Friday, May 31, 2013

Noah Smith and what does it mean to have "predicted the crisis"

In an excellent post, Noah Smith asks the question of what does it mean to have "predicted the crisis" and then challenges anyone who claims to have "predicted the crisis" to examine their track record in light of his analysis.

Naturally, your humble blogger thought this would be an interesting exercise to apply to oneself because I frequently mention that I "predicted the crisis" and the success or failure of the different responses to the crisis.
Since 2008, quite a lot of people have boldly claimed that they "predicted the crisis". 
I confess to having made this claim.
Usually, the claimants use this "fact" to argue for the superiority of their economic school of thought, modeling approach, investing approach, or personal intuition.
I confess that I have in fact used not only my prediction of the crisis, but also the accuracy of my predictions of the success or failure of the various policy responses to the crisis to argue for my approach, the FDR Framework.
But what does it mean to have "predicted the crisis"? 
First of all, there are different things that get labeled "the crisis". These include: 
1. The big drop in U.S. housing prices that started in 2007. 
2. The systemic collapse of the U.S. financial industry that began in 2008. 
3. The deep recession and the long stagnation that began in late 2008. 
Predicting one of these is not the same as predicting the others. 
It is possible, for example, to have missed the housing bubble and the finance industry collapse, but to have successfully predicted, after seeing these events happen, that a deep recession and long stagnation would be the result; this is what Marco Del Negro et al. claim to have done, and a number of pundits and commentators made informal recession predictions after housing peaked in 2006. 
Alternatively, it is possible to have predicted the bursting of the housing bubble without foreseeing the systemic damage that this would cause to the financial system; many writers, such as Bill McBride, Dean Baker, and Nouriel Roubini, seem to have done this (and of course, Robert Shiller). 
It is also possible to have predicted the collapse of the big banks and their mortgage-backed bonds - and made money off of this - while staying agnostic about the macroeconomic consequences; this seems to have made a lot of money for investors like Steve Eisman and John Paulson. 
Of course, in theory it might have been possible to predict all three events.
For the record, my predictions applied to the collapse of the global financial system and what it would take to avoid the deep recession and long stagnation that has occurred since the crisis began on August 9, 2007.
Then there's the question of what it means to "predict" something. Here are some alternative definitions: 
1. You could predict the timing of an event, e.g. when the housing bubble would burst. 
2. You could predict the size or severity of an event, e.g. how much house prices would decline or how much the economy would contract in 2009. 
3. You could predict the duration of an event, e.g. how long our economy would stagnate after the recession, or how long it would be before housing prices reached their pre-crash peak. 
4. You could describe the particular characteristics of an event, e.g. what would cause banks to fail, or whether they would be bailed out, or whether inflation would remain subdued after the recession.
My predictions fall into Mr. Smith's third and fourth category.

Caroline Salas and Bloomberg reported on December 4, 2007 that I was saying the solution for moderating the seizure of the credit markets driven by the toxic subprime mortgage bonds was to make them transparent so that market participants could accurately value them.

For example, Paul Kix and the Boston Magazine reported that I was saying in February 2008 that because of opacity in structured finance securities we faced a downward economic spiral until such time as transparency was brought to these securities.

Subsequently, but well before September 2008, I expanded the need for transparency to apply to all the opaque corners of the financial system, including banks.

After the financial crisis hit, my predictions, many of which are on this blog, then shifted to would a policy response or combination of policy responses policy makers and regulators were pursuing work or not work to end our ongoing financial crisis.

Just to remove any doubt about what policy responses I predicted would work, I have written extensively about the Swedish Model under which banks are required to recognize upfront their losses on the excess public and private debt in the financial system.
Next, there is the question of with what degree of confidence you make a prediction. Saying "this event is a conceivable possibility" is different than saying "the risk of this event is high," which is different from saying "the risk of this event has increased," which is different from saying "this event will happen."
Regular readers of my blog know I don't BS when I make a prediction.  My predictions are all of the variety that "this event will happen."

For example, I predicted that BlackRock assessing individual banks would not restore confidence in the Irish, Greek or Spanish banking system.  In fact, it didn't.
Also, there is the question of how far in advance a prediction was made. That could be important.
Each of my predictions was made when there was still time for policy makers and regulators to listen to the prediction and choose a different policy response that would have been successful.
Finally, there is the question of whether the prediction was made by a model or by a human. 
If it's a model, then there's the hope that humanity has a tool with which to predict future crisis events.
Fortunately, my predictions were based on a model:  the FDR Framework.  The Swedish Model, which is the response to a bank solvency led financial crisis, is a component of the FDR Framework.

I confess, I hope the FDR Framework is not used as a model to predict future crisis events.  Rather, the FDR Framework is a model for how the financial system is suppose to work so that a future crisis can be avoided.

Simply put, what made our current crisis possible was the financial regulators allowed opacity into large corners of the financial system.  If we don't let this happen in the future, we shouldn't have another opacity driven financial crisis.
Anyway, how should we evaluate these claims? 
There are so many different combination of "predictions" and "crises" here that it's very difficult to lay out an explicit taxonomy of who got it "more right," and who got it "less right." 
As a more humble goal, we can examine a specific individual or model, and identify which events he/she/it predicted, with what degree of confidence, and when.
When you look at which events I predicted, the degree of confidence of the prediction and the timing of the prediction, the FDR Framework stacks up incredibly well against any of the alternatives.

Thursday, May 30, 2013

Why Shareholder Rescue Never Comes to end Too Big to Fail Banks

In his ProPublica article, Jesse Eisinger looks at why shareholders don't end the problem of Too Big to Fail banks.

Mr. Eisinger had hoped that shareholders would put pressure on bank management because of low share prices to break up these institutions.

He considered the possibility that because of opacity, shareholders were worried about how the risk would be distributed if they forced a break-up.  So this restrained the shareholders forcing a break-up.

Then, leaving opacity behind, he settled on the idea that shareholders actually prefer banks to take on risk as they have capped downside and unlimited upside.

Mr. Eisinger is on the right track.  However, he failed to see the link between opacity and the type of shareholders that banks attract.

As regular readers know, under the FDR Framework, there is a three step investment process:

  1. Investor independently assesses all the useful, relevant information to determine the risk of and value of the investment;
  2. Investor solicits bids from Wall Street to buy or sell the investment.
  3. Investor compares the price shown by Wall Street to independent valuation to make buy, hold or sell decision.
When there is opacity, as is the case with banks, investors do not have access to all the useful, relevant information and therefore they cannot independently assess the risk or value the investment.  As a result, investors cannot go through the investment process.

So buying or selling shares in a bank is not investing, but rather something else entirely.

As the Bank of England's Andrew Haldane says, banks are "black boxes".  Nobody other than the bank regulators knows what risks are inside these boxes.  This has important implications for the types of shareholders that banks attract.

Investors are not attracted to banks because investors cannot go through the investment process.  They recognize that buying or selling bank shares is nothing more than gambling on the contents of a black box.

Naturally, the shareholders who are attracted to the big banks are not investors who would exert discipline on management, but rather gamblers.  By definition, these gamblers want bank management to take on risk because as Mr. Eisinger noted their downside is capped and their upside is unlimited.

Wednesday, May 29, 2013

How to make bank bail-ins work

In their NY Times' Dealbook column, Neil Unmack and Peter Thal Larsen conclude that the way to make bank bail-ins acceptable is to have banks provide more information so that unsecured investors can assess the risk that they are taking on.

Regular readers recognize that this is a point your humble blogger has been making since the beginning of the financial crisis.

The information that the investors need is to have each bank disclose its current global asset, liability and off-balance sheet exposure details.

It is only with this information that the investors can independently assess the risk of each bank and adjust their exposure to each bank to reflect this risk.

Regulators want banks to be able to go bust like ordinary companies. That means bondholders taking the pain if a bank fails. But if debt investors are to shoulder the risk of suffering a loss, they will need more confidence about what lurks in banks’ balance sheets.... 
A better solution would be improved transparency, as the Committee for the Global Financial System suggested recently.... 
But what to disclose? ...
All of a bank's current exposure details.
Banks will of course say disclosure can be dangerous....
Banks saying disclosure can be dangerous is ironic because up until the late 1930s, a bank disclosing its exposure details was considered the sign of a bank that could stand on its own two feet.
But unsecured bondholders will only accept the possibility of taking the pain in a bank failure if they can price their risk. 
More information is a must.
Without disclosure of each bank's current exposure details, it is simply impossible for market participants to assess the risk of each bank.

If investors are going to be responsible for taking losses, they need the information to assess each bank's risk so they can adjust their exposure to each bank to what the investor can afford to lose given the risk of each bank.

What can be done to end what the BoE's Andrew Haldane calls the "irresistible" urge to bailout banks?

The Wall Street Journal reports that the Bank of England's Andrew Haldane acknowledge the elephant in the room when he observed that financial regulators face an "irresistible" urge to bail-out banks using taxpayer funds rather than bail-in banks using stockholder and unsecured debt holder funds.

Mr. Haldane called for a set of binding rules on authorities to "tie their hands" and force them to bail-in rather than bail-out the banks.

In addition, he wanted higher levels of capital to make it more likely that at a time of crisis the authorities would not ask that the rules be taken off and that the capital on bank balance sheets actually be used.

History has already shown that neither of Mr. Haldane's proposed solution to the irresistible urge has proven to be effective.

Bank regulators will never give up the option of using taxpayer funds to bail-out the banks in a time of financial crisis.  Even if a law is passed today, everyone knows that the law will be repealed if the bank regulators think that the failure to repeal the law will make the financial crisis worse.

Bank regulators also will never require banks to use their book capital to absorb losses during a financial crisis.  Bank regulators see a decline in book capital levels as sending the wrong signals about the safety and soundness of the financial system.  The bank regulators would rather engage in regulatory forbearance and let banks practice 'extend and pretend' to turn non-performing loans into 'zombie' loans.

Your humble blogger calls the banking regulators' "irresistible" urge to bail-out the banks using taxpayer funds the elephant in the room because this urge results from opacity.

Because banks are opaque, in Mr. Haldane's words they are 'black boxes', market participants do not know how risky they are.

As a result, market participants rely on bank regulators who have 24/7/365 access to each bank's exposure details to assess and communicate the risk of each bank.

The failure to properly assess or communicate the risk of each bank results in market participants having more exposure to each bank than they can afford to lose.  It is this excess exposure framed as financial contagion that assures that banks will always be bailed-out by taxpayers.

Regular readers know that there is one simple solution that ends the bank regulators' irresistible urge to bail-out the banks.  Require the banks to disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

With this information, market participants are no longer dependent on the bank regulators' assessment and communication of the risk of each bank.  Rather, market participants can independently assess the risk of each bank and adjust their exposure to what they can afford to lose given the risk of each bank.  This ends the fear of financial contagion.

In addition, with transparency, unsecured debt and equity investors expect to be held responsible for absorbing losses on their investments.  The investors know they face the potential for loss and they have an incentive to exert restraint on bank management so that bank management does not take on excessive amounts of risk.

This is the way our financial system operates under the FDR Framework.

With financial contagion eliminated and investors expecting to absorb losses, there is no reason for bank regulators to still have an irresistible urge to bail-out the banks.

Rules that force a bank's creditors to lose money, rather than the taxpayer, may be insufficient to address the problem of banks being too big to fail, said Andrew Haldane, the Bank of England's executive director for financial stability Tuesday. 
"Faithful implementation" of the regulatory reform agenda that has been pursued in stages since the financial crisis of 2008 is "an absolute necessity," said the BOE official at a conference here on the future of the banking sector. He said, however, that such a move is "necessary, but perhaps not sufficient." 
The central banker said, "when a big bank fails, bail in is never a soft option...the temptation is always there for governments to reach for the check book," referring to when creditors are forced to take losses. He said the temptation to bail out rather than bail in was "irresistible." 
Mr. Haldane said that to get past this problem authorities needed to have set rules that "tied their hands" and that tougher capital standards for banks should be considered. He referenced a proposal in the U.S. to up the leverage ratio for some banks to 15%, rather than the 3% envisaged in international rules known as Basel III. 
"I don't have a magic number, but I do think the time is right within Europe to reopen the debate about whether 97%-debt financed banks is a suitably proved endpoint," he said.

Tuesday, May 28, 2013

BIS moves one step closer to advocating banks disclose exposure details

Bloomberg reports that the BIS is calling for banks to disclose the assets that they have pledged for collateral to secure loans so that investors can do a better job of assessing the risk of each bank.

By calling for pledged asset level disclosure, the BIS has moved one step closer to joining your humble blogger in advocating that banks disclose all of their exposure details.

Regular readers know that it is only with each bank disclosing its asset, liability and off-balance sheet exposure details that market participants, including competitor banks and investors, can assess the risk of each bank.

Banks should disclose the assets they pledge as collateral for loans so that investors have a better gauge of risk, according to a committee of the Bank for International Settlements.... 
“Transparency about the extent to which bank assets are encumbered or are available for encumbrance will allow unsecured creditors to better assess the risks they face,” according to the report. 
After the financial crisis of 2008, banks’ funding models changed, with collateralized borrowing gaining a bigger role. Using assets such as government bonds as security reduces what’s available to be sold to pay unsecured creditors should there be a default and increases the cost of winding up the institution. 

Monday, May 27, 2013

Paul Krugman on "Japan the Model"

In his New York Times' column, Professor Paul Krugman looks at Japan's pursuit of aggressive monetary policy combined with a dose of fiscal stimulus as the model for ending what he sees as the lack of effort by policymakers to fix the global economy.
So the overall verdict on Japan’s effort to turn its economy around is so far, so good. And let’s hope that this verdict both stands and strengthens over time. 
For if Abenomics works, it will serve a dual purpose, giving Japan itself a much-needed boost and the rest of us an even more-needed antidote to policy lethargy. 
As I said at the beginning, at this point the Western world has seemingly succumbed to a severe case of economic defeatism; we’re not even trying to solve our problems. That needs to change — and maybe, just maybe, Japan can be the instrument of that change.
Please re-read Professor Krugman's comments as he has identified a critical problem:  "we're not even trying to solve our problems."

The reason that we are no longer trying to solve our problems is that it means acknowledging what has been done so far did not fix the economic problems.

And this opens up Pandora's Box for policymakers who have adopted the Japanese Model and chosen to protect bank book capital levels and banker bonuses at all costs.

It opens up Pandora's Box because it is clear that the combinations of austerity/monetary stimulus and fiscal stimulus/monetary stimulus have both failed.  As Professor Joseph Stiglitz said in a Bloomberg article,
“Clearly the economy is not back to normal, and to accept this as the new normal would be really wrong.”
Regular readers know that there is a proven solution for ending a bank solvency led financial crisis like the crisis we are currently experiencing.  That solution is the Swedish Model.

Under the Swedish Model, banks are required to recognize upfront their losses on the excess public and private debt in the financial system.  This removes from the real economy the burden of servicing the excess debt and ends the diversion of capital that is needed for reinvestment, growth and to support the social programs.

Since the 1930s when the US first implemented the Swedish Model, banks have been designed to absorb the losses on the excess debt and continue to operate and support the real economy.  Banks can do this because of the combination of deposit insurance and access to central bank funding.

With deposit insurance, taxpayers are effectively the banks silent equity partner when the banks have low or negative book capital levels.  Capital levels that can be rebuilt over several years through retention of 100% of pre-banker bonus earnings.

As Professor Krugman rightly points out, we are not trying to solve our economic problem.  In fact, this is a choice of the policymakers under advice from the bankers.

After all, the bankers stand to lose their cash bonuses if we fix the excess debt problem with the economy.

So long as policymakers don't try to solve our economic problems, the bankers benefit and it is society that bears the costs.

As your humble blogger has said since the beginning of the financial crisis, the question is "When" will policymakers put their countrymen ahead of the bankers?

Friday, May 24, 2013

Martin Wolf and Ken Rogoff agree: "it is not too late to change course"

The Financial Times' Martin Wolf and Harvard professor Ken Rogoff have taken different paths, but they both agree that the current approach to handling the bank solvency led global financial crisis that began on August 9, 2007 is not working and that "it is not too late to change course".

Mr. Wolf sets out in his column what would be included in this change of course.
The right approach to a crisis of this kind is to use everything: policies that strengthen the banking system; policies that increase private sector incentives to invest; expansionary monetary policies; and, last but not least, the government’s capacity to borrow and spend.
Professor Rogoff lays out in his Guardian column what he thinks is wrong with the current approach and therefore what should be included in this change of course.
No one seems to have the power to impose a sensible resolution of its peripheral countries' debt crisis. Instead of restructuring the manifestly unsustainable debt burdens of Portugal, Ireland, and Greece (the PIGs), politicians and policymakers are pushing for ever-larger bailout packages with ever-less realistic austerity conditions.
Interestingly, both Mr. Wolf and Professor Rogoff have come to champion your humble blogger's blueprint for fixing the financial crisis.

For both individuals, the starting point is dealing with the excess debt in the global financial system.  As Professor Rogoff points out:
In a debt restructuring, the northern eurozone countries (including France) will see hundreds of billions of euros go up in smoke.... These hundreds of billions of euros are already lost, and the game of pretending otherwise cannot continue indefinitely....

But the sooner the underlying reality is made transparent and becomes widely recognised, the lower the long-run cost will be.

The way to deal with this excess public and private debt is by adopting the Swedish Model and requiring the banks to absorb upfront the losses on this debt.

By having the banks absorb the losses on the excess debt, the burden of servicing this debt is lifted from the real economy.  Currently, capital that is needed for reinvestment, growth and supporting the social contract is being diverted to servicing this debt.  Ending this diversion will boost the growth rate of the real economy.

Regular readers know that a modern banking system is designed so that the banks can absorb these losses and still continue to operate and support the real economy.

Banks can do this as a result of the combination of deposit insurance and access to central bank funding.  With deposit insurance, when banks have low or negative book capital levels, taxpayers effectively become the banks' silent equity partner.

After absorbing the losses, the banks then rebuild their book capital levels through retention of 100% of pre-banker bonus earnings.

To make sure the bankers don't gamble on redemption while the banks are rebuilding their book capital levels, 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.  With this information, market participants can exert discipline on the bankers to restrain risk taking.

Once the losses have been recognized, to jumpstart the economy, governments need to adopt fiscal stimulus.

At the same time, central banks need to remove the economic headwinds caused by zero interest rate policies and quantitative easing.  They need to restore short term interest rates to Walter Bagehot's lower bound of 2%.

Increasing interest rates from zero to two percent is actually good for economic growth as it ends the Retirement Plan Death Spiral.  Zero interest rates triggered this death spiral as savers, both individuals and companies, reduced their current consumption to offset the lack of earnings on their retirement savings.

Thursday, May 23, 2013

Hedge funds blindly gambling on private label RMBS nervous as $8.7B portfolio goes on sale

Hedge funds that have been blindly gambling by buying private label RMBS securities are getting nervous as an $8.7 billion portfolio of these securities is being offered for sale.

The sale of the portfolio could hurt their gamble in two ways.  First, the seller could accept prices that are lower than the hedge funds are currently exchanging these bonds.  Second, if the portfolio clears at close to market prices, it might encourage other holders of similar portfolios to try to sell their holdings.

As reported by the Wall Street Journal,
The riskiest types of residential mortgage bonds that rewarded investors with double-digit gains last year and almost that again in 2013 are about to be tested. 
Investors are atwitter with anticipation over what will be one of the biggest sales of non-government mortgage bonds since the financial crisis knocked them into deeply distressed states. 
Wall Street dealers are circulating an $8.7 billion list of subprime and other risky residential mortgage-backed securities (RMBS) to investors for a sale next week, demanding that terms be kept quiet until the mission is accomplished, according to Empirasign Strategies, a trade database. 
But the sheer size of the list, whose source isn’t being disclosed, has investors reconsidering the risk-reward equation after the market’s feverish rally over the past year. 
The supply is rivaling multi-billion dollar sales of RMBS by the Federal Reserve Bank of New York in 2011 and 2012, the earliest of which overwhelmed demand and helped drive the market into a tailspin....
The reason the Fed sales overwhelmed demand is that there is no "market" for private label RMBS securities.

Yes, these securities trade.  But because they are opaque, the trades are typically between one hedge fund and another as they gamble on the value of the contents of the brown paper bag that is the security.
In general, nonagency mortgage bonds have gained almost 10% already this year, after more than 20% last year, said Bryan Whalen, a managing director at TCW Group. 
The market — comprised of subprime and other bonds that aren’t backed by the government — has seen consistent demand for the past year as the U.S. housing market recovers and because of its relatively high yields.
Demand from hedge funds has consistently been on the long side as these gamblers are looking for something to buy.
“As deep as the bid has been, seeing close to $9 billion in a short time period is still a lot to digest,” Whalen said....
The fact that $9 billion is considered a lot to digest is a sure sign that there isn't a market for these securities.

In their heyday before the financial crisis began in 2007, there were $2 trillion of these securities outstanding.  So a sale of $9 billion was a non-event.
What would be worrisome is if other sellers also decide that now is the time to capitalize on today’s higher prices. 
Brad Friedlander, a portfolio at Angel Oak Capital, says he is still bullish on nonagency RMBS, but with the caveat if “we see a real cascade of these sales.”
Translation: the hedge fund gamblers only have so much capacity to buy these opaque, toxic securities.

Wednesday, May 22, 2013

Who prevented the second Great Depression?

Since the beginning of our current financial crisis, policy makers and central bankers have continually used as justification for their policies the claim that no matter how distasteful their policies are necessary to prevent a second Great Depression.

This raises an interesting question.  In response to the Great Depression, did the policy makers in the 1930s put in place a financial system to prevent another Great Depression or not?

Current policy makers would like to claim that the Dodd-Frank Act is all about preventing another Great Depression.  If current policy makers were focused on preventing another Great Depression, there is no reason to assume that policy makers in the 1930s did not have the same agenda.  Particularly because the policy makers in the 1930s were living through and had first hand experience with the Great Depression.

Furthermore, if policy maker in the 1930s did have the agenda of preventing another Great Depression, is it possible that their policy prescriptions alone were adequate to have prevented our current financial crisis from becoming the second Great Depression?

Regular readers know that the 1930s policy makers did in fact put in place all the elements that were necessary for dealing with our current financial crisis and avoiding a second Great Depression.  These policy makers assumed that the lessons of the Great Depression would be forgotten (after all, bankers are very good salespeople) and that another period of excess credit creation could occur.

The 1930s policy makers put in place the elements necessary for dealing with the excess credit in the financial system.  Specifically, they understood that the Swedish Model is the way to deal with a bank solvency led financial crisis.  Under the Swedish Model, banks are required to absorb the losses on the excess debt in the financial system and protect the real economy and the social contract.

The 1930s policy makers designed banks to be able to absorb losses should there ever be a credit bubble and still continue to support the real economy.

Banks can do this because of the combination of deposit insurance and access to central bank funding.  With deposit insurance, taxpayers effectively become the banks' silent equity partners during the years the banks are retaining pre-banker bonus earnings and rebuilding their book capital levels after absorbing the losses on the excess debt.

The 1930s policy makers also put in place the concept of automatic economic stabilizer programs.

So what did our current policy makers contribute to handling our current financial crisis and preventing a second Great Depression?

First, they adopted of the Japanese Model.  Under the Japanese Model, bank book capital levels and banker bonuses are protected at all costs.  As a result, the burden of the excess debt is put on the real economy where it diverts capital needed for reinvestment, growth and the social contract to debt service.

So rather than use the financial system as it is designed and bringing an end to our current financial crisis, our current policy makers chose to maximize both the length of our financial crisis and the damage the financial crisis does to the real economy and the social contract.

Of course, the choices made by our current policy makers haven't hurt everyone.  For bankers and their bonuses, it is close to if not the best of times.

Second, despite our current policy makers' claim to have prevented a second Great Depression, this claim is premature until such time as the excess debt has been purged from the financial system and all programs adopted to deal with our current financial crisis are ended.

An example of the programs that must be ended are monetary policies like zero interest rate and quantitative easing.  What will happen to the real economy and the financial markets when central banks try to unwind these policies?  Will unwinding these policies precipitate the second Great Depression our current policy makers claim to have prevented?

Tuesday, May 21, 2013

BoE's Mervyn King: time to stop demonizing bankers

The Guardian reports that the Bank of England's Mervyn King thinks that it is time to stop demonizing bankers for their role in the financial crisis.


It is time to shift the focus to central bankers, financial regulators and policy makers for their failure to prevent the financial crisis and adopt the Swedish Model policies needed to end the financial crisis.

Sir Mervyn King is right that bankers behaved exactly as badly as we should have expected them to behave.  Their behavior was no different in the 1990s and 2000s than it was in the 1920s.

Just like the 1920s, bankers used the veil of opacity to hide bad behavior that allowed the bankers to unjustly enrich themselves.  For example, the bankers manipulated the global benchmark interests including Libor and Euribor.

The only reason that the bankers could get away with this bad behavior was that the central bankers and financial regulators failed to enforce the regulations put in place in response to this bad behavior in the 1930s.

This failure to enforce existing regulations makes the central bankers and financial regulators far more guilty of causing the financial crisis than the bankers.  After all, what made the financial crisis possible was the central bankers and financial regulators being derelict in the performance of their jobs.

Regular readers know that the FDR Framework is not particularly difficult to enforce.  What it requires is the regulators ensure that there is transparency throughout the financial system.

Specifically, for each investment, including banks and structured finance securities, all the useful, relevant data must be disclose in an appropriate timely manner so that market participants can independently assess this data and make a fully informed decision.

A quick check of our financial system shows that six years after the beginning of the financial crisis and wide swathes of the financial system are still shrouded in opacity (banks and structured finance securities).

And why have the financial regulators and central bankers brought transparency back to the financial system knowing that sunlight is the best disinfectant?

One reason might be they are so captured by the industry they regulate that they no longer understand their job is to ensure transparency.  A second reason might be because they are busily writing complex rules that make the financial system even more opaque, more dependent on regulatory oversight and far more vulnerable to crashes.

The outgoing governor of the Bank of England has called on the British people not to "demonise" bankers for the financial crisis
Sir Mervyn King said on Sunday that the failings of the financial and regulatory system were the root cause of the turmoil which struck the world economy almost six years ago. 
King, who leaves the Bank this summer, told Sky News's Murnaghan programme that there was widespread risk-taking in the runup to the credit crunch, and it had been a mistake to give the banking sector such a lofty status in the good times. 
"Where the banks contributed to the problem was that they themselves had taken too many risks on their balance sheet and they simply didn't have enough capital to absorb the losses that were likely to come along...
"I would say to people though, don't demonise individuals here. This wasn't a problem of individuals, this was a problem of failure of a system. We collectively allowed the banking system to become too big, we gave them far too much status and standing in society, and we didn't regulate it adequately by ensuring it had enough capital."
One of the great ironies of the financial crisis is that central bankers like Sir Mervyn King are highly trained economists yet they do not know how a modern banking system is designed to deal with the issue of excess debt in the financial system.

He puts tremendous focus on the amount of bank capital when in fact bank capital is nothing more than the accounting construct where excess debt in the financial system goes to be written off.

In point of fact, modern banks are designed to continue to operate and support the real economy even when they have negative book capital levels.  Banks can do this because of the combination of deposit insurance and access to central bank funding.

With deposit insurance, taxpayers effectively become the banks' silent equity partners when they have low or negative book capital levels.  For the privilege of having the taxpayers as silent equity partners, banks have the responsibility of absorbing the losses on the excess debt in the financial system and protecting the real economy and the social contract.

Monday, May 20, 2013

Who you gonna bet on to end the financial crisis & fix global financial system?

In his NY Times blog, Professor Paul Krugman once again rises to the defense of the economics profession.  This time, he makes the case for why track record is important when deciding who to listen to for advice on how to end the financial crisis and fix the global financial system.

Peter Radford in his blog, Real-world Economics Review, who examines Professor Krugman's response and makes the case for why the response fails:

In his discussion this morning he is critical of a defense of the hedge fund managers made by Jesse Eisinger. That defense rests on the notion that economists have no clue about the economy as demonstrated by their inability to predict the bubble and subsequent collapse. 
There were, of course, many economists who did predict the bubble, but they were not influential enough to have an impact. They remain mostly without influence due to their being outside the profession’s orthodox traditions.
Please re-read the highlighted text as Mr. Radford has nicely summarized that it was the non-mainstream economists who predicted the bubble and that they lack the ability to influence the profession.
Krugman, however, defends the profession against Eisinger’s criticism, and this is where he goes wrong. 
It does not matter that some economists were correct. 
The central orthodoxy of the profession, the source of most advice to policy makers and business people, and the basis of most commonly taught textbooks, totally missed both the possibility and then the existence of  the bubble. Economics was horribly wrong.
Please re-read the highlighted text as your humble blogger has been saying and ironically Professor Krugman agrees with the notion that policy makers should not listen to economists or business people who totally missed both the possibility and then the existence of the bubble.

As the Bank of England's Robert Jenkins observed, it was amazing to watch policy makers turn for advice to the very bankers who created the bubble.

As I added, it was even more amazing to watch policy makers also turn for advice to economists who rely on models that exclude the financial sector.

In their search for advice, the only individuals the policy makers were unwilling to turn to for advice were individuals like myself who predicted the financial crisis and offered before the crisis began a solution for how to moderate the impact of the bubble's bursting.
It hasn’t recovered since. 
Instead it is stuck in an unproductive self-examination that has yet to have much impact. 
Those who were wrong still pronounce and influence policy. They continue unabashedly to teach and perpetuate their errors. 
The profession, such as it is, is splintered into ideological warring camps making no progress towards a newer or more complete understanding of actual economies where things like asset price bubbles can, and evidently do, exist. 
In short economics is a mess and is completely deserving of the skepticism Eisinger attributes to the hedge fund managers.
After all many of them made fortunes by ignoring economic theory, recognizing the bubble, and shorting sub-prime assets. People who have made fortunes by thinking about the real economy and then risking their assets based upon that thinking [or by predicting the financial crisis], have a right to look down on a bunch of academics who opine about theories whose proof only ever resides in carefully constructed and highly constrained alternative worlds known as models. 
To win the respect of hedge fund managers, and anyone else out there in the real world for that matter, academic economists need to demonstrate a commitment to learning from their errors and toss aside erroneous theories. They need to stop regurgitating the same old stuff – some of which dates back to bygone eras and thus predates the development of our modern economy.
A modern economy that regular readers know is based on the FDR Framework which combines the philosophy of disclosure with the principle of caveat emptor (buyer beware).
This is not to say, naturally, that old ideas are necessarily wrong. But a social science like economics has to recognize that societies change and that the ‘social’ part of a social science provides the relevant context for the ‘science’ part. 
Ideas may, therefore, not be timeless. If economists want us to believe they are, then they need to prove that point, and not simply assume it. 
Economists still are stuck within an anachronistic vision of what they do. They may have stellar reputations as responsible professionals within academia,
Reinhart and Rogoff showed that a stellar reputation as an academic economist is worthless from the standpoint of anyone turning to them for policy recommendations.

Unlike most other academic disciplines, economics has no minimum standard for its peer review articles.  So being published should not be taken as a sign that the authors know what they are talking about.
but, by and large, their relationship with society at large seems amateurish and somewhat naive. Indeed they oftentimes deny its existence, preferring instead to remain engaged in scholarly debate within their respective academic bastions....
Fed Chairman Bernanke best exemplified the economic profession's relationship with society when he became visibly upset with consumers for not spending more when the Fed adopted zero interest rate policies (after all, that's what the Fed's model that failed to predict the financial crisis said should happen) and with investors for not rebalancing their investment portfolios to riskier securities.
Krugman wants us to believe that economics is still deserving of respect. But what about the current mess within the profession is so deserving? 
More to the point, and I have argued this before, given the great fractures and ideological splinters within economics, and given the often totally contradictory nature of different economist’s views, on what basis, exactly, does an outsider rest his or her trust? Who do they turn to for reliable advice? 
And how do they identify an economist’s credentials at all? ...
Please note that economics is one of the few fields of academic study where many of its leading thinkers were not trained economists (see: Adam Smith and the invisible hand; Walter Bagehot and the modern central bank).
Put it this way: in light of the evident failure of economic orthodoxy in recent years, were you in need of advice regarding the real economy would you turn to an academic economist? 
Or would you trust your own experience?  Clearly many hedge fund managers and business people choose their own experience. 
And that says a lot about the state of economics, doesn’t it?
Had policy makers turned to individuals like myself for advice regarding the real economy, they would have been told to adopt the Swedish Model and require the banks to recognize upfront their losses on all the excess debt in the financial system.

The Swedish Model is the only known solution for a bank solvency led financial crisis.  It has numerous advantages including it protects the real economy and the social contract.

Furthermore, the Swedish Model is supported by the design of a modern banking system.

However, the Swedish Model is not an economic model.  It is simply the solution for what ails us.

Friday, May 17, 2013

IMF study calls into question the whole approach to regulating banks

The Guardian reports that an IMF study has called into question the whole approach to regulating banks by asking if this approach is really addressing the real issue.

The authors of the study point out the simple fact that had all the proposed regulations been enacted prior to the beginning of the financial crisis they would not have prevented the financial crisis from occurring.

This conclusion is worth repeating.  For all the sound and fury, the proposed regulations would not have prevented the financial crisis.

Naturally, the authors call for seeing if there might be an alternative approach.

Regular readers know that there is an alternative to the combination of complex regulations and regulatory oversight.  That alternative is transparency.

Remarkably, transparency happens to be "low cost" and has a track record of success.

Transparency is particularly effective when combined with the principle of caveat emptor (buyer beware).  This combination makes the buyer responsible for all losses on their exposures.  This gives the buyer an incentive to use the disclose data to assess the risk of their exposures and limit the size of their exposures to what they can afford to lose.

By limiting their exposures to what they can afford to lose, buyers build robustness into the financial system.

This is the exact opposite of what we had in the run-up to the financial crisis and the adoption of the bury them in complex regulation approach.

The financial crisis occurred because of the fragility injected into the financial system by its opaque and heavily regulated corners (structured finance securities and banks).   So naturally, the response as pointed out by the IMF is to add even more opacity and, one of its chief sources, complex regulations.

The authors said: "The structural measures to reform banks such as the US Volcker rule, the UK's Vickers ring-fence, and the EU's Liikanen proposal, which would create functional separation of businesses, all reflect a deep sense of unease with the risk culture engendered by the assumption of trading and speculative investments by deposit-taking banks." 
But they added that the proposed reforms would not have prevented the crisis a tLehman Brothers in September 2008, the event that brought the global financial system to the brink of collapse. 
"Looking back, however, restrictions on proprietary trading or investments in private equity alone would not have prevented major bank failures such as Lehman Brothers. Nor would reorganising the bank into separate subsidiaries in each host and home country have facilitated its global, group-wide resolution." 
The study said Britain, the US and the EU were important financial centres and that they could bring benefits to the global economy if the structural reforms led to greater stability.

And the critical structural reform is to bring transparency to all the opaque corners of the financial system.

Thursday, May 16, 2013

Big banks demonstrate again why regulations won't restrain their activities

The New York Times carried an interesting article on how the big banks managed to undermine any regulation intended to restrain their risk taking.

This provides further confirmation that the combination of complex regulation and regulatory oversight doesn't work to make the financial system safer.  In fact, relying on complex regulation and regulatory oversight makes the financial system riskier and more prone to crashes.  Our current financial crisis being a case in point.

The only proven method for restraining bank risk taking is requiring the banks to disclose on an ongoing basis their current exposure details.  With access to this information, the market then exerts restraint on the banks.
Under pressure from Wall Street lobbyists, federal regulators have agreed to soften a rule intended to rein in the banking industry’s domination of a risky market. 
The changes to the rule, which will be announced on Thursday, could effectively empower a few big banks to continue controlling the derivatives market, a main culprit in the financial crisis. 
The $700 trillion market for derivatives — contracts that derive their value from an underlying asset like a bond or an interest rate — allow companies to either speculate in the markets or protect against risk. 
It is a lucrative business that, until now, has operated in the shadows of Wall Street rather than in the light of public exchanges. Just five banks hold more than 90 percent of all derivatives contracts....
Here is a prime example of why regulation fails.

Did federal regulators think that the problem posed by derivatives was a lack of price transparency?

Hello, the problem posed by derivatives is that the banks can lose a substantial amount of money on them.  Just look at JP Morgan's losses on the London Whale's CDS trade.

The way to restrain banks from exposing themselves to potentially catastrophic losses on a large derivative portfolio is to require that they disclose their current exposure details, including derivatives.

With this disclosure, banks will dramatically shrink their derivative exposures for fear that the market will trade against them.  Jamie Dimon confirmed this when he tried to hide the CDS trade.
In the aftermath of the crisis, regulators initially planned to force asset managers like Vanguard and Pimco to contact at least five banks when seeking a price for a derivatives contract, a requirement intended to bolster competition among the banks. Now, according to officials briefed on the matter, the Commodity Futures Trading Commission has agreed to lower the standard to two banks. 
About 15 months from now, the officials said, the standard will automatically rise to three banks. And under the trading commission’s new rule, wide swaths of derivatives trading must shift from privately negotiated deals to regulated trading platforms that resemble exchanges. 
But critics worry that the banks gained enough flexibility under the plan that it hews too closely to the “precrisis status.” 
“The rule is really on the edge of returning to the old, opaque way of doing business,” said Marcus Stanley, the policy director of Americans for Financial Reform, a group that supports new rules for Wall Street.
So the CFTC's rule making is all about the idea that buyers of derivatives are too lazy to call multiple banks and compare prices.

If buyers cannot be troubled to get competing quotes, they are agreeing to overpay.
Making such decisions on regulatory standards is a product of the Dodd-Frank Act of 2010, which mandated that federal agencies write hundreds of new rules. ...
It is rules like this that further confirm that Dodd-Frank should be repealed (the only worthwhile parts are the Consumer Financial Protection Bureau and the Volcker Rule).
In an interview on Wednesday, Mr. Gensler said that, even with the compromise, the rule will still push private derivatives trading onto regulated trading platforms, much like stock trading. He also argued that the agency plans to adopt two other rules on Thursday that will subject large swaths of trades to regulatory scrutiny. 
“No longer will this be a closed, dark market,” Mr. Gensler said. “I think what we’re planning to do tomorrow fulfills the Congressional mandate and the president’s commitment.”...
Unless market participants know each bank's exposure details, derivatives are a closed, dark market.

If banks are performing the role that they are suppose to, acting as middlemen as oppose to taking proprietary bets, they should have no problem making this disclosure.
While the regulator defended the derivatives rule, consumer advocates say the agency gave up too much ground. To some, the compromise illustrated the financial industry’s continued influence in Washington. 
“The banks have all these ways to reverse the rules behind the scenes,” Mr. Stanley said.... 

Wednesday, May 15, 2013

Almost 6 years after financial crisis began, consensus emerging there is no sovereign debt crisis in EU

In his Reuters Macroscope post, Pedro da Costa explains how a consensus is emerging that the EU is not facing a sovereign debt crisis, but rather a bank solvency led financial crisis.

This is very important because the cure for a bank solvency led financial crisis is well known: adopt the Swedish Model and require the banks to recognize upfront all their losses on the excess private and public debt in the financial system.

Modern banks are designed to absorb these losses and continue operating and supporting the real economy.  Banks can do this because of the combination of deposit insurance and access to central bank funding.  When banks have low or negative book capital levels, deposit insurance effectively makes the taxpayers the banks' silent equity partner.
Instead, argues Blyth, it is merely a sequel to the U.S. financial meltdown that started, like its American counterpart, with dangerously-indebted risk-taking on the part of a super-sized banking sector.
In a new book entitled “Austerity: The history of a dangerous idea,” Blythe writes that sovereign budgets have come under strain primarily because taxpayers of various nations have been forced to shoulder the burden of failed banking systems.
Taxpayers have been forced to shoulder the burden because they are being called on to bailout the banks when the banks are perfectly capable of rebuilding their book capital levels through retention of future earnings.

Taxpayers have also been forced to shoulder the burden because the banks have not been required to recognize the losses on the excess debt in the financial system.  As a result, the taxpayers and the real economy are called on to make the debt service payments on this excess debt.  This diverts capital that is needed for reinvestment, growth and support of the social contract.
"The way austerity is being represented by both politicians and the media – as the payback for something called the ‘sovereign debt crisis,’ supposedly brought on by states that apparently ‘spent too much’ – is a quite fundamental misrepresentation of the facts.  
These problems, including the crisis in the bond markets, started with the banks and will end with the banks. 
The current mess is not a sovereign debt crisis generated by excessive spending for anyone except the Greeks. For everyone else, the problem is the banks that sovereigns have to take responsibility for, especially in the euro zone. That we call it a ‘sovereign debt crisis’ suggests a very interesting politics of ’bait and switch’ at play."
No surprise that bankers and politicians would engage in 'bait and switch'.  After all, the policies that have been adopted were designed to protect bank book capital levels and banker bonuses at all costs.

This has meant putting the bankers ahead of honoring the social contract or serving the best interests of the taxpayers.
So why all the misunderstanding? Why has the crisis become conflated with a government debt problem in the public imagination? 
According to Blythe, this is a convenient way for Wall Street to again saddle the state with massive banking sector losses.
Please re-read the highlighted text as Blythe it is simply marketing by Wall Street to avoid the consequences of its losses and to keep its bonuses flowing in an uninterrupted fashion.
The cost of bailing, recapitalizing, and otherwise saving the global banking system has been, depending on how you count it, between 3 and 13 trillion dollars. 
Most of that ended up on the balance sheets of governments as they absorb the costs of the bust, which is why we mistakenly call this a sovereign debt crisis when in fact it is a transmuted and well-camouflaged banking crisis.
Please re-read the highlighted text as Blythe provides an estimate of how much money the bankers should be reimbursing governments and taxpayers for as a result of their management of the banking system.

Bank of France turns to "super" transparency to restart securitization in EU

Bloomberg reports that the Bank of France is rolling out what it believes is the model for restarting securitization in the EU.

The distinguishing feature of the Bank of France's model is the reliance on making these deals "super transparent" so that market participants can know what they are buying and know what they own.

This is precisely what your humble blogger has been calling for since the earliest days of the financial crisis.

Why would the Bank of France feel the need to roll out deals that are "super transparent" when the ECB has already endorsed the level of transparency provided by the EU DataWarehouse?

Because the Bank of France sees that the EU DataWarehouse doesn't bring transparency that would allow an investor to know what they own or a buyer to know what they are buying.  Rather, the EU DataWarehouse is the industry's effort to retain opacity at the levels associated with opaque, toxic subprime mortgage-backed securities.

Please note, that the Bank of France recognizes that the only way to reduce, if not totally eliminate, the rating firms' role in securitization is to make the deal "super transparent".  When a deal is "super transparent", reliance on rating firms is greatly reduced as investors can do the analysis for themselves or hire a third party expert.

Regular readers know that your humble blogger has defined what it takes for a structured finance deal to be "super transparent".

First, the deal must provide observable event based reporting under which all activities, like a payment or delinquency, involving the underlying collateral are reported to market participants before the beginning of the next business day.

Second, the deal must make available all data fields tracked by the originator of the underlying collateral and the servicer of this collateral.  These firms are experts and would only track data fields that are relevant for valuing or monitoring the underlying collateral.  There is no legitimate business reason for depriving market participants of the right to piggy-back off this expertise.

The Bank of France wants to help banks package loans to businesses into tradable securities with the creation of a special-purpose vehicles, in what could become a template for the euro area. 
As the European Central Bank looks for ways to improve the flow of credit to small and medium-sized enterprises, or SMEs, the project started by the French central bank in July last year could provide one possible solution, the head of its markets division, Alexandre Gautier, said in a telephone interview. 
He’s in talks with the Frankfurt-based ECB and other national central banks on the initiative, which would ideally create securities that qualify as collateral in ECB refinancing operations. While banks can currently securitize SME loans and use them as collateral at the ECB, the process is complicated and not centralized. 
“We want a vehicle that is super simple and super transparent,” Gautier said. “We’d very much like these securities to be eligible in the euro system, but it’s not a condition. We’ll go ahead on our own if we have to to show that it’s doable.”... 
The aim is to make it easier for banks to re-finance existing loans and incentivize them to extend credit to small businesses. That would especially be the case if the new securities were eligible as collateral with the ECB, said Gautier. 
“The banks were very interested but they said that to make it really attractive, any securities should be eligible as collateral for refinancing within the euro system so that they would be liquid in the event of a crisis,” he said. “That’s now what we’re aiming for.” 
ECB President Mario Draghi said on May 2 that policy makers will start consultations with other European institutions on initiatives to promote lending to SMEs in the euro area using asset-backed securities.

Tuesday, May 14, 2013

As market for asset-backed securities rebounds, ratings shopping resumes

In yet another sign that zero genuine financial reform has occurred since the beginning of the financial crisis, Bloomberg reports that as the market for asset-backed securities rebounds, credit ratings shopping has returned.

Regular readers will recall that in the run-up to the financial crisis, rating firms were willing to put a AAA-rating on securities that the firms admitted they did not have adequate information monitor prior to issuance of the securities and after the securities traded in the secondary market.

In fact, structured finance securities developed a nickname: opaque, toxic.  Where the opacity of the security hid its toxicity.

Here we are almost 6 years after the financial crisis began and policymakers and financial regulators have done nothing to bring transparency to the structured finance market.

As regular readers know, the only way to bring transparency to structured finance securities is to require that they disclose on an observable event basis all activities like payments or delinquencies that occur with the underlying collateral before the beginning of the next business day.

It is only with observable event based reporting that investors know what they own and potential buyers can know what they are buying.

Here we are almost 6 years later and policymakers and financial regulators have not brought observable event based reporting to structured finance.

In fact, policymakers and financial regulators have gone out of their way to keep these securities opaque.  For example, the ECB puts its blessing on a data warehouse that provides disclosure on the same frequency as opaque, toxic subprime mortgage-backed securities.

Almost six years after the start of the worst financial crisis since the Great Depression, bond issuers are again exploiting credit ratings by seeking firms that will provide high grades on debt backed by assets from auto loans to office buildings considered inappropriate by rivals. 
Fitch Ratings isn’t grading a deal linked to a Manhattan skyscraper after saying investors needed more protection. The securities won top grades from Moody’s Investors Service and Kroll Bond Rating Agency Inc. 
Blackstone Group LP’s Exeter Finance Corp. got top-tier ratings from Standard & Poor’s and DBRS Ltd. in the past 15 months on $629 million of bonds backed by car loans to people with bad credit histories, even as Moody’s and Fitch said they wouldn’t grant such rankings.
Borrowers are finding more options than ever to get the top ratings that many investors require after U.S. regulators doubled the number of companies sanctioned to assess securities to 10 since 2006.... 
Issuance of bonds linked to loans and leases are staging a comeback as the Federal Reserve (FDTR)’s unprecedented stimulus, including a pledge to keep benchmark interest rates close to zero into a fifth year, pushes investors into riskier assets. 
Banks have arranged $31.5 billion of commercial mortgage-backed securities this year with issuance poised to climb 50 percent from 2012 to $70 billion, according to Credit Suisse Group AG. Issuance of bonds tied to subprime auto debt of $7.7 billion this year compares with $5.7 billion in the first four months of 2012, according to Wells Fargo & Co.... 
“Nothing’s really changed” in the ratings business, David Jacob, former head of structured finance at S&P, said in a telephone interview. Regulation “changed some of the processes that they do, but what led to a lot to this bad behavior hasn’t really changed.”
The only way to bring about true change is to require the structured finance securities to provide observable event based reporting.

With this information, market participants can assess for themselves the risk and value of these securities.  Market participants can either do the due diligence themselves or hire third party experts to do the due diligence for them.

This ends any reliance on the rating firms.  With transparency, rating firms become just another third party expert offering an opinion.
Debt graders led by S&P and Moody’s helped ignite the credit seizure that began in August 2007 by lowering their standards to win business before defaults soared on home loans to subprime borrowers, the Federal Crisis Inquiry Commission said in a January 2011 report
“My plea today is that you take action,” Franken, a Democrat from Minnesota elected to the Senate in 2008, told participants at the SEC roundtable today. “If we maintain the status quo we are leaving ourselves far too vulnerable to another catastrophe.”...
Where the status quo is opacity.  Bringing transparency to opaque securities like structured finance reduces our vulnerability to another catastrophe.

Monday, May 13, 2013

Simon Johnson asks if the Fed is afraid to regulate banks

In his Bloomberg column, Professor Simon Johnson asks if the Fed is afraid to regulate banks and if it is not afraid, why doesn't it require banks to hold a much higher level of capital.

Professor Johnson observes that
capital regulation needs to be about the true ability to absorb losses relative to total assets. Regulators should focus on this measure -- known as leverage -- and its implications for what happens when a financial company faces failure.
It is interesting that Professor Johnson says this because the adequacy of a bank's capital to absorb expected losses is the principle focus of the Fed's bank examination function.  Bank examiners ask the question of do banks have enough capital to absorb the potential losses on the risks the banks are exposed to.

If yes, then the bank examiners think the bank is adequately capitalized.

If no, then the bank examiners write up the bank and require that it raise additional capital.

Apparently, Professor Johnson doesn't think that the Fed's bank examiners are up to the task of evaluating capital adequacy.  He would like someone else to determine when a bank has enough capital.

There are two potential ways to make this determination:  the market or regulatory fiat.

Regular readers know that your humble blogger favors having the market determine if a bank is adequately capitalized.  What is necessary for the market, which includes the bank examiners, to perform this task is having banks disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

With this information, the market can use its valuation expertise to determine if each bank is adequately capitalized or not for the risks that it is taking.

With this information, the market can also exert discipline on the banks so that the banks hold enough capital to absorb their potential losses.  Recall that when banks provided ultra transparency at the beginning of last century, banks maintain a 15+% equity to total asset ratio.

Alternatively, we could have regulators write a regulation requiring banks to hold more capital.  Not only does this involve overcoming the Too Big to Fail bank lobby, but it also means the regulators publicly saying that their bank examiners are not up to the task of evaluating the adequacy of each bank's capitalization.

Ironically, in making the case for the regulators to require the banks to hold more capital, Professor Johnson actually makes the case for doing so by requiring the banks to provide transparency.
Global megabanks are profoundly complex, and intentionally so. Investors and regulators don’t know what risks are being taken. Board members also are usually in the dark. 
Whether top management understands what is happening is an open question: Chief Executive Officer Jamie Dimon is adamant that he had no real knowledge of JPMorgan’s Whale positions, which eventually had a notional value in the trillions of dollars.
Simply requiring banks to hold more capital doesn't address the fact that no one knows what risks are being taken.  Without knowing the level of risk, it is impossible to know if the regulated level of capital is adequate.

The starting point for determining capital adequacy is ultra transparency.  With disclosure comes the ability to assess the level of risk and then exert discipline to ensure there is enough capital to absorb losses.

Sunday, May 12, 2013

Spanish prelate sides with Elliott's Paul Singer to tell Paul Krugman that response to financial crisis destroying society

As reported by the Telegraph's Ambrose Evans-Pritchard, the Spanish prelate has weighed in on the side of Elliott's Paul Singer against Paul Krugman and called for a change in the policies adopted to deal with the bank solvency led financial crisis so that society does not collapse.

Professor Krugman wrote a post in his NY Times blog in which he defended the policies run by Ben Bernanke, the Fed and other central banks as
just what the textbook says you should be doing.
As regular readers know, the economic textbooks are wrong.

This fact is not surprising because leading up to our current financial crisis the models used by economists did not include the banking sector.

This fact is not surprising because even though the global central bankers claim to have read Walter Bagehot's Lombard Street, in which he "invented" the modern central bank, their response to the financial crisis has broken a number of the rules he laid out.  For example,

  • Central banks are suppose to lend freely at high rates of interest against good collateral; or
  • Central banks are suppose to keep interest rates at or above 2% as rates below 2% bring about a change in the behavior of savers.
Regular readers know that there is one response that works every time when dealing with a bank solvency led financial crisis.  That response is to adopt the Swedish Model and require the banks to recognize upfront their losses on the excess debt in the financial system.

The Swedish Model protects society as the banks absorbing the losses spares the real economy from diverting capital needed for reinvestment, growth and the social contract to debt service on the excess debt.

Regular readers know that under the FDR Framework, banks are designed to absorb these losses and continue to support the real economy.  Banks can do this because of the combination of deposit insurance and access to central bank funding.

Unfortunately, the Swedish Model has not yet been adopted to deal with our current financial crisis.  Instead, policymakers and central bankers have adopted the Japanese Model for handling a bank solvency led financial crisis.

Under the Japanese Model, bank book capital levels and banker bonuses are protected at all costs and the burden of servicing the excess debt in the financial system is placed on the real economy.

The results have been predictable (I know, I predicted them).  The global economy is in a Japan-style economic slump and the social contract is being rewritten to the benefit of the rich at the expense of the poor.

As the Spanish prelate said,
"We have to change direction, otherwise this is going to bring down whole political systems," said Braulio Rodriguez, the Archbishop of Toledo. 
"It is very dangerous. Unemployment has reached tremendous levels and austerity cuts don't seem to be producing results," he told The Telegraph.
Austerity will never produce a positive result when facing a bank solvency led financial crisis.  I have been making this point since the beginning of the crisis.
"There is deep unease across the whole society, and it is not just in Spain. We have to give people some hope or this is going to foment conflict and mutual hatred." 
Europe's Catholic bishops have been careful not to stray into the political debate or criticise EU economic strategy but the Archbishop said the current course is untenable.
There are two reasons that the current course is untenable.

First, it is not fixing the underlying problems.

Second, it is causing untold damage to society.
"The Vatican has always been an enthusiast for Europe, but a Europe of solidarity where we help each other, not a Europe of coal and steel. Whether this is possible depends on Germany and Chancellor Angela Merkel," he said. 
Unemployment in Spain has reached 6.2m, or 27pc, despite a growing diaspora of young Spaniards seeking work in Britain, Germany, Brazil, or the Gulf, and an exodus of immigrants returning home. Spain's population fell by 0.7pc last year. 
The jobless rate in the Toledo region of Castilla-La Mancha is 31pc. The rate for youth has jumped to 64pc from 14pc at the peak of the credit bubble. 
Spain has largely avoided the sort of street clashes seen in Greece. People have coped with stoicism, drawing on the deep strengths of Spanish family support. Yet the authority of the state is eroding. A new Metroscopia poll shows that 87pc of voters have lost confidence in premier Mariano Rajoy.
Confidence in the state should erode because it is being run for the benefit of the bankers and not for the benefit of its citizens.
El Mundo fears a slow-fermenting 'crisis of the regime', with almost every institution -- including the monarchy -- in disrepute. It likens the mood to "pre-revolutionary" France in the late 1780s. 
The Archbishop, speaking in the austere episcopal palace of Spain's ancient capital, said the current crisis is doing far more damage than the recession in the mid-1990s when unemployment briefly spiked above 24pc. On that occasion peseta devaluations let Spain regain competitiveness and recover gradually despite austerity cuts. 
This time the country seems trapped in slump. The long-term jobless rate is much higher. 
Unemployment benefits taper off after six months, and stop after two years. There are almost two million households where no family member has a job. 
Europe's Catholic bishops know first-hand from their Cor Unum charitable network just how desperate it has become. "We can try to mitigate the effects by giving basic help to people left totally unprotected, but we can't create jobs," said the Archbishop. 
"We are seeing families who used to middle class needing help. This is totally new. As a matter of honour, they won't come to us until they have exhausted everything,"
As we approach the sixth anniversary of the beginning of our current financial crisis, it is time to acknowledge that the response to the financial crisis has been a failure.  If it were a success, policies like zero interest rates and quantitative easing would no longer be pursued.

The time has come to adopt the Swedish Model.  

History shows that within a year of adopting the Swedish Model the bank solvency led financial crisis is over and growth has returned to the real economy.

Saturday, May 11, 2013

One of best indicators of genuine reform in financial sector shows no reform

In his Guardian banking blog, Joris Luyendijk interviews an equity sales director who explains how Wall Street profits from both valuation and pricing opacity when it buys or sells derivatives and why it is fighting so hard to retain opacity.

The equity sales director compares his product, which represent an investment in the real economy, with derivatives, which represent a zero-sum bet on the direction of, for example, interest rates.
Which brings me to complex derivatives. The culture of equity is so different from derivatives. We try to build relationships with clients who invest money in real companies, for the long term. Complex derivatives traders work with a far larger and diffuse pool of clients, who could decide at any point to switch from one product to the next.... 
With complex derivatives it's very much about here and now, as you can make money in a market that's going down as well as up. There's no direct relationship with the economic cycle. 
My clients choose to deal with me for the quality of advice, the execution of their trades and the value of our research. With complex derivatives it's mostly driven by price. 
Often complex derivatives are not traded on an open exchange but over the counter [OTC] – in other words, it's an agreement directly between bank and client. One reason is that OTC derivatives are usually custom-made for the client, so there's only of them in the world. 
To illustrate how transparency in equity works, suppose a client places an order to buy a particular stock at careful discretion which is trading at 25. My trader goes into the market and executes it for 25.12. At the end of the day my client sees on his information terminal that the day's average price was 25.10. Did he overpay? He calls me and I go over to our trader. If it's really the trader's fault we might take the loss and give the client a better price. Otherwise we could lose our reputation and he will go elsewhere. 
Now, with OTC derivatives, how does a client find out he was disadvantaged? There's no exchange. Traders and clients base prices for OTC derivatives on a number of 'Greeks' – parameters indicating levels of volatility and other derivative characteristics of the product. 
It all comes down to client's ability to understand these Greeks' their sophistication. There is a huge difference between genuinely sophisticated clients and those eager to be seen as professional who actually don't grasp [all of] it. 
I have heard OTC derivatives traders use the term 'rape and pillage'. That means selling a less sophisticated client a financial product carrying a high likelihood of blowing up and causing that client never to deal with you again. 
"Rape and pillage" was not confined to large investors or corporations.  Regular readers might recall that UK banks were involved in the mis-selling of interest rate derivatives to small companies and individuals.
A lot of regulation has come in to prevent this, but in some non-EU jurisdictions these can still be sold. Again, note the difference with equity. A client can lose money on my recommendations, but it is almost impossible to bring down the client. 
"You could argue that OTC derivatives are among the best indicators of the degree of genuine reform in the financial sector. 
If reform of OTC derivatives is one of the best indicators of genuine reform in the financial sector, what  does reform in this area show?
One reason the crisis of 2008 got so bad was that banks had these totally opaque derivatives on their books, so nobody knew who had what.
Nobody knew which banks were solvent and which were not.  So it is very clear that the reform that is needed is to bring transparency to bank derivatives books.
Since then there's been a fight to improve transparency but banks resist with all their means.  Transparency correlates inversely with profitability; it has always been like that. 
Given that transparency will reduce the profitability of the banks, the banks are fighting to retain opacity in the derivatives and about their exposure details (their books).

So have the banks been successful in retaining their profitability and fending off transparency in derivatives and their exposure details?


Since OTC derivatives are one of the best indicators of genuine reform in the financial sector, the lack of transparency shows there has not been genuine reform in the financial sector.

Thursday, May 9, 2013

Paul Krugman misses Bernanke's role in disrupting the default/insolvency cycle

In his NY Times blog, Professor Paul Krugman tries to understand the rage directed at Ben Bernanke for lowering interest rates as the economic textbooks say he should be doing during a time of high unemployment and low growth.

Professor Krugman specifically cites Paul Singer's observation that Bernanke's policies are destroying the very fabric of society.

What Professor Krugman misses, and his miss is not at all surprising given that macro economic models do not include the financial sector, is Bernanke's role in disrupting the default/insolvency cycle.

What Mr. Singer and others who have expressed rage at Mr. Bernanke's policies realize is his policies are pushing the cost of the excess debt in the financial system onto savers and through austerity undermining the social contract.

Regular readers know that modern banks are designed to absorb the losses on the excess debt in the financial system and protect the real economy and social contract.  Banks provide this protection because absorbing the losses means that capital that is needed for reinvestment, growth and supporting the social contract is not diverted to making debt service payments on the excess debt.

But wait a second, isn't all Chairman Bernanke doing is lowering rates as the economic textbook suggests?

Chairman Bernanke is doing one more thing.  He is covering up the losses that are currently on and off the bank balance sheets.

Everyone knows that these losses exist, but Chairman Bernanke pretends they don't.

Because he pretends these losses don't exist and signs off on the Fed's bank solvency stress tests, bankers are able to receive enormous cash bonuses that would otherwise be used to rebuild bank book capital levels.

Because he pretends these losses don't exist, firms that should have gone out of business are allowed to continue operating.  This in turn distorts the economic system.

Everyone knows why Chairman Bernanke and the financial regulators wouldn't want the true magnitude of the losses to be known today.  They are fearful of that a second Great Depression could occur.

What Chairman Bernanke and his fellow financial regulators fail to consider is that everyone already knows there are tremendous losses buried in the global financial system.

It did not escape the market's attention that Spain just announced that over 15% of the debt on its banks' balance sheets had to be restructured in the last year.

It did not escape the market's attention that recently Cyprus banks had losses exceeding 20% of their asset value.

What has also not escaped the market's attention is that banks are designed to absorb these losses and rebuild their book capital levels over several years through retention of future earnings.

The source of rage that individuals like Paul Singer feel is that Chairman Bernanke and the financial regulators who did not see the financial crisis coming are now treating someone who did see the financial crisis coming like a child.

I am reminded of that famous movie line: "you couldn't handle the truth".

Hello, the guys who predicted this crisis know that the losses are huge.  They just don't have precise figures for how large the losses are.

They also know something about how the financial system operates.

What their rage is saying is that the financial system is perfectly capable of absorbing the losses that the Chairman and the rest of the financial regulators are hiding.

Wednesday, May 8, 2013

Who to listen to or is it possible for a non-PhD to penetrate economists' echo chamber

Paul Krugman ran an interesting post on who policymakers and the public should listened to when it comes to a solution for ending our current financial crisis (hat tip Jonathan Portes).

According to Professor Krugman:
Jonathan Portes has a nice little essay, which gets better than I have at the essential issue: it’s not just about the individual track record:
My answer to it is that policymakers and the public should listen to economists
While policymakers listening to economists is definitely an improvement over listening to the bankers who got us into our current difficulties, this is an extraordinarily low bar to get over and doesn't suggest why economists should be listened to rather than some other market participants.
who fulfill two critera: first, they have made empirically testable predictions (conditional or unconditional – see Krugman here) that have proved, by and large, to be broadly consistent with the data; and second, they base those predictions on an analytic framework (not necessarily a formal model) that is persuasive. 
These criteria were the basis for the economics profession to discount the prediction of the financial crisis made by William White and a handful of other economists.  Their predictions were good at using the data.  Their predictions were bad at using an analytical framework.
In other words, getting it right alone is not enough; it should be possible to show your workings – to explain why you got it right. Otherwise, your predictions may be interesting, but they tell you little about how to formulate policy.
Fortunately, your humble blogger has both gotten his predictions right and has been able to show his work using an analytical framework.
Quite. Place not your faith in gurus, even if they got some big stuff right — and that goes for me, too.
Even though it is nice to be a guru, I wouldn't place your faith in me either.
It’s always about the model, not the man....
I would place your faith in the model and the model that did the best job of predicting our current financial crisis and why easy monetary policy combined with austerity or fiscal stimulus has not ended the crisis is the FDR Framework.

This is not surprising as the FDR Framework is the foundation on which our financial system is built.
One side note: One thing that’s striking in Portes’s discussion — and something I very much agree with — is the irrelevance of formal credentials. 
As we’ve debated how to deal with the worst slump since the 1930s, a distressing number of economists have taken to arguing on the basis that they have fancy degrees and you don’t — or in some cases that well, you may have a fancy degree too, and even a prize or two, but in the wrong sub-field, so there. 
But all this counts for very little, especially when macroeconomics itself — or at any rate the kind of macroeconomics that has dominated the journals these past couple of decades — is very much on trial. 
If a PhD in economics counts for so little Professor Krugman, why don't you give me a call so we can discuss the FDR Framework and what it takes to end the bank solvency led financial crisis.

What I can tell you is every economist who thinks they have a solution for the financial crisis or how to fix the banking system I have talked with has been immediately dismissive of the FDR Framework despite its track record at predicting what has actually happened.

You would like to solve the financial crisis and redeem macroeconomics.  Here is your chance.