Despite Lord Turner's claim, it was not impossible to spot Libor manipulation

Reuters reports that in his testimony before the Parliament Commission on Banking Standards, Lord Turner, the head of the UK's Financial Services Authority, asserted that it was impossible to have had a police force big enough to spot the manipulation of Libor.

This statement is false and underscores why bank regulators by themselves will never be up to the task of policing the financial system.

Had the banks been required to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details, there would have been a police force big enough and motivated enough to spot manipulation of Libor and other benchmark interest rates.

Even if Libor and the other benchmark interest rates had been compiled in an opaque manner, market participants could still have double checked what the interest rates against the actual transactions entered into by the banks.

A discrepancy between the benchmark interest rates and what was actually occurring would have been noticed.

Why would market participants have been looking to see if there was a discrepancy between the benchmark interest rates and the transactions the banks actually engaged in?

Because the market participants who had an exposure to Libor and the other benchmark interest rates had a financial incentive to do so.

Regular readers know that the global financial system is based on the FDR Framework which combines the philosophy of disclosure with the principle of caveat emptor (buyer beware).

This framework provides a much bigger police force than just the financial regulators as every market participant has an incentive to look out for themselves.

One of the causes of our current ongoing financial crisis is the regulators' information monopoly when it comes to financial institution.  It was and still is only the financial regulators who have access to all the useful, relevant information for assessing the banks.

What the manipulation of the benchmark interest rates and the financial crisis have shown is that the financial regulators are not up to the task of replacing the market and all of its participants when it comes to policing the banks.

Since the beginning of the financial crisis, I have repeatedly said that the financial regulators should give up their information monopoly, require the banks to provide ultra transparency and then piggyback off of the market's ability to both analyze the banks and to enforce discipline on the banks.

There is a role for financial regulators.  It is just not as a replacement for the market.  It is as a second line of defense should market participants fall prey to some popular delusion.

Regulators could not have spotted the "lowballing" of Libor interest rates during the financial crisis even if they had looked, Britain's Financial Services Authority said.

But financial market participants could and more importantly would have if they had access to each bank's exposure details.

The watchdog's chairman, Adair Turner, told a parliamentary commission on banking standards on Wednesday it was much easier to see abuses in share trading by using computers.

Same computers could have spotted Libor manipulation.  What is required is that the computers have the actual transaction data.

Manipulation of the London interbank offered rate (Libor) during the 2008 crisis, for which three banks - Barclays BARC.L, Royal Bank of Scotland and UBS - have been fined so far was far harder to see, he said. 

"There was no information on the trader manipulation," Turner told the commission....

There was no information disclosed to the market that would allow it to discover that traders were manipulating the benchmark interest rates.

The regulators had and still have a monopoly on the information that would have shown that the rates were being manipulated.  It is only the regulators who have access to each bank's current global asset, liability and off-balance sheet exposure details.

The fact that the regulators were not up to the task of discovering the interest rate manipulation even after they had been told about it (see NY Fed and Tim Geithner), does not mean that the market would not have discovered it.

Neither the FSA, the CFTC - two of the regulators that have fined the three banks - or other regulators had ways to see the trader manipulation, Turner said. "We could not have got at it by intensive supervision. You just cannot have a police force big enough to spot all these problems."

When the banks are required to provide ultra transparency, there is a plenty big enough police force as every participant in the market has an incentive to police the banks.

While whistleblowing was one of the few ways to report illegal activity, Turner said trading room mentality was detached from the real economy as some traders see their job in front of a screen as being like playing a computer game, asking "Why shouldn't I cheat?".

With banks being required to provide ultra transparency, the answer to why shouldn't I cheat is because I will be caught! 

There is a reason that sunlight is the best disinfectant!

Over 200,000 signatures on EU petition calling for more bank transparency

The Guardian reports that an EU petition asking that banks provide more transparency collected over 200,000 signatures.

The petitions specifically called for banks to disclose both what they made and the taxes they paid on a country by country basis.

And why is this necessary?  Avaaz, the lobby group leading the campaign, sees transparency as necessary to "tame bank trickery".

A point that your humble blogger has been making since before the beginning of the financial crisis.

More than 200,000 people have signed a petition calling on European Union finance ministers to force banks to reveal how much they tax they pay and the profits they generate in individual countries. 

The lobby group Avaaz is leading the campaign and called on the finance ministers to force banks to "tame bank trickery". 

Banks are currently only obliged to disclose how much tax they pay in total, rather than how much tax they pay in the individual countries in which they operate. 

Sharon Bowles, a British member of the European parliament, said: "This petition, signed by over 190,000 EU citizens – including myself – demonstrates that taxpayers can no longer accept untransparent accounting practices by global banks." 

I agree with Sharon Bowles that taxpayers can no longer accept opaque accounting practices.  That is why I have been championing requiring the banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

We have known for 60 years how to deal with too much public and private sector debt

In a terrific Guardian column, Nick Dearden contrasts how Germany's excess post-World Wars debt was handled with how the excess debt in the global financial system is now being handled.

Sixty years ago, Germany's debt was written down and creditors were given an incentive to buy goods produced in Germany.

Today, debtors are forced to adopt a number of policies that destroy both real economies and the social contract.

Regular readers know that your humble blogger has championed the solution applied to Germany's debt since the beginning of the financial crisis.  I have called this the Swedish model under which the banks recognize upfront the losses on the excess public and private debt in the financial system.

It is not surprising that 60 years ago, the Swedish model would have been applied to Germany's debt.

The Swedish model had first been applied in the US during the early 1930s and, according to the NY Fed, it broke the back of the Great Depression.  The US policymakers knew that applying the Swedish model to Germany's debt would have the same positive impact on Germany's economy.

Fast forward to today and note that it is the German policymakers who have taken the lead on insisting that all debt must be repaid regardless of the consequences.

Did the German policymakers forget something that was instrumental for rebuilding their country?

Sixty years ago today, an agreement was reached in London to cancel half of postwar Germany's debt. That cancellation, and the way it was done, was vital to the reconstruction of Europe from war. It stands in marked contrast to the suffering being inflicted on European people today in the name of debt. 

Germany emerged from the second world war still owing debt that originated with the first world war: the reparations imposed on the country following the Versailles peace conference in 1919. 

Many, including John Maynard Keynes, argued that these unpayable debts and the economic policies they entailed led to the rise of the Nazis and the second world war.

It is important to keep in mind the link between unpayable debts and destructive economic policies.

By 1953, Germany also had debts based on reconstruction loans made immediately after the end of the second world war. Germany's creditors included Greece and Spain, Pakistan and Egypt, as well as the US, UK and France. 

German debts were well below the levels seen in Greece, Ireland, Portugal and Spain today, making up around a quarter of national income. But even at this level, there was serious concern that debt payments would use up precious foreign currency earnings and endanger reconstruction..... 

the country's creditors came together in London and showed that they understood how you help a country that you want to recover from devastation. It showed they also understood that debt can never be seen as the responsibility of the debtor alone.... 

The debt cancellation for Germany was swift, taking place in advance of an actual crisis. Germany was given large cancellation of 50% of its debt. The deal covered all debts, including those owed by the private sector and even individuals. It also covered all creditors. No one was allowed to "hold out" and extract greater profits than anyone else.... 

Perhaps the most innovative feature of the London agreement was a clause that said West Germany should only pay for debts out of its trade surplus, and any repayments were limited to 3% of exports earnings every year. 

This meant those countries that were owed debt had to buy West German exports in order to be paid. It meant West Germany would only pay from genuine earnings, without recourse to new loans. And it meant Germany's creditors had an interest in the country growing and its economy thriving. 

Following the London deal, West Germany experienced an "economic miracle", with the debt problem resolved and years of economic growth.

Please re-read the highlighted text as it confirms that the Swedish model works.

The reason that the Swedish model works is that it lifts the burden of servicing the debt from the real economy.  Capital that is needed for growth, reinvestment and to support the social contract is not diverted to debt service. As a result, the real economy continues to grow.

The same result would occur if the Swedish model was adopted by Western countries including the UK and US.

The medicine doled out to heavily indebted countries over the last 30 years could not be more different. 

Instead, the practice since the early 1980s has been to bail out reckless lenders through giving new loans, while forcing governments to implement austerity and free-market liberalisation to become "more competitive".

As a result of this, from Latin America and Africa in the 80s and 90s to Greece, Ireland and Spain today, poverty has increased and inequality soared. In Africa in the 80s and 90s, the number of people living in extreme poverty increased by 125 million, while economies shrank. In Greece today, the economy has shrunk by more than 20%, while one in two young people are unemployed. In both cases, debt ballooned. 

The priority of an indebted government today is to repay its debts, whatever the amount of the budget these repayments consume. In contrast to the 3% limit on German debt payments, today the IMF and World Bank regard debt payments of up to 15-25% of export revenues as being "sustainable" for impoverished countries. The Greek government's foreign debt payments are around 30% of exports....

The "strategy" in Greece, Ireland, Portugal and Spain today is to put the burden of adjustment solely on the debtor country to make its economy more competitive through mass unemployment and wage cuts. But without creditors like Germany willing to buy more of their exports, this will not happen, bringing pain without end.

This policy is what I have called the Japanese model.  Under the Japanese model, bank book capital and banker bonuses are protected at all costs and the burden of the excess debt is placed squarely on the real economy.

The result is at best a Japan-style economic slump.  At worse, the result is a Greece-style depression. Under either the economic slump or the depression result, the debt is not repaid.

The German debt deal was a key element of recovering from the devastation of the second world war. In Europe today, debt is tearing up the social fabric. 

Outside Europe, heavily indebted countries are still treated to a package of austerity and "restructuring" measures. Pakistan, the Philippines, El Salvador and Jamaica are all spending between 10 and 20% of export revenues on government foreign debt payments, and this doesn't include debt payments by the private sector. 

If we had no evidence of how to solve a debt crisis equitably, we could perhaps regard the policies of Europe's leaders as misguided. But we have the positive example of Germany 60 years ago, and the devastating example of the Latin American debt crisis 30 years ago. The actions of Europe's leaders are nothing short of criminal.

SEC shines light on derivative backed notes

Bloomberg reports that the SEC is pushing the large banks to disclose to investors just how much money they are making on derivative backed notes.

Specifically, the large banks will be required to say how they value the securities.

Lenders from JPMorgan Chase & Co. to Bank of America Corp. that sold $51 billion of securities backed by equity derivatives the past two years are being pushed by regulators to disclose that the banks valued the debt as much as 10 percent less than customers paid. 

Banks are being given 10 days to tell the U.S. Securities and Exchange Commission whether they will comply with rules intended to increase transparency in the structured-notes market, the SEC said in a letter sent to some banks this month.  

Goldman Sachs Group Inc., Bank of America, and Royal Bank of Canada began disclosures as early as May on securities sold at prices that were typically 2 to 4 cents on the dollar more than where the banks valued them, data compiled by Bloomberg show. 

Regulators are increasing oversight of equity-linked note sales that have soared 39 percent the past two years as investors buy them as an alternative to traditional bonds with record-low yields. 

The securities generally are sold to individuals who lack pricing models employed by banks to value the securities, which use derivatives to boost yields. 

“These are complex and opaque products, and the more sunshine and disclosure, the better,” said Jacob Zamansky, a lawyer at Zamansky & Associates in New York representing investors in lawsuits over structured notes. “It’s important that the SEC focus on the disclosure of structured products because they’re exploding in sales to ordinary retail investors.”

Please re-read the highlighted text again and recall Yves Smith's dictum:  nobody on Wall Street is compensated for creating low margin, transparent products.

These securities are just another example of Wall Street profiting behind a veil of opacity.

The five-page letter sent to banks Feb. 21 doesn’t set a date for when all structured-note issuers must include market valuations in offering documents. The SEC will require banks to provide a “narrative disclosure” of how it valued the securities.

They also will be required to explain why the value they place on the note may be higher than the price at which an investor could sell the security on secondary markets immediately after being issued, according to the letter. 

Regulators “believe that investors should be able to understand the difference between the issuer’s valuation and the original issue price that they are paying for the structured note,” the SEC said in the letter, signed by Amy Starr, head of the agency’s capital markets trends office in Washington.

Chasing yields, hedge funds look to riskier piece of CMBS deals

Bloomberg reports that in their search for higher yielding securities hedge funds are looking at the riskier B-piece of commercial mortgage backed securities.

Hedge funds are preparing to muscle in on the riskiest part of the $550 billion commercial mortgage bond market, where a handful of firms control the fate of deals. 

Ellington Management Group LLC, Saba Capital Management LP and a fund of MatlinPatterson are among investors considering purchases of so-called B-pieces of newly issued commercial property bonds, according to people familiar with the three firms’ plans who asked not to be identified because the information is private. 

Buyers of the securities are the first to lose money when buyers default; in exchange they earn higher returns and control over which mortgages are included in new deals created by Wall Street. 

The investments, which can yield as much as 24 percent, are dominated by loan specialists -- Rialto Investments and Eightfold Real Estate Capital bought 16 of the 27 B-pieces sold last year -- when about $35 billion of mortgage bonds were issued, according to Deutsche Bank AG. 

The pool of buyers is poised to widen as new issuance soars and investors try to ferret out ways to get high-yielding returns as the Federal Reserve holds interest rates close to zero into a fifth year. 

“Funds are increasingly getting more creative in terms of complexity and illiquidity,” said Rael Gorelick, co-founder and principal of Charlotte, North Carolina-based Gorelick Brothers Capital LLC, which invests in mortgage funds. “This is a rates- are-low story. Where else are you going to go?”

Please re-read the highlighted text as it nicely summarizes the 'interest rate' bubble that the Fed is creating as a result of its pursuit of zero interest rates and quantitative easing.

Investors are chasing yield just like they did in the run-up to the financial crisis.  There is no reason to believe that the end result will be any better.

China looking to expand its asset-backed securities market

Bloomberg reports that China is looking to expand its asset-backed securities market.  The big question is how will it do this?

Will it require that asset-backed securities provide observable event based reporting  so investors can know what they are buying and know what they own or will it allow the securities to provide out of date information that leaves buyers and sellers blindly gambling on the contents of a brown paper bag?

China may allow more firms to develop asset-backed securities businesses with the goal of boosting liquidity, the nation’s market regulator said. 

The China Securities Regulatory Commission will lower its threshold for securities companies to undertake such businesses, the CSRC said today on its website. Asset-backed securities could be based on accounts receivable, credit assets, bonds, stocks and commercial properties, it said. 

The CSRC issued draft rules for the asset-backed securities business today and asked for public feedback, according to the statement. 

China Development Bank Corp., the nation’s largest policy bank, sold 9.27 billion yuan ($1.5 billion) of asset-backed securities, the bank said Sept. 7, in the country’s first such sale since 2008. 

The difficulty of assessing risk in bonds that are backed by loans was a major contributor to the 2008 global financial crisis.

Senator Warren grills Ben Bernanke over policy of financial failure containment

Senator Elizabeth Warren used Fed Chairman Ben Bernanke's semi-annual visit to the Senate Banking Committee as an opportunity to expose the fundamental flaws in the policy of financial failure containment and its corollary, the Geithner Doctrine.

• the policy directly leads to the creation of Too Big to Fail.  

• the policy directly leads to the Too Big to Fail banks receiving a sizable subsidy because market participants think the financial institutions will be bailed out.  No market participant believes that orderly liquidation authority under the Dodd-Frank Act will ever be imposed.

As reported by the Huffington Post,

Warren pressed the Fed chairman about whether the government would bail out the largest banks again, as it did during the financial crisis. 

"We've now understood this problem for nearly five years," she said. "So when are we gonna get rid of 'too big to fail?'" 

Regular readers know that we won't be rid of Too Big to Fail until banks are required to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

Ultra transparency is needed to make investors in the banks responsible for any losses on their investments.  When an investor can independently assess the risk of an investment, they can adjust both the amount and price of their exposures to reflect this risk.

So long as banks continue to be 'black boxes', there is a moral obligation to bailout the investors as they are investing based on a reliance on what the bank regulators have to say about the risk and solvency of each bank.

Warren also asked whether big banks should repay taxpayers for the billions of dollars they save in borrowing costs because of the credit market's belief that they won't be allowed to fail, repeatedly citing a recent Bloomberg study estimating that the biggest banks essentially get a government subsidy of $83 billion a year, nearly matching their annual profits....

One way for the big banks to repay taxpayers for the subsidy would be for the banks to hold their excess reserves at the Federal Reserve in an account that doesn't pay them interest.  These reserves would be used to fund the portfolio of securities the Fed purchased as a result of pursuing quantitative easing.  The earnings on these securities would flow through to the US Treasury.

he said the market was wrong to give banks any subsidy at all (in the form of lower borrowing costs), insisting that the government will in fact let banks fail. 

The 2010 Dodd-Frank financial reform law has given policymakers the tools to safely shut down big, failing banks, he claimed. 

But when repeatedly pressed by Warren, Bernanke's confidence seemed to waver. 

"The subsidy is coming because of market expectations that the government would bail out these firms if they failed," Bernanke said. "Those expectations are incorrect. We have an orderly liquidation authority. Even in the crisis, we -- uh, uh -- in the cases of AIG, for example, we wiped out the shareholders..." 

"Excuse me, though, Mr. Chairman," Warren said. "You did not wipe out the shareholders of the largest financial institutions, did you, the big banks? 

"Because we didn't have the tools," Bernanke replied. "Now we could -- now we have the tools." 

Of course, the policy of financial failure containment relies on these tools and that they work.  A really, really big "if" surrounds these tools as they apply to the Too Big to Fail.

Regular readers know that your humble blogger prefers the policy of financial failure prevention upon which our financial system is based.  It is far better to prevent a bank's failure by subjecting it to market discipline made possible by ultra transparency than to deal with a failed bank.

Later, when pressed again by Warren, Bernanke suggested that the government's tools to wind down a big bank that is failing were still a work in progress -- or at least that financial markets have not yet been convinced of their power. 

"Some of these rules take time to develop -- um, uh, the orderly liquidation authority, I think we've made progress on that," he said. "We've got the living wills -- I think we're moving in the right direction ... We do have a plan, and I think it's moving in the right direction." 

"Any idea about when we're gonna arrive in the right direction?" Warren said. 

"It's not a zero-one kind of thing," Bernanke stammered in response. "Over time we will see increasing, uh, increasing market expectations that these institutions can fail."

Until the banks are required to provide ultra transparency, we will never see increasing market expectations that these institutions can fail.

Market participants know that in the absence of ultra transparency regulators will not use the ordinary liquidation authority because it is an admission that they failed to properly oversee the banks.

Regulators will always play for time and hope that the bank can generate enough earnings to cover the hole in its balance sheet (this policy has been in effect since the 1980s and covered the savings & loans, Security Pacific and now the Too Big to Fail).

He later added, "As somebody who's spent a lot of late nights dealing with these problems, I would very much like to have confidence we can close down a large institution without causing damage to the economy."

The only way you can close down a large institution without causing damage to the economy is if there is ultra transparency.

With ultra transparency, market participants adjust their exposure to what they can afford to lose as the financial institution gets closer to needing to be liquidated.

Without this ability to adjust their exposures, there is no way to close a large institution without causing damage to the economy (this is the basis for financial contagion).

Bernanke suggested that banks would eventually lose some of the benefits of size and would shrink themselves voluntarily -- news that might surprise JPMorgan Chase CEO Jamie Dimon, who was again extolling the benefits of his bank's size even as Bernanke spoke.

If banks were required to provide ultra transparency, they would most certainly shrink themselves.  It wouldn't be voluntary, but rather as a result of market discipline as market participants raise the cost of funds to these banks to reflect their actual risk levels.

Banks still too clever for regulators

In her Guardian column, Jill Treanor looks at how banks manipulate their risk weighted asset calculations and concludes that banks can game the Basel III rules and fool the bank regulators about how risky they really are.

She sees the regulators being misled about the true risk of the banks as a big problem.

Our current financial crisis showed just how big a problem regulators underestimating the risk of banks is.  Based on representations by regulators that financial innovations had made the banks less risky, investors, including other banks, invested too much capital at too low a rate in the banks.

Regular readers know that the only way to end bankers gaming the system and avoiding future misallocation of capital to the banking system is if the banks provide ultra transparency.

With access to each bank's current global asset, liability and off-balance sheet exposure details, market participants can assess the risk and solvency of each bank.  Based on this assessment, market participants can adjust both the amount and price of their exposure.

After the banking crisis it became clear that banks had been too smart for their regulators and it seems this is still the case, if the findings of a survey by Europe's top banking regulator is anything to go by.

Without ultra transparency, there is no reason to believe there will ever be a time when banks are not too smart for their regulators.

Simply put, bankers are better paid than regulators and they have a financial incentive to find or use their lobbying to create the loopholes in any regulation.

The only way for regulators to catch up to the banks is if the regulators harness the analytical and discipline ability of the markets.

This is easily done by requiring the banks to provide ultra transparency.  

With ultra transparency, the regulators can then tap the banks themselves for help in analyzing and exerting discipline on their competitors.  The banks have an incentive to do this because they have to manage their own risk including the risk of their exposures to the other banks.

The European Banking Authority has found discrepancies in the ways banks measure the riskiness of their assets. This could reduce the amount of capital they need to hold.

No surprise with this finding.

One of the advantages of ultra transparency is that it creates a "market" price for bank assets.

The EBA, which oversees regulation of banks across the European Union, concluded there were "material differences" in the way risks are measured across 89 banks in 16 countries. 

Andrea Enria, chairman of the EBA, said some of the differences could be accounted for by more explanation about the methodology being used. "But this is not enough. The remaining dispersion is significant and calls for further investigations and possibly policy solutions," he added. 

Quite. The Financial Services Authority is already on the case: in November the Bank of England's financial policy committee told banks to make a more "honest" assessment of potential losses they face and to report to the regulator by March....

If banks were required to provide ultra transparency they would have an incentive to be as conservative as possible in valuing their assets.  Banks that aren't conservative in valuation would be signaled out as being riskier and would have to pay more for funds.

Unless regulators can be confident about the riskiness of the assets banks hold they cannot have any confidence that banks have enough capital.

It is not enough that the regulators have confidence about the riskiness of the assets banks hold.  Since the beginning of the financial crisis which the bank regulators missed and the subsequent nationalization of banks that passed the regulators' stress tests, market participants no longer trust the regulators' representation about the riskiness of the banks.

Ultra transparency is needed so that market participants can have confidence about the riskiness of the assets banks hold.

Barclays to disclose pay details of its staff

The Guardian reports that Barclays is going to disclose the pay details for all of its 140,000 employees.

Barclays is expected to reveal next week that hundreds of its staff are paid more than £1m, in the most detailed disclosure yet about how much its 140,000 employees take home each year. 

In a move that could force rival banks to follow suit, Barclays is preparing to report how much its staff earn through a wide range of pay scales, shedding light on the pay of its lowest and highest paid staff.

Please re-read the highlighted text as transparency always results in a race to the top.  Banks that do not provide an equal level of transparency are seen as hiding something.

Under the direction of chairman Sir David Walker, Barclays is to adopt a new way of providing information about pay when it publishes its annual report next week, potentially re-igniting the row over the high bonuses handed out in the City.... 

In 2009, Walker was commissioned by the Labour government to review standards in banking following the bank bailouts and called for pay to be disclosed in bands above £1m. But when the coalition came to power in 2010 he had backed down, saying such a move needed international cooperation. Walkers' brackets for bands at the time of his 2009 report were £1m to £2.5m, £2.5m to £5m and in bands of £5m thereafter. The recipients were not to be named. 

He appears to be going further in the disclosures that will be made by Barclays by including the lowest pay grades. Shortly after his appointment to the bank's board in September he was the first witness at the parliamentary commission on banking standards and called for more disclosure of bankers' pay, suggesting that the pay of the top "50 to 100" highest paid bankers should be released. 

Under UK rules banks are required to publish the pay of all boardroom directors. Since the financial crisis banks have been required to disclose the pay of the five highest paid staff reporting to the chief executive although this has now been increased to the eight highest paid staff. 

Other rules require banks to publish information about the number of "code staff" – those responsible for managing and taking risks – and broad details about how they are paid. 

It is remarkable how little transparency there is whenever the regulators get involved in setting complex rules.

No wonder the market cannot exert discipline on banker pay.  It is really hard to exert discipline when there is essentially zero useful information.

UK debt downgrade represents opportunity to adopt policy that will benefit real economy

At the end of last week, Moody's downgraded the UK's debt.  Initial reaction to this was best summarized by the Guardian,

[from Ed Balls] "The downgrading of Britain's credit rating is, in the chancellor's own words, a 'humiliation' for this government … The first economic test he set himself has been failed by this downgraded chancellor. 

Yet, as we have seen today, he remains in complete denial, offering more of the same failing medicine, even though Moody's now agrees that 'sluggish' growth is the main problem."... 

"Over a weekend, he went from saying he must stick to his plan to avoid a downgrade to saying that the downgrade is the reason why he must stick to the plan. He used to say that a downgrade would be a disaster; today he says it does not matter. 

But he still warns that a downgrade in future might be a problem – until it comes along; then he will have the same excuses. It is utterly baffling and completely illogical. He is just making it up as he goes along."...

[From George Osborne] the downgrading was a "stark reminder" of the debt problems built up in Britain. ... 

"We can either abandon our efforts to deal with our debt problems, and make a difficult situation very much worse, or we can redouble our efforts to overcome our debts, make sure that this country can earn its way in the world, and provide for our children a very much brighter economic situation...

The debt downgrade was not a surprise.  As your humble blogger has been saying since the beginning of the financial crisis, so long as the burden of the excess debt in the financial system is placed on the real economy, the result will be a Japanese style economic slump.  The debt downgrade is simply confirmation of this.

What Moody's downgrading the UK debt did do is create an opportunity for UK policymakers to step back and evaluate the results of the policy of financial failure containment and the Japanese model for handling a bank solvency led financial crisis that was adopted in 2008.

An examination of the results would show that the financial crisis was a blip for the bankers who have continued to receive outsized pay packages and has been a disaster for the real economy with the elderly, the poor, savers and the under 30 year olds being particularly hard hit.

If a policymaker was not angling for a Tony Blair high paying advisory role with a bank, a policymaker might be tempted to look around and see if there was an alternative policy that might work better.

Finding this policy is not too hard as Iceland recently received an upgrade on its debt rating.

While not perfectly implemented, Iceland's policymakers understood that the policy of financial failure prevention and the Swedish model for handling a bank solvency led financial crisis was better for both the real economy and maintaining the social contract.

Under the Swedish model, banks are required to recognize upfront the losses on the excess public and private debt in the financial system.  This protects the real economy as capital that is needed for growth and reinvestment is not diverted to debt service on the excess debt.  This protect the social contract as the real economy continues to generate the funds need to pay for the social contract.

The Swedish model does have one significant downside.  It dramatically reduces cash payments to bankers or policymakers/senior advisors to the banks for a number of years - until such time as the banks have been able to retain sufficient earnings to rebuild their book capital levels.

As always, your humble blogger is hopeful that there exists a country whose policymakers but the citizens of the country ahead of the banks.  If the UK is that country, I expect that the policymakers will acknowledge what they are doing is not working and turn to the Swedish model.

If the UK were to do so, I confidently predict that the real economy will show significant improvement within 12 months.

Mark Carney: banks and regulators need to do more to rebuild trust in financial system

Mark Carney, the Bank of Canada's Governor and the next Governor of the Bank of England, gave a speech in which he observed that banks and regulators need to do much more to rebuild trust in the financial system.

As Bloomberg reported,

“It has been said that, ‘trust arrives on foot, but leaves in a Ferrari.’” 

There has been a “significant loss of trust by the general public” due to the excesses that led to the 2008 financial crisis, as well as allegations of wrongdoing in areas such as the setting of the London interbank offered rate, a benchmark interest rate known as LIBOR, Carney said....

The lack of trust has depressed the stock price of banks such as London-based Barclays Plc (BARC) and Frankfurt-based Deutsche Bank AG, and is “restraining the pace” of the global recovery, Carney said. It has also “increased the cost and lowered the availability of capital for non-financial firms.”...

Carney also called on banks to improve the transparency of their accounting and conduct regular “stress tests” of their balance sheets. 

One of the biggest blows to public trust came from the “perception of a heads-I-win-tails-you-lose finance,” he said. “Bankers made enormous sums in the run-up to the crisis and were often well compensated after it hit. In turn, taxpayers picked up the tab for their failures.”

Financial reforms must include “measures that restore capitalism to the capitalists,” Carney said.

At the end of the day, there is only one reform that builds trust and restores capitalism to the capitalists.

That reform is requiring the banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

With this level of disclosure, market participants can assess the risk and solvency of each bank.  With the ability to assess, market participants take on the responsibility for absorbing all losses on their exposures to the unsecured debt and equity of each bank.  This restore capitalism to the capitalists.

With this level of disclosure, bankers can no longer engage in bad behavior behind a veil of opacity.  Sunshine acts as the best disinfectant.  And with this sunshine, trust returns.

Banks seek to maintain ability to manipulate Libor and similar rates

A Bloomberg article shows how a major bank lobbying organization defends the banks' ability to manipulate Libor and similar benchmark interest rates.

The reason that banks are trying to defend their ability to manipulate Libor and similar benchmark interest rates is that this manipulation is immensely profitable for the banks.

Regular readers know that the only solution for restoring trust in Libor and similar benchmark interest rates and ending the ability of the banks to manipulate these interest rates is to base these interest rates off of actual transactions that are reported by the banks under ultra transparency.

Under ultra transparency, banks are required to disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

With this information, the market for unsecured interbank lending unfreezes and remains unfrozen as the banks with deposits to lend can assess the risk and solvency of the banks looking to borrow.

Libor and similar benchmark interest rates can then be based off of all or a subset of the transactions that result in the interbank lending market.

The London interbank offered rate will face a prominent U.S. critic today as financial regulators look to improve oversight after three banks paid more than $2.5 billion in fines to settle interest-rate rigging charges...

The gold standard for oversight of Libor and similar benchmark interest rates is requiring the banks to provide ultra transparency.

CFTC Chairman Gary Gensler has questioned the long-term viability of Libor and other benchmark rates, saying the underlying markets must be based on transactions and not estimates from banks. 

“One of the really challenging things is how systemic this is,” Gensler said in a Feb. 21 interview. “This is like a reference rate that is too big to replace.... 

“Anchoring to real transactions is essential to have confidence in these benchmarks,” Gensler said in the interview. “The banks are right now estimating something that isn’t an active market.”

Requiring the banks to provide ultra transparency results in a twofer:  an active unsecured interbank lending market so banks don't have to estimate anything and the ability to anchor these benchmark interest rates to real, verifiable transactions.

The Global Financial Markets Association, a trade association representing securities advocacy groups in Europe, the U.S. and Asia, said benchmarks don’t need to be based on actual transaction data.

Please re-read the highlighted text as here is the big bank lobbying firm defending the banks' ability to manipulate Libor and similar benchmark interest rates.

Some markets have little transaction volume and still benefit from having a benchmark, the groups said.

The reason that some markets have little transaction volume is that banks are 'black boxes' and the banks with deposits to lend are uncomfortable lending to banks looking to borrow because they cannot assess the risk or solvency of the borrowing banks.

By curing the 'black box' problem with ultra transparency, the market unfreezes and has lots of transaction volume.

“GFMA believes that it is unnecessarily limiting to mandate that a benchmark be based solely on actual transaction data,” the organization said in a Feb. 11 letter to the task force.

Please re-read the highlighted text as the big bank lobbying firm is defending the banks' ability to manipulate Libor and similar benchmark interest rates by claiming it is a good thing.

At the same time, the big bank lobbying firm is arguing against requiring the banks to provide ultra transparency so that Libor and similar benchmark interest rates could be based off of actual transactions.

“Provided that a sufficiently robust governance and control framework is in place and there is clear transparency, benchmarks determined under a variety of methods can be of great value to users.”

Translation:  financial regulators please substitute a combination of complex rules and regulatory oversight for the combination of transparency and market discipline.

With the combination of complex rules and regulatory oversight, the banks can continue to manipulate for profit Libor and similar benchmark interest rates.

With transparency and market discipline, banks lose their ability to manipulate Libor and similar benchmark interest rates. 

Are European policymakers about to trigger EU-wide bank run

Reuters reports that EU policymakers are looking at making bank depositors bear some of the cost of bailing out the banks in Cyprus.

Once established, this policy will apply to banks in Spain, Italy, France ... and the EU-wide run on the banks will be on as a) no one can tell if any EU bank is solvent and b) there is plenty of anecdotal evidence that none of the EU banks is solvent.

European policymakers are split over how to handle a bailout of Cyprus, with Germany and some other countries pushing for bank depositors to bear part of the cost and many other member states worried such a move will cause a bank run. 

Euro zone officials say momentum has built in recent days behind the idea of "bailing-in" Cypriot bank shareholders and depositors, although the specifics of how such an operation would be carried out have not been pinned down....

Germany, Finland and the Netherlands are among those who say taxpayers cannot be expected to go on financing euro zone bailouts, saying it is time for owners and depositors in risk-laden banks to accept losses on investments. 

The concern is that announcing such a move will provoke the immediate, large-scale withdrawal of deposits from all Cypriot banks, where a large number of international investors, including many Russian and British companies, hold accounts....

While Cyprus is the euro zone's third smallest economy with annual GDP of only around 18 billion euros, a bank run could have repercussions across the single currency bloc and re-ignite the debt crisis, officials warn. 

"We have to consider that risk," said one euro zone officials whose country is undecided about whether a bail-in of depositors is the right course of action. "It's a real option but some countries don't want it."

I happen to agree that unsecured bank debt and equity holders should bear losses.

However, the necessary condition for these investors to hold losses is that the banks provide ultra transparency and disclose their current global asset, liability and off-balance sheet exposure details.

With this information, investors can assess the risk and solvency of a bank and can adjust both the amount and price of their exposure to a bank to reflect this assessment.  As a result of having the information on which to make an informed investment decision, the investor is responsible for all losses on their exposure.

Unfortunately, this is not the case.  As the Bank of England's Andrew Haldane says, current bank disclosure leaves them resembling 'black boxes'.

If they were only black boxes, then losses could be imposed on the gamblers who buy the unsecured debt and equity of these black boxes.

Banks are not just black boxes.  Banks are black boxes where the bank regulators have been making public comments about the content of these black boxes.  Specifically, bank regulators have been saying that they are solvent.

Oops.  How can you impose a solvency related loss on an investor who relied on the bank regulators' statements that the bank was solvent?

The simple solution is to realize that banks are designed to operate with low or negative book capital levels and to not bail out the banks.

By requiring the banks to provide ultra transparence, the market can exert discipline so that the bankers do not gamble on redemption as they retain future earnings to rebuild their book capital levels.

Head of UK bank regulator: "banks' assets wrongly valued"

The Telegraph reports that the newly appointed head of the Bank of England's bank supervision area says that banks are not valuing their assets correctly.

That banks are not valuing their assets correctly is not news.  Your humble blogger has been talking about this since the beginning of the financial crisis and the adoption of regulatory forbearance (which turns non-performing loans into 'zombie' loans the banks claim are performing) and the suspension of mark to market accounting (which lets bank management mark their securities to mythology).

What is newsworthy about the statement is that the regulator wants to end these deceptive practices and have the assets actually properly valued.

Regular readers know that the only way to properly value the assets is to have the banks provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

With this information, the market can an will value the assets.

This has several advantages including:

1. Markets are designed to price assets so the price of the assets reflects not just the regulators' or bankers' opinions; and
2. Markets are not influenced by the lobbying of the banks for higher asset valuations;

With this information, the market will also exert discipline on the banks so that any losses that are currently being hidden on or off the banks' balance sheets are recognized.

The new PRA, which will be a division of the Bank of England, will take over the prudential operations of the FSA – ensuring banks hold enough capital and liquidity to withstand shocks unaided. 

It is intended to be the first line of defence in preventing the UK’s largest banks from ever returning to the point they reached four years ago, when their failure threatened to bring down the entire financial system.

The new PRA should use the market as leverage to fulfill its role as the first line of defense in preventing UK banks from threatening to bring down the entire financial system.

PRA can easily do this by championing requiring the banks to provide ultra transparency.

With this information, the PRA can access the market's ability to analyze data to identify banks that have a higher risk profile.

With this information, the PRA can piggyback on the market's ability to exert discipline on these banks to reduce their risk profile.

Among the body's first tasks will be an assessment of the risks being taken by large banks. 

An assessment that the market and its experts is more qualified to perform than the PRA and its staff.

Mr Bailey told The Times there was a need to "bring this capital debate to a head and ask what is it we are concerned about". 

He added that regulators believed there were still problems with bank balance sheets: 

“Some assets are valued in a way I don’t think is sufficiently prudent. That is not lying. That’s a matter of judgment.”

In matters of judgment like asset valuation, it is better to have an independent third party value the assets than the regulators or the bankers.  That independent third party is the market.

The Cambridge-educated economist cautioned that banks remained too big to fail.

A problem that requiring the banks to provide ultra transparency cures as the market exerts discipline on these banks to reduce their risk profile.

He believed too that the industry faces a small “tail risk” that fines over Libor, mis-sold interest rate hedging products and other wrongdoing could cause institutions to “keel over”.

Banks are not like non-financial firms.  They don't keel over.  They only go out of business when the regulators close them down.

Banks are designed to operate with low or negative book capital levels.  They can do this because of the combination of deposit insurance and access to central bank funding.  Deposit insurance effectively makes the taxpayers the banks' silent equity partner when they have low or negative book capital levels.

Mr Bailey will also become the third deputy governor of the Bank of England. In his role as one of the three deputy governors of the Bank, Mr Bailey will have responsibility for prudential regulation. He will also become a member of the Court of Directors (the governing board of the Bank) and a member of the Financial Policy Committee.

Geithner Doctrine worked as financial crisis just a 'blip' for bankers

Under the leadership of the US Treasury and Federal Reserve, prior to the current financial crisis global financial regulators abandon the policy of financial failure prevention that the global financial system is based on in favor of the policy of financial failure containment.

The policy of financial failure containment is embodies in its corollary, the Geithner Doctrine.  Under the Geithner Doctrine, as Yves Smith says, no action shall be taken that hurts the profitability or reputation of a bank that is too big to fail or politically connected.

Under the policy of financial failure containment and the Geithner Doctrine, at the beginning of financial crisis most western economies adopted the Japanese Model for handling a bank solvency led financial crisis.

Under the Japanese Model, bank book capital levels and banker bonuses were protected at all costs.

The Financial Times reports that it is mission accomplished when it comes to having protected banker bonuses.

At the same time, the cost to the global economy has been significant and is still rising.

As regular readers know, there is an alternative to the policy of financial failure containment, the Geithner Doctrine and the Japanese Model.  The alternative is the policy of financial failure prevention and the Swedish Model.

Under the Swedish Model, banks are required to recognize upfront the losses on the excess debt in the financial system.  By having the banks recognize these losses, the real economy is protected as it does not have to divert capital needed for reinvestment and growth to debt service.

Of course, under the Swedish Model, banker cash bonuses are limited until such time as the bank has rebuilt its book capital level through retain earnings.

The financial crisis has been “little more than a blip” for London bankers who were being paid more three years after it hit than before and were more likely to be employed than other workers, a report has found. 

The financial sector has proved remarkably resilient with wages in the City rising, while other workers saw pay fall between 2008 and 2011, according to research from the London School of Economics. 

Inequality before the crisis was driven by high pay in the financial sector and does not look set to stop, said Brian Bell of the Centre for Economic Performance, a co-author of the report. 

“The sector which in some sense caused the whole crisis is the sector which seems immune to almost any employment effect,” said Mr Bell. “Traders earning millions are in some sense not replaceable . . . so they have remarkable bargaining power within firms.”

Actually, requiring banks to provide ultra transparency and disclose their current global asset, liability and off-balance sheet exposure details would go a long ways to reducing the leverage of the traders.

Exposing their positions to other market participants would dramatically shrink the profitability of their bets as market participants trading against the bank would limit the upside of the bank's positions and maximize the downside.

With profits lowered and risk raised, banks would reduce the size, if not completely eliminate, the bets taken by traders.  The result is much less compensation for bank traders.

London’s finance workers took home 14.2 per cent more in salary and cash bonuses for 2011 than they did in 2008, compared with a 3.7 per cent rise – a real terms fall – for all other workers.

The top 10 per cent of bankers saw their wages rise by an average 8.6 per cent over the three years, more than the 2.3 per cent rise for the top decile of all workers. 

The report shows that a worker in the finance industry was still 2.2 per cent more likely to be employed than workers in other sectors....

Bottom line:  the policy of financial failure containment, the Geithner Doctrine and the Japanese Model have been wonderful for protecting banker pay.

And what does the real economy and the rest of society have to show for it?

Adoption of austerity policies and a rewriting of the social contract.

Two Labour MPs said the report showed that the financial sector – much of which was bailed out by the state – had not changed its ways. 

Lisa Nandy, MP for Wigan, said it was “business as usual” for parts of the banking industry and the government should “not be letting them get away with it”. 

“It demonstrates that finance executives and investment bankers have learnt nothing from the financial crisis,” she said. 

Paul Flynn, Labour MP for Newport East, said banks were part of a “dependency culture”. “It proves that the wages of sin are handsome,” he said.

Of course, this was the goal of the policy of financial failure containment, the Geithner Doctrine and the Japanese Model for handling a bank solvency led financial crisis.

EU bank regulator to create liquidity ranking for assets

In yet another example of the substitution of the combination of complex rules and regulatory oversight for the combination of transparency and market discipline, EU bank regulators are going to create a liquidity ranking for assets held by a bank.

Bloomberg reports that the European Banking Authority will start ranking assets by their liquidity in an effort to assure that banks have adequate liquidity to protect themselves from a sudden loss of short-term funding.

Regular readers know this whole exercise is not needed if the banks are required to provide ultra transparency and disclose their current global asset, liability and off-balance sheet exposure details.

With this information, market participants, including the bank regulators, can exert discipline on the banks to maintain adequate liquidity.

Europe’s top banking regulator will start ranking financial assets in order of liquidity as it implements international rules to protect banks from a sudden loss of short-term funding. 

The European Banking Authority will create a “scorecard” of asset liquidity, the agency said in an e-mailed statement, as part of requirements that banks hold a buffer of assets, known as the Liquidity Coverage Ratio, they can quickly sell to survive a 30-day credit squeeze. 

The EBA’s analysis will also “identify the features that are of particular importance to market liquidity” and report to the European Union’s executive body, the regulator said....

Regular readers might recall that the EBA was the bank regulatory authority that determined that the disclosures made by opaque, toxic subprime mortgage-backed securities were adequate for banks to know what they own.

Given this history, there is zero reason to believe that the EBA is capable of identifying the features that are important for liquidity or creating a useful asset liquidity scorecard.

The LCR is part of an overhaul of global financial rules, known as Basel III, intended to prevent a repeat of the financial crisis that followed the 2008 collapse of Lehman Brothers Holdings Inc.

Please note the substitution of the combination of complex rules and regulatory oversight that failed to prevent the financial crisis for the combination of transparency and market discipline that protected the sectors of the financial system that did not freeze during the financial crisis.

EU Commission turns up pressure on banks over Libor

The Financial Times reports that the EU Commission is turning up pressure on the banks to settle the Libor interest rate rigging scandal by pointing out that it can assess a fine equal to 10% of each bank's annual revenue for every market it was involved in manipulating rates.

At first blush, the idea that a bank could lose 30% of its annual revenue for having manipulated benchmark interest rates on a global basis (Libor, Euribor and Tibor) sounds like a significant penalty.

However, consider that these rates have probably been manipulated for 2+ decades and suddenly a fine of this size might not be large enough to make the banks disgorge all the profits they made from manipulating the benchmark interest rates.

To date, the fines assessed to the banks have been the equivalent of parking tickets and will do absolutely nothing to stop bankers from engaging in manipulating interest rates in the future.  What the fines will do is send a message to the bankers not to leave an electronic trail while they are manipulating interest rates.

The European Commission’s 18-month antitrust investigation, previously known to include yen and euro interbank rates, has been extended to include Swiss franc-denominated swaps and poses a significant regulatory threat to the financial institutions under scrutiny, according to people familiar with the probe. 

The commission can impose a maximum penalty equivalent to 10 per cent of a company’s global turnover for each cartel it is found to be involved with. A bank implicated in all three rate-fixing cases could, for example, face fines of up to 30 per cent of total revenues.... 

Libor scandal expands into Swiss franc denominated swaps

Reuters reports that the Libor interest rate manipulation scandal is now expanding into the market for Swiss franc denominated swaps.

This is not surprising as there is no reason to assume that bad behavior by bankers that was hidden behind a veil of opacity in one market would not occur in other markets.

As everyone knows, sunshine is the best disinfectant for bad banker behavior.  That is why your humble blogger has been advocating requiring 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 could monitor what the banks were doing and exert discipline where the bankers were behaving badly.

The European Commission's 18-month long antitrust probe into yen and euro interbank rates has been broadened to include Swiss franc-denominated swaps, posing a significant regulatory threat to financial institutions under scrutiny, the Financial Times reported on Thursday....

The paper, citing people involved in the probe, said the EU is informally exploring the potential for settlements but some companies are reluctant to open discussions over what they see as unfounded allegations.

European banks resort to manipulation to make their capital ratios look better

In yet another article on the manipulation of capital ratios by the banks, the Wall Street Journal looks at how European banks are attempting to look better and disguise their true financial condition.

Regular readers know that the Basel capital requirements are an open invitation to the banks to manipulate their reported capital ratios.

By design, Basel capital requirements hide the true leverage and risk of the banks (I say this as an individual who helped to create Basel I and the reason for hiding the true leverage and risk was to allow the banks to earn a higher ROE - the regulators believed this was necessary to attract capital).

The Bank of England's Andrew Haldane notes what a good job the Basel capital requirements do at hiding leverage and risk when he observed that there are literally millions of assumptions that go into calculating Basel III.

Big European banks are boosting a key gauge of their financial health through largely cosmetic maneuvering, even as regulators in some countries try to crack down on the practice. 

The only way to crackdown on the practice 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 calculate capital ratios for each bank themselves.

Banks are recalculating the risks in their loan portfolios and trading books in flattering ways, a move that has the effect of raising their ratio of capital to "risk-weighted" assets—a metric that investors and regulators use to assess banks' abilities to absorb unexpected losses. 

While such maneuvering has been going on for years, analysts say it appears to be accelerating at some major European banks, which are under pressure to raise their capital ratios as new regulations known as Basel III start phasing in this year.

Fitch: mortgage bonds need better transparency

According to a Wall Street Journal article, Fitch asserted that mortgage bonds need better transparency so that investors are protected and originators and issuers have an incentive to do a better job underwriting the mortgages.

Regular readers know that the transparency investors need in order to fully enforce the reps and warranties of each deal is observable event based reporting.  Under observable event based reporting, every activity like a payment or delinquency involving the underlying collateral are reported to the investors before the beginning of the next business day.

With observable event based reporting, investors can know what they are buying and what they own.

As a result, they can enforce the reps and warranties for each mortgage that violates the terms of these reps and warranties as soon as the violation occurs.

Mortgage bond issuers that are relieving lenders of some potential liabilities may be exposing investors to additional risks of weak underwriting and defective loans, Fitch Ratings said in a report Wednesday. 

Fitch focused on proposals to recast the so-called representations and warranties in private mortgage-backed securities, which are legal testaments to the quality of the assets packaged into a securitization. 

Facing billions of dollars in claims over bubble-era mortgages that have caused investor losses, the issuers are trying to provide some degree of protection to lenders in the future, to the extent that investors will allow. 

Some rep and warrant provisions in recent residential mortgage-backed securities have provisions that Fitch "deems weak," the rating firm said in a statement. 

For example, some of the provisions relieve lenders from demands to repurchase faulty loans after fewer than 36 months, it said. 

"The balance between protecting both lenders and investors in new RMBS deals requires greater clarity and transparency so that investors remain protected and lenders remain incentivized to make sound underwriting decisions," Fitch said.

Thomas Hoenig: bank accounting masks risk of banks

Bloomberg reports that FDIC Vice Chairman Thomas Hoenig wants bank accounting changed so that it properly reflects the risk of the banks.

Specifically, he wants to force the banks to include their off-balance sheet exposures on their balance sheets.  For derivatives, this means showing the gross amount of exposure and not the net amount of exposure.

Regular readers know that accounting for financial institutions actually creates opacity.  It creates opacity because it hides the risk of the individual exposures in summary accounts.

The only way to convey the risk of each bank is to have the banks 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 assess the risk and solvency of each bank.  Without this information, market participants cannot assess the risk and solvency of each bank because accounting turns them into 'black boxes'.

Warning: Banks in the U.S. are bigger than they appear. 

That label, like a similar one on automobile side-view mirrors, might be required of the four largest U.S. lenders if Thomas Hoenig, vice chairman of the Federal Deposit Insurance Corp., has his way. 

Applying stricter accounting standards for derivatives and off-balance-sheet assets would make the banks twice as big as they say they are -- or about the size of the U.S. economy -- according to data compiled by Bloomberg. 

“Derivatives, like loans, carry risk,” Hoenig said in an interview. “To recognize those bets on the balance sheet would give a better picture of the risk exposures that are there.”

Gary Gensler: 'Setting' Libor still not clean despite scandal

The BBC reports that Gary Gensler, head of the CFTC, sees a lot that much be done before 'setting' of Libor and other benchmark interest rates like Euribor and Tibor is done so that they cannot be manipulated.

Regular readers know that what must be done is that the banks must be required to provide ultra transparency so that these benchmark interest rates can be based off of actual transaction from a deep, liquid unsecured bank debt market.

Ultra transparency is the key to unfreezing and keeping unfrozen the interbank lending market as it provides the data that banks with deposits to lend need to assess the risk and solvency of banks looking to borrow.

Specifically, under ultra transparency banks disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

Ultra transparency is also the key to basing benchmark interest rates off of actual transactions.  These transactions are disclosed by each bank.  Market participants can then determine which transactions to include in the benchmark interest rates.

Without ultra transparency, benchmark interest rates will still be subject to manipulation even if there are complex rules and regulatory oversight of setting process.

The way that the key Libor interest rate is set in the UK is still not clean and free of fraud, according to a top US regulator. 

"We have a lot more work to do," Gary Gensler, chairman of the Commodity Futures Trading Commission, told the BBC in London. 

He suggested that the rate was often "completely made up".....

Speaking of the scandal, Mr Gensler spoke of "pervasive rigging" and said authorities could not guarantee the rate is fraud-free, but refused to criticise the FSA or suggest that setting the rate should be moved to the US....

Please re-read the highlighted text again as Mr. Gensler has just confirmed what your humble blogger has been saying that the only way to guarantee that the benchmark interest rates are free of fraud is through ultra transparency.

Complex rules and regulatory oversight as suggested in the Wheatley Review will simply not guarantee an absence of fraud nor do they provide a reason for the market to trust the resulting benchmark interest rates.

So why did the Wheatley Review not publish your humble blogger's suggestion of ultra transparency and instead championed a combination of complex rules and regulatory oversight that will not work?

Mr Gensler compared the manipulation of rates to an estate agent trying to sell you a house. 

"They are trying to reference the price of the houses in the neighbourhood [when] there have been no transactions in the neighbourhood and furthermore, the agent is not willing to share the data and is often just making it all up," he said.

A problem that ultra transparency alone solves.

The BBA told the BBC it would not comment on Mr Gensler's comments but said: "The BBA has strongly stated the need for greater regulatory oversight of Libor". It added that it was working closely with the government and regulators to change the system. 

A government-commissioned review suggested taking the responsibility away from the BBA and placing it in the hands of an outside authority, such as a commercial body or an industry group.

This is an example of regulatory capture.

The British Banking Authority asked its regulator to do something that the combination of complex rules and regulatory oversight cannot accomplish.  Rather than respond by requiring ultra transparency, the regulatory response was to pursue a path that would allow the banks to continue manipulating the benchmark interest rates as before.

PIMCO shocked by prices paid to gamble on toxic RMBS

Bloomberg reports that JP Morgan is trying to bring a non-agency backed residential mortgage-backed security to market and PIMCO is shocked by the terms that gamblers are willing to accept to place their wager on these securities.

As everyone knows, residential mortgage-backed securities are opaque.  Therefore, buying these securities is simply blindly betting on the contents of a brown paper bag.

Leading up to the financial crisis, buying these securities was a losing bet for the gamblers and selling these securities was a winning bet for Wall Street.

Since nothing has changed, most notably these securities still do not offer observable event based reporting under which all activities like a payment or default on the underlying assets are reported before the beginning of the next business day so market participants can know what they are buying or know what they own, there is no reason to believe the gamblers won't lose again.

Which is precisely why PIMCO cannot believe the prices paid by the gamblers.

JPMorgan Chase & Co. is seeking to sell securities tied to new U.S. home loans without government backing in its first offering since the financial crisis that the debt helped trigger. 

The deal may close this month, according to a person familiar with the discussions. 

Servicers of the underlying loans may include the New York-based lender, First Republic Bank and Johnson Bank, said the person, who asked not to be identified because terms aren’t set. 

The market for so-called non-agency mortgage securities is reviving as the Federal Reserve’s $85 billion a month of bond purchases help push investors to seek potentially higher returns. 

As deals accelerate, Pacific Investment Management Co. is questioning the prices paid. 

At the same time, a weakening of contract clauses that offer protection to investors if the loans don’t match their promised quality is stoking debate, said Kroll Bond Rating Agency analyst Glenn Costello. 

“There’s a pretty heavy dialogue going on right now between all participants in the market about what makes sense,” Costello, who is based in New York, said last week in a telephone interview....

What makes sense is that the deals provide observable event based reporting.

JPMorgan is telling investors its deal’s terms may allow some of the so-called representations and warranties about the mortgages from originators or itself to expire after 36 months to 60 months, the person said. Such contract clauses, which can be used to force loan repurchases, have led to billions of dollars of costs for banks on debt made during the housing boom. 

After Credit Suisse included so-called sunsets of 36 months on certain buyback promises in a November deal, Standard & Poor’s, the only grader to rate the bonds, said in a statement that the move didn’t affect its view of the debt’s risks. The ratings firm cited the “exceptionally high credit quality” of the loans and that all of them had been reviewed by third-party firms before being packaged into the securities.

Interesting to note the use of third-party firms to review the mortgages and the reluctance of the issuers to provide the data on the mortgages to all market participants so that investors can do their own independent assessment.

As everyone knows, one of the weak spots in securitization is the reliance on third parties making representations about the quality of the underlying collateral and the deal.  A prime example of this was the rating firms.

Yet, here is Wall Street trying to repackage and sell the same snake oil.

Rivals including Fitch Ratings, which publicly called S&P’s grades too high, are taking a more skeptical view. Changes such as sunset provisions and clauses that void loan-quality warranties if borrowers default after events such as job losses or illness generally should require greater so-called credit enhancement, said Rui Pereira, a managing director at Fitch. 

Credit enhancement can include some bonds taking losses before others, cash reserves or payments from the underlying assets that exceed coupons on the securities created. 

“Less investor-friendly provisions are something we need to take into account,” Pereira said last week in a telephone interview.

Issuers are seeking to move past a framework for representations and warranties provided by Redwood that represented a “gold standard,”Kathryn Kelbaugh, a senior analyst at Moody’s Investors Service, said last month during a panel discussion at a securitization conference in Las Vegas. 

In Redwood’s latest deal, it may sell a top-rated class as large as $561.2 million with a 2.5 percent coupon at about 102 cents on the dollar, a person familiar with that offering said today, asking not to be named because terms aren’t set. 

That compares with current prices of about 99 cents on the dollar for Fannie Mae-guaranteed 2.5 percent securities, according to Bloomberg data. 

Bonds issued in recent months by Redwood have been “insanely expensive” by comparison with Fannie Mae debt, Pimco’s Scott Simonsaid in an interview yesterday. 

“I can’t believe someone would pay anywhere near where they have sold them,” said Simon, the mortgage-bond head at Newport Beach, California-based Pimco, manager of the world’s largest mutual fund.

 It is hard to argue with Mr. Simon's observation about the Redwood deal or the prices gamblers are paying for other opaque residential mortgage-backed securities.