UK bank demonstrates regulators' capital ratio conundrum

Regular readers know that your humble blogger thinks that bank capital requirements are incredibly dangerous (without transparency, they suggest banks are stronger and less risky than they really are) and bank capital requirements suffer from numerous problems like the fact that they are implemented on a pro-cyclical basis.

The Guardian carried an interesting article on this pro-cyclical implementation of capital requirements featuring Nationwide and the Bank of England.

The Bank of England has denied that its insistence on Nationwide holding a bigger capital cushion had forced the UK's largest building society to slow its launch of small business lending. 

The Bank of England's actions are pro-cyclical if in fact requiring the bank to hold more capital reduces its lending capacity and this reduced lending capacity has a negative impact on borrower access to funds for growth and reinvestment in the economy.

Nationwide admitted plans to expand lending to small- and medium-sized enterprises (SMEs) are unlikely to take effect until 2014 at the earliest. 

It said plans to begin lending to smaller firms were still under development but "moving slowly"; , it denied a report that it had shelved a planned launch date for later this year....

Where there is smoke, ....

The Bank of England refuted any suggestion that Nationwide's decision to hold off from a launch into the SME sector was due to its demands on capital strength. 

A very tough assertion to prove.

A spokesman added: "The plan agreed with Nationwide to meet the 3% leverage ratio in 2015 will not result in them restricting lending to the real economy. Therefore it is wrong to blame their SME decision on the regulator."...

Banks have a limited number of ways to increase their ratio of equity to assets.  They can retain earnings or sell stock to increase the amount of equity.  Alternatively, they can decrease the amount of assets on their balance sheets.

The Bank of England spokesman suggests that Nationwide intends to meet the 3% leverage ratio by retaining earnings and/or selling stock.

However, regulators warned the lender had rapidly expanded its mortgage business while still wrestling with an overhang of bad commercial property loans. 

It was rebuked in July by the regulator, the Prudential Regulatory Authority (PRA), for running an aggressive lending policy without adequate reserves to insure against a possible collapse.

So much for retaining earnings to increase equity.

To build up reserves, banks take a provision for loan loss as an expense through their income statement.  This drives down earnings, so there is a lower level of earnings that can be retained.

Apparently Nationwide is planning a stock offering if meeting the higher capital ratios is not going to reduce its lending capacity.

But can it sell stock?

Analysts at credit ratings firm Standard & Poor's followed with a warning that a doubling in the losses on commercial property loans to £450m weakened the lender's financial position. 

S&P downgraded Nationwide's credit rating this month and signalled that further downgrades could follow without a rapid improvement. 

"These impairment charges have hindered Nationwide's internal capital generation. As a result, we have revised down our assessment of its risk position to 'adequate' from 'strong'," it said.

In the absence of disclosure of Nationwide's current asset, liability and off-balance sheet exposure details, why would anyone buy stock in Nationwide?

Without this information, there is no way of knowing what additional losses might be hidden on and off its balance sheet.

So if Nationwide cannot increase its equity from either retained earnings or stock sale, then the only way to increase its leverage ratio is by decreasing its assets.

Decreasing assets strongly suggests a reduction in Nationwide's lending capacity and that it will be more difficult for borrowers to access credit for growth and reinvestment (i.e., sure as heck looks like regulator's requirement to increase capital levels is pro-cyclical and is making downturn in economy worse).

In banking, too much simplicity is dangerous

In his Financial Times editorial, Standard Chartered's chief executive, Peter Sands, puts forth a robust argument for why relying on too much simplicity in the form of bank capital requirements is dangerous for taxpayer wealth.

Simply, these capital requirements, whether specified as a leverage ratio or a risk-weighted ratio or a combination of the two, don't present a true picture of the risk that each bank is actually taking.

Regular readers know that the only way for market participants to assess the risk of each bank is if each bank discloses on an ongoing basis its current asset, liability and off-balance sheet exposure details.  It is only with this information, that market participants have the data they need to actually assess each bank's risk.

As shown by our current financial crisis, when market participants cannot assess the risk the banks are taking, bad things happen to taxpayer wealth.  Specifically, policymakers and financial regulators find it irresistible to reach into the taxpayers' back pocket to bailout the banks and ensure the uninterrupted flow of bonuses to the bankers.

How can people trust banks using their own models when they are so opaque and produce such different results?

Only requiring banks to provide transparency eliminates this problem.

When market participants have access to the exposure detail data, market participants can use their own models to assess each of the banks.

This concern underpins the enthusiasm for the leverage ratio, and why some advocate a return to the so-called “standardised approach”. 

Under this approach, there are no sophisticated models – simply standard risk-weightings for different categories of asset that all banks have to apply. This gives the appearance of comparability, but it is entirely illusory. 

Massive differences in risk profile are simply smoothed out by very crude assumptions. 

Like the leverage ratio, it assumes lending to a start-up and an established multinational are equivalent risks, and takes no account of collateral. Indeed, imposing the standardised approach amounts to imposing a very poor model we know is wrong.

With transparency, the massive differences in risk profile are not smoothed out by very crude assumptions.

In fact. the massive differences in risk profile are exposed for all to see.

The standardised approach and leverage ratio share two characteristics. 

First, they simplify a complex reality. But the allure of simplicity should be resisted if the simplification so dangerously distorts and obscures the real picture. 

Your humble blogger agrees with Mr. Sands that the allure of the simplicity of capital ratios as a measure of bank solvency is a simplification that dangerously distorts and obscures the real picture.

Capital ratios are a form of regulatory opacity.

It is only with transparency into the underlying exposure details that a real picture of the risk each bank is taking can be seen.

Second, they narrow the difference in regulatory approach between risky and safe assets, creating perverse and powerful incentives for banks to run higher risk portfolios....

Your humble blogger agrees with Mr. Sands that capital ratios allow bankers to operate behind a veil of opacity and take on far more risk in their portfolios.

It is only with transparency into the underlying exposure details that market discipline can be exerted on the banks to restrain their risk taking.

The fact that different institutions give apparently similar assets different risk weightings is a real problem, and it has created a serious credibility gap. 

Some of the differences between model results are good, reflecting real variations in intrinsic risks and in the effectiveness of different banks’ risk-management approaches.

When each bank is required to disclose its current exposure details, the market gets to see which banks are being overly aggressive and which banks are being conservative in the management of their risks.

Why should ECB's bank asset quality review be believed?

Given Mario Draghi's commitment to do whatever it takes, why should the ECB's review of the asset quality at the EU banks be remotely believable?

Please recall, this is not the first time a governmental entity has overseen an asset quality review.  Previously, these reviews were done in Ireland, Greece, Cyprus, Portugal and Spain.

The result of these reviews was predictable.  The banks took additional reserves for potential losses and the governments declared their balance sheets had been cleaned up.

Of course, the banks were not required to disclose their current asset, liability and off-balance sheet exposure details so that market participants could confirm that all their losses had been recognized.

A few savvy market participants recognized that this lack of transparency was the equivalent of waving a giant red flag and announcing that the banks were still hiding losses on and off their balance sheet.

These market participants' insight have always been confirmed as shortly after the asset reviews it would be shown that there were in fact many more losses hiding on and off the bank balance sheets.

This pattern has held true whether the asset review was carried out by the government itself or using an "independent" third party (accounting firm or BlackRock).

This pattern has also held true when the asset quality review has been combined with stress tests.

So your humble blogger's question stands: why in the absence of transparency would anyone believe the results of the ECB's asset quality review?

One of the downsides of the ECB running an asset quality review without requiring the banks to provide transparency is that ECB puts itself in the position of now having to accept as collateral any of the assets it reviewed and didn't require loss recognition on.

From a Financial Times article on the ECB's asset quality review,

Within a matter of weeks, assuming legislative go-ahead, the ECB is expected to establish its new “single supervisory mechanism”, hiring the 1,000 staff it will need to police the banks, and making its mark with a tough root-and-branch Asset Quality Review (AQR) to determine how truthful banks are being about the loans on their balance sheets....

Properly done, the exercise could quickly establish the ECB as a tough regulator and help restore investor faith in Europe’s lenders. A succession of botched stress tests over recent years and laggardly recapitalisation of troubled lenders have deterred investors from backing the sector. 

A credible AQR, followed immediately by a stress test to show how balance sheets would stand up to further trouble, would, it is hoped, convince the world that Europe’s lenders are as resilient as US banks okayed by the Federal Reserve’s annual Comprehensive Capital Analysis and Review (CCAR).

No one thinks the US banks are okay.  Everyone knows that as a result of the stress tests the US on an annual basis renews the vow made by then US Treasury Secretary Tim Geithner when he pledged the full faith and credit of the US to keep the banks solvent.

All of which explains the flurry of preparations. 

Italy’s Intesa SanPaolo has been the most upfront about its desire to be ready for the ECB process. This month the bank revealed a “conservative” 30 per cent increase in the amount it has set aside to cover bad loans, undertaken explicitly “in the light of the [ECB’s] asset quality review”....

In the absence of exposure detail transparency, how would anyone know if a 30 percent increase in the amount set aside to cover bad loans is "conservative" or not?

Based on the history of Ireland, Greece,.... it is a fairly safe bet that this additional 30% will not be shown to be conservative and that much more in the way of losses will materialize.

The ECB exercise is set to implement new pan-European definitions of non-performing loans, standardising an NPL as anything that is 90 days past due, and also forcing banks to categorise all exposures to a single borrower as non-performing, even if only one of a number of loans is actually in default....

In the presence of regulatory forbearance which allows banks to engage in 'extend and pretend' and turn non-performing loans into 'zombie' loans, it is nice to have a standard, but the regulators have already undercut it.

Autonomous, an independent research house, predicts the changed definitions could increase problem loans by an average of 40 per cent – forcing weaker banks to raise fresh capital. Lenders in Germany, Austria and France could face the biggest shocks in the AQR....

I guess Autonomous doesn't see the 30% increase in loan loss reserves as conservative.

But a litany of ifs and buts still hangs over the whole process. Most immediately, it is still uncertain whether the EU will deliver the legal go-ahead to empower the ECB next month.  

More fundamentally, there is still disagreement about how to deal with a bank if it fails to plug a capital shortfall under its own steam. 

Here, too, Europe must learn from the US, where the government’s Tarp scheme injected capital as necessary back in 2009. For the ECB exercise to work, the sovereign-focused European Stability Mechanism must become a bank bail-out vehicle of last resort.

The issue for a bank fixing its book capital shortfall is can it generate earnings after all the losses have been realized.

If a bank can generate earnings after taking the losses on its dud exposures, it can recapitalize itself over time by simply retaining earnings.

If a bank cannot generate earnings after taking the losses on its dud exposures, it should be resolved.

ECB discovers why transparency into bank current exposure details needed

Reuters reports that the ECB has discovered why transparency into bank current exposure details is needed.

Policymakers at the European Central Bank had initially hoped that the asset review would feed into the stress tests in part because it is difficult to measure the sturdiness of a bank without knowing precisely the contents of its balance sheet.

Please re-read the highlighted text as your humble blogger has been saying this since the beginning of the financial crisis.

Without ultra transparency, there is simply no way of knowing if a bank is sturdy, as in solvent, or unstable, as in insolvent.

Without ultra transparency, stress tests are meaningless.

EU trying to harmonize definition of non-performing loan

Reuters reports that for the ECB's bank asset quality review test the EU is attempting to come up with one definition of what is a non-performing loan.

It is not surprising that there are several definitions of non-performing loans.

Since the beginning of the financial crisis bank, regulators have engaged in regulatory forbearance.  Under regulatory forbearance, banks are allowed to engage in 'extend and pretend' to turn non-performing loans into 'zombie' loans.

Naturally, each bank is going to engage in extend and pretend in a way that minimizes the non-performing loans on and off their balance sheets.

The current attempt to harmonize the definition of non-performing loans confirms what your humble blogger has said about the results of the bank regulator run stress tests as being meaningless.

The current attempt to harmonize the definition of non-performing loans also confirms what your humble blogger has been saying about the importance of requiring banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

With ultra transparency, regulatory forbearance and extend and pretend is ended.  Markets will exert discipline by rewarding banks that clean up their bad debt exposures.

Banks across the European Union will be asked to use a single definition for bad loans in the upcoming review of their loan books, a senior EU regulatory source told Reuters, making it harder for banks to conceal the state of their businesses behind local conventions.... 

A senior EBA source told Reuters a key feature of the asset quality review will be harmonizing the way banks categorize loans. EU supervisors use a host of different ways to classify troubled or non performing loans, making it difficult to compare across jurisdictions.... 

The 2011 version of the stress tests, which relied entirely on national supervisors' submissions and definitions, was widely criticized for finding that Europe's 70 largest banks collectively needed just 106 billion euros ($140.62 billion). 

The EBA is keen to ensure this round of stress tests has more credibility, and sees consistency of definitions and transparency of information as a key way of ensuring this.

Italy's banks may be forced to seek capital from government

Reuters reports that Italy's banks may be forced to seek capital from the government if they recognize some (all?) of the losses currently hiding on and off their balance sheets.

Italy is following the same failed strategy as Ireland, Portugal, Greece, Cyprus and Spain.

Step 1:  Have the banks announce modest losses
Step 2:  Hope market participants will be dumb enough to belief the banks when they claim to have cleaned up their balance sheets.
Step 3:  Failing to find enough dumb investors, the government will stand ready to buy any equity that market participants don't want.

There is no reason for investors to buy equity in any Italian bank in the absence of transparency that discloses that bank's current global asset, liability and off-balance sheet exposure details.  It is only with this information that the investor can confirm that all losses have been realized and an assessment of the remaining risk made.

Under pressure from the Bank of Italy, banks are cleaning up their balance sheets before a health check-up on asset quality by the European Central Bank (ECB) expected in early 2014, before it takes over supervision of euro zone lenders mid-year. 

That may force them to turn to the market or the state for cash. 

"If done properly, the asset quality review should result in loan losses spiking in the second half, dividend cuts and potential capital increases," analysts at Berenberg said in a note to clients. 

Monte dei Paschi, the country's scandal-hit No. 3 lender, and a string of mid-sized banks look particularly vulnerable. 

"Italian mid-tier lenders are among the weakest in Europe," Royal Bank of Scotland chief credit strategist Alberto Gallo said. 

He estimates that Monte dei Paschi, which posted its fifth straight quarterly loss on Wednesday, may need up to 5 billion euros over the next three years, on top of a 4.1-billion-euro state bailout it received in February. 

The bank will find it difficult to lure private investors for such a sizeable amount - more than twice its market capitalisation, potentially requiring more support from Italy's cash-strapped government, Gallo said.

ECB says Europe faces Japanese style lost decade if banks not fixed

Reuters reports that according to the ECB, Europe faces a Japanese style lost decade if banks not fixed.

Regular readers know that your humble blogger said this almost six years ago when the EU, UK and US adopted the Japanese Model for handling a bank solvency led financial crisis.

It is nice to see with four years left to go in the decade, the ECB agrees and has produced a study the confirms all of observations about the failings of the Japanese Model that I have made.

Decision makers should move quickly to repair the euro zone's ailing banking system to avert a Japanese-style lost decade of minimal growth and inflation, a European Central Bank study said on Thursday. 

"The risk is the emergence of a situation of the type experienced in Japan during its 'lost decade'," the study said. 

"Fragile banks have an incentive to continue financing troubled and inefficient firms, so as to avoid recognising further losses." 

The unwinding process can become a long-lasting drag on the economy, the research paper said. 

"In this constant balancing act, policy interventions should, therefore, avoid delaying the necessary adjustment process." 

Once banks' balance sheets have been cleaned, corporate defaults might have a much smaller impact on the economy, it said.

Swiss banking regulator adopts bail-ins, but in time of crisis will this work

Reuters reports that the Swiss banking regulators have adopted the following structure for absorbing bank losses before a taxpayer funded bailout: shareholders, contingent convertible holders, unsecured debt holders and then senior debt holders.

While this sounds like a good plan, there is one small detail that hasn't been addressed: implementation during a time of financial crisis.

One of the primary lessons learned from our current global financial crisis is that bank regulators will not require banks to recognize their losses if the result would be to reduce the level of bank book capital.

Why?

For fear of sending a message about the safety and soundness of the banking system.

The result is that bank regulators have an irresistible urge to use taxpayer funds instead.

Regular readers know that the way to end this irresistible urge is to require the banks to provide transparency into their current global asset, liability and off-balance sheet exposure details.

With this level of transparency, market participants can assess and know the current condition of each bank.

Should a bank need to be recapitalized through bail-in, market participants know this and the size of the bail-in.  As a result, actually implementing the bail-in doesn't send a message that threatens the safety and soundness of the banking system.

Switzerland shouldn't bail out its largest banks again before asking creditors and shareholders to stump up, the local financial regulator said on Wednesday. 

Authorities have been grappling since the collapse of U.S. investment bank Lehman Brothers five years ago with the question of how banks regarded as systemically important - or too big to fail (TBTF) - can be recapitalised without causing panic or needing taxpayer cash.... 

The regulator recommended spreading bank losses across a range of creditors, including shareholders, holders of contingent convertible (CoCo) instruments (which may convert into equity under certain conditions) and owners of debt including senior debt. 

"This recapitalisation must be sufficient to meet the needs of all group companies in Switzerland and abroad," FINMA said in its position paper. "This buys time with regard to restructuring the affected banks so that they can return to viable operation."

Why have banks been exempt from recognizing losses since beginning of financial crisis?

On the sixth anniversary of the beginning of the global financial crisis, it is time to end the myth surrounding why banks have been exempt from recognizing losses from the crisis that they created.

I have chosen to write on this topic because recently I have been involved in a series of twitter exchanges where the justification given for a whole range of monetary and fiscal policies is based entirely on the assumption forcing the banks to recognize their losses would lead to a "disaster".

But is this disaster just a convenient myth spread by bankers or is it true?  And if it is true, who is it a disaster for?  Let's look at the question of who it is a disaster for first.

Is it a disaster for public and private borrowers?  No. They have their debt written down to a level that they can afford.

Is it a disaster for homeowners when neighbors have their debt written down and house prices decline? No.  Just like stocks, it is nice to sell at the top, but this is not guaranteed.  In the meantime, the neighborhood is better off as each of the owners can afford to maintain their property.

Is it a disaster for loan origination?  No.  Banks are senior secured lenders and having the debt written down means that the value of the assets pledged as security are not artificially inflated.  Lenders have to take into account this artificial inflation in price because it is likely to not be there when the collateral for the new loan is needed as a source of repayment.

Is it a disaster for the capacity to hold loans in the financial system?  No.  Selling loans out right to private investors (insurance companies, pension funds, hedge funds) or through syndication to other banks or securitization is commonplace in the US.  In Europe, the equivalent is the covered bond.

Is it a disaster for bank book capital levels?  Yes.  Bank book capital is the accounting construct through which losses on loans flow.  When losses are realized, bank book capital declines.

Is it a disaster for bank regulators?  Yes.  Bank regulators, through the bank examiners, attempt to determine if a bank is holding enough capital to absorb any losses that arise.  When their estimation of the probability of default (PD) and the loss given default (LGF) are too low, this is exposed when banks have to recognize their losses and bank book capital becomes a negative value.

Is it a disaster for bankers?  To answer this question, we also answer the question of is the notion of disaster just a convenient myth spread by bankers.

As Economist William White pointed out, if you ask a banker, there is never a good time to recognize their losses.  This is not surprising.  Bankers have an incentive to sell the disaster myth as recognizing losses would eliminate their bonuses.

But is it true that banks recognizing their losses would lead to a disaster?

The starting point for determining if  this is true is to look at the FDR Framework and see if banks are specifically exempted from recognizing losses.

The FDR Framework combines the philosophy of disclosure with the principle of caveat emptor (buyer beware).  Under the principle of caveat emptor (buyer beware), all market participants are responsible for all losses incurred on their investments.

The FDR Framework and its related legislation in the 1930s does not exempt banks from taking losses.

But what about any bank specific legislation like Glass-Steagall that was passed in the aftermath of the Great Depression or subsequently?

Again, legislation does not exempt banks from the consequences of their actions.  Legislation does however through deposit insurance exempt depositors from the consequences of the bank's actions.

But what happens if the losses at the banks are so big that disaster occurs?  Disaster for banks having large losses can only be that the taxpayers through the deposit guarantee would lose money should the losses be recognized.

Interestingly, this very scenario was planned for by the legislation that came out of the Great Depression.  By design, the legislation made banks special.  Unlike every other company, banks cannot go out of business unless the government steps in and puts them out of business.

Why can banks operate even when they have negative book capital levels or are insolvent (where the market value of the bank's assets is less than the book value of its liabilities)?

Because the combination of deposit insurance and access to central bank funding allows a bank to continue to operate.  Deposit insurance effectively makes the taxpayers the bank's silent equity partner when it has negative book capital or is insolvent.

Over the last 40 years there have been plenty of examples of banks that were insolvent but continued to operate for years.

Over the last 40 years there have been plenty of examples of banks that market participants knew would have had negative book capital levels if regulators had not intervened and prevented the banks from recognizing their losses.

Examples of banks like this include, but are not limited to, the money center banks with their exposure to loans to Less Developed Countries in the mid-1980s, US Savings and Loans with their concentration in low interest mortgages during a high interest rate period throughout the 1980s, and most recently all of the major global banks with their exposures to structured finance securities.

Please note that in each of these examples market participants were aware that the banks were or are hiding significant losses on and off their balance sheets.  Despite the existence of these losses, depositors continued to do business with these banks.

Why do business with an insolvent bank?

Because depositors don't care about solvency because of the deposit guarantee.

Why do bank regulators allow insolvent banks to continue to operate?

Because as long as the bank has the capacity to generate income in excess of its expenses it can use future earnings to rebuild its book capital level and return to solvency.  Plus the burden of paying for the disaster stays with the banks and not the taxpayers as retention of future earnings means the banks pay for their losses.

So if depositors aren't going to run and the banks are capable of generating income in excess of their expenses to pay for the losses incurred by the banks, what is the disaster lurking if banks are required to recognize their losses?

The disaster is it crushes banker bonuses.

Paul Krugman on what everyone got wrong about our current financial crisis

In his NY Times blog, Professor Paul Krugman discusses the three major issues that everyone has gotten wrong about our current financial crisis.

All modesty aside, it is publicly documented that I got each of these issues right.

Professor Krugman see these three issues as

a good way to get at the broader question of why recovery has been so sluggish. 

The starting point is that we had a monstrous housing bubble, and Janet Yellen recognized it in real time....

So did I.  So if recognizing a monstrous housing bubble in real time qualifies one to be Fed Chairman, then I am qualified.

It’s important to notice that just being willing to see the obvious here puts Janet Yellen way ahead of a lot of people who still presume to give us advice on the economy. 

But Yellen initially thought the damage from a bursting bubble could be contained, although she was starting to worry by 2007. 

Why was she wrong? Matt emphasizes the financial crisis — the way the bursting bubble created a run on the shadow banking system. And that’s clearly key to understanding the severity of the 2007-9 slump. 

Yes, it is critically important to understand the shadow banking system.

If one understands the shadow banking system you would recognize that we did not have a run.

When investors cannot value a security they are unwilling to lend against it.  To characterize an unwillingness to blindly bet as a run simply shows a lack of understanding of the shadow banking system.

Unfortunately, the economy didn’t come roaring back. Why? 

The best explanation, I think, lies in the debt overhang. For the most part, even those who correctly diagnosed a housing bubble failed to notice or at least to acknowledge the importance of the sharp rise in household debt that accompanied the bubble...

And I would argue that this debt overhang has held back spending...

Your humble blogger recognized the debt overhang and has been saying since the beginning of the financial crisis that banks need to recognize upfront their losses on this excess debt if the real economy is going to emerge from its economic malaise.

It is nice that a Nobel prize winning economist agrees with my analysis.

Finally, nobody really anticipated the disastrous response of policy, above all the squeeze on public spending at a time when we needed more government spending to sustain the economy until private balance sheets were repaired. 

Actually, I anticipated the disastrous policy response.  I even said what was needed as a policy response back in December 2007 before the financial crisis reached an acute stage.

Since then, I have used this blog to explain before a policy is adopted why it will not work to end the current financial crisis.

Given that Professor Krugman has established what it takes to be an expert on our current financial crisis who's opinion should be listened to, I look forward to talking with Professor Krugman and others on what it really will take to end this crisis.

It is time to think the unthinkable and raise interest rates

Allister Heath triggered an epic twitter debate when he called for the Bank of England to do the unthinkable and raise interest rates.

On the one side, represented by former Monetary Policy Committee member Danny Blanchflower, were those who argued that we continue to need near zero interest rates until such time as the economy recovers and unemployment drops close to pre-financial crisis levels.

On the other side, represented by Ros Altmann, an economist who focuses on retirement issues, were those who argued that zero interest rate policies hurt the real economy by stifling demand.

Regular readers won't be surprised that your humble blogger (tweeting @tyillc) joined in the debate.

Before going further, let me remind readers that unlike Ms. Altmann and Mr. Blanchflower, I do not have a PhD in Economics.  As a result, like Walter Bagehot, the Economist Magazine editor who invented the modern central bank, I focus on what is actually happening and providing a framework for understanding what it will take to end our current financial crisis and prevent future financial crises.

To his credit, Mr. Blanchflower presents an energetic defense of the indefensible.  He argues that given the current level of unemployment there is no empirical support in a peer reviewed economic article that supports the notion that interest rates should be raised.  The economic literature calls for aggressive monetary stimulus.

Hmmm...is this the same peer group of economists that failed to predict the financial crisis?

Hmmm...is this the same peer group that is making economic forecasts at both the Bank of England and Fed and since the beginning of the financial crisis has routinely predicted better economic performance than has occurred?

I called Mr. Blanchflower's position indefensible because the peer reviewed economic literature never considers that there might be an inflection point where the strong relationship between lower interest rates and lower unemployment no longer holds.

Regular readers know exactly where this inflection point is:  it is Walter Bagehot's 2% lower bound.  He observed in the 1870s that economic behavior changes when interest rates drop below 2% and as a result said interest rates must be kept above this level.

Once one realizes there is an inflection point, it is easy to explain why the Bank of England and the Fed are predicting better economic performance than has occurred.  Below the inflection point, economic behavior changed and this change in behavior is not incorporated into the models used by the Bank of England and the Fed.

On the other side of the debate, Ms. Altmann supported Mr. Heath's observation on the impact of the zero interest rate and quantitative easing policies.

Keeping rates artificially low for extended periods of time inevitably distorts economies and misallocates resources. 

It allows unsustainable projects to survive, pushes bond, equity and property prices too high, depresses the value of sterling without, in a modern economy, boosting exports, messes up the pensions market, and incentivises consumption over saving – and all of that even before inflation begins to rear its ugly head.

Ms. Altmann puts forth the arguments the regular readers are familiar with under the Retirement Plan Death Spiral.  Current consumption is reduced as savers, both individuals and corporations, offset the loss of earnings on their retirement plans by saving more money.

As you can imagine, the debate became show me the empirical proof versus here is the anecdotal evidence.

To see if Mr. Blanchflower might acknowledge that maybe zero interest rates and quantitative easing are not the appropriate policy response to a bank solvency led financial crisis, I introduced the WSJ interview of Anna Schwartz.

Ms. Schwartz observed that these policies were wrong, wrong, wrong.

Mr. Blanchflower asked if this was the best I could do.

Naturally, I responded with a yes.  After all, Ms. Schwartz was an expert on the Great Depression and co-authored THE book on monetary policy.

To see if there were a position of compromise, I introduced the simple fact that back when I was working at the Fed and the Fed was taming inflation the economy was not particularly sensitive to changes in interest rates of less than 1%.

Despite Alan Greenspan cutting rates by a quarter of 1% at a time, there is no reason to believe the real economy has gotten to be more responsive to changes in interest rates.  Does anyone really think a company doesn't move ahead with a project because the cost of debt goes up by 0.25%?  Does anyone really think people don't buy a house because the cost of debt goes up by 0.25% (hint: they buy a smaller house)?

Faced with this fact, Mr. Blanchflower offered the real reason that central bankers will never be able to allow interest rates to increase.

@tyillc @rosaltmann @asentance because mortgage holders have had falling real wages compensated for by low mtg payments so if rise disaster

Translation: central bank policy is held hostage by excess public and private debt in the financial system and the need to protect bank book capital levels and banker bonuses.

I would like to thank Mr. Blanchflower for a) his willingness to engage in the discussion and b) his insights.

I would be remiss to not share one other insight.  As Mr. Blanchflower observed, he and I can debate what the policy should be, but the policymakers need to get it right.

In two days, it will be six years since the beginning of the financial crisis and the policymakers have not gotten right.  As documented by the Dallas Fed, the cost of the financial crisis has now grown to well in excess of $12 trillion with no end in sight.

Fannie and Freddie look to run out the clock on reform

The International Financing Review had an interesting article on how Fannie Mae and Freddie Mac are trying to run out the clock on reform of the US mortgage finance system.

It came out shortly before President Obama announced his support for reform along the lines of the Corker/Warner bill in the Senate.

President Obama supports, according to a Bloomberg article,

A reformed system must have a limited government role, encourage a return of private capital and put the risk and rewards associated with mortgage lending in the hands of private actors, not the taxpayers.

Regular readers know that the only way to achieve President Obama's goal for a reformed system is by setting up an independent securitization platform that provides observable event based reporting on the performance of the mortgages underlying each security whether the security is a covered bond, securitization or something else that Wall Street creates.

Naturally, Fannie Mae and Freddie Mac do not want to see this type of reform occur.

One way that Fannie Mae and Freddie Mac are running out the clock on reform is by developing their own securitization platform.  Based on documents released by their regulator, the FHFA, this platform will disclose mortgage performance data once per month.

As we learned in the run-up to our current financial crisis, once-per-month or less frequent performance reporting is useless.  Subprime mortgage-backed securities provided this frequency of disclosure and they were called "opaque" by market participants.

The only reporting frequency that lets all market participants know the current status of each mortgage is observable event based reporting.  Under observable event based reporting, every activity like a payment or delinquency involving the underlying mortgages is reported to market participants before the beginning of the next business day.

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

When investors know what they are buying and know what they own, there is little or no need for Fannie Mae and Freddie Mac.

This is understood by Fannie Mae and Freddie Mac and that is why they are taking action to make sure it doesn't occur.

Key to GSE reform: disclosure

The key to success for any GSE reform and getting private investors to absorb more of the risk of default on mortgages is information.  Specifically, disclosure of information so that investors can "know what they are buying" and "know what they own".

In the run-up to the financial crisis, we learned that once-per-month or less frequent disclosure was inadequate to know what you were buying or know what you own.  We know this because sub-prime mortgage-backed securities disclosed on a once-per-month basis and they were referred to as "opaque".

It is only disclosure on an observable event basis that allows investors to know what they own or know what they are buying.  

This can be easily shown with a clear plastic bag, which represents observable event based reporting, and a brown paper bag, which represents once-per-month or less frequent disclosure.  Which is easier to value the contents of: paper or plastic?

Under observable event based disclosure, any activity like a payment or delinquency involving the underlying collateral is reported to market participants before the beginning of the next business day.

The National Association of Insurance Commissioners, the only non-conflicted buy-side regulator, thinks highly enough of the need for observable event based reporting that it included it in its future of mortgage financing white paper.

This information is best collected and distributed through a securitization platform.

Please note that both the Senate (Corker, Warner) and House bills call for the creation of this securitization platform.

Based on this, you would expect that Fannie Mae and Freddie Mac would, rather than delay and create their own platform, simply use the exiting securitization platform operating in Europe, the EU Data Warehouse.  

This is particularly true because the EU Data Warehouse's pricing model is to charge enough to break-even.  This pricing model caps what a Fannie Mae and Freddie Mac securitization platform could charge and effectively means that there would be no return on, let alone return of, US taxpayer funds used to build the platform.

The case for not using the EU Data Warehouse is it doesn't provide observable event based reporting.  However, based on disclosures by Fannie Mae and Freddie Mac they are not intending to provide observable event based reporting either.

Key problem with technocratic financial regulation: it doesn't work

Since the beginning of the financial crisis, global policymakers have indulged in an unprecedented ramp-up of technocratic financial regulation.

Technocratic financial regulation substitutes complex rules and regulatory oversight for transparency and market discipline.

There is just one key problem with this approach:  our current global financial crisis was the result of the failure of technocratic financial regulation and there is no reason to believe that technocratic financial regulation could be successful in preventing a future financial crisis.

The failure of technocratic financial regulation can be seen in the bailout of the banks.

Banks are "black boxes" into which only the banking regulators can look.  When they looked in the run-up to the financial crisis, the regulators told everyone that they had very little risk.

Whether this statement was the result of not being able to assess bank risk or they were concerned with the safety and soundness of the financial system is irrelevant.  What was relevant was the bank regulators failed to restrain bank risk taking.

When the financial crisis began, it was apparent to everyone that nobody, including the bank regulators, could tell which banks were solvent and which were insolvent and the most likely choice was all of the major banks were insolvent.

Policymakers acting upon the recommendation of the bank regulators choose to cover up the failure of complex rules and regulatory oversight to prevent the financial crisis.  The result was adoption of the Japanese Model for handling a bank solvency led financial crisis and protection of bank book capital levels and banker bonuses at all costs.

Given the global failure of technocratic financial regulation, there was and still is absolutely no reason to bet the financial system's stability on the bizarre notion that the outcome will be better next time.

This is particularly true because under the FDR Framework, the global financial system is designed to be anti-fragile.  Where there was transparency and market discipline, the global financial system functioned without need for government intervention even during the most acute phase of the crisis.

As Adam Levitin nicely summarizes technocratic financial regulation, it is:

Add two parts capital and one part co-cos, mix with risk retention requirements and garnish with macroprudential regulation...

In fact, as more and more complex regulations are enacted it becomes less and less clear that banks are becoming less as oppose to more risky.

The Financial Times reports on the conflict between simple bank capital leverage ratios and bank liquidity coverage ratios,

Can regulation make banks less safe? What has happened in the past week certainly seems to suggest so. 

Three large European banks – Barclays, Deutsche Bank and Société Générale – moved to partly dismantle one of their main bulwarks against another liquidity crisis: their massive cash reserves....

The bosses of all three banks sung the same refrain to explain the wind-down of cash and safe assets: It will help them boost their leverage ratio, a gauge of financial soundness that measures a bank’s equity against its overall assets....

Banks’ drive to reduce their liquid holdings reverses a trend that started after the collapse of Lehman Brothers in 2008. Since then, banks have tended to hoard large reserves of easy-to-sell assets. .... 

Regulators have pushed banks to do this as part of the lessons learnt from the global liquidity crunch of 2007-09. The first-ever global liquidity standards – an early element of the Basel III rule book called the liquidity coverage ratio – require banks to stockpile enough liquid assets to sustain their operations for 30 days if faced with another crisis....  

European bank executives might thus simply be using a reduction in their cash pools as a neat lobbying tool, trying to shock regulators into moderating leverage requirements. 

But even if that is the case, their key argument is worth listening to: Leverage ratios do not make a distinction between liquid, non-risky assets such cash on one side and high-risk, illiquid instruments such as complex securitisation products on the other. For leverage purposes, an asset is an asset. ... 

There is certainly a rationale for a leverage ratio threshold that will make banks safer by forcing them to hold more equity in relation to their assets. But it makes no sense to persist with definitions of leverage that clash with the objectives of liquidity rules.

BIS blames creditors and bank regulators for current eternal financial crisis

As reported by the Telegraph, the BIS laid the blame for the current ongoing global financial crisis on the creditors (banks) and their regulators.

Specifically, the BIS said the mechanism for dealing with the excess debt in the global financial system is jammed because bank regulators refuse to require banks to recognize upfront the losses on their debt.

By design, banks are suppose to absorb upfront the losses on the excess debt so as to protect the real economy.  If they do not do so, the burden of the excess debt is place on the real economy.

This burden takes two forms: debt service and misallocation of capital.  Together these forms of burden result in the real economy not having the capital it needs for reinvestment and growth as well as not properly allocating the capital it does have.

A clear recipe for economic stagnation.

Your humble blogger predicted this economic outcome at the beginning of the financial crisis when global policymakers and bank regulators adopted the Japanese Model for handling a bank solvency led financial crisis.

Under this model, the mechanism for dealing with losses on excess debt is intentionally jammed as bank book capital levels and banker bonuses are protected at all costs.

Regular readers know that your humble blogger also pointed out that with adoption of the Swedish Model under which banks recognize upfront the losses on the excess debt the real economy is protected.

It is nice to have the BIS agree with my analysis.

The Switzerland-based watchdog said unprecedented imbalances have built up in the global system and these are failing to self-correct because the mechanism is jammed.... 

The BIS said European banks played a huge role in stoking the pre-Lehman credit bubble. They rotated $1.25 trillion into US debt alone between 2003 and 2007, greater than the combined purchases of Asia and OPEC. It said banks funnelled money into southern Europe regardless of risk in "expectations of a bail-out" if any country got into trouble. 

"European banks were negligent in assuming – and their regulators in allowing – such exposures. Overlending was as responsible for the ensuing crisis as over-borrowing."... 

The watchdog called for "symmetry in adjustment between creditors and debtors" to avoid repeating the 1930s, warning that global recovery will remain stunted until the creditors chip in.

Banks rigged rate at retirees' expense

Having felt comfortable manipulating benchmark interest rates like Libor for their personal gain, it comes as no surprise that Bloomberg reports bankers were also manipulating for their personal gain the more obscure swap benchmark rate, the ISDAfix.

This rate was used by pension funds trying to hedge their positions.

Just like Libor, the solution to end manipulation by the bankers is using transparency into both the actual transactions and each bank's current exposure details.  With this information, market participants can determine if the banks entered into trades in an attempt to manipulate this rate.

U.S. investigators have uncovered evidence that banks reaped millions of dollars in trading profits at the expense of companies and pension funds by manipulating a benchmark for interest-rate derivatives. 

Recorded telephone calls and e-mails reviewed by the Commodity Futures Trading Commission show that traders at Wall Street banks instructed ICAP Plc brokers in Jersey City, New Jersey, to buy or sell as many interest-rate swaps as necessary to move the benchmark rate, known as ISDAfix, to a predetermined level, according to a person with knowledge of the matter. 

By rigging the measure, the banks stood to profit on separate derivatives trades they had with clients who were seeking to hedge against moves in interest rates. 

Banks sought to change the value of the swaps because the ISDAfix rate sets prices for the other derivatives, which are used by firms from the California Public Employees’ Retirement System to Pacific Investment Management Co....

Bankers had the exact same motive to manipulate this benchmark interest rate as they did to manipulate Libor.

CFTC investigators are piecing together evidence that shows swaption traders at banks worked with rate-swap traders at their own firms to manipulate ISDAfix, the person said. 

The swaption traders told their rate-swap colleagues the level at which they needed ISDAfix to be set that day in order to bolster the value of their derivatives positions before these were settled the next day, the person said. 

The rate-swap trader would then tell a broker at ICAP, the biggest arranger of the contracts between banks, to execute as many trades in interest-rate swaps as necessary to move ISDAfix to the desired level. 

This would be done just before 11 a.m. in New York, the time when current trades are used to create reference points that help determine the final ISDAfix rates, the person said.

Hiding behind a veil of opacity, bankers used a similar technique to manipulate this benchmark interest rate as the technique they used to manipulate Libor.

In manipulating ISDAfix, ICAP brokers profited from the commissions they received from the interest-rate swap trades banks ordered to influence the benchmark, the person said. 

Banks were willing to endure trading costs with the brokers that may have reached hundreds of thousands of dollars because they stood to earn millions on swaptions by manipulating ISDAfix by as little as a quarter of a basis point, or 0.0025 percentage point, the person said....

ICAP manages an electronic screen known as 19901 on which rate-swap prices are displayed throughout the day to about 6,000 corporate treasurers and money managers so they can value positions. 

The trades displayed on the screen are used to create the reference points for ISDAfix rates, according to ISDA’s website. 

ICAP then sends the reference point to banks, which either accept it as their contribution to the benchmark or submit a different value.

Trader explains why dishonesty rewarded on Wall Street and only transparency can end bad behavior

In his must read Guardian column, Joris Luyendijk interviews a Trader from London's City who explains why dishonesty is rewarded on Wall Street and how only transparency can end misbehavior.

Regular readers know that sunlight is the best disinfectant.  The trader describes what happens when Wall Street and the City are left to operate behind a veil of opacity.

The trader presents petty theft as an every day occurrence.

"Where I worked people seemed obsessed with power structures and keeping on top. For instance when someone was made redundant a remaining trader would do a deal between his book and that person's, creating a profit in his book and a loss in that of the person leaving...."

Left unsaid is that the trader creating a profit in his own book has his compensation based on the profitability of his book.  From the bank's perspective, the position hasn't changed, just the payout.  So effectively, the trader has stolen money from the bank.

The trader explains how they use opacity to take risks knowing that if the bet pays off they are well compensated and if the bet loses they will just move on to the next bank.

"In the end the bank is like a shell. You need a place to trade from, this is how we saw our bank. Sometimes an entire team can be poached and go from one bank to another. There's no loyalty either way. And the top at your bank has no idea what's going on, how could they? Why would anyone tell them what's going on?

The trader explains Wall Street and the City's ethics.

"Of course traders are constantly inquiring across the bank: what's happening? What are our big clients like institutional investors doing? Then they 'front run' those investors; buying ahead of them so when the price rises due the subsequent buying, they pocket the difference. 

"Chinese walls [between deal making, asset managing and trading bankers]? Bullshit. We could simply log on to our system and see what was happening and what they were doing all the time. 

"If there is a lot of money at stake then people will not adhere outside rules and they will evade Chinese walls....

Next, the trader explains who Wall Street and the City use the complexity and resulting opacity of the financial products they sell to benefit at the expense of their customers.

"My advice to people dealing with the financial sector is: never buy anything that's complex. Because the more complexity the more opportunities there are to screw you over. 

Finally, the trader highlights how important the role of caveat emptor (buyer beware) is when dealing with Wall Street and the City.

Traders see the capital markets as a zero-sum game.  If they win, you must lose.

Individuals and small companies see their relationship with the bank as a partnership with the goal of both parties winning.  This makes individuals and small companies susceptible to being mistreated and sold products like interest rate swaps.

I just can't get my mind around how banks can still call clients in the corporate world and say, look we've got this great idea that's going to make you a lot of money. I mean, what are they thinking? 

Nobody in the City can be trusted because they don't work for you, they work for themselves. 

"I do wonder why there seem to be so many somewhat dishonest people in the bank, and why the most dishonest are often the ones to walk away with the most money."

Nuns and analysts alike recognize need for transparency into bank commodity earnings

Reuters ran an article highlighting the need for transparency as "for nuns and analysts alike, bank commodity earnings are a mystery".

The simple fact is that banks are not required to provide transparency.

Remember that under the 1930s Securities Acts, the government is given the responsibility for ensuring that all market participants have access to all useful, relevant information in an appropriate, timely manner so the market participants can independently assess this information and make a fully informed decision.

Commodities is one, but not the only area where the government is not fulfilling its responsibility of ensuring transparency to all market participants.

When the government does not fulfill its responsibility and ensure transparency, the market does not work properly as market participants are not able to assess and properly value risk.

Our current financial crisis is the result of market participants not having access to all the useful, relevant information in an appropriate, timely manner so that they could independently assess and properly value risk.

When the Reverend Seamus Finn got an email from Goldman Sachs last week, the giant Wall Street bank was addressing an issue that was already on his mind. 

"We were getting ready to go back to them and talk to them about commodities anyway," said Finn, who heads up faith-consistent investing for the Missionary Oblates, a Washington DC-based Catholic group that owns Goldman shares.... 

But it left unanswered many of Finn's questions about what the bank is doing in the sector.... 

The statement sent to Finn and later released widely did not address one of his broader concerns: that no one outside the banks themselves knows for sure how big their commodity trading arms are, how much they trade, or how much money they make. 

"We would like more disclosure on that," Finn said.

He is unlikely to get his wish. 

While the country's largest banks are required to disclose their activities in some consumer-facing businesses such as mortgages, there is no similar requirement for them to do so on the commodities side....

Please re-read the highlighted text as this experience not only applies to commodities, but also to all the other opaque areas of the financial system ranging from the banks themselves to Libor to structured finance.

"I don't think you have any banks that are properly disclosing commodities revenue," said George Kuznetsov, head of research and analytics at Coalition, a British consulting firm that employs more than 100 researchers to scrutinize public disclosures and conduct interviews to estimate trading revenues for investment banks. 

The issue is becoming increasingly important as politicians press the banks for more insight into the risks they are taking by owning metals warehouses or chartering oil tankers, and as some seek buyers for their physical commodities holdings. ...

The lack of clarity over trading operations has long been a vexing issue across other desks as well, such as foreign exchange and equities....

In sum, it's big money: the top ten global banks collectively made about $6 billion trading commodities last year, down 24 percent from in 2011, according to Coalition. 

The banks say that they are providing regulators and investors with all the information they are required to give. 

"Our disclosures are in line with all relevant reporting requirements and provide investors with all material information," said a spokesman for Morgan Stanley. He said the bank provides data on the main drivers of results across its three core business lines but does not break down earnings to a "product" level like commodities. 

Critics say the disclosures still leave much to be desired. 

"They really don't tell us much," said Robert McCullough, an energy economist who spent six years litigating an electricity market manipulation case against Morgan Stanley. 

"If you wanted an estimate of what their position was in electricity in 2001, six years of litigation was not sufficient to get it," he said.

To accurately assess the risk of a bank's commodity business, market participants need the bank's current exposure details.

Clearly, there is a significant gap between what market participants need to accurately assess risk and what the government has decided represents all the material information.

In terms of financial system risks, the Federal Reserve, which regulates banks, has the power to make on-staff visits and request data sets from the banks on their commodities activities. 

The agency also keeps on-site staff at the banks who are dedicated to monitoring commodities. 

So the government's solution is to give the Federal Reserve an information monopoly on all the useful, relevant information.

But that is not enough, according to some former examiners. 

"There's a sophistication gap between the regulator and the bank that they regulate," said Mark Williams, a former Federal Reserve bank examiner and energy executive who now teaches finance at Boston University. 

"The commodities are where the more sophisticated transactions take place," he said....

As Mr. Williams observes, the Federal Reserve is not up to the task of accurately assessing this information.  Even if it were, there is another problem: communicating this assessment to the other market participants.

If the Federal Reserve isn't capable of accurately assessing the information and the market participants who are capable of assessing the information don't have access to the information, then the result is that there is no one overseeing and exerting restraint on the banks risk taking.

This is a prescription for banks to take on excessive risk and engage in bad behavior.

As has been shown numerous times since the start of the financial crisis, bankers were and still are only too willing to fill this prescription by taking on excessive risk and engaging in bad behavior.

Goldman Sachs, for instance, reported only $100 million in "commodity and other" trading revenues to the Fed in 2012. In a separate filing with the SEC, the bank said it made $575 million trading commodities. Industry sources actually pegged Goldman's commodity revenues closer to $1.25 billion for the year. 

Asked about the different figures, a spokesman for Goldman Sachs said: "We disclose figures in the way we are required. That may not correspond to the way we actually measure the performance of certain trading businesses." He declined to provide a figure for the bank's commodity trading revenues....

With so much uncertainty around the headline numbers, attempting to separate banks' paper bets on commodities from physical trading - the segment most at risk from regulators - is all but impossible....

That hasn't stopped some influential groups from calling on banks to step up their reporting. 

Last year, the CFA Institute - which confers the Chartered Financial Analyst credential to investment professionals worldwide - endorsed a report calling for banks to improve their risk disclosures to investors. 

Banks' trading books, in particular, remain "very opaque" to investors, said Vincent Papa, the institute's director of financial reporting policy. 

"In many cases, they give you a figure which they deem to be meaningless from an internal management standpoint," Papa said. "They just give it for compliance reasons. That's not beneficial to investors. It's about giving relevant information, rather than just ticking the boxes."...

Transparency needed to end Wall Street's ratings game

Reuters ran an article describing how rating firms, in a replay of the run-up to the financial crisis, are once again using more favorable ratings to win business.

Regular readers know that the way to end this ratings game is to require transparency.  Specifically, valuation transparency so that all market participants have access to all the useful, relevant information in an appropriate, timely manner.

With equal access to the useful, relevant information, market participants can choose to independently assess this information for themselves or hire a third party expert to do the assessment for them.

Regardless of whether market participants do the assessment themselves or hire a third party the result is the dependence of the financial system on the rating firms is ended.

They become nothing more than a third party expert competing for business.

Five years after inflated credit ratings helped touch off the financial crisis, the nation’s largest ratings agency, Standard & Poor’s, is winning business again by offering more favorable ratings. 

S.& P. has been giving higher grades than its big rivals to certain mortgage-backed securities just as Wall Street is eagerly trying to revive the market for these investments, according to an analysis conducted for The New York Times by Commercial Mortgage Alert, which collects data on the industry. 

S.& P.’s chase for business is notable because it is fighting a government lawsuit accusing it of similar action before the financial crisis. 

As the company battles those accusations, industry participants say it has once again been moving to capture business by offering Wall Street underwriters higher ratings than other agencies will offer. 

And it has apparently worked. Banks have shown a new willingness to hire S.& P. to rate their bonds, tripling its market share in the first half of 2013. ... 

“The general consensus was that these changes have let them get their market share back,” said Darrell Wheeler, a bond analyst at Amherst Securities....

But David Jacob, who ran the S.& P. division that rated mortgage-backed bonds until 2011, said that in his time at the company, after the financial crisis, he saw employees adjusting criteria in response to business pressure. 

“It’s silly to say that the market share doesn’t matter,” said Mr. Jacob, who is now retired. “This is not God’s holy work. It’s a business.”...

But Mr. Shugrue said that the little things being allowed could turn into steps toward much bigger problems. 

“You can see that we are slipping our way back to 2007,” he said.