Saturday, March 31, 2012

In latest twist in Libor manipulation, hedge fund asked for rate change

In the latest twist in the investigation into the banks manipulation of Libor, the Telegraph reports that a trader at RBS claims a hedge fund asked that the bank change the interest rate.

Tan Chi Min, a former RBS trader who claims he was wrongfully dismissed by the bank after it fired him for allegedly trying to manipulate Libor - the average rate at which banks lend to each other - said he had received the request in 2007 from Brevan Howard. 
"Brevan Howard telephoned on 20 Aug 2007 to ask the defendant to change the Libor rate," according to a paper filed with the Singapore High Court cited by Bloomberg. 
The court filing alleges RBS "received this request without objection".... 
Mr Tan claimed in his filing that Scott Nygaard, head of short-term markets finance at RBS, knew about the call from Brevan Howard. However, the filing contained no further details to support his allegations. However, he is reported to have said he would provide further evidence at a later stage....  
He claims in his lawsuit that asking for changes in Libor was "common practice" among RBS traders and that the bank "took requests from clients" to alter the rate.
Regulators across the world are investigating whether banks manipulated Libor during the financial crisis. ... 
Libor is used to price about $360 trillion (£225 trillion) of financial products around the world, including everything from small business loans to complex financial derivatives. 
The rate is set from a daily survey of leading banks, which are each asked to submit their borrowing rate every morning. The survey is undertaken on behalf of the British Bankers' Association, which represents the interests of the UK banking industry.
Since it is based on a survey, Libor is subject to manipulation.

To eliminate all chance of manipulation, Libor should be based off of the actual cost to the banks to raise funds in the capital markets.  This can easily be done by requiring the banks to disclose all of their deposit liabilities.

With this data, market participants could independently calculate Libor.

The advantage of requiring the banks to disclose all of their deposit liabilities is that it lets the market participants get a clearer picture of what a bank's funding cost truly is.

Another advantage of basing Libor off of real trade data is it is consistent with what Libor is suppose to represent .... the average cost for banks to raise funds.

Friday, March 30, 2012

UK's Asset Protection Scheme confirms sell-side wants ultra transparency too

In the HM Treasury's review of its performance during the financial crisis, it description of how the Asset Protection Scheme was implemented ends for all time the debate over does the sell-side want ultra transparency into each bank's asset, liability and off-balance sheet exposure details.

With limited in-house expertise, the Treasury turned extensively to external advisers and experts....

A senior external advisor observed 
[The] APS was a project on an unprecedented scale. [The] Treasury was dealing with bank books which were hugely complex, banks themselves did not understand them [...]. 
Treasury and their financial advisers wanted as much detail and data as they would need for securitisation. They were incredibly data hungry.”
My bet is Treasury and its financial advisers wanted the exposure details synonymous with ultra transparency.

The fact that Treasury turn to market participants to analyze the exposure details confirms two other observations.
  • Market participants know how to transform the large amount of data released under ultra transparency into useful, relevant information; and
  • Regulators can piggy-back off the expertise of the market participants.
Regular readers will recall that under my blueprint for saving the financial system, your humble blogger recommends that regulators piggy-back off the market participants' ability to transform the data released under ultra transparency into useful, relevant information.  

This should be done not only in times of crisis, but also as part of the ongoing conduct of micro- and macro-prudential regulation.

Searching for muppets, the sell-side says its ok to chase yield and buy opaque securities

Having loaded up their balance sheets with opaque toxic structured finance securities, the sell-side turns to the mainstream media for help finding investing muppets.  Without questioning the message, the mainstream media 'reports' that it is ok for the buy-side to chase yield and buy these securities.

So what exactly has changed about these opaque toxic structured finance securities since investors were chasing yield and buying them before the beginning of the financial crisis?


They are still opaque.  A buyer of these securities is simply blindly gambling as the lack of current information on the performance of the underlying collateral makes it impossible to know what you own.

On the other hand, Wall Street has an informational advantage when it comes to these securities.  The source of this informational advantage is their ownership of the entities servicing the underlying collateral.  Wall Street can get regular updates on how the underlying collateral is performing  that are not available to investors.

Hence, only an investment muppet would buy a security that they cannot value and Wall Street can...

From a Financial Times article,
Allen Appen, head of European financing solutions at Barclays Capital, says it has taken time for the stigma attached to many European securitisation deals since the financial crisis to recede and for investors to realise that mortgage loans from Dutch and British markets have in some cases performed better than other funding instruments. 
While some European investors have been unwilling to return to the European RMBS market, a few large US banks, some of which were active before the crisis, “are now hugely acquisitive and driving the secondary market,” Mr Appen says. More recently there has been interest from large Japanese banks. 
The scale of US investor appetite can be seen in the frequency and size of dollar tranches in the new issue market, says Gareth Davies, head of European asset-backed securities and covered bond research at JPMorgan. Relative to US securitised products, the UK and Dutch markets offer more attractive value for investors, he says. 
A three-year UK, dollar-denominated RMBS transaction would print at about 140 basis points over Libor, the benchmark interbank borrowing rate, compared with its nearest US equivalent credit card-backed securities trading at nearer 14bp. 
In the US, some of the securities at the heart of the financial crisis – bonds backed by home loans struck during the boom years of the past decade – have rallied sharply this year. Amid rising hopes for US economic recovery, they have benefited from investors’ voracious appetite for yield while official benchmark rates remain very low.
But growth of the European securitisation market, and RMBS in particular, is still heavily constrained. Proponents argue that regulators have “tarred all securitisation products with the same brush”. They say the problems coming out of the US crisis related to bad loans and not to the products themselves....
Naturally that is what the sell-side and its industry trade groups would say.  They benefit from the inability of investors to be able to assess the risk and hence properly value these securities.

The products themselves are fundamentally flawed.

They are designed to be opaque.  By design, investors do not receive all the useful, relevant information in an appropriate, timely manner so they can make a fully informed investment decision.
Rick Watson, head of capital markets at the Association for Financial Markets in Europe [an affiliate of the sell-side's lobbying organization], ... says there continues to be “a misunderstanding about the differences between various securitisation products and the risks they carry”. 
How true.  Opacity guarantees that there is no way the investors can understand the risks of the various securitization products.
Work is under way on a labelling scheme that would help investors identify the highest-quality securitisation products.
Adding a label does not change whether an investor has access to the data they need in order to know what they own.

Adding a label through the Prime Collateralised Securities (PCS) initiative is simply a sell-side effort to repackage a product that is designed not to provide investors with the data they need in order to monitor or value the security.
Rebranding efforts aside, there are more fundamental issues.... 
Yes, opacity is a much more fundamental issue.

Thursday, March 29, 2012

Arthur Levitt: 'there should be transparency'

In a Bloomberg article, Arthur Levitt discusses the inherent tension between buyer and seller of a financial product and concludes that resolving this tension requires transparency.

Goldman Sachs Group Inc. (GS) should stop promoting itself as “putting customers first” because the slogan ignores conflicts inherent in trading, said Arthur Levitt, the former Securities and Exchange Commission chairman and a senior adviser to the firm. 
“We probably ought to stop saying that because nobody really puts customers first,” Levitt, 81, said in an interview with Erik Schatzker on Bloomberg Television today. “Business is a tension between sellers and buyers.”...

Goldman Sachs made 60 percent of its revenue last year from sales and trading, outweighing businesses that advise clients on takeovers, financing and money management. Levitt said the company shouldn’t emphasize putting clients first because it doesn’t recognize the reality of the trading business. 
“There is a logical, reasonable, fair, understandable tension between a seller of a product and a buyer of a product,” Levitt said. “That’s not to stay that buyers should beware. It is to say there should be transparency.”
Transparency so that the buyer has access to all the useful, relevant information in an appropriate, timely manner so they can independently assess this information and make a fully informed investment decision.

Who captured the Fed?

In a must read NY Times' Economix column, economists Daron Acemoglu and Simon Johnson look at the myth of central bank independence and the implications for monetary and regulatory policy.

A hundred years ago, monetary policy – control over interest rates and the availability of credit – was viewed as a highly contentious political issue. 
People on the left of the political spectrum feared the central bank would be used to prop up Wall Street banks; those on the right thought it would unduly expand the role of government, giving too much power to politicians....
Incredibly, the fears of both the left and the right have been realized with the Fed.

There is no doubt that Fed policies are propping up Wall Street banks.  These policies range from regulatory forbearance on troubled assets to suspension of mark-to-market accounting to stress tests proclaiming all is well.

There is also no doubt that Fed policies have given too much power to politicians.  The Greenspan Put reflects this as the Fed was an equal opportunist across Republican and Democratic administrations when it came to lowering rates whenever the stock market declined.
The origins of the Federal Reserve System lie in an emotional debate, conducted more than 100 years ago, about whether the government should seek to affect interest rates – and support the credit of Wall Street firms during times of crisis – and, if so, how.... 
The Federal Reserve System, created in 1913, was a uniquely American compromise, trying to balance public and private interests. Banks controlled the boards of the 12 regional Feds – with big Wall Street firms holding great sway over the New York Fed, which had a disproportionate influence within the system as a whole — and still does. 
This version of the system presided over a crazed and highly leveraged stock market boom in the 1920s and the catastrophic collapse of credit in the early 1930s, while protecting the big Wall Street firms. 
So clearly there was a lesson for the Fed to learn here about the need for regulating Wall Street firms.
Under Franklin Delano Roosevelt, the role of the Federal Reserve Board of Governors, based in Washington, was strengthened, and Wall Street was more generally constrained by effective changes to a wide range of banking and securities laws. 
Banking and securities laws that have been repealed over the last 30+ years.

However, these banking and securities laws did give the Fed a significant responsibility in bank supervision and regulation.

A responsibility that the Fed abandoned under Chairman Greenspan in the run up to the financial crisis as part of his personal adherence to the ideas of enlightened self-interest and market discipline.
These reforms and the effects of World War II pulled the central bank away from powerful bankers and further into the orbit of elected officials. 
Unfortunately, as the United States and other countries learned after 1945, clever politicians can use central banks to manipulate the business cycle, boosting output growth and cutting unemployment ahead of elections.... 
The chairman of the Federal Reserve is nominated by the president to a four-year term (subject to confirmation by the Senate); anyone who would like be reappointed needs to please the White House.... 
One way of pleasing the White House is to please Wall Street.  Hence the accolades for Greenspan and Bernanke for their policies of stepping in and lowering interest rates whenever the stock market declines (originally known as the Greenspan Put).
In 1979 Paul A. Volcker became chairman of the Fed and tamed inflation by raising interest rates and inducing a sharp recession. The more general lesson was simple: Move monetary policy further from the hands of politicians by delegating it to credible technocrats. 
Thus was born the idea of independent central bankers, steering the monetary ship purely on the basis of disinterested, objective and scientific analysis. When inflation is too high, they are supposed to raise interest rates. When unemployment is too high, they should make it cheaper and easier to borrow, all the while working to make sure that inflation expectations remain under control. 
Increasingly, however, it seems that technocratic policy-making is just a myth. We have come full circle, and the Wall Street banks are calling the shots again.
A myth created by economists.

I worked at the Fed during this time in the area that was directly responsible for producing the monetary aggregates and the research to show the influence of the Fed's policy on inflation.

It was common knowledge that the White House wanted inflation to be defeated.
Crucially, the idea that politics is just about electioneering misses the point. 
Politics is about getting what you want, not just through the ballot box but by persuading people in public office to take actions that help you.... 
Monetary policy has an impact on inflation, output and employment. But it also has a major impact on stock market prices. Any central banker raising interest rates is reducing stock market values and thus eroding the bonuses of top bankers and other chief executives. 
Those people will lobby, asserting that higher interest rates will undermine the economy and cause us to plummet into recession, or worse. 
In principle, the Fed could stand up to the bankers, pushing back against all specious arguments. In practice, unfortunately, the New York Fed and the Board of Governors are quite deferential to financial-sector “experts.” Bankers are persuasive; many are smart people, armed with fancy models, and they offer very nice income-earning opportunities to former central bankers. 
Regulatory capture at its finest.
We have lost track of the number of research notes from major banks pleading for easier credit, lower capital requirements, delay in implementing financial reforms or all of the above. 
In recent decades the Fed has given way completely, at the highest level and with disastrous consequences, when the bankers bring their influence to bear – for example, over deregulating finance, keeping interest rates low in the middle of a boom after 2003, providing unconditional bailouts in 2007-8 and subsequently resisting attempts to raise capital requirements by enough to make a difference. 
It is not surprising that being led by economists, the Fed gave way.

Supervision and regulation is all about detail and the economists at the top of the Fed are big picture monetary policy oriented individuals.  A focus on the type of detail necessary for successful supervision and regulation is hard for these individuals as they have been trained to make assumptions rather than examine all the small details.

A classic example of how the economists do not understand the small details is the ongoing discussion of raising capital requirements.  What part of the OECD's observation that bank book capital is meaningless do economists and finance professors not understand?

When the Fed practices regulatory forbearance and encouraged an end to mark-to-market accounting, the Fed undermined the relationship between bank book equity and the true financial condition of the bank.  Bankers seem to get this point as the interbank lending market periodically freezes as every bank knows that it is hiding losses on and off its balance sheet and assumes that the other banks are too!

The reason your humble blogger has advocated for requiring banks to provide ultra transparency and disclose on an ongoing basis their current asset, liability and off-balance sheet exposure details is that it frees market participants from dependence on a Fed that is subject to both regulatory and political capture.

With this data, market participants can determine the riskiness of each bank.  Base on this assessment, market participants can adjust their exposure to each bank to what they are willing to lose.  Unlike the regulators, this market discipline is not subject to being captured by the bankers.

Who are the muppets that Wall Street takes advantage of?

The muppets that Wall Street takes advantage of are any investors who buy opaque structured finance products or the stocks and bonds of banks with disclosure practices that make them resemble 'black boxes'.

The investor is a muppet because they are blindly betting as oppose to investing which requires the ability to assess what you are buying and know what you own.

As described in a Guardian article discussing muppets for structured products,
So who were the muppets then? All interviewees said that the term is common on investment banking desks and trading floors. A former salesman with a major bank said: "If one client always calls in with an order 10 minutes after markets close, you will call him a muppet. It's London slang for idiot." 
But there seems to be a second category of muppets, and they are found in a second area in equity derivatives, called structured products. These are complex, bespoke contracts for individual clients designed by "structurers". 
One insider likened them to holiday packages: "You can shop around yourself for the best deals for a hotel, ticket, tour, etcetera. But just as most tourists leave that to a specialist travel agency, most clients will leave it to their bank to find and put together the right combination of financial instruments." 
And this, interviewees agreed, is where mischief, or worse, is possible. 
In the words of one such former structurer: "There are very sophisticated parties out there. But there are also smaller players who basically have no idea what they're doing. Some small savings bank perhaps, or some municipality. What got to me after a while is how I'd be lying in the faces of these less sophisticated parties. And I'd be thinking, wow, this is my parents' pension money down the drain. Some guy working for a small bank in Belgium would be called 'muppet', that's very likely." 
The former salesman concurred: "It's an open secret that there is this group of less sophisticated institutional investors, mainly from southern Europe, who would buy things they didn't understand." 
Interviewees stressed that all banks are ripping these players off, not just Goldman Sachs. And they have been doing this for years.
Of course, this leaves out of the discussion all of the Eurozone banks that purchased tranches of US sub-prime mortgage backed securities or CDOs.

Wednesday, March 28, 2012

The dangers of our new regulations

In a Financial Times column, Peter Sands, group chief executive of Standard Chartered, takes on the approach to addressing systemic risk employed by the Bank of England's Financial Policy Committee.

Regular readers know that Sir Mervyn King said the approach was 'an experiment'.  An experiment that your humble blogger felt needed to be supplemented with the tried and proven approach of disclosure, specifically requiring ultra transparency.

Not surprisingly, Mr. Sands is nervous about the 'experiment'.
Before the crisis, financial regulation focused on averting the failure of individual banks, and wasn’t much good at that.  
Which of course raises the question of why we would continue to have the stability of the financial system dependent on regulators?
Now there’s much more focus on preventing systemic crises. In the jargon, we’ve moved from focusing on “micro-prudential regulation” to a much greater emphasis on “macro-prudential regulation”....  
Please note that better disclosure helps with both micro-prudential and macro-prudential regulation.

With ultra transparency, each bank is required to disclose on an on-going basis its current asset, liability and off-balance sheet exposure details.  With this information, market participants, including the regulators can independently assess the risk of the banks.

Based on this risk assessment, market participants can then adjust their exposure to each bank to what they can afford to lose.

At the micro-prudential level, this adjustment is called market discipline and acts as a brake on banks taking too much risk.

At the macro-prudential level, this adjustment virtually eliminates concerns about contagion as the failure of one firm will not bring down others.
At Standard Chartered, we are very supportive of the concept of macro-prudential regulation, and the establishment of the [Financial Policy Committee]. We are dismayed, however, by the way it has defined its role....
The FPC’s approach appears simultaneously extremely interventionist and extraordinarily blinkered. 
It wants to be able to vary bank’s capital requirements in aggregate and by sector, and to be able to vary the leverage ratio, with little or no limit on the degree of required variation, or scant requirement to justify the intervention. 
It might not be obvious from the somewhat technical language, but in effect the FPC wants to control how much lending there is in every aspect of the economy, from manufacturing to mortgages, and how much it costs. 
This reeks of 1970s style quasi-nationalisation of the industry.... We know how well that went. 
... there are good reasons to be concerned about this approach. 
First, it represents an extraordinary concentration of power in the FPC. Its decisions will affect the cost of credit for every business or individual in Britain. So you have to be very concerned about its capabilities and accountability....  I think this notion that one committee should be able to anticipate all risks and micro-manage such an important part of the economy is dated and wrong. History suggests direct command and control is as flawed as complete laissez faire
One of the strengths of disclosure is that it lets the market help both the micro-prudential and FPC do its job.  It does this by letting both sets of regulators piggy-back off the market's analytical capabilities.

I know I have made this point many times before, but, for example, Peter Sands and Standard Chartered are better at analyzing HSBC and because of their exposure have more motivation to comprehensively analyze HSBC than the regulators.  The same is true for HSBC analyzing Standard Chartered.

The regulators should tap this analytical expertise to identify risks at individual institutions and to the financial system.
Second, the FPC seems remarkably insouciant about what investors in bank equity and credit will think about their interventions. Already battered by banks’ own mistakes, equity investors will, I think, take one look at the idea of their returns being dictated by the FPC and run a mile.  
This matters. Put bluntly, if investors can’t be convinced that investing in banks will deliver appropriate returns, capital will be sucked out of the industry, causing credit availability to fall and the cost of credit to rise.... 
The FPC will no doubt respond by claiming investors will appreciate the fact that the industry is now much safer and will demand much lower returns. While articulated as if it were a theological certainly, this verges on deliberate self-delusion. There is no evidence that the cost of equity for banks has come down. 
It is doubtful that the cost of equity for banks has come down because under current disclosure practices banks are 'black boxes'.

When market participants cannot assess the risk of investment, they charge more.

If banks provided ultra transparency, market participants could assess the risk of each bank.  Banks with low risk and high returns would see their cost of equity drop while banks with high risk and low returns would see their cost of equity climb.

I suspect the Mr. Sands feels Standard Chartered is in the low risk/high return category and therefore would be happy to provide ultra transparency as it would result in a significant increase in his firm's stock price.
Third, this obsession with controlling what banks do misses the point. Yes, banks can be a source of systemic risk, but they are far from the only one. And trying to manage all types of systemic risk through interventions in the banking system is an odd way of going about it. 
Take property bubbles. Most banking crises have their roots in property asset inflation, whether commercial or residential. For that reason, virtually every country that has an effective macro-prudential framework deploys loan-to-value or loan-to-income limits, in combination with other tools, to constrain lending on property....
A strength of disclosure is that it is easy for market participants to monitor loan-to-value or loan-to-income and see when they move close to bubble territory.  As a result, market participants can cut back on their exposure and naturally apply the brakes.
What worries me as well is that the FPC seems blind to some of the biggest risks to financial stability. Look at the Bank of England, the Federal Reserve and the European Central Bank. 
All three have seen a huge expansion in their balance sheets, are much more leveraged, and have deployed innovative tools on an unprecedented scale. Central banks are in new and uncharted territory, with unpredictable and potentially profound consequences....
There is no reason that their balance sheets should also not be subject to ultra transparency.

Regulators' 9% Tier I capital target induced credit crunch trumps ECB's LTRO

The Telegraph reports that the financial regulators' 9% Tier I capital target induced credit crunch trumps the ECB's LTRO program.

European banks cut lending lines to companies last month, defying the central bank's grand plan to stem the crisis with a flood of more than €1 trillion (£838bn) of cheap loans.
As predicted on this blog, requiring banks to achieve a meaningless 9% Tier I capital ratio would cause a severe contraction in credit across the Eurozone.

Furthermore, the 9% Tier I capital ratio is doing nothing to restore confidence in the Eurozone banks.  Without ultra transparency where banks disclose on an on-going basis their current asset, liability and off-balance sheet exposure details, market participants cannot tell which banks are solvent and which are not.

As a result, the interbank lending market is frozen and the on-going run on the Eurozone banks continues to reduce their deposit base.

The European Central Bank (ECB) said loans to the real economy fell in February, scotching claims that radical long-term refinancing operation (LTRO) would stem the crisis. 
Open Europe's Raoul Ruparel said: "The LTRO has succeeded in avoiding a severe funding crunch...[But] it does not tackle the underlying lending risks which the banks are still keen to avoid, particularly with the looming recession in Europe." 
As Spain faces a general strike on Thursday, economists called for the eurozone to use its bail-out funds to support the country's banks. 
Finance ministers are under pressure to boost Europe's "firewalls".... 
But Jens Weidmann, Bundesbank president, warned that "just like the 'Tower of Babel' the 'Wall of Money' will never reach heaven". 
Italy's premier Mario Monti warned against blaming sinner states: "It was in fact Germany and France that were loose concerning the public deficits and debts," he said. "If the father and mother of the eurozone are violating the rules, you could not expect...[others] to be compliant."

Time for economists to eat humble pie...again

Stein Ringen, a professor of sociology at Oxford's Green Templeton College, had an interesting Financial Times column in which he examines the behavior of economists.
Economists are no more likely always to agree than any other experts but there was a remarkable unanimity as the crisis unfolded: Europe was on the edge of the abyss; bold and rapid action was needed from strong governments.... 
Economists warned politicians not to dither. In the New York Times Paul Krugman poured scorn over Europe’s politicians, collectively, in terms that, had he used them about say, black people, he would have been all but up for incitement to racial hatred. What was needed, it was argued, was more “firepower”, higher “firewalls” and bigger “bazookas”, with no delay.... 
Had the balance of opinion among economists prevailed, private bondholders, who had lent recklessly, would have been let off scot-free at European taxpayers’ expense....
Actually, by dragging out the restructuring of Greece's debts, the banking sector was given time to reduce its exposure.

Rather than the banking sector acting as a safety valve and absorbing the losses on the excesses in the financial system related to Greek debt, these losses were transferred to the real economy.  After the debt restructuring, Greece has almost as much debt as before and its government is locked into austerity policies for the next several years.

So the economists got the timing for restructuring the debt right.  Had it occurred two years earlier, the level of Greek debt would be substantially lower and the need for austerity policies much less acute.

What economists got wrong was arguing for bailing out the banking system and transferring the losses to the real economy.
I have no problem with the “chief economists”, whose job is to protect the banking sector, but what about the independent academic economists? 
It should not be the job of any economist to protect the banking sector.

Bankers are fully capable of taking care of themselves.

Moreover, the institutions that they run are capable of operating for years with negative book capital.  So long as depositors believe the state's guarantee of their money and central banks are willing to provide liquidity, an insolvent bank can continue to operate and support the real economy.
They fell victim to an exaggerated confidence in themselves. Most of us in the social sciences are aware of our limitations. Economists, for their sins, have worked themselves into a frenzy about being “scientific”. Overconfidence leads to hubris. The economists let their guard down. 
First, they neglected careful description of the problem....
True.  Since August 9, 2007, we have been dealing with a bank solvency led financial crisis.  On that date, BNP Paribas said it could not value opaque structured finance securities.

Since the largest banks are also 'black boxes' that were holders of these opaque structured finance securities, this meant that banks could no longer assess the solvency of the other banks.  As a result, by September 2008, the interbank lending market froze.
Second, they neglected the need for precise language. 
“Firewalls”, “firepower” and “bazookas” are not terms of analysis. Contagion? What does that mean? 
Economists of all people should know that trust in our modern financial system is based on disclosure.  Having access to all the useful, relevant information in an appropriate, timely manner so that a buyer can know what they are buying is a necessary condition for the invisible hand to operate properly.

Economists should have been leading the discussion on the need for banks to provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details.  After all, they know this is the data that is needed so that market participants can assess the risk of each bank and adjust their exposure to what they can afford to lose ... bringing an end to contagion.

Economists should have been leading the discussion on the need to make available on an observable event basis the current performance information on the underlying collateral for each structured finance security.  After all, they know that with this data the structured finance market would be restarted as market participants can independently value and based on this independent valuation trade the securities.

Economists should have been leading the discussion on the asymmetric information flow enjoyed by Wall Street and how they used it to bet against their clients.  After all, economists know that until the information flow is rebalanced, clients who have been burned will not return to the market.

Economists should have been leading the discussion on how pursuing the Japanese model for a bank solvency led financial crisis was going to dramatically increase the cost of dealing with the crisis without solving the underlying problem.  After all, economists know that the Swedish model of requiring the banks to absorb the losses on the excesses in the financial system today works.
And third, they indulged in predictions, the economist’s ultimate vanity, but their models are no more than equations with countless unknowns
The need to predict, a psychological urge in the economic tribe, led to the wildest warnings....  
One lesson is clear: beware the experts who come bearing advice and in particular economic experts.
Your humble blogger can forgive economists for making predictions.  After all, I predicted the financial crisis and what it would take to moderate its impact.

Time to set banking regulation right

In an article on Vox EU, Jacopo Carmassi and Stefano Micossi observe that it is time to set banking regulation right and address three critical shortcomings of the Basel prudential rules.

What caught your humble blogger's attention was the way the authors described the three critical shortcomings as being the result of opacity.

Together, they make the case for requiring banks to provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details.

Excessive leverage and risk-taking by large international banks were among the main causes of the 2008–09 financial crisis and the ensuing sharp drop in economic activity and employment. Enormous costs were borne by taxpayers and societies at large. 
In reaction, world leaders and central bankers undertook to overhaul banking regulation, including by rectifying the failed Basel prudential rules with the new Basel III Accord. Many scholars have commented on the proposed reforms, especially the US’s Dodd-Frank Act (eg Acharya and Richardson 2011). 
Europe is now considering how to transpose the new Basel III Accord, with the proposed Capital Requirements Directive IV, now before the European Parliament and Council. 
In our study published last week (Carmassi and Micossi 2012) we argue that these reforms are not enough; they fail to correct the three critical shortcomings of Basel prudential rules, namely:
  • Reliance on banks’ risk management models for the calculation of capital requirements.
These are opaque and open to manipulation.
Hence, bank capital is meaningless.  A point that the OECD also made.
  • Lack of public accountability of supervisors.
Given the opacity of solvency rules, the supervisors may stand beside their regulated entities in delaying loss recognition and ‘gambling for resurrection’, thus raising the ultimate cost of bank failures for taxpayers.
Hence, the selection of the Japanese model for how to address a bank solvency led financial crisis over the Swedish model.
  • Weak market discipline.
Clear metrics of capital strength are not available to investors and the public at large.
Without ultra transparency, there is no market discipline as market participants do not have access to the data they need to independently assess the risk of each bank and to subsequently adjust the amount and price of their exposure based on this assessment.

Prudential bond: a mixture of covered bond and RMBS

The International Financing Review ran an article describing a bond being offered by a unit of Prudential Financial Inc.  The bond is a mixture of a covered bond and a residential mortgage-backed security (RMBS).

What makes this bond interesting is it highlights the need for ultra transparency and why structured finance securities must be required to disclose on an observable event basis the underlying collateral performance.

The offering, titled Prudential Covered Trust 2012-1, was given a Single A rating by Standard & Poor’s, and may be the first bond of its kind: linked to the corporate credit risk of an insurance company, but involving legacy RMBS assets....
Underwriters Deutsche Bank (structuring lead), Barclays, and Wells Fargo launched the 3.5-year issue this afternoon and were set to price it at Treasuries plus 250bp, nearly 100bp wider than a standard three-year senior unsecured corporate bond issue from Prudential (typically Treasuries plus 145bp to 150bp). 
The offering contains features of both covered bonds and RMBS, but is not truly either. 
The assets of a covered bond remain on the balance sheet of the issuer throughout the tenure of the issue. MBS issues, for the most part, are off balance sheet, given the sale of the assets to a special purpose vehicle (SPV), or trust. 
The Prudential transaction is fully guaranteed by PFI and offers semi-annual payments, making it closer to a covered bond. 
However, it differs from covered bonds in several ways: it offers sequential payments to investors, instead of a fixed bullet; the RMBS collateral is off balance sheet, and the payments are contingent on the underlying cashflows from the RMBS. 
The rating on the deal is solely linked to the credit rating of Prudential. 
PFI deposits RMBS into a trust and then issues notes and certificates to investors.  The 470 underlying RMBS issues – mostly subprime, including some Re-Remic bonds – are provided by a unit of PFI, called Prudential Insurance Co. of America. 
The issue was rated by the Insurance Ratings team at S&P, who are only concerned about the corporate rating of PFI, which is providing the guarantee. 
However, the raters are not concerned – nor do they know – the market value of the RMBS assets used as collateral. It is not germaine to the ratings analysis, they say. The notional, or original balance, of the RMBS is approximately three times the size of the note issuance, but it’s not clear what the current market value of the distressed RMBS is.
Without information on the current performance of the underlying collateral provided by ultra transparency, the 470 underlying RMBS issues cannot be independently valued by market participants.  As a result, there is no market for these issues.

Since there is no way to value the underlying RMBS issues, the bond needs the guarantee from Prudential.

The question is why would Prudential pay a premium to issue a bond like this as oppose to a straight bond offering?  Capital arbitrage?

Equity derivative structurer: 'you have to read the fine print ... otherwise there is information asymmetry'

The Guardian ran an interview with a former equity derivatives structurer.  His comments highlight the critical role that having ultra transparency into a financial product plays and why Joseph Stiglitz highlighted information asymmetry as a major contributor to the credit crisis.

"I have read Greg Smith's resignation letter from the equity derivatives desk at Goldman Sachs. For me, it goes back to the values in an organisation. If you could sell your product for double the price, would you do it? I would say, in business, that's legitimate, provided your clients have adequate information. 
"This is an important rule with structured derivatives that clients ignore at their peril. You have got to read the small print. You need to bring in a lawyer who explains it to you before you buy these things – otherwise there is information asymmetry. 
Information asymmetry is not restricted to the small print.
"There is a lot of mis-selling, and not just in derivatives. The mortgage brokers in the US who sold low-income people those sub-prime mortgages. Low-income people didn't understand finance, didn't comprehend that interest rates would jump after a short discount period. That's mis-selling. 
"If a financial tool is abused and mis-sold, this does not disqualify the tool.
Information asymmetry also exists when complex products are sold to buyers who are unable to understand what they are buying.  This information asymmetry can reflect a lack of knowledge of finance on the part of the buyer or it can reflect the design of the financial product.

Tuesday, March 27, 2012

Would George Osborne and HM Treasury like help in getting a small business bond market going?

A Telegraph article reports that Chancellor George Osborne has HM Treasury working on plans to create a small business bond market.
The Chancellor told the Treasury Select Committee that officials were poring over plans to package up small business loans into bundles that could be bought and sold by institutional investors. 
Mr Osborne said this practice of securitising small business loans had been ended by the credit crunch but he hoped to support small businesses by giving them another source of funding. 
"Restarting it is not easy and we're not aware of any country that has successfully done this on a large scale since the crash," Mr Osborne told the Committee. "It's a big challenge. We're actively looking at it."
Regular readers know that the reason it has been difficult to restart the practice of securitization is that the buyers are on strike until such time as they are provide with ultra transparency into the underlying collateral and its performance.

Leading up to the credit crunch, buyers were under the mistaken impression that the rating agencies had access to and were monitoring the current performance of the underlying collateral so as to make timely adjustments to their ratings.

In the fall of 2007, the rating agencies testified before the US Congress that they had no different access to information on the underlying collateral performance than did the buy-side.

With this testimony, the structured finance market began to freeze and by September 2008 had frozen over.

The key to thawing the structured finance market and ending the buyers' strike is to provide current information on the underlying collateral performance so the buyers can know what they own.

To do this requires that information on the collateral is updated on an observable event basis.  An observable event involving the underlying collateral includes a payment is made, a payment is missed, the obligor defaults, the obligor declares bankruptcy and the collateral is modified.

Your humble blogger is looking forward to talking with representatives of HM Treasury, consulting with them and coordinating a conflict of interest free ABS data warehouse to restart the structured finance market.

Finally, please note, your humble blogger was recently approached by representatives of the largest investors in structured finance securities (for investors, think pension funds, insurance companies and mutual funds) about helping them create RMBS 2.0.

Financial crisis: the result of increasing leverage and decreasing financial regulation

By co-incidence, both Bill Gross, a famous bond fund manager for PIMCO, and Bill Black, a well-known law professor, recently wrote about long-term trends in the financial markets.  Mr. Gross wrote about increasing leverage.  Mr. Black wrote about decreasing financial regulation.

The reason I am highlighting what they wrote is the trend of increasing leverage was reinforced by decreasing financial regulation.

As Mr. Gross said,
Whether you date it from the beginning of fractional reserve and central banking in the early 20th century, the debasement of gold in the 1930s, or the initiation of Bretton Woods and the coordinated dollar and gold standard that followed for nearly three decades after WWII, the trend towards financial leverage has been ever upward. 
The abandonment of gold and embracement of dollar based credit by Nixon in the early 1970s was certainly a leveraging landmark as was the deregulation of Glass-Steagall by a Democratic Clinton administration in the late 1990s, and elsewhere globally. 
And almost always, the private sector was more than willing to play the game, inventing new forms of credit, loosely known as derivatives, which avoided the concept of conservative reserve banking altogether. 
Although there were accidents along the way such as the S&L crisis, Continental Bank, LTCM, Mexico, Asia in the late 1990s, the Dot-coms, and ultimately global subprime ownership, financial institutions and market participants learned that policymakers would support the system, and most individual participants, by extending credit, lowering interest rates, expanding deficits, and deregulating in order to keep economies ticking. 
Please note that what Mr. Gross describes as being learned about how policymakers and financial regulators would support the system is all post the Federal Reserve's effort to break the back of inflation in the early 1980s.  Clearly, that effort led to a recession.

However, that inflation fighting effort plus the Regan presidency set in place the conditions necessary for the policymakers and financial regulators to pursue the support of the system Mr. Gross describes.

In his description of financial deregulation, Mr. Black starts with the Regan presidency and its contribution to ending financial regulation.  He then recounts the deregulatory efforts under both Republican and Democratic administrations.

The Garn-St Germain Act of 1982, which deregulated savings and loans (S&Ls) and helped drive the debacle, was passed with virtually no opposition.... 
The Competitive Equality in Banking Act of 1987 (CEBA) was the product of two cynical political deals. The context was that the Reagan administration refused to allow the Federal Savings and Loan Insurance Corporation (FSLIC) to admit that there was a crisis requiring governmental funds and refused to allow FSLIC to draw any funds on its Treasury credit line.  
We have certainly come a long way since then in the willingness to use taxpayer funds.
We had spent all but $500 million in the FSLIC fund closing some of the worst S&L control frauds.  The S&L industry had over $1 trillion in liabilities and was deeply insolvent, so we were running the insurance fund on fumes and dreading a potential nationwide run.... 
A potential run because depositors might think that the government was not going to back the deposit guarantee provided through the FSLIC.

Had the government simply reaffirmed its backing of the fund, there would have been no need to worry about a run on the S&Ls and the regulators would have been better positioned to deal with the insolvent firms.

Instead, the government pursued a policy endorsed by the industry.
The S&L control frauds saw the FSLIC recapitalization bill as an opportunity. They had disproportionate political power because political interference was their best guarantee of delaying our closure of their S&L. My contemporaneous joke was that the frauds’ always obtained their highest return on assets from their political contributions.... 
The first political deal was between the frauds and the League. It was called the “Faustian bargain.” The League agreed to support “forbearance” provisions drafted by the frauds’ lawyers that were cleverly designed to make it difficult for us to take enforcement actions and appoint receivers. The frauds agreed to stall passage of the bill and to support the League’s proposed reduction in FICO bond issuances to $5 billion.... 
The second cynical deal was struck in 1987 by the Reagan administration and Speaker Wright. Wright agreed to withdraw his opposition to the $15 billion size of the FICO bond issuance. Treasury Secretary Baker agreed that the administration would not reappoint Edwin Gray as Chairman of the Federal Home Loan Bank Board (Bank Board) and that the administration would not oppose the forbearance provisions, drafted by the frauds’ lawyers, which the House had added to the bill.... 
Ultimately of course, most of the insolvent S&Ls had to be closed.
In 1993, “Reinventing Government” had total bipartisan support. Vice President Al Gore led the Clinton administration effort. Reinventing government was premised on the view that government was a failure and the private sector was a success that the public sector should emulate. I will mention only two of the anti-regulatory policies that it led to in banking. 
In 1993, the Clinton administration killed the Bank Board’s loan underwriting rules that had proven successful and essential in stopping the S&L debacle and suing and prosecuting the control frauds that drove the crisis. The old rule is what we used in 1990-1991 to stop S&Ls that were making liar’s loans. This was the single most destructive rule change in banking rules in the most recent financial crisis....
The Gramm-Leach-Bliley Act of 1999, which repealed the Glass-Steagall Act, passed with overwhelming support and the active sponsorship of the Clinton administration and the Congressional leadership of both parties. The Glass-Steagall Act was adopted because we investigated the causes of the Great Depression, principally through the Pecora investigation, and found that combining investment and commercial banking led to conflicts of interest that produced recurrent abuses and helped trigger the crisis.... 
In the late 1990s, Brooksley Born, the head of the Commodities Futures Trading Commission (CFTC), realized that credit default swaps (CDS) posed a potential severe danger and sought to review whether the CFTC should adopt regulation to respond to the danger. The Clinton administration, Alan Greenspan, and the congressional leadership of both parties rushed to adopt the Commodities Futures Modernization Act of 2000. The 2000 Act passed with overwhelming support and created a regulatory black hole that Enron exploited to cause the 2001 California energy crisis and AIG executives exploited to become wealthy and drive AIG insolvent.
We can now add to this list of bipartisan financial deregulatory disasters the JOBS Act of 2012. I have explained in prior articles that the Act is the product of a feeding frenzy by lobbyists who are finally able to enact every fraud-friendly provision they ever dreamed of making law....
Mr. Black then discussed what political environment is necessary to adopt laws that actually address what is wrong with the financial system.
If the government exposes and sanctions the elite frauds that drive the crisis it can create (briefly) the political space for real reform legislation. 
If, however, the government fails to expose and hold accountable the elite ... political space for real reform will not be created and any reform bills may be large, but they will not be fundamental. 
This is the problem with passing the Dodd-Frank Act without providing the Financial Crisis Inquiry Commission ample resources and time to finish its investigation into the causes of the crisis first.

Mr. Black concludes by observing that
We are living with a public policy for financial regulation that closely resembles a ratchet. With rare exceptions immediately following fraud epidemics that become scandals, regulatory policy only moves in one direction further loosening restrictions. 
The more crises these failed anti-regulatory policies create, the looser the regulations become and the more severe the crises become. We are destroying our economy and other nations, particularly in Europe, are following our lead with equally self-destructive results. 
We have trashed a regulatory system that was the envy of the world.
A regulatory system that had and was intended to have as its foundation transparency.

Monday, March 26, 2012

Equity derivative sales: 'it is all about counter-party risk and transparency'

The Guardian published an interview with a senior equity derivatives salesman.  He summarized the business as follows:

"In equity derivatives, there is flow trading in very standardised contracts, and there are the more complex structured products. 
"In flow, you are making money from commissions on the trades you make for clients. 
Right now it's very hard to make any money in flow trading, let alone rip clients off.  As I said, the contracts for equity derivatives are completely standardised and transparent, publicly traded on the exchange. 
Please note that it is hard to rip clients off with a standardized, transparent financial product.
Clients can get the product from 10, 15 market makers at a bank or brokerage firm, so they play us off against each other. 
"There are some really big hedge funds out there, and in the current market, they can get very good prices. 
"As for the more complex, structured products … There is now an incredible legal and compliance framework you have to work through. 
Clients got severely burnt in the sub-prime crisis and with the Lehman default, when their complex structured products blew up in their faces. 
So right now, the less complicated a product is, the more their appetite. It's all about counter party risk and transparency.
Please note that the buyers are on strike and not buying opaque, complex structured products.  What they are willing to buy has to be transparent.

Bill Black: The insanity of regulators' race to the bottom

Regular readers know that your humble blogger likes to provide other perspectives on why ultra transparency is needed to shine light into all the opaque corners of the financial system.

A post by Bill Black that appeared on Naked Capitalism looks at what happens when the regulators engaged in an insane race to the bottom.

Mr. Black uses as his example the JOBS Act - an Act that will repeal most of the 1930s disclosure regulations for firms with less than $1 billion in revenue.
The JOBS Act is insane on many levels.  
It creates an extraordinarily criminogenic environment in which securities fraud will become even more out of control.   
One of the forms of insanity is the belief that one can “win” a regulatory “race to the bottom.”  The only winning move is not to play in a regulatory race to the bottom.  
The primary rationale for the JOBS Act is the claim that we must win a regulatory race to the bottom with the City of London by adopting even weaker protections for investors from securities fraud than does the United Kingdom (UK). 
The second form of insanity is that the JOBS Act is being adopted without any consideration of the findings of the Financial Crisis Inquiry Commission (FCIC), the national commission to investigate the causes of the current crisis.  I am not aware of any proponent or opponent of the JOBS Act (other than me) who has cited the findings of FCIC.  Everyone involved has ignored the detailed finding of a huge investigative effort.  
The FCIC report explained repeatedly how the three “de’s” (deregulation, desupervision, and de facto decriminalization) had produced the criminogenic environment that drove the financial crisis.  
The FCIC report specifically condemned the “regulatory arbitrage” that the worst actors exploited by choosing to be (not very) regulated by the “winners” of the regulatory race to the bottom.  The FCIC report shows repeatedly how damaging the anti-regulatory fervor in general and the race to the bottom in particular proved....

The tenth form of insanity is that the JOBS Act’s primary theme is dramatically reducing transparency in securities law.  
If there is any nearly universal principle that writers about the ongoing global crisis emphasized that we needed to learn it was the exceptional virtue of transparency.  
Greater transparency makes private market discipline possible, it greatly enhances regulatory effectiveness, it discourages fraud, and it aids investors in making decisions.  
The JOBS Act repeatedly embraces opaqueness.  
We have known for millennia that this increases fraud. 
For every one that doeth evil hateth the light, neither cometh to the light, lest his deeds should be reproved.   John 3:20 – 1769 Oxford King James Bible ‘Authorized Version

Sunday, March 25, 2012

Shunning a proven tool, Sir Mervyn King says new financial stability tools are 'an experiment'

A Telegraph article reports how the head of the Bank of England, Sir Mervyn King, describes the tools chosen by the Financial Policy Committee to promote financial stability as 'an experiment".  Specifically,
the central bank knows "absolutely nothing" about how the policy instruments its new watchdog, [the Financial Policy Committee], has asked for to combat systemic financial risks will work in practice, and that it will need to win a battle of hearts and minds when it starts using them.
And what exactly are the unproven tools that have been asked for to prevent another financial crisis?
The FPC is seeking from parliament the power to ensure banks have countercyclical capital buffers, the ability to force banks to hold more capital against exposure to specific sectors judged risky and the power to set leverage ratios.
Of these tools he observes,
"One thing I want to stress is that this is an experiment. It really is an experiment," he said of the policy instruments at a conference in Washington on Saturday. 
"We know absolutely nothing about how these instruments are going to work. It is very important that we play it safe and be cautious."
If he is worried about playing it safe and this is a concern that all of us share, then why did the Financial Policy Committee not chose to have "Direction over disclosure requirements"?

As regular readers of this blog know, for the last 70+ years the dividing line between financial stability and instability has been disclosure.

  • Those areas of the financial system which are characterized by disclosure (where market participants have access to all the useful, relevant information in an appropriate, timely manner)  have been stable even in the presence of instability in other parts of the financial system for the last 70+ years.
  • Those areas of the global financial system which are characterized by opacity (where market participants do not have access to all the useful, relevant information in an appropriate, timely manner) have been prone to instability.  
In fact, the current financial crisis occurred and is still occurring in those areas characterized by opacity like banking and structured finance.

The reason that the Financial Policy Committee elected to gamble with financial stability and not have "Direction over disclosure requirements" was laid out in its statement from its March 16, 2012 meeting.
In principle, powers to require financial institutions to publish consistent information in a timely manner about their activities could be a powerful tool in fostering awareness of risks in the financial system and allowing market participants to take appropriate mitigating actions, thus enhancing market discipline.  
In reality, requiring financial institutions to provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details will allow market participants to independently assess the risk of each bank and to take appropriate actions with regards to the amount and pricing of their exposure to each bank.

This would bring market discipline to the banking system for the first time since the introduction of deposit insurance in the 1930s.
Disclosure issues had accounted for a significant part of the Committee’s deliberations over the past year and the Committee was engaged through several channels in promoting transparency to enhance financial stability.   
But the Committee recognised that a general power to set disclosure requirements may not meet the test set by HM Treasury that powers of Direction should be specific.   
The Committee agreed that, at some point in the future, it might need to be able to compel specific disclosure to mitigate systemic risk. 
So a key question was whether HM Treasury might be prepared in this particular area to ask Parliament to grant the FPC a broad power of Direction over disclosure, within any appropriate constraints, without knowing what specific future disclosure the FPC would judge necessary to tackle systemic risks.
In short, the FPC has no intent of using the authority to compel disclosure until after the next financial crisis.

However, the whole point of disclosure is that it prevents the next financial crisis from occurring in the first place because, as the FPC observed, it fosters awareness of the risks in the financial system and allows market participants to take appropriate mitigating actions.

Please re-read the highlighted text because by not asking for and then using authority to compel disclosure the FPC is gambling with financial stability.

If the FPC had disclosure authority, it would be expected to use it.  This expectation of use would raise the question of what is all the useful, relevant information that needs to be made available in an appropriate, timely manner for banks and structured finance securities.

As this blog has said many times, the answer to this question is ultra transparency.

Returning to the Telegraph article,
Like other central banks, the Bank of England is grappling with how to spot potentially systemic risks to the financial system and wider economy even as other indicators of health, such as inflation, are under control.
Actually, your humble blogger is less interested in whether central banks can spot potential systemic risks than in putting into place disclosure which has proven successful over the last 70+ years in helping market participants avoid these risks and the related financial instability these risk cause in the first place.

Sir Mervyn said that the FPC narrowed its choice of instruments to three because it will be important to explain to parliament and the wider public why it is or isn't using them. 
"If we are to maintain the ability to act independently and make unpopular decisions, it will be pretty crucial to explain what we are doing and why," said Sir Mervyn. "Setting realistic expectations of what can be achieved is an important ingredient."
If the FPC had the authority to compel disclosure, but did not use it, when the next financial crisis emerged from an opaque corner of the financial system, it would be very difficult to explain to parliament and the wider public why the FPC did not compel disclosure.

Not having the authority to compel disclosure provides two benefits to the FPC
  • It allows the FPC's to gamble with financial stability.  If it identifies and heads off a source of financial instability, it is a hero.  
  • If not, it also preserves the FPC's ability to say that the next financial crisis isn't its fault because it emerged from an opaque corner of the financial system.
This head the FPC wins, tails the taxpayer loses is simply a variation of what the banks also do under the cover of opacity.

Committee to Save the World and its successors instead destroying Western capitalism

Bloomberg published a long article on the Committee to Save the World, its successors and the negative impact they have had on Western capitalism.

Before looking at the article, it is useful to remind oneself that the way the successors got to be successors was by actively supporting and not arguing against the efforts of the Committee to Save the World.
In 1999, Alan GreenspanRobert Rubin and Lawrence Summers were celebrated as “The Committee to Save the World” on the cover of Time magazine. Today, their successors are still picking up the pieces. 
The three were hailed as the brightest economic minds of their generation, whose free-market solutions quelled the Asian financial crisis while generating economic growth of almost 5 percent in the U.S. 
Yet their model of unfettered capitalism eventually invited disaster. 
The trio’s deregulatory approach encouraged banks to take risks that later threatened the U.S. financial system....
Actually, the trio's deregulatory approach allowed what Ferdinand Pecora, who led the Senate committee that investigated Wall Street after the 1929 Crash, called "legal chicanery and pitch darkness" to re-emerge as "Wall Street's stoutest allies."
“The ’90s were a time of triumphalism in Washington economic circles and in the American economics profession in general. Certainly Greenspan and Rubin and Summers didn’t help to combat that.”...
In fact, they championed the idea that market discipline was superior to regulatory discipline and therefore that the regulatory infrastructure set up in the 1930s should be eliminated.

The only problem with this idea is that market discipline is only superior to regulatory discipline when there is ultra transparency.  Ultra transparency is the necessary condition for market discipline.

Without ultra transparency, market participants do not have all the useful, relevant information they need in an appropriate, timely manner.  As a result, they cannot properly assess risk and enforce the appropriate level of market discipline.
The “committee’s” successors, including Treasury Secretary Timothy F. Geithner and Federal Reserve Chairman Ben S. Bernanke, are trying to rein in the risk that was allowed to build under their predecessors as they write rules under the Dodd-Frank Act of 2010, the most sweeping overhaul of the financial system since the 1930s. 
“If these protections had been in place, then we would not have faced the risk of this severe a crisis with this much basic damage,” Geithner, 50, said at a Feb. 2 news conference to discuss the law. The U.S. had “allowed a very large amount of risk to build up outside the formal banking system without the safeguards we put in place after the Great Depression.”...
The primary safeguard that was put in place in the 1930s was ultra transparency.

Had the SEC insisted that structured finance securities provide disclosure on an observable event basis for the underlying collateral, market participants would have been able to assess the risk of these securities and far less would have been sold.

Had the SEC insisted that banks provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details, far fewer derivative securities would have been sold as market participants would have seen the risk of these securities and exerted market discipline on the banks.
Greenspan, Rubin and Summers also advocated repeal in 1999 of Glass-Steagall, the Depression-era law separating deposit- taking institutions from investment banking. The blurring of lines accelerated the growth of risky activities that often took place in the so-called shadow-banking system, outside the reach of bank supervisors.... 
Greenspan, in an interview, said blaming the crisis on lack of derivatives regulation and the repeal of Glass-Steagall amounts to a “rewriting of history.”...
This is one of the few times your humble blogger agrees with Mr. Greenspan.

A major cause of this crisis was the failure by regulators to ensure that ultra transparency existed throughout the financial system.  Instead, under the inspired leadership of Greenspan, Rubin and Summers, financial institutions were allowed to benefit from opacity both with regards to their own disclosure and the innovative financial products they created.
“All the problems which are being attributed to the lack of bank regulation could have been contained by higher levels of capital,” Greenspan said. “You can’t forecast which products are going to fail or become toxic. You can, however, let banks do what they want to do over a broad range of activities, but require that they have enough capital to thwart default and contagion.”...
Actually, you can forecast which products are going to fail or become toxic.  In the 1920s, we learned that these products are all characterized by opacity and a lack of ultra transparency.

As for higher levels of capital, if it is never used to absorb losses, then higher levels of capital are of no value.

Given that Mr. Greenspan feels that capital is there to thwart default and contagion, he must subscribe to the Swedish model and requiring banks to absorb the losses on all the excesses in the financial system today.
The three “were a lot too optimistic about the capacity of the financial markets to stabilize themselves and absorb shocks,” Robert Solow, winner of the 1987 Nobel prize for economics, said in an interview.

Still, he said, it’s “wrong just to blame three individuals who were prominent and overconfident.” If Greenspan, Rubin and Summers had “taken action about leverage, including in the shadow-banking system, there would have been an enormous outcry and they’d have been vilified from the other side.”...
All that was needed was enforcement of the ultra transparency requirement.

With this information, market participants could have protected themselves.
Summers, asked after a Feb. 13 speech in Calgary whether regulators missed a chance to take action on derivatives that could have prevented part of the financial crisis, said “there’s no question that it would be better if the kinds of regulation that have now been put in place to ensure much greater transparency, much greater transparency on runs, much more reliance on exchanges, had been put in place earlier.”
“Just how much different the path would have been would depend on a large number of details,” he said. “It’s very hard to judge. It’s clear that we’ve learned a lot about the dangers of unregulated markets.”
Yes we have, however, based on Dodd-Frank and the resulting regulations, it is not at all clear that anything has been learned about the need for ultra transparency.

For example, Congress is passing the JOBS bill which repeals 1930s era disclosure requirements for firms with less than $1 billion in revenue.
Both the financial industry and regulators should have done more to curb the excesses, Donald Kohn, who spent 40 years with the Federal Reserve, including as vice chairman from 2006 to 2010, said in an interview. 
“First and foremost, the private sector didn’t assess the assets it was buying very well, didn’t look under the hood very hard,” he said.
That the private sector didn't assess the assets it was buying very well was and still is a function of the lack of ultra transparency.

As Mr. Kohn knows well, disclosure by banks leaves them resembling what the Bank of England's Andrew Haldane calls 'black boxes'.
“And the cops weren’t on the beat. Regulators saw some problems coming, but not all of them. I wish we had done more on the mortgage side, but especially on the financial- intermediary side. The private sector didn’t do enough and we didn’t override them.”...
Under the FDR Framework, the role of the regulators is to ensure that there is ultra transparency and market participants have access to all the useful, relevant information in an appropriate, timely manner.

In fact, the regulators have been a barrier to providing market participants with ultra transparency.  Simply put, the financial regulators have protected their monopoly on this information (remember, the bank examiners have access 24/7/365).

Saturday, March 24, 2012

Jean-Claude Trichet: radical central bank action should not disguise crisis

In a Telegraph article, Jean-Claude Trichet, the former head of the ECB, expressed his opinion that while radical central bank action has been justified it should not disguise the fact that the global economy has yet to emerge from a multi-year crisis.

No one should think that "because of the forthcomingness (of central banks), there is no crisis," Jean Claude Trichet told a conference in Washington on Saturday. That should be a "collective, collegial message from the central banks." 
"No one would have expected that such a long time after Lehman we would still have the scale of expansion in our balance sheets."
Actually, your humble blogger did think that central bank actions would continue.  I even said so prior to Lehman.

The way I phrased it was that until we had disclosure (ultra transparency) and could value structured finance securities (and other opaque parts of the financial system including banks) we were in a downward spiral with no logical stopping point.
However, the French banker who stepped down after eight years at the helm of the ECB in October, said that the move by his Italian successor, Mario Draghi to offer European banks cheap, three-year loans was "fully justified." 
Mr Draghi began offering the loans in December amid fears that one of the Continent's financial institutions would collapse as their sources of private funding dried up.
And of course the reason for fear of a collapse in a financial institution's access to sources of private funding is opacity.  Just as your humble blogger predicted.

The reason that access to private sources of funding dries up is that the private sources of funding cannot evaluate the risk of an investment in the financial institution and the likelihood they will be repaid.

If financial institutions had to provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details, market participants would be able to assess the risk of these firms.  Market participants would then adjust the price and amount of their exposure to these firms based on their on-going risk assessments.

As the risk of the financial institution increases, the price of the market participant's exposures would go up and the amount of their exposures would go down.

While bank management might not like the high price they have to pay to attract funds, so long as market participants can assess the risk of the bank, funding should be available.