Structured finance investors: current proposed disclosure standards inadequate

A 2012 Q4 survey of investors in asset-backed securities, mortgage-backed securities and structured credit securities by Principia reveals that 59% of these investors think that the proposed loan level disclosure standards will not be sufficient to adequately perform due diligence.

We asked investors whether the current standards for disclosure of loan level data, for example via the European DataWarehouse, Project RESTART, EDGAR or the BoE and ECB templates, will provide sufficient data to adequately perform due diligence on ABS/MBS/CDO investments.... 

59% remain unsure as to whether the new market standards will be sufficient. This is a general finding across all asset classes...

Please re-read the highlighted text and as you are doing so ask yourself what percentage of portfolio managers would say that IBM's disclosures are sufficient to adequately perform due diligence (your humble blogger would expect 90+% as no one refers to IBM as a 'black box').

Regular readers are not surprised by this survey result.  It confirms what your humble blogger has been saying about the sell-side and its lobbyists like ASF, AFME (formerly ESF) derailing efforts to bring greater transparency to structured finance securities.

Regular readers know that there are two aspects to disclosure:  what is disclosed and when it is disclosed.

To date, the sell-side has managed to prevent adequate loan level disclosure standards by focusing the discussion on what is disclosed in the specific data fields in the templates proposed by ESF, Project Restart, EDGAR, the BoE and the ECB.

While very time consuming, this whole discussion of specific data fields to include in the templates ignores a simple relevant fact: the data fields that should be disclosed are all the data fields tracked by the loan originator and servicer that are not borrower privacy protected.

The originator and servicer are experts and as such every field that they track is a field that they feel is important for monitoring and valuing the individual loan.  These experts wouldn't track a data field they didn't think was important because it costs them money.

However, even if the disclosure templates were thrown away and all the data fields tracked by the originators and servicers were provided to investors, this would not be a big enough change in disclosure to get remotely close to 90+% thinking the disclosure was sufficient to adequately perform due diligence.

The simple fact is that investors recognize that 'when' data is disclose is a critical factor in determining if the disclosure is adequate for performing due diligence.

Structured finance securities are created by setting aside specific assets for the benefit of the investors.  The physical equivalent of this would be to put these assets in a bag.

'When' addresses the question of is the bag paper or plastic.

It is a brown paper bag if 'when' is the same reporting frequency as exists for opaque subprime mortgage-backed securities.  This is the frequency that has been adopted by the sell-side and shows up in the European Data Warehouse and Project Restart.

The bag is plastic if 'when' is observable event based reporting under which all activities like a payment or delinquency involving the underlying assets are reported to market participants before the beginning of the next business day.

It is only be adopting observable event based reporting with all the non-borrow privacy protected data fields tracked by the originators and servicers that 90+% of structured finance investors will think the disclosure was sufficient to adequately perform due diligence.

Other Interesting Observations

1) The investors have confessed that when it comes to buying ABS/MBS/CDO securities they are blindly gambling on the contents of a brown paper bag.

59% of investors are saying that the proposed standards are not sufficient to adequately perform due diligence.  If the proposed standards are not sufficient, what does that say about existing disclosure standards?

2) The proposed disclosure standards are unlikely to encourage former or new investors to buy ABS/MBS/CDO securities.

If 59% of existing investors see themselves as blindly gambling on the contents of a brown paper bag because of disclosure is not sufficient to adequately perform due diligence, why would former or new investors want to gamble too?

Bank accountants, 'going concern' statement and the need for ultra transparency

At the heart of every bank annual report is a statement by the auditor attesting to whether the bank is a going concern or not.

Like the suspension of mark-to-market accounting and the granting of regulatory forbearance to transform dud loans into zombie loans, the going concern statement has also been gamed by the financial regulators since the beginning of the financial crisis on August 9, 2007.

The financial regulators gamed the going concern attestation by promising to support the banks during the current crisis.

Clearly, the UK auditors are not comfortable making misrepresentations as they suspect that the UK government will not support the insolvent banks forever.  As a result, the UK auditors are pushing to offload the responsibility for making the going concern determination.

Regular readers know that the way to relieve the UK auditors of their discomfort 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 information, market participants can adjust the value of the bank's exposures and determine for themselves whether a) the bank is solvent or b) the bank has the ability to generate the necessary earnings to become solvent again.

With ultra transparency, the UK auditors can rely on the market's view of whether a bank is a going concern or not.

From a Financial Times article,

Struggling banks should not use vague promises of state aid to keep investors in the dark about their fragility, according to new UK guidance aimed at avoiding a repeat of the confusion experienced during the financial crisis. 

The Financial Reporting Council said on Wednesday that bank directors and auditors should not rely on generalised words of support from central bankers or the government when deciding whether the institution remained a going concern. 

“Directors and auditors are responsible for making their own judgments about the future solvency and viability of the bank,” it said. A “nod” or “wink” implying state support was not enough, added Marek Grabowski, FRC director of audit policy. 

The updated FRC guidance follows controversial secret talks between UK bank auditors and the government at the height of the crisis. 

Companies must declare in their accounts whether they view themselves as a going concern, meaning they have enough cash and access to funding to survive for at least a year. 

They must also tell investors if there is a material uncertainty about this status, although such a disclosure would probably be so catastrophic for a bank that regulators would intervene first. Auditors verify the going concern assertion.

Requiring the banks to provide ultra transparency ends the reliance on a wink and a nod from bank regulators.

Given that the bank regulators have all said that the banks are currently solvent, one of the findings of the stress tests, now is the perfect time to have them begin providing ultra transparency as there should be no chance of a catastrophic failure by a bank when its exposure details are disclosed.

Once ultra transparency is in place, the market votes every day on whether a bank is a going concern or not.

Before green-lighting their clients’ 2008 accounts, however, UK bank auditors asked the government for broad confirmation it would continue to prop up ailing financial institutions. 

Lord Myners, then City minister, responded by saying the government would take “whatever action is necessary to maintain financial stability, protect depositors and protect the taxpayer”. 

The implication that banks could be described as going concerns because of the expectation of sustained state backing was subsequently ridiculed as “Alice in Wonderland” logic during House of Lords hearings....

However, banks have in fact received sustained state backing since the beginning of the current financial crisis.

The FRC ... is trying to meet the needs of investors for candid information without undermining confidence in the banking system.

Ultra transparency both meets the needs of investors for candid information and improves confidence in the banking system.

Monte dei Paschi scandal is all about lack of transparency

In summarizing the Monte dei Paschi derivatives scandal, Reuters highlights how the lack of transparency at the bank led directly to a lack of oversight either by the bank's senior management, its board or its financial regulators.

The lack of transparency contributed to this scandal at many levels.

The secret document at the heart of the Monte dei Paschi banking scandal lay for months in a concealed safe in a 14th century Tuscan palace....

Lack of transparency resulted in a secret derivative contract.  By definition, the counter-party to the contract knew of the document.

As I discussed in an earlier post, when all banks are required to provide ultra transparency and report on an ongoing basis their current global asset, liability and off-balance sheet exposure details, a simple cross-check of exposures would have identified the existence of this contract.

Nomura and Deutsche Bank would have wanted to do this cross-check because they would have wanted to receive the benefit of the derivative contract.  If the other side doesn't acknowledge a deal, how do you enforce it?

The document found at the 540-year-old bank's head offices - which are appropriately in a restored ancient fortress - was a contract mandating Japanese bank Nomura to carry out deals on behalf of Monte dei Paschi.

How could Nomura carry out deals on the bank's behalf without anyone at the bank being aware of it?

It revealed that, unbeknown to the new management under Viola, two derivatives transactions known as "Alexandria" which had looked separate were in fact linked. This meant they should have received different accounting treatment, leading to heavy losses. 

This discovery prompted an internal inquiry that has, so far, revealed losses of up to 720 million euros ($977 million)....

What do these derivative contracts say and how much more could Monte dei Paschi lose?

The Bank of Italy is also under fire, with critics accusing it of lax oversight and lack of transparency about suspected financial irregularities at the Tuscan lender....

How is it that the Bank of Italy didn't notify the board and senior management of Monte dei Paschi and tell them to suspend all trading until the financial irregularities were fixed?

Whether the contract was deliberately hidden or simply forgotten, Monte dei Paschi's former top management seems to have had little idea of what traders in the finance department that negotiated such risky deals were doing - despite repeated complaints from internal auditors, according to senior sources with knowledge of the situation and documents seen by Reuters. 

Three years before the document was uncovered, Monte dei Paschi's own risk control unit and its audit committee had already expressed serious concerns to Vigni about the way the bank's finance department handled risky trades. 

Internal documents obtained by Reuters show an audit of the department in August and September 2009 had uncovered a "systematic overshooting of risk limits" in the management of the group's 24-billion euro proprietary portfolio. 

Proprietary trading involves a bank taking trading positions in securities such as stocks or bonds to make profits for itself, rather than trading on behalf of a customer. 

Close examination of the documents, which included letters addressed to Vigni outlining the internal auditors' misgivings, suggest that the finance department operated like a bank within a bank, entering into derivative trades and hedging bets that went wrong with little scrutiny from Vigni or then Chairman Giuseppe Mussari....

ex-finance department chief Gian Luca Baldassarri and his team were viewed as the real bosses inside the bank, with a weak understanding of markets among the top management allowing them to engage freely in opaque financial deals....

As we know, by definition derivatives are opaque.  

"The risk management unit constantly raised alarm bells," said a senior source with direct knowledge of the situation. "However, these were very powerful people."...

And what did the financial regulators do when the risk management unit raised alarm bells?

Baldassarri - who worked at the bank between 2001 and 2012 - and another Monte dei Paschi manager in London are referred to as "the five percent gang", according to a judicial document seen by Reuters. 

This document contains minutes of a 2008 interrogation conducted by a Milan magistrate of a former Dresdner Bank employee, Antonio Rizzo, as part of a separate Milan inquiry. 

The "five percent" label refers to a fixed fee that, according to Rizzo, the duo would ask for themselves for every financial transaction they managed to push through....

The former mid-level manager said Monte dei Paschi's top brass didn't grasp what the finance department was doing from its offices overlooking the Renaissance buildings of Siena. "They could do what they wanted because no one really understood what they were doing, neither Mussari nor Vigni," the official said....

Please recall that had the bank been required to provide ultra transparency, the lack of understanding by senior management would not have been so problematic.  Market participants would have pointed out the problem and exerted discipline to fix the situation.

Prosecutors are now also investigating "Alexandria", the complex 2009 structured transaction with Nomura, and two other deals - the 2008 "Santorini" trade with Deutsche Bank and the 2006 "Nota Italia" trade with JP Morgan. 

Deutsche has said its deal had been approved by Monte dei Paschi. JP Morgan declined comment. 

The documents obtained by Reuters do not refer specifically to the three derivative trades, which are alleged to have been used to conceal losses at Monte dei Paschi....

When banks are required to provide ultra transparency, they cannot conceal losses.

In addition to the internal audit committee and the risk management department, some board members also criticised the type and size of investments carried out by the finance department and the lack of accountability, sources said. 

In 2011, two board members - Francesco Gaetano Caltagirone and Axa representative Frederic Marie de Courtois d'Arcollieres - raised questions about what they said was an excessive exposure to Italian government bonds, according to a source close to the matter.... 

Monte dei Paschi's 25-billion euro Italian government bond portfolio made a net return of just 65 million euros in the first nine months of 2012 because of a fall in benchmark European interest rates. 

It would have made around 1 billion euros a year had the bank not carried out interest rate swaps in 2009 that moved almost the entire portfolio to floating rates, which fluctuate in line with the market, from fixed rates....

And who was the counter-party who receives the benefit of the fixed rate payments?  Is this deal part of the effort to conceal the losses?

"As in all banks there was a structure that could take risks and another one that was supposed to monitor that. As far as I know the Bank of Italy was aware of this model, and asked for changes. Probably this model was inadequate."

And who monitors that the bank is properly monitoring its risk?  With ultra transparency, it is the market.

A November 9, 2010 Bank of Italy report, also seen by Reuters, showed how inspectors from the central bank had raised concerns about risky derivatives trades after they visited the bank from May to August 2010. 

The inspectors specifically raised the deals with Nomura and Deutsche, which are now at the heart of the scandal.

The Bank of Italy - led until 2011 by Mario Draghi who is now the European Central Bank Chief - has said it realised the "true nature" of the contracts late last year, after Monte dei Paschi's new management discovered the document in the safe.

This highlights how the regulators' information monopoly makes the financial system unstable.  Clearly, the regulators did not realize the 'true nature' of the contracts.  The result is a bank scandal.

Had the bank been required to provide ultra transparency, market participants, including derivative experts, would have seen these deals and understood their 'true nature'.  

Lessons from Icesave: who is a depositor and who is an investor

The Guardian ran an editorial on Iceland prevailing in its interpretation of how deposit insurance is suppose to work.

the decision in favour of Iceland has thrown a far more troublesome spotlight on the legal relationship between all European states and the guarantees purportedly offered by their banks to retail depositors. 

Troublesome, or has the ruling highlighted the critical distinction between depositor and investor?

The Icesave ruling effectively defines a depositor as an individual or company from the host country and everyone else is effectively defined as an investor.

This distinction is logical because a deposit guarantee is really between the government and its citizens.

Can this deposit guarantee be expanded beyond a country's citizens?

Yes.  For example, if the country is a member of the EU.  In this case, the deposit guarantee is extended to the citizens of the EU member countries.  However, it is not extended to citizens outside of the EU.

Why are citizens outside of the EU treated differently?

Because they are really investors.  These citizens are making an investment choice.  They could deposit their funds with a bank in their country and receive a lower return or deposit their funds with a foreign bank and receive a higher return.

What advice would George Osborne today offer ordinary retail savers thinking of placing their savings with an online account offered by a bank based in a financially weak European member state? 

The advice should be that the retail saver should think of themselves as an investor.

The question they have to ask is does the higher interest income earned on the account adequately compensate them for the risk of not being repaid if the bank becomes insolvent.

And what sanction might a financially stretched government face if its desperate banks went chasing foreign deposits, knowing the accompanying guarantees were flimsy?

The lesson from the Icesave case is that foreign depositors must think of themselves as investors.  As an investor, they are responsible for all losses on their investments.  As a result, the need to ask the question of "will the deposit guarantee actually cover my deposits".

If it is a bank in an EU member country and the investor is from an EU member country, the answer is the deposit guarantee covers their deposits.

If it is a bank in a small, financially stretched, non-EU member country, the answer is the deposit guarantee does not cover their deposits.  This is a reasonable conclusion from a practical standpoint even if the deposit guarantee in theory did cover their deposit as there is no reason to believe that a small, financially stretched country could make good on the guarantee anyway.

How to put the Too Big to Fail genie back in the bottle

To date, the two primary methods discussed for putting the Too Big to Fail genie back in the bottle are to either break them up by regulatory fiat or subject them to a super-sized dose of the combination of complex rules and regulatory oversight.

There is a third way:  subject them to market discipline and let them shrink themselves as a result.

Subjecting the TBTF to market discipline requires adopting the FDR Framework as it applies to banks.

• First, the global financial institutions must provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

• Second, any remaining financial crisis programs like regulatory forbearance and suspension of mark-to-market accounting need to be ended.

With ultra transparency, market participants are given access to all the useful, relevant information in an appropriate, timely manner for independently assessing and making a fully informed decision.

With the ending of the financial crisis programs, market participants are reminded that going forward they are responsible for all losses that are incurred on their exposures to the TBTF.

Knowing that they are responsible for losses on their exposures to the the TBTF, market participants will assess the risks that the TBTF are taking and adjust the return they require on their exposures to the TBTF to reflect this risk.

Sources of risk that will drive up the return investors require include complexity (think all those subsidiaries engaged in regulatory or tax arbitrage), proprietary trading (gambling is risky business) and interconnectedness with other financial institutions (no investor wants to lose their money because a dumb competitor blows up).

Faced with a much higher cost of capital and lower share price, management of the TBTF will be under pressure (i.e., market discipline) to reduce the risk and complexity of their institutions.

How they reduce the risk and complexity is their choice.  The point is the result will be a much lower risk and less complex financial institution that, while it is unlikely to fail, could in theory fail without bringing down the financial system.

Italian bank derivative scandal ongoing reminder why banks should provide ultra transparency

As more information comes out about Monte Paschi's derivative scandal, the more the scandal confirms that banks must be required to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

Why?

Because bank regulators cannot be relied on to a) properly assess the risk of each bank, b) accurately communicate this risk to market participants and now c) effectively follow-up when banks engage in accounting irregularities.

As a result, market participants need the banks to provide ultra transparency so a) market participants can independently assess the risk of each bank and b) exert market discipline on the banks so that their accounting statements reflect the true financial condition of the bank.

From a Bloomberg article, we learn that even though it regulated Monte Paschi, the Bank of Italy did not think that it was responsible for 'policing' the bank even after it uncovered a previously unreported derivative transaction.

To say this is troubling is an understatement.

The Bank of Italy under former Governor Mario Draghi spotted accounting irregularities that allowed Banca Monte dei Paschi di Siena SpA to mask losses more than two years before the lender was forced to say it will have to restate profit. 

In 2010, “a problem came to light” on Monte Paschi’s booking of a structured deal called Santorini, Italy’s Rome- based central bank said in a report dated Jan. 28. 

The Bank of Italy alerted “other authorities” a year later and talks with those regulators, which it didn’t identify, haven’t concluded. It didn’t explain the delay in forcing the bank to disclose the information. 

The Bank of Italy’s account of Monte Paschi’s use of derivatives, released yesterday, calls into question its oversight of the world’s oldest bank, which is seeking the second taxpayer bailout in four years....  

“I would have expected the Bank of Italy to have requested transparency from Monte Paschi back in 2010 after reviewing the transactions,” said Carlo Alberto Carnevale-Maffe, professor of business strategy at Milan’s Bocconi University. “Hidden documents found recently wouldn’t have changed the substance of the original findings.”

Had all banks been required to provide ultra transparency, Monte Paschi wouldn't have "hidden documents" in the first place.

But assuming that Monte Paschi did not want to disclose the derivative deals, market participants, including regulators, could still have found out about these deals by looking at the disclosures made under ultra transparency by Monte Paschi's counter-parties.

With ultra transparency, the ability to look at the counter-parties' exposure details is a simple check and balance on each bank's disclosure of its exposure details.  This simple check and balance improves the reliability of each bank's financial statements.

The Bank of Italy said that as early as 2010 it sought daily liquidity reports from the lender as margin calls on Santorini drained funds. 

The regulator said a week ago Monte Paschi hid documents, impeding its analysis of the “true nature” of the company’s dealings. 

Regulatory oversight of Monte Paschi was “continuous and thorough” and the bank remains solid even with a capital shortfall and possible losses linked to structured deals, Finance Minister Vittorio Grilli said in parliament yesterday....

The highlighted text is a simple restatement of why market participants cannot rely on regulators to a) properly assess the risk of a bank and b) accurately communicate this risk.

Santorini helped Monte Paschi obscure a 367 million-euro loss from an older derivative contract with Deutsche Bank, according to more than 70 pages of documents outlining the deal and obtained by Bloomberg News. As part of the arrangement, the Italian lender made a losing bet on the value of the country’s government bonds. 

The bank’s new management is still trying to determine the extent to which Santorini and two other derivative deals were used to distort earnings. Monte Paschi never disclosed the effect of the 2008 deal in its annual reports. 

The bond bet was among transactions that drew the Bank of Italy’s scrutiny as early as 2009 as repo operations were “resulting in the absorption of high liquidity margins,” the regulator said in its Jan. 28 report....

The highlighted text shows why, in the absence of ultra transparency, bank financial statements cannot be relied on as they contain a) distortions in valuations that are done with regulatory approval such as suspension of mark-to-market accounting and creation of 'zombie loans' under regulatory forbearance and b) distortions in valuations by the banks themselves including not reporting the impact of derivative exposures or as shown by JP Morgan's Whale trade, understating losses.

Monte Paschi told the Bank of Italy in 2011 the structured deals were part of its “carry trade” strategies and weren’t submitted to its administrative body.... 

Italy’s third-largest bank and prosecutors are now reviewing three money-losing derivative deals, Santorini, Alexandria and Nota Italia. 

The lender said it discovered in October that former managers signed a “mandate agreement” with Nomura Holdings Inc. (8604) to cover losses on a mortgage-backed derivative called Alexandria with new, riskier derivatives. 

The hidden document, proving the link between the unprofitable Alexandria derivative with the new one, should have led the bank to book a loss of more than 200 million euros on the original transaction, instead of spreading it over the 30- year maturity of the new deal....

The Bank of Italy’s role isn’t to “police” Monte Paschi, the current governor, Ignazio Visco, 63, said Jan. 25 in an interview with Bloomberg Television in Davos, Switzerland. 

The Bank of Italy “summoned the senior management of Monte Paschi” and of the foundation that is its biggest shareholder in November 2011 “to make them face up to their responsibilities and ask Paschi to quickly and definitively turn around the way it conducts its business,” the report said.

The role of policing the banks actually belongs to the market.  However, market participants cannot police the banks so long as the financial regulators have a monopoly on all the useful, relevant information in an appropriate, timely manner.

By ending the regulators' information monopoly and requiring the banks to provide ultra transparency, market participants have access to the information they need to actually police the banks.

Monte Paschi risks further losses of as much as 500 million euros on a 2010 securitization of about 1.5 billion euros of real estate loans, dubbed “Chianti Classico,” weekly Panorama said today, citing documents that include minutes of board meetings from November and December of last year. ... 

“New derivative accounting policies are needed in Europe to avoid similar situations in the future,” said Giuseppe Di Taranto, professor of financial history at Rome’s Luiss University. “There’s too much room for interpretation under current rules.”

The new derivative accounting policy is that banks must disclose all of their derivative exposures.

SEC Commissioner Troy Paredes: Sophisticated investors better at valuing contents of brown paper bag

In an astonishing report by Securitization Intelligence, in his keynote address at the ASF 2013 conference, SEC Commissioner Troy Paredes offered

his views on Regulation AB II’s requirement that private 144a offerings include elements of disclosure usually limited to publicly registered transactions, saying that he has previously expressed concern “that we were going too far in treating the private market just like the public market, and that, as a consequence of that, we may compromise the value that the private market brings to bear.” 

He added that the thought that the relative lack of legal protections for investors in the private-label market makes such disclosure requirements important is obviated in part by the sophistication of the investors in the space. 

“I remain unpersuaded that the fundamental reason that the securitization market has been struggling in the last few years is because we don’t have a piling on of regulatory demands,” he said. 

“That’s not to say there is not some room for improvement” in disclosure enhancements, but that the SEC could “end up undercutting the objective of trying to move the ball forward when it comes to the securitization market being conditioned to take off again.” 

To which Deutsch replied, on behalf of attendees who received less resolute answers from some regulatory panelists yesterday, “Hallelujah, brother.” [confirming that ASF is a sell-side dominated group and doesn't represent the buy-side's interests.]

As long as Commissioner Paredes brought up the issue, I thought I might describe exactly what disclosure requirements are needed for both publicly registered and private 144a offerings.

From my post, Turning lemon mortgage-backed securities into lemonade

Disclosure has two components:  what is disclosed and when it is disclosed.  I would like to focus on “when” it is disclosed. 

Everyone knows that structured finance securities involve taking specific assets, like mortgages, and setting them aside for the benefit of the investor.  The physical equivalent of this would be to put them into a bag.

Once the mortgages are in the bag, it is important to know what is in the bag currently. 

 Why? 

If an investor does not know what is in the bag currently, they cannot take the first step in the investment cycle.  

The first step is to independently assess the risk and value the underlying collateral so the investor can know what the investor is buying and, after buying, know what they own. 

The second step is to compare this independent assessment to the prices shown by Wall Street. 

The third and final step is to make a buy, hold or sell decision based on the difference between the investor’s independent valuation of the security and the price shown by Wall Street. 

Please note that without the ability to know what is in the bag currently, it is impossible to accurately assess what is going to come out of the bag eventually. The lack of knowing what is in the bag currently prevents investors from performing their own independent assessment and makes meaningless hiring an expert third party to do the assessment for them.  

Simply put, without current information of what is in the bag, investors cannot go through the investment cycle. 

Buying securities in the absence of an independent assessment is not investing.  Buying securities that cannot be independently assessed is the equivalent of blindly betting on the contents of a brown paper bag.  And, once the securities are purchased, the investor has no ability to know what they own. 

In case you doubt this, let me show it to you using a brown paper bag to hold the underlying collateral. 

On the first business day of last month, $100 went into the bag.  On the third business day of this month, a trustee report with granular level data was issued that showed the bag contained $75 at the end of the last month.  This was made up of 3 $20 bills and 3 $5 bills. 

So the question is:  what is in the bag currently? 

Based on the fact that $25 came out of the bag last month, there are a number of ways of guessing what is in the brown paper bag? First, we could guess that nothing has been taken out of the bag and it still holds $75. Or a $5 bill has been removed and left $70 in the bag.  Or a $20 bill has been removed and left $55 in the bag?  Or both a $5 bill and a $20 bill have been removed and left $50 in the bag? 

By simply asking what is in the brown paper bag currently, I have already created a $25 spread between the $75 a seller might reasonably value the contents of the brown paper bag at and the $50 a buyer might be willing to offer. 

Let me assure you that with this wide a spread, the contents of the brown paper bag are not going to sell. 

This valuation problem has been shown to be particularly acute for mortgage-backed securities since the beginning of the financial crisis.  At that time, buyers came to doubt the ability of the borrowers to make their future payments.  The more doubt, the more likely the market is to freeze as it is impossible to get buyers, who think that the bag is more likely to have $50, and sellers, who look at last month's performance and think the bag has $75, to agree on price. 

Another way we can approach asking what is currently in this brown paper bag is to use a sophisticated model.  We recognize that last month $25 came out of the bag.  This is roughly $0.85 per day.  So we can value the contents of the brown paper bag by multiplying the day of the month it is today by .85 and subtracting the resulting value from the end of the month value shown in the last trustee report. 

Today is the 6th, so the model suggests a value of $69.90 ($75 minus $5.10).  The price suggested by the model doesn't seem unreasonable if a $5 bill is removed from the bag. 

However, a buyer is significantly overpaying if there has been a sharper decline in the value of collateral in the bag and a $20 bill has been removed.  This is analogous to what happened with sub-prime mortgage-backed securities where there was a rapid decline in the value of the collateral. 

This problem of guessing what is in the bag would go away if we were talking about a clear plastic bag.  The investor would know what is in the bag currently as the contents of the bag can be seen and are a knowable fact. 

This is true whether the investor is Commissioner Paredes' sophisticated investor or not.

As a result, investors could independently assess the risk and value the collateral.  With this assessment, the investor “knows what they are buying” and "knows what they own". With this assessment, the investor can make an investment decision to buy, hold or sell based on the prices being shown by Wall Street. 

So turning the mortgage market from lemons to lemonade simply requires recognizing that it is a choice between “Paper or Plastic”.  With “Paper”, you get lemons.  With “Plastic”, you get lemonade. 

So how can each of the structured finance securities be put into the equivalent of a clear plastic bag? 

This can be easily done as the servicer information systems are designed to track and report on the underlying collateral on an observable event basis. 

With observable event based disclosure where all activities like a payment or delinquency involving the underlying collateral are reported before the beginning of the next business day, the investor knows what is in the bag currently. 

Observable event based disclosure is associated with a clear plastic bag.  All other frequencies of disclosure are associated with a brown paper bag and lemons.

Too Big to Jail: Senators Brown and Grassley ask the right questions

In the following letter (hat tip Neil Barofsky) to the Department of Justice, Senators Brown and Grassley look at the emergence of a group of banks that is too big to fail and want to explore how this threatens to undermine the ability to prosecute the individuals employed by these firms (think too big to jail).

The large number of private and government lawsuits since the global financial crisis continues to undermine public confidence in our financial markets.  This confidence can only be restored by demonstrating that there are consistent rules in place that provide accountability for wrongdoing and deter financial predators.

Unfortunately, many of the settlements between large financial institutions and the federal government involve penalties that are disproportionately low, both in relation to the profits which resulted from those wrongful actions as well as in relation to the costs imposed upon consumers, investors, and the market. 

The nature of these settlements has fostered concerns that “too big to fail” Wall Street banks enjoy a favored status, in statute and in enforcement policy.  This perception undermines the public’s confidence in our institutions and in the principal that the law is applied equally in all cases. 

On settling with Swiss Bank UBS for Libor manipulation, for example, you said, “[t]he impact on the stability of the financial markets around the world is something we take into consideration.  We reach out to experts outside of the Justice Department to talk about what are the consequences of actions that we might take, what would be the impact of those actions if we want to make particular prosecutive decisions or determinations with regard to a particular institution.”

In an interview with Frontline, outgoing Assistant Attorney General Lanny Breuer defended the Department of Justice’s inability to prosecute large financial institutions by saying, “but in any given case, I think I and prosecutors around the country, being responsible, should speak to regulators, should speak to experts, because if I bring a case against institution, and as a result of bringing that case, there’s some huge economic effect — if it creates a ripple effect so that suddenly, counterparties and other financial institutions or other companies that had nothing to do with this are affected badly — it’s a factor we need to know and understand.”

These statements raise important questions about the Justice Department’s prosecutorial philosophy.  In order to explore the Justice Department’s treatment of potential criminal activity by large financial institutions, please answer the following questions and provide the following information:

             1. Has the Justice Department designated certain institutions whose failure could jeopardize the stability of the financial markets and are thus, “too big to jail”?  If so, please name them.

             2. Has the Justice Department ever failed to bring a prosecution against an institution due to concern that their failure could jeopardize financial markets?

             3. Are there any entities the Justice Department has entered into settlements with, in which the amount of the settlement reflected a concern that markets could be impacted by such a settlement?  If so, for which entities?

             4. Please provide the names of all outside experts consulted by the Justice Department in making prosecutorial decisions regarding financial institutions with over $1 billion in assets.

             5. Please provide any compensation contracts for these individuals.

             6. How did DOJ ensure that these experts provided unconflicted and unbiased advice to DOJ?

Our markets will only function efficiently if participants believe that all laws will be enforced consistently, and that violators will be punished to the fullest extent of the law.  There should not be one set of rules that apply to Wall Street and another set for the rest of us. 

Mohamed El-Erian: Wall Street banks are still sicker than you think

In an article in the Atlantic, Pimco's Mohamed El-Erian claims the banks have largely recovered from the financial crisis and sees three issues that must be resolved before banks will be able to complete their recovery.

As analysts pour over the details of the recent earnings announcements by U.S banks, one thing is clear: The banking system has largely overcome a complex set of self-inflicted injuries.... 

Banks fueled the worst of the 2008 global financial crisis with a combination of three crippling, self-created problems: too little capital, too many doubtful assets and a risk-taking culture gone mad.... 

With exceptional public sector support from the Federal Reserve and other government agencies .... 

Meanwhile, popular anger remained high, fueled by what many considered as an overly lenient treatment by the U.S. Treasury and the Federal Reserve.  

And it sure did not help that some banks were inclined to quickly resume some highly controversial practices.

The recent set of earning announcements by banks point to significant progress in overcoming the three big problems. Capital cushions are now big and deep, asset quality has improved significantly, and internal incentives are being re-aligned. In addition, banks seem to have placed part, though not all, of their litigation risk behind them.

Given that the banks are 'black boxes', there is no way for Mr. El-Erian to prove his assertion that 'capital cushions are now big and deep, asset quality has improved significantly'. [With the suspension of mark-to-market accounting and adoption of regulatory forbearance, bank book capital and asset quality, think 'zombie loans', is overstated.]

What we do know is that the interbank lending market remains essentially frozen.  This is a market where banks with deposits to lend provide unsecured funding to banks looking to borrow.

The reason that the interbank lending market froze at the beginning of the financial crisis was that the banks with deposits to lend knew the banks looking to borrow were holding doubtful assets.  There was a real question about the solvency of the borrowing banks and their ability to repay the unsecured debt.

The only way to answer this question is to provide the banks with deposits to lend the necessary information for assessing a bank's solvency.

Nothing has happened since August 9, 2007 to provide this information and banks with deposits to lend continue not to lend.

Mr. El-Erian lays out his three big remaining issues

(1) Most important among these is the still-unresolved debate on whether and how to break up large banks that are "too big to fail," "too complex to fail, "too interconnected to fail" and"too big to manage." 

(2) Regardless of where they find themselves on the size issue, banks are yet to fully re-align their operating models with current-day realities.... 

(3) Because banks got off way too easily in 2009-2010 -- even escaping a windfall profit tax -- society remains suspicious of bankers and their motivations....

Do not under-estimate the importance of these three factors. 

Absent their timely and comprehensive resolution, the funding of the real economy will remain sub-optimal, liquidity in capital markets will continue to contract, and gains in financial soundness will come at the cost of significant efficiency losses.

Regular readers know that all three of Mr. El-Erian's issues can be easily solved by requiring the banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

Ultra transparency addresses "too big to fail", "too complex to fail", "too interconnected to fail" and "too big to manage" through the use of market discipline.  Specifically, once market participants have the information they need to assess the risk of each of these banks, each bank's cost of funds will move to reflect its risk.

Banks that are too complex, interconnected or un-manageable will pay a much higher cost to access funds than banks that are not complex, have limited their interconnections to what they can afford to lose and are manageable.

This higher cost of funds (and the related lower stock price) is the market's way of disciplining the banks.  Rather than pay this higher cost of funds, banks have an incentive to shrink.  This takes care of the too big to fail problem.

Ultra transparency also helps to align the banks' operating models with today's reality.  Specifically, it ends activities like manipulating benchmark interest rates (see Libor) and taking proprietary bets (disincentive to gamble because market can trade against positions so as to minimize their profitability).

Finally, ultra transparency addresses society's suspicion of bankers and brings with it a new cultural reality.  Market participants know that sunshine is the best disinfectant as bad behavior by the bankers is immediately exposed and can be effectively disciplined.

Pension experts: QE is a 'monumental' mistake

The Guardian reports that pension experts have gone before a Parliament committee and explained why the Bank of England's pursuit of quantitative easing (QE) has been a 'monumental' mistake and how the economy would recover if the BoE stopped pursuing all the related low interest rate policies.

Regular readers of this blog will be familiar with the arguments that the pension experts put forward on why QE should be abandoned as they were presented here first.

The Bank of England's policy of pumping money into the economy has been a "monumental mistake", pensions experts have warned . 

A committee of MPs heard that measures taken by the Bank to drive the economy had backfired by squeezing individuals' incomes – both pensioners and those in work – and forcing companies to divert cash into pension funds rather than investing.

I referred to these two economic headwinds as the retirement fund death spiral.  The trigger for the death spiral is the adoption of zero interest rate and related policies like QE.

Both individuals and companies move to offset the loss of earnings on their savings and reinforce the negative feedback loop.  Individuals do this by cutting back current consumption and saving more.  Companies offset the decline in earnings on pension funds by diverting cash rather than investing.

The actions by both individuals and companies reduce aggregate demand.  Since the BoE wants to boost aggregate demand, it pursues the low interest rate policies even more aggressively.  The result is a further drop in aggregate demand as both individuals and corporations move to offset the loss income.

That individuals change their spending and saving habits in the face of low interest rates has been known since the 1870s.  Walter Bagehot, the father of modern central banking, even stated that interest rates should never be less than 2%.

Ros Altmann, pensions expert and director general of Saga, said current policies devalued pensioners' incomes, making them less willing to spend: "Quantitative easing and ultra-low interest rates have hampered the spending power of those in the economy who were not over-indebted and who would otherwise have spent money." ...

Altmann said ending the QE programme was much more likely to herald a period of growth than its introduction had done. "History will judge this as a monumental mistake," she said. "If we do not have any more quantitative easing, the economy will be freer to grow than if we do."

Please re-read the highlighted text as Ros Altmann has nicely summarized what your humble blogger has been saying about why zero interest rate policies never work to boost demand and why abandoning these policies would actually produce the growth in the economy that central bankers want.

Under the QE programme, the Bank of England has bought £375bn of UK government bonds, or gilts, with newly created electronic money. It now owns almost a third of all gilts in the market. This huge influx of demand has driven gilt prices higher and means yields, or the effective interest rates on them – which represent government borrowing costs – are at record low levels. 

That has the unintended consequence of pummelling pension funds, which use gilt yields to calculate their future liabilities. When gilt yields plummet, pension fund deficits effectively balloon. 

The National Association of Pension Funds (NAPF) estimated last year that QE had increased pension deficits by at least £90bn over the past three years. 

Current regulations mean companies must plug those holes. Mark Hyde Harrison, the chairman of NAPF, said businesses are now having to contribute to their pension schemes instead of investing for the future, which negates any positive impact of QE....

Please re-read the highlighted text as Mr. Harrison has described the retirement fund death spiral triggered by zero interest rate policies.

QE has also reduced the incomes of recent retirees using their pension pot to buy an annuity, which sets the size of their income for life, as annuities are also linked to gilt yields. 

Altmann said monetary easing had acted like a "tax increase" on older people. She said the economy is in "unprecedented territory" and the gilt market had never been distorted in such a way. 

The Bank of England had not properly considered whether carrying out a policy which penalises certain sections of society is acceptable, because it has assumed that the path it has taken was the only option. 

QE is not creating growth and is hampering the spending of people who are not particularly burdened with debt because they are "worried about what's coming next," she said.

Please re-read the highlighted text as Ms. Altmann has made a very important point.  Specifically, the pursuit of zero interest rate policies including QE sends a message that undermines consumer confidence as these policies reflect the simple fact that central banks are still in crisis management mode.

SEC's Jesse Litvak case shows the value of opacity to Wall Street

In a must read post, ZeroHedge looks at the SEC's case against Jesse Litvak and his conduct in selling mortgage-backed securities.  What ZeroHedge reveals is just how much money Wall Street makes from  opacity.  Specifically, opacity as it applies to both the securities and trading in the Over the Counter (OTC) market.

Regular readers know that since before the financial crisis even began, your humble blogger has been trying to bring transparency to the opaque structured finance market.

My focus has been on bringing 'valuation' transparency as oppose to 'price' transparency as price transparency without valuation transparency is worthless.

The reason that valuation transparency is critically important is that it is valuation transparency that makes it possible for an investor to go through the three step investment process:

1. Independently assess all the useful, relevant information to assess the risk and value the security.  This independent assessment can be done by the investor or an expert third party (think fund manager or an expert hired by the fund manager) hired by the investor.
2. Find out what price Wall Street will buy or sell the security at.
3. Make a decision to buy, hold or sell the security based on the difference between the price shown by Wall Street and the independent valuation.  If a decision is made to buy, limit the purchase to what the investor can afford to lose given the assessment of the risk of the security.

It is under valuation transparency that an investor is provided with access to all the useful, relevant information in an appropriate, timely manner so that the independent assessment of this information can take place.

Without valuation transparency, it is impossible to complete step one of the investment process.

If a buyer or seller of a security cannot complete step one of the investment process, they are reduced to gambling when they buy, hold or sell a security.  Specifically, the buyer or seller is gambling that the price shown by Wall Street reflects the fair value of the investment.

What the Jesse Litvak case shows is how Wall Street uses the simple fact that the buyer or seller is gambling and doesn't know what the fair value of the investment is to profit.  This profit goes away if there is valuation transparency as the buyer or seller knows what the fair value of the investment is and won't transact if the price doesn't reflect this value.

For many years one of the best jobs on Wall Street in terms of a mix of job safety and compensation, was to be a fixed income trader-cum-salesman working for a major bank with a deep balance sheet, which could hold illiquid securities on its prop account, to dispose of as the "flow" (or clients) required, and on unsupervised and unregulated terms that were simply a verbal arrangement between the bank trader and the end client, usually a counterparty trader working for a major institutional buyside shop, including mutual or hedge funds. 

Since for the most part, the buyside traders operated with other people's money, they were largely indiscriminate on the fine pricing nuances of the acquisition (or disposition) of the securities at hand, and while to the "other people's money" under management whether a given bond was bought for 55 or 55.75, or a given MBS was sold for 72-6 or 72-16 meant little (after all the trade was driven by a big picture view that the security would go up or down much more and certainly enough to cover the bid/ask spread, resulting in much larger profits upon unwind), the transaction price had a huge impact for the bank traders-cum-salesmen arranging said deals. 

Because when one is selling a $40 million MBS block, a 1 point price swing equals a difference of $400,000. Make 15 such deals per year, and one's $1,000,000 bonus (assuming a ~15% cut on the profits) is in the bag....

Bottom line:  the lack of valuation transparency allows Wall Street to extract a significant amount of profits as the buy-side is only gambling when it buys opaque structured finance securities ('trade was driven by the big picture view that the security would go up or down ... resulting in much larger profits upon unwind').

When there is valuation transparency, buy-side firms have a fiduciary duty to use this information.  This immediately ends Wall Street's ability to skim the bid/ask spread.

In short: the highly lucrative and extremely profitable bid/ask skimming that every bond trader engaged in for years has been impossible in equities for the simple reason that the bid/ask spread on most equity-related securities is minute and the market is far deeper and (at least used to be) far more liquid.

And the reason that the equity markets are far more liquid has to do with the ready availability of valuation transparency for most firms ('black box' banks are the exception).

It also explains why 4 years after the Great Financial Crisis, there is still no centralized, computerized trading portal for OTC trades, including corps, CDS, loans, etc. 

Doing so would mean that the banks would give up billions in additional commissions that they could charge if all such trades were facilitiated by the kind of sales coverage middlemen described above. 

Because while a salesman was incentivized to peel as much as they could of a given trade, they would at best pocket some 10-15% of the total spread. The rest went to the bank, and thus to management in the form a massive bonuses: comp at banks is not 40% of revenue for nothing, with some money left over for "retained earnings."

Please note, ZeroHedge has laid out why Wall Street is fighting to protect opacity.

But there is no reason to worry about Wall Street's profitability as it has shown itself to being equally adept at making money where there is valuation transparency (see the end of fixed commissions on stock trades for example).

With opacity, Wall Street makes a lot of money on each transaction, but there are very few transactions.  With valuation transparency, Wall Street makes a little money on each transaction, but the volume of trades is significantly higher.  As a result, Wall Street firms actually ends up making more money when there is valuation transparency.  They just have to work harder to make their money.

Ex-compliance officer makes case for banks providing transparency

In a must read interview on the Guardian, an ex-compliance officer talks about regulators, high-frequency trading and transparency.

His view of the impact of transparency on banks is

What's more, you cannot have a banking environment that is risk free, gives high returns while being highly transparent. That's logically impossible. If you're transparent in what you're doing then others will see it and get in on the action driving down returns.

And why is it necessary that banks generate high returns?  Isn't a low risk banking environment that is highly transparent preferable from the perspective of society?

His view on the fundamental reason that regulators are ineffective

My impression was that regulators were not always alive to how things work in practice. 

The ones I dealt with were often economists, essentially philosophers who had learned to build models. 

Why understand how things actually work in practice when you can just make assumptions to plug into models?  A classic example of this is the bank stress tests.  Is there any surprise that the banks can pass stress tests for capital adequacy and then need to be nationalized shortly thereafter.

Finally, he offers his perspective on high frequency trading

The effect of HFT on the trading floor is fascinating. You can't see the HFT programme, as it is embedded in the computers. So you notice it negatively, when traders complain because something isn't working. And you notice it when you're watching the order book on a screen, and you see movement when the programme buys or sells.

It's when there's a panic that you really realise just how strange and evanescent these programmes are. How do we access them? In the last resort people can actually rip out the cable from the computer. I've seen that happen, but it seems ridiculously primitive in such technological environments. 

No human being could ever do what computers now do with high frequency trading. No human being can see what HFT does. We can only see it afterwards, when it already has made its impact. 

This raises important questions for regulators. HFT is very difficult to corset, to manage. Regulators will probably never have the manpower to monitor all the data, to follow all transactions. So a significant portion is delegated to innovative technology. Many people I have interviewed are genuinely concerned over this.

Perhaps rather than trying to monitor high frequency trading, the regulators should ban it until such time as they are actually capable of monitoring it and making sure that its impact on the financial markets is positive.

By letting high frequency trading continue right now, the financial regulators are effectively gambling with the stability of the capital markets and the financial system.  A gamble that doesn't appear prudent to your humble blogger.

Transparency: to stop firms from gaming tax system, make them admit what they are doing

A Guardian article provides yet another example of requiring transparency and letting the benefits of sunshine clean up bad behavior.  In this case, the behavior being cleaned-up is the exercise in tax deferral.

Lloyd Blankfein, the boss of Goldman Sachs, is unrepentant about plans – now dropped – to help the bank's already highly paid traders avoid paying the top rate of income tax. 

To recap, Goldman had been thinking about deferring part-payment of bonuses from 2009, 2010 and 2011 into the new tax year to help recipients benefit from a fall in the top rate of tax from 50% to 45%. 

The firm surrendered only after Sir Mervyn King, governor of the Bank of England, said he found the idea "depressing" and Treasury minister Sajid Javid quietly intervened. 

There is, of course, nothing illegal about moving payments beyond 6 April, when the new tax year begins, but there is a question about whether it can be justified morally.... 

tax specialists at the likes of PricewaterhouseCoopers, Ernst & Young, KPMG and Deloitte – all of whom have been called before the public accounts committee this week – should be forced to think about the advice they give to companies when it comes to "tax planning". The advice should comply not just with the letter of the law but the spirit too. ...

the government should seize upon an idea raised by the corporate governance body Pirc last week when it wrote to remuneration consultants to ask them what advice they have been giving about deferring bonuses. Crucially, Pirc suggested the consultants should advise clients to disclose any such wheezes in annual voluntary reports.... 

Embarrassment forced Goldman to reconsider its deferral plan. Being forced to admit to tax schemes for staff in annual reports may well prove to be an effective deterrent for others.

Iceland and deposit guarantees

Your humble blogger has written extensively about deposit guarantees and the role they play in allowing policymakers to adopt the Swedish Model for handling a bank solvency led financial crisis.

Specifically, I have asserted that deposit guarantees make the taxpayers the 'silent equity partner' of the banks when the banks have low or negative book capital levels.

Why?

Because the government is both explicitly and implicitly on the hook for making the depositors whole.

More importantly, depositors assume that governments will honor their deposit guarantee.  From the time they open their first bank account they are told not to worry about bank book capital levels (please recall, when a 6-year old opens a bank account, their parents answer their question of how do they know they can get their money back by saying the government guarantees the 6-year old will get their back and not "look at a bank's financial statements and if the book capital level is positive....).

The case of Iceland and its handling of deposit guarantees confirms the expectation that government's will honor their deposit guarantees.

However, the case of Iceland reminds everyone that foreign depositors who only have an account at a bank to earn a higher rate of interest should recognize that they are "investors" and as investors they should not assume that they will be repaid under the country's deposit guarantee program.

As reported by the Wall Street Journal,

Iceland won a sweeping victory in a court fight over its responsibilities to foreign depositors in the Icelandic bank Landsbanki, which failed in 2008. 

The court of the European Free Trade Association on Monday said Iceland didn't breach European Economic Area directives on deposit guarantees by not compensating U.K. and Dutch depositors in Landsbanki's online savings accounts, known as Icesave accounts.... 

The EFTA Court sets up a vexing question: If deposit-guarantee programs don't protect everyone, are they really effective?  

That issue was raised by the European Commission, the EU's executive arm, which joined the case against Iceland.... 

Yes, deposit-guarantee programs are still effective even if they don't protect everyone.

They are effective even with a distinction between "depositors", individuals and firms that have a reason other than interest earned for having money at a bank, and "foreign investors", who have money at the bank solely for the purpose of receiving a higher interest rate.

Foreign investors recognize that under the FDR Framework the principle of caveat emptor (buyer beware) applies and they are responsible for all losses on their exposures.  Hence, they have an incentive to independently assess the risk of investing money in a bank of a small country.

Because its banks opened Internet arms seeking deposits from foreigners, Iceland had an unusually high proportion of foreign depositors in the system..... 

These foreign depositors were investors.

Iceland didn't force losses on domestic depositors. In the windup of the banks, the authorities put domestic deposits and assets into new "good" banks and left foreign deposits in the old, insolvent banks. 

The EFTA Surveillance Authority argued that Iceland violated nondiscrimination rules by treating domestic depositors differently. 

The court agreed with Iceland that the transfer didn't break the rules. 

The EU's common-market rules require that every country establish a deposit-guarantee program that provides a minimum level of compensation to savers in case of a bank failure.  

Iceland's banking collapse took down all the island's major banks, and the Icelandic deposit-guarantee fund didn't have nearly enough money to pay out insurance. 

At the core of the Icesave case is exactly what a country must do in such a total failure. 

Iceland said its obligation was simply to make sure that a reasonable guarantee plan existed. The U.K. said a country is obliged to make sure that insured depositors are actually paid. 

The Icelandic government expressed "considerable satisfaction" that the country's stance had prevailed in the Icesave case....

By compensating their depositors, the U.K. and the Netherlands received priority claims on the assets of the failed Landsbanki. The ministry said it expects those assets will be enough to pay all the British and Dutch claims. 

A spokesman for the European Commission, Stefaan De Rynck, said the commission would "maintain its interpretation" of the deposit-guarantee requirements in the 27 member states of the EU, where Mr. De Rynck says the guarantees must "also apply in the event of a systemic crisis." ...

The message from the EU being that both "domestic" depositors and "foreign investors" can expect an EU member states deposit guarantee to cover their bank deposits.

The Icesave affair has been an acrimonious backdrop to Iceland's relatively successful attempt to recover its economic footing in the aftermath of 2008.... 

Iceland adopted the Swedish Model and required its banks to recognize upfront the losses on the excess debt in the financial system.  By sparing its real economy the burden of servicing this excess debt, Iceland has seen its real economy bounce back quickly.

The British shelled out £2.35 billion ($3.7 billion), and the Dutch €1.32 billion, to repay their depositors in Landsbanki shortly after it collapsed....

As it became clearer that Landsbanki's assets would cover most, if not all, of the balance, the impact of the dispute faded.....

Opacity: why its hard to make sense of Wall Street's trading revenue

In his NY Times Dealbook article, Peter Eavis examines how opacity makes it hard to make sense of Wall Street's trading revenues.  He sees how Wall Street reports its trading revenues as part of the broader debate on opacity.

Under the FDR Framework, there is not suppose to be a debate about opacity in which the Wall Street firms have a voice.

It is the government's responsibility under the FDR Framework to ensure that market participants have access to all the useful, relevant information in an appropriate, timely manner.

The government was given this responsibility because the firms providing the disclosure are going to want to disclose as little as possible.

This responsibility puts the burden on the government to ensure that market participants have access to all the useful, relevant information.

Please note the use of the word "all".  It is there so that government regulators error on the side of requiring disclosure of too much information rather than error on the side of too little information.

Please note the use of the words "useful, relevant information".  These words are there so the government regulators error on the side of requiring disclosure of too much information rather than error on the side of too little information.  So long as one market participant thinks that the information is useful and relevant it must be disclosed.

Traders at the top Wall Street firms racked up nearly $80 billion of revenue last year. But understanding how they produced all that money is far from simple. 

The financial crisis revealed the dangers of banks having murky balance sheets. And some investors think banks’ disclosures are still inadequate. 

One of the primary causes of the financial crisis was opacity across wide swathes of the financial system including 'black box' banks and 'brown paper bag' structured finance securities.

The fact that any investor thinks banks' disclosure is still inadequate says that the government, through the SEC, is not doing its job and fulfilling its responsibility to ensure that market participants have access to all the useful, relevant information in an appropriate, timely manner.

“The major financial institutions in the U.S. and around the globe are utterly opaque,” Paul Singer, the founder of a large hedge fund called Elliott Management, said last year.

At a conference this week, Mr. Singer clashed with Jamie Dimon, chief executive of JPMorgan Chase, over the subject of bank transparency. In the exchange, Mr. Dimon said hedge funds were hardly transparent and added that JPMorgan’s annual report was 400 pages long.

In an earlier post, I noted that Mr. Dimon observing that hedge funds were hardly transparent was a red herring irrelevant argument.  The issue is not whether an investor does or does not provide transparency.  The issue is whether the firm that is making the disclosures is transparent.

Mr. Dimon makes that assertion that because JP Morgan's annual report is 400 pages long, his firm is providing all the useful, relevant information in an appropriate, timely manner.

Clearly this is not the case as Mr. Singer observes that JP Morgan is opaque and his analyst cannot understand the risk of JP Morgan's derivative portfolio.

At the start of the financial crisis, your humble blogger defined what constitutes all the useful, relevant information in an appropriate, timely manner for banks.  This is ultra transparency under which the banks disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

If JP Morgan provided this amount of disclosure, Mr. Singer's analysts would be able to independently assess the risk of JP Morgan and he could then adjust his exposure to JP Morgan to reflect this risk and his capacity to absorb losses.

Trading results are good place to start when assessing whether banks release sufficient information...

Shareholders benefit from good disclosures because they can better assess what value to place on a bank’s business. Trading revenue is not only large – it can also be extremely volatile, bolstering profits one quarter, then hurting them the next. With the right data, investors can do a better job of identifying what drives revenue up and down....

When it comes to sales and trading, Wall Street firms have differing levels of disclosure.

All Wall Street firms should be brought to the gold standard for disclosure:  ultra transparency.

Abandon, don't electrify ring-fence

In his Financial Times op-ed, Andrew Tyrie, the chairman of the Parliament's Commission on Banking Standards, argues for 'electrifying the ring-fence' between investment and retail banking because banks will relentlessly lobby until the ring-fence has been effectively torn down.

I agree with Mr. Tyrie's observation about the behavior of bankers and what the final result of adopting a ring-fence will be.

What your humble blogger disagrees with Mr. Tyrie on is substituting the combination of complex rules and regulatory oversight (which is what an electrified ring-fence would be) for the combination of transparency and market discipline.

If banks were required to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details, this would go further to eliminating casino banking and the danger it presents to utility banking than a ring-fence would.

With ultra transparency, market participants have access to all the useful, relevant information in an appropriate, timely manner so they can independently assess the risk of each bank and make a fully informed decision.  The result of this independent assessment will be market discipline on the banks to reduce their risk taking.

Ultra transparency also has the added advantage that risk reduction is enforced by the market and not by regulators and policymakers who are subject to being lobbied over time.  So ultra transparency directly addresses Mr. Tyrie's concerns about long-term enforceability of reforms.

The Parliamentary Commission on Banking Standards, which I chair, supports the creation of this ringfence. However, in our report scrutinising the draft legislation, the commission also concluded that without significant changes it may well not achieve its objectives. 

The ringfence must be “electrified” if it is to stand a better chance of success – in other words, if the banks test the ringfence too much, they will get a shock. 

Any reform where there is significant doubt about its long term viability is a reform that shouldn't be pursued.

We therefore recommended a reserve power for full separation, an approach Sir John himself endorsed in evidence to the commission this month. 

The regulators, too, have told the commission they want electrification. And they have come forward with proposals to give it practical effect. 

The banks, on the other hand, do not want electrification. They seem to be the only ones. 

The lobbying campaign against this proposal predictably started the moment our report was published – just as it did when the ICB first suggested introducing a ringfence. 

The strength of the industry’s lobbying, even at this early stage, makes the case eloquently for electrification. Even while chastened by public anger over their role in the financial crisis and subsequent revelations such as Libor rigging , they are lobbying....

Please note that the banks have been lobbying against any proposed reform since the beginning of the financial crisis.

Your humble blogger has documented this lobbying in the area of structured finance reform.  The bottom line is the banks have effectively blocked reform.

Even when the EU passed legislation mandating that banks know what they own and that the issuers provide the data to make this possible, the banks managed to lobby the banking regulators and have these regulators agree that opaque, toxic subprime mortgage backed securities qualify for know what you own.

The other way that banks succeed in their lobbying is by keeping certain reforms off the table.  Banks have successfully blocked bringing transparency to all the opaque corners of the financial system by "supporting" through their lobbying the combination of complex rules and regulatory oversight as a replacement for transparency and market discipline.

All history tells us that banks will be at the ringfence like foxes to a chicken coop unless they are incentivised not to do so. On past evidence, they will test it nonstop and try to persuade politicians to alter it in their favour. 

Electrification is therefore essential to ensure that the banks comply not just with the rules of the ringfence but also with the spirit. 

We must legislate now for more benign economic circumstances, when banks are under less intense scrutiny. At that time, politicians will be particularly susceptible to lobbying and the integrity of the ringfence will be most at risk.

 Our proposals help protect the ringfence from such pressures in the long term. Banks see it as a starting point for negotiations; we view it as a starting point for a more stable and sustainable banking system.... 

Mr. Tyrie is wrestling with the issue of how to enforce any complex regulation in light of what we know about the banks' ability to relentlessly lobby.

This issue goes directly to the heart of why the combination of complex rules and regulatory oversight fail catastrophically and make the financial system far more unstable.  Ultimately the banks will get around the regulation.

This is why your humble blogger has been pounding the table on the issue of requiring the banks to provide ultra transparency.  It is a simple regulation that the market can enforce.

Of course, structural reform is by no means the only way to improve banking standards and the commission will now be largely focusing on the second phase of its work. This will involve examining whether changes in areas such as corporate governance, competition, the regulatory and tax framework, and the civil and criminal law could enhance standards and improve behaviour in the banking industry.

Regular readers know that sunshine is the best disinfectant of bad banker behavior and ultra transparency is the gold standard for sunshine.

Regular readers also know that ultra transparency is the key to restoring trust in the banks.  After all, providing ultra transparency use to be the sign of a bank that could stand on its own two feet because it had nothing to hide.

Your humble blogger hopes that Mr. Tyrie and his commission will consider it.