

Since the disclosure is ongoing, the interbank market remains liquid (although the borrowing banks might not like the cost of funds that their risk suggests they should pay).

Second, it allows Libor to be based off of actual trades rather than off of easily manipulated guesses.
We've had the Summer of Love, the Winter of Discontent and the Arab Spring. Now get ready for the Autumn of Libor.... 
But for traders, regulators and investors, the return from vacation will be dominated by talk of Libor—the flawed interest rate that governs at least $300 trillion of financial instruments. And not just because several banks will follow Barclays PLC and pay regulators to settle charges that they tried to manipulate Libor
After convincingly impersonating the Keystone Kops for years, U.K. regulators have sprung into action with plans to reform Libor, raising the prospect of a complete overhaul in coming months.... 
As the man in charge of the reforms, Martin Wheatley, a top official at the U.K.'s Financial Services Authority, told me last week: "This is bigger than just Libor. It's about investor confidence in financial markets so we want to fix it."...
As regular readers know, the only way to restore investor confidence in the financial markets is to provide ultra transparency.  Confidence flows because investors trust their own independent analysis of all the useful, relevant information.
His recipe for fixing Libor can be read between the lines of a paper he issued a couple of weeks ago. Ostensibly, the 58-page report keeps an open mind. But because the U.K. government is rushing to enshrine the Libor changes into legislation—responses are due in by Sept. 7 and Mr. Wheatley has to make his recommendations by the end of that month—the broad outlines are taking shape. Indeed, Mr. Wheatley will be stateside this week for discussions with U.S. regulators. 
In short, Libor is likely to remain the key financial rate but with important modifications to the way it is calculated and policed. 
Talk of replacing Libor with other benchmarks is likely to remain just that for two reasons: No substitute would easily work for all the financial instruments Libor serves, and rewriting derivatives contracts tied to Libor would be an herculean, and legally fraught, task. 
The "new and improved" Libor would almost certainly do away with the current gymnastics-scoring-meets-clairvoyance method of calculation. 
At present, large banks submit daily estimates of their costs of funding to a trade group, which eliminates the highest and the lowest numbers and calculates the rate as the arithmetic mean of the rest. Banks aren't required to say whether those estimates reflect their true cost of funding—an omission that increases the scope for manipulation. 
A simple-sounding remedy would be to force banks to use actual market transactions. The problem is that it would be hard to find enough deals covering all of Libor's 15 maturities and 10 currencies, especially in periods of financial stress.
Actually, this lack of deals is a reflection of the interbank lending market being frozen.  It is easy to permanently thaw this market:  require the banks to provide ultra transparency.
The most likely solution is a hybrid system in which banks would still quote their estimated costs but would be required to back them up with as many actual transactions as possible and document how they got to the numbers. 
"Blending quote- and transaction-based approaches may prove to be the most practical solution," Anthony Murphy, a former HSBC PLC executive who is now at the consultancy Promontory Financial Group LLC, wrote in a recent note.
A hybrid system is something championed by the banking industry seeking to retain opacity.
Mr. Wheatley said there is support for a hybrid approach. "People are saying, 'You just can't leave it to pure judgment; you have to have the real input.'"...  
Better calculations and stricter policing should make Libor more credible. Whether they will buttress the investing public's confidence in the process, however, is another matter.
Regular readers know that anything short of ultra transparency is inadequate for restoring confidence.

Sunday, August 26, 2012

Bank of England's Spencer Dale explains how QE triggers Pension Death Spiral

In a Telegraph column defending Quantitative Easing, the Bank of England's Spencer Dale explains how QE triggers the Pension Death Spiral.
Put simply, if interest rates fall, then a pension fund needs a bigger pool of assets to meet its future obligations. But if its liabilities are matched by a combination of gilts and equities, the increase in the value of those assets as interest rates fall is broadly similar to the increase in liabilities. The capital gain offsets the impact of the lower level of interest rates, leaving the net position of the pension fund broadly unchanged. 
Where QE has caused difficulties is for those defined-benefit pension schemes that were already in substantial deficit. In this case, QE is likely to have increased the size of the deficit. 
Although QE raised the value of the assets and liabilities by a similar proportion, if the liabilities were greater than the assets to start with, this would have led to a widening in the gap between the two. 
But even in this case, the burden of these increased deficits is likely to fall on the company’s shareholders and future employees, rather than those nearing retirement.
Please re-read the highlighted text as Mr. Dale explains how QE triggers the Pension Death Spiral.

The Pension Death Spiral refers to the economic doom loop caused by the transfer of resources from the real economy to support the pension funds.

Specifically, as interest rates decline, the company now has to make up the shortfall.  It does this by transferring money that would otherwise be reinvested in the business.  This transfer of money reduces economic growth which in turn restarts the cycle as interest rates are kept low which in turn requires more money be transferred to the pension fund and away from growing the real economy.

The same downward spiral applies to future employees.  If the burden of making up the pension shortfall is their problem, they reduce their current consumption in order to save for retirement.  The bigger the pension burden, the bigger the drop in current consumption.  Again, the real economy is subject to an economic doom loop.
Our economy is still labouring under the effects of the financial crisis. The task for monetary policy is to stimulate the economy and return it to a path of stable growth, low inflation (and a more normal level of interest rates). That will be for the good of everyone in our society.
So the question is, when will the central bank start pursuing policies to stimulate the economy and return it to a path of stable growth by raising interest rates?

Saturday, August 25, 2012

Professional rot in economics as some 500 economists line up as political hacks

In a must read Bloomberg editorial, Professor Laurence Kotlikoff discusses how the professional rot in economics has transformed the profession into political hacks.

Regular readers know that the Queen of England called into doubt the competence of the profession by asking how if everything was going so well, the economics profession did not see the financial crisis coming.

Professor Kotlikoff provides a possible answer to why the economics profession did not see it coming.  Simply, none are so blind as those whose job depends on their not seeing.

Some 500 of my colleagues in economics, almost all academics, have signed a statement applauding former Governor Mitt Romney’s economic plan and condemning President Barack Obama’s handling of the economy. 
The statement amounts to an endorsement of Romney’s presidential candidacy. As such, it represents a disservice to the economics profession as well as to the statement’s signatories, five of whom are Nobel laureates. 
The 500 signatures including 5 Nobel laureates just shows the scope of intellectual capture that the Financial-Academic-Regulatory Complex (FARC) has managed to achieve in the academic space.
Economics holds itself out as a science, yet here we have supposedly impartial scientists declaring that all of Romney’s proposed economic policies are good and that everything the president has done on the economics front has been misguided and flawed. 
No impartial economist would make such blanket assertions. By their very nature, such statements represent political, not scientific, opinion.  
Yet the signatories not only identified themselves as professional economists; they also specified their university or other institutional affiliations, thereby implicating places such as the University of Chicago in their political pronouncements.... 
Economists on both sides of the political spectrum have long used the credibility of their institutional affiliations as an 'endorsement' of their opinion.
The decision of the 500 U.S. economists, many from the leading ranks of the profession, to trade in their credentials as economists for that of campaign workers is just the latest sign that something’s rotten in economics. 
The documentary “Inside Job,” demonstrated how prominent economists failed to disclose, as standard ethics require, when they are being paid for their professional opinions. 
Please re-read the highlighted text and recall that none are so blind as those whose jobs depend on their not seeing.
Then there is the increasingly nasty op-ed war pursued by political economists, such as Paul Krugman and Glenn Hubbard, who have so closely aligned themselves with one of the two parties that it’s impossible to know where their politics stop and their economic analyses begin. 
The worst part of all this is that the new political economics routinely diverges so far from economic theory and fact....

Economic theory isn’t up for grabs. Economic facts aren’t a matter of choice. And the integrity of the economics profession isn’t free for disposal. The 500 economists owe our profession a sincere apology.

Top economists agree that Iceland's choice of Swedish model is right way to deal with bank solvency led financial crisis

In a post on ZeroHedge, blogger George Washington documents how top economists agree that the Swedish model is the right choice for handling a bank solvency led financial crisis.

As regular readers know, since the beginning of the financial crisis your humble blogger has been pushing for adoption of the Swedish model.

Under the Swedish model banks are required to recognize and absorb the losses on the excess debt in the financial system today.  Subsequently, they can rebuild their book capital levels through retention of 100% of pre-banker bonus earnings and the sale of stock.

Having the banks absorb the losses on the excess debt protects the real economy.

If the losses were not absorbed by the banks, then the real economy would have to support the excess debt.  This diverts capital from being used to rebuild and expand the real economy to debt service.  The result of this diversion of capital is to put the real economy into a downward spiral.

The EU, UK and US have chosen not to require the banks to absorb the losses on the excess debt and, predictably, their economies are suffering accordingly.

Finally, in my posts on the Swedish model, I have written extensively about Iceland referencing the same articles as used by Mr. Washington.  I present most of his post as it is a nice summary of what I have been saying.

Nobel prize winning economist Joe Stiglitz notes:
What Iceland did was right. It would have been wrong to burden future generations with the mistakes of the financial system. 
Nobel prize winning economist Paul Krugman writes:
What [Iceland's recovery] demonstrated was the … case for letting creditors of private banks gone wild eat the losses. 
Krugman also says:
A funny thing happened on the way to economic Armageddon: Iceland’s very desperation made conventional behavior impossible, freeing the nation to break the rules. Where everyone else bailed out the bankers and made the public pay the price, Iceland let the banks go bust and actually expanded its social safety net. Where everyone else was fixated on trying to placate international investors, Iceland imposed temporary controls on the movement of capital to give itself room to maneuver. 
Actually, since the Swedish model was first used by the US to break the back of the Great Depression in the 1930s, the rules have been to let the banks absorb the losses.
Krugman is right.  Letting the banks go bust – instead of perpetually bailing them out – is the right way to go. 
We’ve previously noted:
Iceland told the banks to pound sand. And Iceland’s economy is doing much better than virtually all of the countries which have let the banks push them around. 
Your humble blogger has been making this observation and explaining how the putting the burden of the excess debt on the real economy creates a downward economic spiral.
Bloomberg reports:
Iceland holds some key lessons for nations trying to survive bailouts after the island’s approach to its rescue led to a “surprisingly” strong recovery, the International Monetary Fund’s mission chief to the country said.

Iceland’s commitment to its program, a decision to push losses on to bondholders instead of taxpayers and the safeguarding of a welfare system that shielded the unemployed from penury helped propel the nation from collapse toward recovery, according to the Washington-based fund....


Iceland refused to protect creditors in its banks, which failed in 2008 after their debts bloated to 10 times the size of the economy. 
The IMF’s point about bondholders is an important one:  the failure to force a haircut on the bondholders is dooming the U.S. and Europe to economic doldrums. 
The IMF notes:
[The] decision not to make taxpayers liable for bank losses was right, economists say. 
In other words, as IMF put it:
Key to Iceland’s recovery was [a] program [which] sought to ensure that the restructuring of the banks would not require Icelandic taxpayers to shoulder excessive private sector losses. 
Icenews points out:
Experts continue to praise Iceland’s recovery success after the country’s bank bailouts of 2008.

Unlike the US and several countries in the eurozone, Iceland allowed its banking system to fail in the global economic downturn and put the burden on the industry’s creditors rather than taxpayers.


The rebound continues to wow officials, including International Monetary Fund chief Christine Lagarde, who recently referred to the Icelandic recovery as “impressive”. And experts continue to reiterate that European officials should look to Iceland for lessons regarding austerity measures and similar issues. 
Barry Ritholtz noted last year:
Rather than bailout the banks — Iceland could not have done so even if they wanted to — they guaranteed deposits (the way our FDIC does), and let the normal capitalistic process of failure run its course.

They are now much much better for it than the countries like the US and Ireland who did not....

“Iceland did the right thing … creditors, not the taxpayers, shouldered the losses of banks,” says Nobel laureate Joseph Stiglitz, an economics professor at Columbia University in New York. “Ireland’s done all the wrong things, on the other hand. That’s probably the worst model.”

Ireland guaranteed all the liabilities of its banks when they ran into trouble and has been injecting capital — 46 billion euros ($64 billion) so far — to prop them up. That brought the country to the brink of ruin, forcing it to accept a rescue package from the European Union in December.


Countries with larger banking systems can follow Iceland’s example, says Adriaan van der Knaap, a managing director at UBS AG.

“It wouldn’t upset the financial system,” says Van der Knaap, who has advised Iceland’s bank resolution committees.
In fact, the modern banking/financial system is designed so that the banks can absorb the losses on the excess debt in the financial system without upsetting the system.

Friday, August 24, 2012

Bank of England rolls out defense of Quantitative Easing

To no one's surprise, the Bank of England rolled out its defense of Quantitative Easing and discovered that the benefits of QE offset any costs.

According to an article in the Guardian,
The Bank of England calculated that the value of shares and bonds had risen by 26% – or £600bn – as a result of the policy, equivalent to £10,000 for each household in the UK. It added, however, that 40% of the gains went to the richest 5% of households.... 
Clearly, QE is a policy that exacerbates inequality in wealth.
However, Threadneedle Street said that QE had helped all sections of the population by sparing the country from a deeper slump. The rise in asset prices after QE was announced in early 2009 followed sharp falls in the two previous years. 
"Without the Bank's asset purchases, most people in the UK would have been worse off," it said in a paper prepared in response to queries from the Commons Treasury committee...
Is this a statement of belief or fact?
"Economic growth would have been lower. Unemployment would have been higher. Many more firms would have gone out of business. This would have had a significant detrimental impact on savers and pensioners along with every other group in our society. All assessments of asset purchases must be seen in that light."... 
"By pushing up a range of asset prices [such as equities and bonds], asset purchases have boosted the value of households' financial wealth held outside pension funds, although holdings are heavily skewed with the top 5% of households holding 40% of these assets."
Apparently QE is just a variation of trickle down economics.  By boosting the wealth of the rich, the BoE would have us believe that the rich convert so much of this additional wealth into consumption that it has a meaningful impact on economic growth.

As for how well QE and zero interest rate policies work, David Rosenberg had an interesting observation:

It is rather amazing that a 2.8% yield on the long bond couldn't do the trick. By hook or by nook, it looks like the Fed is going to make an attempt to drive the rate down even further — but if that was the answer, wouldn't Switzerland, Japan and Germany be in major economic booms right now seeing as how low their 30-year bond yields are? 
This is exactly the point that your humble blogger has been making since zero interest rate policies and QE were adopted.  Clearly the economic headwinds created by these policies offset the benefits of these policies.

Regular readers know that Walter Bagehot, the man who wrote the book, Lombard Street, on modern central banking, knew this and said to never take interest rates below 2%.  He was well aware of Mark Twain's observation about being more concerned with the return of his money than the return on his money.

He said this in the 1870s before the development of computers and massive economic models.  Of course, the economic models run by computers wouldn't know that the assumptions they are based on don't work below 2% unless the economists who created the models specified this fact.

Based on available evidence, we might guess that it is highly likely that this fact wasn't specified as central banks in the EU, Japan, the UK and the US keep pursuing zero interest rate policies and QE.

Lack of data limits ratings Moody's et al will to assign to rental home structured finance deals

Bloomberg reports that apparently even the rating firms learned from the sub-prime mortgage/CDO disaster that having access to all the useful, relevant information is necessary for valuing or rating a structured finance security.

Regular readers know that all the useful, relevant information includes both historical data and observable event based reporting.  

Moody's links its ability to initially rate a security to access to historical information (presumably it has access to observable event based reporting on the underlying assets during the rating process).

However, as was learned at the beginning of the financial crisis, it is observable event based reporting that is needed if investors are going to know what they own and be able to value the securities.  Moody's confirmed this in its testimony to Congress when it explained why in the absence of observable event based reporting it was unable to update its ratings in a timely manner.

Potential issuers of securities tied to U.S. home rentals may not be able to obtain the credit ratings they seek because of a dearth of historical data on the business, according to Moody’s Investors Service. 
The risk to investors with the unprecedented rental-home bonds would be tied mainly to the quality of property managers and the variability in net revenues from tenants and eventual home sales, the New York-based ratings firm said today in a report. 
Moody’s listed the types of data it will probably seek, saying debt issuers may not always be able to overcome limited information by structuring deals with more investor protection. 
“In some stressed cases, credit enhancement would not be able to mitigate the concern associated with limited historical information and requested ratings would not be achievable,” analysts led by Kruti Muni and Joseph Snailer wrote....
Ratings companies, which helped create the U.S. housing bubble that began to burst in 2008 by granting inflated grades to mortgage bonds, have begun commenting on how they would approach assessing bonds created through private securitizations that such investors could use for financing. 
With securitizations, the graders compare potential losses on the underlying assets with the so-called credit enhancement provided for specific classes of the deals. That can include some bonds taking losses before others, cash reserves or asset cash flows that exceed coupons on the securities created.

Moody’s has been approached by “numerous real-estate market participants” seeking insight into how it would assess such deals, though none has presented “a specific transaction or deal structure to us,” according to its report today. 
The ratings company said it’s unclear whether the transactions will involve securitization trusts owning homes or loans to operators. Each approach carries different risks, Moody’s said. 
Fitch Ratings said Aug. 8 that it’s unlikely to grant investment-grade ratings in the top AAA or AA categories to deals backed by single-family rental properties. 
The reasons include the “limited performance data for the sector and individual property management firms” as well as for “market rents, rent roll histories, vacancy rates, and supply and demand.” The “ambitious growth strategies by regional operators looking to expand their portfolios rapidly over the near term” is another concern, New York-based Fitch said. 
Standard & Poor’s released a report in May examining the “emerging asset class” that contained fewer details on how the New York-based company will approach grading the deals.

Bank unsecured debt market remains unhealthy

The Wall Street Journal reports that despite a shortage of fixed income investments the bank unsecured debt market essentially remains closed.

Regular readers know there are two reasons the bank unsecured debt market is not functioning.

First, to restore investor interest, banks need to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.  Investors need this information if they are going to be able to independently assess the risk of each bank and adjust the amount and price of their exposure.

Without ultra transparency, investors are being asked to blindly bet on the contents of a 'black box'.

Second, central banks have been pursuing policies that favor banks using the central banks as a source of low cost financing.  The result of this has been that banks have pledged most, if not all, their high quality collateral to the central banks.

With banks using so much central bank funding, investors in unsecured bank debt have become even more deeply subordinated than they normally would be.  This increase in risk also drives up the interest rate that the investors need to be paid to compensate them for this risk.

Europe's banks have jumped on the August market rally to sell a type of debt that had been their main source of funding before the sovereign-debt crisis, but analysts warn that the recent rush doesn't signal a return to health, with some deals struggling to attract much demand. 
Banks issuing euro-denominated senior, unsecured bonds-a type of debt backed by a bank's credit-worthiness rather than collateral-have raised €8 billion ($9.98 billion) this month, according to Société Générale data. That compares with nothing last August, and just €4.5 billion the year before, the data show..... 
And with banks repaying bondholders at a faster rate than they are selling new debt, investors are finding themselves flush with cash that they urgently need to put to work, boosting the appeal for banks to sell bonds....
One of the under-appreciated features of setting up funds to invest in specific types of securities is that regardless of what is happening in the market for these securities, these funds will continue to invest so long as they have investable cash.

Managers of these funds say they continue to invest regardless of the risk of the securities because their investors have made the asset allocation decision and want exposure to these securities.

More cynically, managers of these funds invest because telling their investors that they are blindly betting with the investors' cash would not be good for job security.
The recent string of bond deals also shows only the biggest names among Europe's banks have the trust of investors. "We've seen a lot of issuance but it has been top-tier institutions coming to market," Roberto Henriques, a bank credit analyst at J.P. Morgan Chase & Co., said....
Actually, this reflects the belief that the biggest banks are Too Big to Fail and the investors will be bailed out.

Thursday, August 23, 2012

Discussion of Bank of England's authority highlights need for guarding the guardians

It has taken five years since the beginning of the financial crisis, but the conversation has finally turned to the issue of 'who guards the guardians' of the financial system and what sort of authority should they actually be given.

As reported by the Guardian, former Monetary Policy Committee member Kate Parker observed
Treasury plans to hand the Bank of England extra powers to oversee the banking system will give unelected officials too much power... the steady erosion of democratic control over regulation of the financial system would accelerate under proposals by the coalition government to create a super-watchdog in Threadneedle Street.
She said oversight should be the job of the Treasury, based on advice from the Bank of England and other bodies involved in banking regulation. 
Echoing fears among many MPs that Bank of England governor Sir Mervyn King and his successors will control an unwieldy empire of regulatory committees that could challenge the Treasury's democratic mandate, Barker criticised government plans to create a financial policy committee (FPC) alongside the Bank's monetary policy committee (MPC), which sets interest rates. 
"More policy decisions should be left in the hands of the chancellor, rather than unelected officials at the Bank of England. Mervyn King's successor will be appointed to an unduly powerful role for an unprecedented eight-year term," she said. 
The FPC differs from the work previously carried out at the Financial Services Authority because it aims to "assess and steer the financial system as a whole, rather than focusing on individual organisations, which will now become the responsibility of the Prudential Regulatory Authority", she says. For example, FPC members will have the power to restrict mortgage lending if there are concerns about a possible credit bubble, as there was before the 2007 banking crisis. 
Barker criticises the Treasury for delegating unpopular decisions to the FPC that should be made by parliament.
This discussion of the authority of the Bank of England is not restricted to the UK.  It also applies in the EU where the ECB is seeking to gain bank supervision responsibility and the US where the Fed is responsible for bank supervision and also sits on the Financial Stability Oversight Council.

In his Telegraph column, Damian Reece seconds Kate Parker's conclusion.
Legislation is passing through Westminster that will usher in a new Bank Governor with too much power and not enough accountability. 
Sir Mervyn King, and his successor, may be called Governor but their job is not to govern. 
Barker’s report should prove useful to MPs trying to reverse some of the Chancellor’s plans which will delegate yet more authority to the Bank – authority which should stay within the remit of politicians. 
The problem is acute when it comes to macro-prudential regulation – basically controlling the economy’s safety valve to stop it overheating. It’s proposed this is done by yet another Bank of England committee – the Financial Policy Committee, which is every policy wonk’s fantasy come true....
In the US, macro-prudential regulations is the responsibility of the Fed and the Financial Stability Oversight Council.

The Financial Stability Oversight Council in not just every policy wonk's fantasy come true, but is also every Wall Street CEO's fantasy come true.  The Council is run by the US Treasury Secretary.

As thoroughly documented by Neil Barofsky in his book, Bailout, the US Treasury is an advocate for Wall Street's and not Main Street's interests.  As a result, through its control of the Financial Stability Oversight Council, Treasury is now able to push Wall Street's interests onto the very organizations that are suppose to be regulating Wall Street.

Outside of Washington DC, it is common sense that the Financial Stability Oversight Council is unfit for purpose of protecting the real economy.
Far from giving the Bank more power to run our economy, we should be insisting on No 11 taking that responsibility. The resident of that address is accountable to Parliament and removable every five years, rather than a Governor who changes every eight years and then by an opaque selection process.
Mr. Reece did not learn a key lesson from the Nyberg Report on the Irish banking crisis.  The key lesson is that elected officials have an incentive to not lean against the wind.  When the real estate bubble was growing, it generated lots of tax revenue that the elected officials could use on their favorite programs.  No elected official would want to cut the growth in tax revenue when there is no apparent danger.

On the other hand, Mr. Reece does understand that there is a problem anytime that there is opacity involved.

Opacity in selection process for the next Governor of the Bank of England means it is highly unlikely that this individual will have to document that they predicted the current financial crisis.  Without having predicted this crisis, it is highly unlikely this individual could predict a future crisis or develop policies that will get us out of the current crisis.

The solution to guarding the guardians is to bring transparency to all the opaque corners of the financial system.

If banks are required to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details, market participants can independently assess the risk of the banks and adjust the amount and price of their exposure accordingly.

The ability to independently assess what is going on means that market participants can exert discipline on both the banks and their regulators.

It also means that the collective result of having each market participant limiting their investments to what they can afford to lose is stability in the financial system.

How to simplify the Volcker Rule

In an American Banker editorial, William Isaac and Richard Kovacevich look at how to simplify implementation of the Volcker Rule.

Regular readers know that your humble blogger has already suggested the simplest way to implement the Volcker Rule and eliminate proprietary trading regardless of where the trade occurs and is accounted for on or off the bank balance sheet.

The simplest way to implement the Volcker Rule is to require the banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

With this level of disclosure, there is no hiding proprietary trading from the market or escaping discipline to close the position.

As the authors observe,

Regulators, politicians, bankers, and former Federal Reserve Chairman Paul Volcker himself are all searching for a simple, easy to understand, yet effective way to implement the Volcker Rule that is consistent with a safe and sound banking system....
Only ultra transparency meets all of these criteria.  It is simple.  It is easy to understand.  It is effective.  It is consistent with a safe and sound banking system.
The Volcker Rule, which is part of the Dodd-Frank financial reform law, is intended to impose strict limits on banks engaging in "proprietary trading" – i.e., betting the bank's capital by significant speculative trading in financial instruments.
Ultra transparency virtually eliminates proprietary trading as disclosure of these trading positions invites market participants to trade against the bank.
Congress, as usual, gave general direction to the regulators to figure out how to implement the concept.  
The regulators' proposed rulemaking on the Volcker Rule is a whopping 298 pages of complexity that is not only difficult to understand but nearly impossible to monitor and regulate.  There is a better way....
The better way is to require ultra transparency and simply leave the Volcker Rule as it is; a simple statement that bans proprietary trading.
But like many financial products, especially loans, proprietary trading indeed has risk.  This risk should be carefully and intelligently monitored and regulated. 
The question regulators are trying to answer is this:  Is the risk of holding an inventory of securities to enable customers to readily buy or sell securities through a bank reasonable, or is it so excessive that changes in the market price of that inventory could put the institution in serious jeopardy?
By requiring the banks to provide ultra transparency, the market can see if the banks are holding "inventory" or making "proprietary trades".

Market discipline will not be limited to just the proprietary trades.  It will also extend to the issue of is the bank holding so much inventory that it puts itself at risk.  In this case, market discipline will take the form of a lower stock price and higher cost of borrowed funds as market participants need to be compensated for the "inventory" risk.
It's perfectly legitimate and logical that a financial institution, like any seller of products in any industry, would hold more of a product in inventory if it thinks the price of that product might go up in the near future, and hold less of it if the bank thinks the price might go down.  We would not call this proprietary trading but rather common sense....
It's foolhardy to try to read the minds of traders at financial institutions to determine if the inventory they are keeping is larger than the expected demand....  
The authors make a very important point.  It is hard to tell where holding inventory to satisfy customer demand ends and where proprietary trading begins.

That is why ultra transparency is the only solution that works.  In the case of a proprietary trade, market participants can exert discipline through trading against the bank.  In the case of excessive inventory, market participants can exert discipline through demanding a higher return to compensate them for the risk the bank is taking.
Financial institutions cannot earn more than their cost of capital without taking risks. 
Moreover, they are of no value to their customers or the economy unless they take prudent risks.
A key feature of ultra transparency is that it does not prevent financial institutions from taking risks.  It subjects the financial institutions to market discipline and hence acts as a restraint to only take prudent risks.

Tuesday, August 21, 2012

'London Whale' lawsuit highlights need for banks to provide ultra transparency

As reported by Bloomberg, public pensions are suing JP Morgan for providing false information about its credit default swap trades.

Regular readers know that if JP Morgan had been required to provide ultra transparency and disclose on an ongoing basis its current global asset, liability and off-balance sheet exposure details the public pensions would have had access to the information they needed to independently and accurately assess the situation.

As a result, with ultra transparency there would be no basis for the lawsuit (as an aside, the trade probably wouldn't have occurred if there was ultra transparency because the market would have exerted discipline on JP Morgan to restrain its risk taking).

Public pension funds from Arkansas, Ohio, Oregon and Sweden will be lead plaintiffs in a group lawsuit against JPMorgan Chase & Co. (JPM)over trades made by Bruno Iksil, known as the “London Whale.” 
U.S. District Judge George Daniels in Manhattan ruled today that lawsuits against the New York-based bank should be consolidated into a class action. The pension funds allege they lost as much as $52 million because of fraudulent activities by JPMorgan’s London chief investment office.... 
“The public pension funds, a group which includes some of the largest public pension funds in the world, have far and away the ‘largest financial interest’ in the relief sought by the class in these cases,” Gerald Silk, a lawyer with Bernstein Litowitz Berger & Grossmann LLP, said Aug. 9 in court papers. 
JPMorgan Chief Executive Officer Jamie Dimon said in July the firm’s chief investment office had $5.8 billion in losses on the trades so far, and the figure may climb by $1.7 billion in a worst-case scenario. Iksil amassed positions in credit derivatives so big and market-moving he became known as the London Whale.

The pension funds allege they sustained losses after being given false information that hid the nature of the bank’s trades. 

HSBC to fight British regulator 'to the death' to save dividend

The Telegraph carried an interesting article that provides an insight into how banks pressure their financial regulators when it comes to the amount of capital they hold.

In this particular case, HSBC argues that the British regulator don't understand how financial markets work and that paying dividends is a necessity.

It is well known that paying dividends is not a necessity.  Just look at all those high growth non-dividend paying tech stocks.

Paying dividends does broaden the pool of eligible investors, but it is not a necessity.

HSBC is willing to “fight to the death” to prevent British regulators from attempting to force it to stop paying its dividend in order to preserve capital. 
The bold statement by group finance director Iain Mackay reflects the continuing battle between regulators – including the Financial Services Authority (FSA) and the Bank of England’s new Financial Policy Committee (FPC) – and banks over capital enhancements. 
In the statement, made to analysts earlier this month, Mr Mackay criticised certain FPC members, alleging that they did not comprehend fully the way capital markets work.... 
Explaining the challenges banks such as HSBC face, Mr Mackay said: “They [regulators] believe banks are capable of reinforcing their capital by cutting the variable compensation of their employees, by restricting dividends to their shareholders and by raising capital in the marketplace.” 
But Mr Mackay said such thinking was misplaced. “From Stuart’s [Gulliver, HSBC chief executive] and my perspective, we will fight to the death if they go after our dividends. That is not on. 
“If you expect to be able to raise capital in the marketplace at any point, you’ve got to remunerate your shareholders. So from our standpoint, pretty much everything else will go before the dividend.”...
He went on to suggest that among certain parts of the regulatory sector there is a view “that the shareholder doesn’t matter”, something that he finds “more than a little bit worrying”. 
Actually, it is not in the regulator's mandate to worry about the shareholder.  They are suppose to worry about ensuring that shareholders have access to all the useful, relevant information in an appropriate, timely manner so they can assess the risk of investing in a bank and adjust the amount and price of their investment.
Mr Mackay’s frank comments are a window into the bank’s continued difficult relationship with regulators.

Monday, August 20, 2012

British (EU and US) banks still face the financial precipice

In reporting on the Bank of England Paul Tucker's statement that "gentlemen, by Christmas it could all be over", the Telegraph's Harry Wilson provides a terrific summary of why the western banking system is still on the financial precipice.

Regular readers know that the financial crisis would be over if the policymakers and financial regulators were to pursue the Swedish model for handling a bank solvency led financial crisis with ultra transparency.

Under the Swedish model, the modern banking system is used as it was designed to be used an it absorbs all the losses on the excesses in the financial system to protect the real economy and society.

Instead, policymakers and financial regulators continue to pursue the Japanese model which protect bank book capital levels and banker bonuses at all costs.

The result is an endless stream of bailouts as the losses in the financial system are transferred to the taxpayers and the real economy.  This in turn deprives the real economy of the capital it needs to support growth or reinvest to maintain its current level.

As reported by Mr. Wilson,

"Gentlemen, by Christmas it could all be over". These are the words of the Bank of England’s deputy governor at a key meeting of banks late last year. Why was he so worried?.... 
Attempts to bolster market confidence had failed. Stress test after stress test was doing little to disprove the widely-held belief among investors that the problems of the European banking sector were vast and that bank debt was a needlessly risky purchase. 
Everyone knows that market confidence is the result of providing market participants with access to all the useful, relevant information in an appropriate, timely manner.  It is transparency that allows market participants to make independent assessments.  Confidence flows because market participants trust their own independent assessments.

Everyone knows that there is no reason to trust the analytical ability of the financial regulators.  They did not see the financial crisis coming (if they did, why didn't they do their jobs and prevent it?).  The stress tests followed by nationalization of banks that pass the tests confirms the lack of analytical ability.
Once the titans of finance, many of Europe’s largest banks now found themselves in the strange and uncomfortable position of being unable to raise money from the large institutions they had made billions of pounds from over the previous two decades.
Who would invest in a 'black box'?  It is no mystery why no one would want to invest in Europe's or anyone else's largest banks.

In the absence of ultra transparency and the ongoing disclosure of their current global asset, liability and off balance sheet exposure details, banks are black boxes.  Who would invest in a black box where they cannot assess the risk of their investment?
To central bankers the problems were more than bad, they were terrifying. To those charged with managing the financial system, the potential calamity they saw on the horizon was not just as bad asLehman Brothers’ collapse three years earlier – it was worse. 
The September minutes of the Bank of England’s Financial Policy Committee (FPC) spoke euphemistically of “severe strains” in funding markets. In part, this reflected the fact that British banks were in a relatively better position compared with many of their Continental rivals, having already spent two years cutting risk and building up capital and liquidity buffers to withstand any new shock. 
However, to those fluent in central banker-speak, the tone of some of the language was shocking, suggesting that despite all the preparations, the British banking system was far from the fortress that was being portrayed.... 
Isn't the problem a lack of transparency?  Why should the financial regulators be in a position to portray the condition of the financial system as something it is not.
Inside the Bank of England something close to panic had gripped the institution. Among senior managers a sense of foreboding had taken hold. ... 
In late October, the Bank made clear its fears to the heads of Britain’s major lenders. The Old Lady of Threadneedle Street was worried the UK’s biggest banks could be swept away by the financial calamity it saw building up in the eurozone banking system.
At a meeting at the Financial Services Authority’s Canary Wharf headquarters at the end of October, Paul Tucker, deputy governor of the Bank of England and the man responsible for the financial stability of the British financial system, shocked the assembled banking elite as he opened the private session. 
“Gentlemen, you could all be out of business by Christmas,” Mr Tucker, a candidate to be the next Governor of the Bank, said to his shocked audience. 
He went on to explain the situation he saw developing and how threatening he thought it could be to even the largest and most financially strong of institutions. Repeating the September minutes of the FPC, Mr Tucker urged all the banks to build even larger liquidity buffers and raise yet more capital. 
“We were left scratching our heads,” said one senior banking executive present. “As soon as I got out, I reported back what Paul Tucker had said and I immediately called my team in to go through every risk exposure we had to see if there was anything we had missed.”
Of course, what has been missed since before the financial crisis is that in the absence of ultra transparency no bank can independently assess the risk or solvency of any other bank and as a result, they cannot properly adjust the amount and price of their exposures to other banks.
Others present were less than impressed by Mr Tucker’s dramatic warning and critical of the Bank’s performance in the months after the meeting. 
“They certainly made some strong statements to us, but they then did very little about it,” complained one banker also present at the meeting. 
“It was obvious the financial system was in a very difficult place, but it’s not exactly constructive to predict doom and gloom and then do nothing.”...
There should be no surprise that the financial regulators did nothing, it is up to the individual banks to be assessing risk and making the appropriate adjustments.

If there was transparency this could and would occur.  It would occur because the market could and would exert discipline on banks to restrain their risk taking.

However, in the absence of ultra transparency, everyone is left to guess what the real level of risk is and what steps they should be taking to reduce their risk exposure.
What happened in France last year is an object lesson in what happens when confidence evaporates. As euro break-up fears flared, attention had begun to focus on the large potential losses lenders such as Credit Agricole, BNP Paribas and Societe Generale would have should Greece exit the currency.... 
In a matter of months, funds more than halved their exposure to the French banking system, removing a crucial short-term source of dollar funding to the banks. For the banks, this raised several problems, as they relied to a greater or lesser extent on the money market funds to provide the liquidity that supported the US investment banking operations they had all developed over the previous two decades.
However, it was not just money market funds that were getting nervous about France. In mid-September, a Deutsche Bank call for clients hosted by analysts saw bankers peppered with questions from Middle Eastern companies, including oil giant Saudi Aramco, about the health of French banks....

It is impossible to know the composition of a bank’s corporate deposits, however Middle Eastern wealth funds and conglomerates have hundreds of billions of dollars in cash held with banks around the world. The hint they could be getting ready to pull their money could spell death for any bank....
But whatever banks were doing themselves to salvage the situation – and with the UK looking into the abyss as well – for central bankers the risks had grown far too great, and on November 30, six central banks, including the Bank of England, the Federal Reserve and European Central Bank, led by Mario Draghi, announced a co-ordinated intervention to provide cheap dollar funding to lenders....
Naturally, the financial regulators jumped in with another bailout.
Although the banks had made it past Christmas, the cost was immense and the various schemes have not removed the fundamental problem for many banks that are still loaded up with toxic loans likely to cost them billions of euros in losses over the coming years. 
British banks have done more than most to come to terms with their toxic legacy, but few think they are out of the woods yet and the prospect of a new crisis is an ever-present worry for central bankers and regulators. 
Mr Tucker’s warning remains: “Gentlemen, you could all be out of business by Christmas.”
Please re-read the highlighted text as we are destined to repeat this cycle of financial crisis requiring bailouts until such time as the banks are required to provide ultra transparency and as a result recognize all the losses on the excesses in the financial system.