Trust Your Instincts

FT's Gillian Tett shines light on need for ultra transparency

2012-03-08T18:47:00.001-05:00

In her Financial Times column, Gillian Tett looks at the need to collect all the useful, relevant data and make it available to the market so that it can be used.

Her column covers many of the topics this blog has discussed including Wall Street's Opacity Protection Team, the Office of Financial Research (where transparency goes to die) and who is capable of analyzing the data and has an incentive to do so.

If Greece were to descend into disorderly default, how big would the financial hit be? That question has been stirring up intense debate in the markets; and, of course, among regulators too. With negotiations about Greek debt having dominated the headlines, it has been important to understand the “what if” scenarios.

But amid the number-crunching, there is a bigger question too: just how much information is really available about the likely impact of any Greek shock?

Very little.

After all, when the financial system went into shock in 2008, following the Lehman Brothers collapse, it became clear that modern finance was plagued by a data fog; although investors could find timely information about equities, say, there was very limited transparency about other areas, such as the repo market or credit derivatives (partly because banks had a commercial interest in maintaining that fog).

Please re-read the highlighted text as it neatly summarizes why there is a need for ultra transparency throughout the financial system and the creation of the Mother of all financial databases.

It is not only regulators who want to answer the questions like what is the impact of the Greece debt restructuring going to be, but also market participants like investors.

Since then, global regulators have pledged reforms. And in some senses, considerable progress has been made.

Today banks and other financial institutions are filing far more detailed reports on those repo and credit derivatives trades, and regulators are exchanging that information between themselves.

Meanwhile, in Washington a new body – the Office of Financial Research (OFR) – has been established to monitor those data flows and in July US regulators will take another important step forward when they start receiving detailed, timely trading data from hedge funds, for the first time.

This is just more of the same in terms of regulators trying to maintain their information monopoly.

But there is a catch: although these reports are now flooding in, what is still critically unclear is whether the regulators – or anybody else – has the resources and incentives to use that data properly.

If this data were made available to all market participants, there is no doubt that the market participants have the resources and incentive to use that data properly. There is the potential to make a significant amount of money from doing so!

Said another way, not only do market participants have a monetary incentive to use the data, but they also have the expertise to analyze the data too!

The bitter irony is that this information tsunami is hitting just as institutions such as the Securities and Exchange Commission are seeing their resources squeezed; getting the all-important brain power – or the computers – to crunch those numbers is getting harder by the day.

That means that important data – on Greece, or anything else – could end up languishing in dark corners of cyberspace. That is a profound pity in every sense.

After all, if the data could be properly deployed, it might do wonders to show how the modern global financial system really works (or not, in the eurozone.)

Where properly deployed means all market participants have access to it.

Conversely, if data ends up partly unused, that not just creates a pointless cost for banks and asset managers – but could also expose government agencies to future political and legal risk, if it ever emerges in a future crisis that data had been ignored.

That US repo market is a case in point. Before 2007, this was a sector that epitomised the sense of data fog: timely information about activity was patchy, partly because investor and public interest was extremely low.

The lack of timely information was not the fault of the investors, it was the fault of the regulators.

Regulators are responsible for ensuring that market participants have access to all the useful, relevant information in an appropriate, timely manner. This applies to all the currently opaque corners of finance like banks, structured finance securities, Libor rate setting...

But when the crisis erupted at Bear Stearns and Lehman Brothers in 2008, the importance of the repo market became clear. So regulators started to demand far more detailed data from banks, money market funds and other institutions; most notably, they now collect so-called N-MFP submissions, which contain the first granular data on individual securities....

A team from ratings agency Fitch recently spent several weeks combing through those obscure N-MFP forms, for example, and then collated them to provide a fascinating – and once-unimaginable portrait – of this shadowy sector.

Showing that market participants do know how to use the granular level data that ultra transparency would provide.

This reveals that the use of structured finance collateral has recently risen, but haircuts on repo trades have fallen; the top five institutions now represent just 60 per cent of the market, down from 80 per cent in 2008.*

But this snapshot only emerged because Fitch stumbled on these forms and then took the initiative to laboriously comb through thousands of individual files. Without that adhoc effort, there is no system in place to let a casual observer collate those trades, or track the market as a whole.

Showing that the market does have an incentive to assess the data that granular level ultra transparency would make available.

Maybe this will change. Recent innovations in IT in theory make it easier than ever to track complex global data flows....

Yesterday for example, IBM's Watson signed up its first financial client, Citigroup. Watson is designed to be able to track and turn the complex global data flows into real information.

But real change requires political will – and resources. Sadly, that remains patchy, at best. And don’t expect the banks to take the lead: although bank trade groups say they tentatively support the introduction of LEIs, they have also just written to regulators complaining about the costs of the OFR, in an effort to clip its wings.

For the moment, in other words, there are still plenty of financial players who seem disinclined to blow away the data fog; be that in Greece, or anywhere else.

Naturally, Wall Street's Opacity Protection Team does not want the data fog to be blown away. Wall Street has a financial interest.

As Yves Smith observed on Naked Capitalism, no one on Wall Street received large bonuses for designing low margin, transparent products.

Opacity provides Wall Street with the opportunity to make money based on the mis-assessment of risk/value by other market participants.

Economists agree, the Japanese model for bailing out banks works

2012-03-08T15:14:00.000-05:00

The IGM Forum asked its panel of economic experts from elite universities whether they agreed or disagreed with the following statement:

Because the U.S. Treasury bailed out and backstopped banks (by injecting equity into them in late 2008, and later committing to provide public capital to any banks that failed the stress tests and could not raise private capital), the U.S. unemployment rate was lower at the end of 2010 than it would have been without these measures.

Regular readers know that bailing out and bankstopping the banks are policy choices made after adopting the Japanese model for handling a bank solvency led financial crisis. Under the Japanese model, policies are adopted to preserve bank book capital levels and effectively transfer the losses from the excesses in the financial system onto the real economy.

The alternative is the Swedish model for handling a bank solvency led financial crisis. Under the Swedish model, banks absorb the losses today on the excesses in the financial system to protect the real economy. Subsequently, bank book capital is restored through a combination of future retained earnings and equity issuance.

The economists response to the statement were:
27% Strongly Agree
51% Agree
7% Uncertain

When weighted by the confidence of the economists in their response, the results were:
43% Strongly Agree
52% Agree
4% Uncertain

The bottom line: economists agree that adopting the Japanese model and its policy prescriptions was beneficial. But why did the economists overwhelmingly support adopting the Japanese model?

Here are some of their responses:

"Macro performance depends partly on credit from banks, which would have otherwise been impaired. Europe has a related growth issue now." Darrell Duffie, Stanford

"If the banking system had collapsed, unemployment would certainly have been higher in 2010". Pinelopi Goldberg, Yale

"The fact it was necessary doesn't mean we should be happy about it." Austan Goolsbee, Chicago

"It is hard to imagine the mess we would still be in if most of our large banks had failed." Richard Schmalensee, MIT

"The question presumes Paulson’s forced alternative. If the only choice is between evil and Armageddon, evil might look ok." Luigi Zingales, Chicago

In short, the economists either did not know that the Swedish model existed and had been shown to be successful or they ignored it.

One reason that the economists may have ignored the Swedish model was they might not have known that an insolvent bank can continue to operate until it is closed by regulators. Banks can do this because they have both their deposits guaranteed by the government (this stops a run on the bank) and unlimited liquidity from the central bank (which is willing to lend against good collateral).

In the late 1980s, the US Savings and Loans were an example of banks that were insolvent (the market value of their assets was less than the book value of their liabilities) that continued to operate and support the real economy (in fact, they were very aggressive in supporting the real economy in terms of lending on commercial real estate in a bid to gamble on redemption).

NY Times' Peter Eavis calls Citigroup's Pandit's bluff on transparency

2012-03-08T12:23:00.000-05:00

In a NY Times Dealbook article, Peter Eavis observes that Citigroup's Pandit likes to talk about transparency, but fails to back up this talk with action.

Citigroup‘s chief executive, Vikram S. Pandit, likes to talk about transparency, and on Wednesday he repeated his call for new ways to compare the risks at different banks....

Taking questions at the Citi Financial Services Conference at the Waldorf-Astoria in New York, Mr. Pandit was asked whether the bank’s risk management had improved since the financial crisis.

As part of his response, he reiterated his belief, stated in an opinion piece in The Financial Times in January, that banks and regulators could make new types of disclosures that would allow investors to compare risks across different banks. “Let’s make sure we get a level playing field and let’s get the information out in the market place so they can decide,” he said Wednesday.

As regular readers know, the starting point for new ways to compare the risks at different banks is to require all banks to provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details.

With this data, market participants will be able to assess the risk of each bank and make meaningful comparisons between banks.

Without this data, banks will remain 'black boxes' and market participants will continue to be unable to assess their risk or make meaningful comparisons.

That’s an admirable aim, but ... until investors get a better idea [of Citigroup's exposure details]... they have reason to call on Mr. Pandit to first apply more transparency to his own bank.

Rating agencies refuse to apologize for role in financial crisis

2012-03-07T21:33:00.000-05:00

A Telegraph article describes how Moody's and S&P refused to apologize for their role in the financial crisis under questioning by the UK's Treasury Select Committee.

Representatives from Moody's and Standard & Poor's stopped short of apologising for the losses suffered by investors after they failed to spot the crisis brewing in the US sub-prime mortgage market, despite being repeatedly pressed by the Treasury Select Committee....

During the session, in which witnesses faced a hostile line of questioning from MPs, the agencies seemed to want to play down their role and stressed that investors should base their decisions on a range of opinions and information, and not just those of the ratings agencies.

"Ratings are opinions. They are one piece of important information which is available to the market and investors, but there are many other pieces of relevant information around about credit decision making," Mr Crawley said.

"We have been clear that we do not expect an individual investor, or at the other end of the spectrum a sophisticated asset manager, to rely solely on what we provide."...

As previously discussed, the rating firms' business model is built on the idea that they have access to relevant data that other market participants do not. Hence, there is a reason that ratings are one piece of important information.

In the case of structured finance securities, prior to the financial crisis, it was assumed and the rating firms did nothing to dispel the notion that the rating firms had access to and used in their ratings current information on the assets that served as collateral for each security.

This current data was not available to the other market participants.

In the fall of 2007, the rating firms testified before the US Congress that they did not have current data on the performance of the underlying collateral and in fact that they did not have any different access to information on the underlying collateral than other market participants.

Mr Tyrie made it clear he was unhappy with the outcome of the session in his concluding remarks, and said issues including competition within the sector, regulation and the debt issuer pay model would be explored further.

He said: "It appears that you have left the committee unconvinced that many of the problems attached to risk rating agencies in 2008 have yet been adequately addressed."

Following the session Mr Tyrie added: "If even one of the ratings agencies had drilled down deeper into the structure of products developed [in the run-up to the crisis] and challenged them, we would all be in a much better place now."

The simple solution for eliminating the financial market's reliance on a small number of rating firms and unfreezing the current frozen structured finance markets is to require ultra transparency.

In the case of structured finance securities, ultra transparency is next business day disclosure of an observable event (for example, a loan payment, a delinquency, a default, a loan modification) involving the underlying collateral.

With observable event based reporting, market participants would have access to the current performance of the underlying collateral. As a result, not just the current rating firms, but anyone who wants to could rate the securities.

Did Bloomberg's editorial board call for ultra transparency solution for fixing Libor

2012-03-07T14:22:00.001-05:00

In the view of Bloomberg's editorial board, markets deserve a borrowing rate banks can't manipulate. They assert that

Ideally, it would reflect an actual trading market rather than the “what if” quotes that underpin Libor. The market should be very active and used by a wide variety of participants, making it difficult to manipulate. It should also be useful for banks and other institutions that want to hedge against changes in interest rates....

Any transition from Libor to a new benchmark will take a long time. Traders will resist change. And even if all new contracts are tied to repo rates starting in the near future, some of the loans that reference Libor will be around for decades to come. But those are small obstacles in the way of a change that could have major consequences, not the least of which would be an honest benchmark for interest rates paid by millions of corporations and homeowners.

Fortunately, there is an easy way to achieve the Bloomberg editorial board's ideal rate.

That is to require banks to provide ultra transparency and disclose on an on-going basis their current asset, liability and off balance sheet exposure details. Market participants could use the details on the banks liabilities to calculate Libor.

As a result, Libor would reflect actual trading, be almost impossible to manipulate, retain its usefulness in hedging against changes in interest rates and, most importantly, could rapidly be substituted for the current Libor with an absolute minimum of disruption (after all, Libor would now show what it was previously represented as showing).

Is massive imbalance in Eurozone central banking system cause for concern?

2012-03-07T13:06:00.000-05:00

Der Spiegel ran an interesting article that asks the question of 'is the massive imbalance in the Eurozone central banking system a cause for concern?"

The article focused on the fact that the German central bank has almost 500 billion euros of claims while the central banks of Greece, Spain, Portugal, Ireland and Italy owe over 600 billion euros.

How is the system suppose to work?

Here's an example: A Greek business buys a truck from a German company. The Greek company's local bank in Thessaloniki transfers the payment for the truck to the German company's bank in Stuttgart.

Because the payment is carried out through the two countries' central banks, this creates a liability on the part of Greece's central bank toward the ECB within the Target2 system, while the German Bundesbank now has a claim from the ECB for the same amount.

The balance evens out when money flows from Germany to Greece, as happened most years before the crisis: The commercial bank in Greece would borrow the money it needed for its loan to the Greek business, for example, from a German bank.

What gave rise to the current imbalance?

But in a financial crisis, they can potentially lead to catastrophe because the cash flow between banks suddenly falters. This is what has happened since 2007:
Banks in all of the euro zone countries have had to hold onto their money. They withdrew from supposedly unstable countries, and loans that expired were not renewed.
The fears of the wealthy also came into play: Concerned that their money might soon lose its value, they began to pull out of Greece, Ireland and Portugal, then later Spain and Italy as well. This left banks in those countries with a smaller pool of savings they could pass on as loans.
The result of all this was that Greece and the other countries in crisis no longer had enough money to fund all of their imports. If Greek banks wanted to offer further loans, for example to pay for the purchase of German or Dutch products, they had to borrow from their central bank.
The central bank, in turn, simply created money out of nothing, charging it to the entire euro zone as an outstanding claim within the TARGET2 system. "These countries simply pull money off the printing press," Sinn complains.
Even worse, the central banks also grew increasingly lax in the collateral they required for loans they made to banks in their country. Whereas in the past they accepted only government bonds with top-level credit ratings, now they began to accept second and third-tier securities.

This can be seen clearly in the statistics: Just between 2005 and 2010, the volume of securities accepted by central banks rose from €8 billion to €14 billion -- and has likely increased even more since then.

Especially those banks in crisis countries, which are already reliant on their central banks, now submit even their worst securities. Greek banks, for example, have primarily their own country's sovereign bonds on their books. No one on the free market wants these securities, but the Greek central bank continues to accept them as collateral, issuing new money to the banks in exchange.

"Private cash flow is replaced by public cash flow," Sinn explains.

This becomes dangerous if those securities ever need to be used, for example if Greece leaves the monetary union or declares bankruptcy. At that point, Greek bonds would be valueless, and the probability that Greece's central bank will be able to repay its debts to the euro system becomes miniscule.

Naturally, the article asks what happens if one or more of the countries with a central bank that owes money leaves the Eurozone. Could Germany through its central bank lose 500 billion euros?

The real answer is it depends.

It depends on whether or not the individual central banks are enforcing the Eurozone central banking system's collateral requirements or not.

Specifically, when the Eurozone central banking system lends to a bank against its collateral the Eurozone central banking system does not advance as much as the collateral is currently worth. In fact, there is a schedule for the haircuts applied to the collateral.

It is my understanding that after the loan has been made, in theory, if the value of the collateral declines, the borrowing bank is suppose to provide additional collateral. [This is done to protect the Eurozone central banking system from risk should the value of the collateral decline.]

But are the national central banks requiring the posting of additional collateral in practice?

If yes, even if a country leaves the Eurozone, its central bank should have adequate collateral to ensure that it can repay what it owes to the Eurozone central banking system.

If no, then the Eurozone central banking system is exposed to and could have losses should one or more nations leave the Eurozone.

What caught my attention about the imbalance in the Eurozone central banking system was here is a classic example of disclosure (we know which national central banks are creditors or debtors) without transparency (we don't have the information needed to know if there is adequate collateral available to minimize the risk of loss).

Wall Street understands there is no end to intervention so long as Japanese model pursued

2012-03-07T10:39:00.000-05:00

In a Telegraph article, Britain is praised by Deutsche Bank for how it has implemented the Japanese model for handling a financial crisis.

Under the Japanese model, governments protect meaningless bank book capital and transfer the losses on the excesses in the financial system to taxpayers and the real economy.

What caught my attention was that after praising the last five years of implementing the Japanese model, the analysts then observed that to continue successfully implementing the Japanese model will require several more years of intervention.

As Japan has shown and these analysts confirm, there is no end to the intervention required to implement the Japanese model.

As your humble blogger has pointed out, the only way to end the bank solvency led financial crisis is to abandon the Japanese model and adopt the Swedish model. Five years is more than enough time to show that the Japanese model does not work.

Deutsche Bank analysts said that despite the country's vulnerability to the crisis because of its high debt level, "the UK authorities have done a good job to date" in limiting the effects, benefiting from control over its currency and its own central bank.

As a result of independence the pound fell sharply, the Bank of England increased its balance sheet aggressively and consistently, giving investors a clear signal of intent, and the Government was early to respond with austerity.

Since the beginning of the crisis the Bank has cut interest rates to an historic low of 0.5pc and voted for a £325bn injection of new money into Britain's ailing economy....

"The UK has also been earlier than most of its international peers in starting to address the significant budget deficits left by the financial crisis."

As a result, the FTSE has been one of the best performing developed markets during the crisis, they noted. Other countries, including those at the periphery of the eurozone, have struggled to respond effectively to the crisis, they said.

"So, likely the best sovereign policy post crisis is to devalue, slowly cut your budget deficit and allow your central bank to have licence to intervene at will.

The Japanese model policies.

"Going forward we still think that we are set to need a few more years of heavy intervention to ensure that five years of relatively successful crisis management isn’t wasted.

"This is by no means the end of this rolling crisis but it probably isn’t the end of intervention."

Japan is at 2+ decades and counting. There is no reason to believe that the UK, US and EU will be any different.

IBM's Watson and ultra transparency

2012-03-06T15:19:00.000-05:00

IBM's Watson was developed to handle the data that requiring ultra transparency in the financial system would make available.

In a Bloomberg article, Citigroup has become the first financial services client for IBM's Watson. The intent is to use Watson's analytical capabilities to transform the data Citigroup has into information.

[IBM's] Watson computer, which beat champions of the quiz show “Jeopardy!” a year ago, will soon be advising Wall Street on risks, portfolios and clients.

[Citigroup, Inc] the third-largest U.S. lender, is Watson’s first financial services client, IBM said yesterday. It will help analyze customer needs and process financial, economic and client data to advance and personalize digital banking....

IBM executives say Watson’s skills -- understanding and processing natural language, consulting vast volumes of unstructured information, and accurately answering questions with humanlike cognition -- are also well suited for the finance industry.

Financial services is the “next big one for us,” said Manoj Saxena, the man responsible for finding Watson work. IBM is confident that with a little training, the quiz-show star that can read and understand 200 million pages in three seconds can make money for IBM by helping financial firms identify risks, rewards and customer wants mere human experts may overlook....

Watson “can give an edge” in finance, said Stephen Baker, author of books The Numerati and Final Jeopardy, a Watson biography. “It can go through newspaper articles, documents, SEC filings, and try to make some sense out of them, put them into a context banks are interested in, like risk.”...

Watson offers a “more global” picture by looking beyond financial data, Saxena said. For example, Watson can comb 10-Ks, prospectuses, loan performances and earnings quality while also uncovering sentiment and news not in the usual metrics before offering securities portfolio recommendations....

This would be particularly useful for analyzing and assessing the risk of structured finance securities and financial institutions.

Some of the biggest financial institutions have already built big data centers. IBM is competing with most other major technology companies to sell them tools to analyze and use accumulated information, Versace said.

“Apparently Citi gets it -- analytics is the new core in competitive banking,” Versace said. “The ability to efficiently and effectively exploit big data, advanced modeling, text analytics, in memory and real-time decisions across channels and operations will distinguish those that thrive in uncertain and uneven markets, from those that fumble.”...

Parts of Watson could already be combined with other IBM technologies to help banks with regulatory compliance by surveying internal documents and flagging those that seem amiss, Baker said. ...

IBM plans to use Watson in financial services “mostly for portfolio risk management, they’re not going to do stock picking,” CLSA’s Maguire said in a Feb. 17 phone interview. “They think that Watson can make a difference.”

How a secret Goldman loan ended up fleecing Greece

2012-03-06T14:36:00.000-05:00

Bloomberg ran an interesting article on how Goldman used a secret loan to help Greece meet the requirements for joining the EU.

By itself, this secret loan makes the case for requiring financial institutions to provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details.

Would this secret loan have taken place if the next day Goldman would have had to report this exposure?

Would Greece have been allowed into the EU after financial regulators saw this transaction and brought the EU policy makers' attention to it?

The article also discussed the cost of this secret loan. A cost that was significantly higher due to the fact that the loan was suppose to be kept secret.

Greece’s secret loan from Goldman Sachs Group Inc. (GS) was a costly mistake from the start.

On the day the 2001 deal was struck, the government owed the bank about 600 million euros ($793 million) more than the 2.8 billion euros it borrowed, said Spyros Papanicolaou, who took over the country’s debt-management agency in 2005.

By then, the price of the transaction, a derivative that disguised the loan and that Goldman Sachs persuaded Greece not to test with competitors, had almost doubled to 5.1 billion euros, he said.

Papanicolaou and his predecessor, Christoforos Sardelis, revealing details for the first time of a contract that helped Greece mask its growing sovereign debt to meet European Union requirements, said the country didn’t understand what it was buying and was ill-equipped to judge the risks or costs.

“The Goldman Sachs deal is a very sexy story between two sinners,” Sardelis, who oversaw the swap as head of Greece’s Public Debt Management Agency from 1999 through 2004, said in an interview.

Goldman Sachs’s instant gain on the transaction illustrates the dangers to clients who engage in complex, tailored trades that lack comparable market prices and whose fees aren’t disclosed. Harvard University, Alabama’s Jefferson County and the German city of Pforzheim all have found themselves on the losing end of the one-of-a-kind private deals typically pitched to them by securities firms as means to improve their finances.

“Like the municipalities, Greece is just another example of a poorly governed client that got taken apart,” Satyajit Das, a risk consultant and author of “Extreme Money: Masters of the Universe and the Cult of Risk,” said in a phone interview. “These trades are structured not to be unwound, and Goldman is ruthless about ensuring that its interests aren’t compromised -- it’s part of the DNA of that organization.”....

“Greece actually executed the swap transactions to reduce its debt-to-gross-domestic-product ratio because all member states were required by the Maastricht Treaty to show an improvement in their public finances,” Laffan said in an e- mail. “The swaps were one of several techniques that many European governments used to meet the terms of the treaty.”...

Under Eurostat accounting rules, nations were permitted until 2008 to use so-called off-market rates in swaps to manage their debt. Greek officials, including Sardelis, say they learned that other EU countries such as Italy had employed similar methods to shrink their debts, taking advantage of the secrecy of over-the-counter derivatives compared with swaps traded on exchanges....

Greece was handicapped, in part, by the terms Goldman Sachs imposed, he said.
“Sardelis couldn’t actually do what every debt manager should do when offered something, which is go to the market to check the price,” said Papanicolaou, who retired in 2010. “He didn’t do that because he was told by Goldman that if he did that, the deal is off.”...

Gustavo Piga, a professor of economics at University of Rome Tor Vergata and author of “Derivatives and Public Debt Management,” sees a different lesson.

“In secret deals, intermediaries have the upper hand and use it to squeeze taxpayers,” Piga said in an interview. “The bargaining power is in investment banks’ hands.”

The Mother of All Market Manipulations: the Libor interest rate

2012-03-06T14:06:00.002-05:00

As the probe into the setting of the Libor interest rate continues, it is important to keep in mind that we are talking about the Mother of All Market Manipulations.

According to an article in the Financial Times, we are talking about approximately $350 Trillion worth of contracts, including securities, worldwide that, if the allegations are true, were manipulated by the large banks.

By way of comparison, the US Treasury market is less than $15 trillion.

Said another way, we think of central banks as setting interest rates across the yield curve, but their tools are crude and not nearly as effective as picking up the phone and colluding with your 'competitors' to set the Libor interest rate.

The manipulation of the Libor interest rate is an example of the self-serving activities undertaken by the large banks under the cover of opacity.

If banks were required to provide ultra transparency, they would not have been in a position where they could have manipulated the Libor interest rate. With ultra transparency, banks would have disclosed their current liability details and Libor would be based off the actual cost of funds to the banks.

UK regulators and global banks are discussing a potentially far-reaching overhaul of the calculation and regulation of interbank lending rates, amid claims that the benchmark for $350tn contracts worldwide may have been subject to manipulation.

The review comes as regulators in North America, Europe and Japan have expanded their year-long probes into alleged manipulation of the London Interbank Offered Rates, and other benchmark lending rates, which help set the price of financial products, including mortgages and credit cards.

The Libor rate-setting process is not considered a regulated activity under the UK Financial Services and Markets Act, but US and European banks and interdealer brokers have suspended or fired more than a dozen traders in recent months following allegations of abuse....

Strongly suggesting that where there is smoke there is most definitely fire.

The British Bankers’ Association, which sponsors Libor, ... said in a statement: “As part of the normal reviewing processes of Libor, a number of contributing banks met today to consider future regulatory and market developments, such as the incoming liquidity rules, relevant to the parameters that Libor measure.”

It added that “a technical discussion with interested groups including users of the rate will commence shortly”, and promised to keep the market and government officials updated.

People familiar with what was discussed in the meeting said the review could encompass everything from revamping the way Libor rates are set to imposing new regulatory oversight and compliance requirements on participating banks.

S&P blocked by banks after derailing Goldman's CMBS deal

2012-03-06T11:05:00.000-05:00

Bloomberg ran an article that reaffirms the case for bringing ultra transparency in the form of observable event based reporting to structured finance.

The article discussed how banks are turning to other rating firms after S&P derailed a CMBS deal being sold by Goldman. The clear intent of the action is to both hurt S&P financially and to send a message to the other rating firms to play ball.

What caught your humble blogger's attention is the fact that the rating firms are still being paid to issue a rating as part of the process for selling structured finance securities.

If there were ultra transparency in the form of observable event based reporting, market participants would have access to the current information on the underlying collateral before the security is sold. Market participants could then independently assess this information or hire a third party to assess the information for them.

This would eliminate the need for a paid rating.

In the case of the rating firms, all the rating firms would have access to the data and could provide their own rating. In fact, they might try to be the third party that is paid by market participants to assess the information disclosed under ultra transparency.

Standard & Poor’s is frozen out of the commercial-mortgage bond market by the biggest underwriters after derailing a $1.5 billion sale byGoldman Sachs Group Inc. (GS) and Citigroup Inc. last July.

Since then, those banks along with JPMorgan Chase & Co. (JPM), Deutsche Bank AG and Morgan Stanley have bypassed S&P’s credit ratings as they issued $11.3 billion of debt linked to skyscrapers, shopping malls and hotels, according to data compiled by Bloomberg.

They’re turning to Kroll Bond Ratings Inc. and Morningstar Inc. (MORN) after S&P, the world’s largest credit- rating company, forced bankers to pull an offering they’d already committed to sell, roiling the $600 billion market....

Ed Sweeney, a spokesman for S&P, said the New York-based company’s CMBS analysts weren’t available to discuss the situation. “We believe our ultimate success will be based on the value investors derive from the ratings and research,” he said in an e-mail.

Ranking structured products such as CMBS and collateralized debt obligations is one of the most lucrative areas for rating firms. They generally charge between $1 million and $2 million to grade a CMBS deal, which are bundled loans tied to commercial properties sliced into securities of varying risk, according to a September paper by Andrew Cohen, a researcher at the Federal Reserve....

About one-third of investors polled in a Deutsche Bank survey said they preferred deals without an S&P ranking, the Frankfurt-based lender said in a Feb. 27 report. About 15 percent said they look forward to those rated by the new entrants. More than half said the rating companies didn’t play a role in their investment decisions....

“We didn’t think we would get on as many transactions as we did last year,” Eric Thompson, Kroll’s head of CMBS in New York, said in a telephone interview in February. “We view it as an indicator of folks in the marketplace looking for a fresh voice.”

As investigation into manipulation of Libor continues, regulators consider overhaul

2012-03-06T10:42:00.000-05:00

To no one's surprise, or at least not regular readers of this blog, the opacity surrounding the setting of the Libor rate allowed the big banks to manipulate this rate.

Even less surprising, now that the market's attention is focused on this manipulation, the financial regulators are considering how to overhaul the setting of the Libor rate while protecting both the banks' control of and the opacity of the process.

There is one simple solution to restore confidence in Libor rates while also eliminating the ability of the banks to manipulate this rate.

By requiring banks to provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details, the data necessary to calculate Libor is readily available.

Libor is suppose to be a reflection of the average cost the banks incurred to access the credit markets.

With ultra transparency, the simple way to calculate Libor is to look at what it actually cost each of the banks to access the funding market and then, after eliminating the high and low cost banks, averaging the remaining banks.

With ultra transparency, all market participants could independently perform this calculation. As a result, Libor is once again trusted.

A Bloomberg article discussed the on-going investigation into the manipulation of the Libor rate and the regulatory effort to overhaul how Libor is set.

U.K. regulators and banks met to discuss revisions to the setting of global interest rates after lenders faced allegations that they manipulated the benchmark for about $360 trillion of securities.

The meeting was held yesterday to “consider future regulatory and market developments” for the London interbank offered rate, the British Bankers’ Association said in a statement today.

Regulators and banks now plan to initiate a “technical discussion” about “likely future developments” with market participants who rely on Libor, the BBA said.

U.K., U.S., Canadian and Japanese regulators have been investigating whether banks misstated Libor submissions to hide their difficulty raising funds or to benefit trading positions in interest rate derivatives tied to the benchmark.

The probes have called into question whether lenders can be trusted to set, with no regulatory oversight, a rate that is linked to everything from floating-rate mortgages to commercial loans.

Who would possibly think that it is a good idea to "trust" lenders to set this rate in a completely opaque process?

Libor is generated through a daily survey of firms conducted on behalf of the BBA in which banks are asked how much it would cost them to borrow from one another for 15 different time periods, from overnight to one year, in currencies including dollars, euro, yen, and Swiss francs. After a predetermined number of quotes are excluded, those left are averaged and published for each currency before noon.

Run on Greek banks is staggering

2012-03-05T14:44:00.000-05:00

An article in the Irish Times discusses how Greek bank deposits have fallen by 70 billion euros since the beginning of 2009.

This loss of confidence in the Greek banks was easily avoidable. As this blog has recommended, the EU needed to backstop the Greek government's deposit guarantee using the temporary European Financial Stability Fund and then the long-term stability mechanism.

The result of the backstop would have been to stop the loss of confidence in the Greek banks by reassuring depositors that they could get their funds back. Instead, without the backstop, the combination of doubts about the solvency of Greek banks and the government has provided an incentive for depositors to withdraw their funds.

The figure is an indication of the massive loss of confidence in the country’s economy as it repeatedly came close to bankruptcy.

Evangelos Venizelos said only €16 billion of the funds withdrawn from Greek banks was sent abroad, mostly to the UK. The rest was largely spent as families and businesses ate into their savings, or hoarded by households preparing for the worst-case scenario - a debt default or Greece’s exit from the euro.

“This money, if it existed in the banks, would allow for loans to be made to businesses, for the economy to move, for unemployment to be tackled,” Mr Venizelos said in an interview on Antenna Television.

He stressed the importance of restoring confidence in order to encourage the return of funds to the banks, insisting that a new bailout deal and a major bond swap designed to slash Greece’s overall debt will strengthen the financial sector....

“Many billions are kept in homes. They are, as we say, in mattresses or in boxes,” the minister said of the missing deposits. “Of course, others have been spent on taxes, for families to live, for businesses to survive.”...

But with the possibility that Greece might default on its debts and ultimately have to leave the European Union’s joint currency, the euro, many depositors have also withdrawn their money for safekeeping elsewhere, either abroad or stashed in homes.

Iceland trial is a victory for transparency and democracy

2012-03-05T14:10:00.000-05:00

Like the Nyberg Report on Ireland's financial crisis, through a trial of its former Prime Minister, Iceland is exploring the extent of "the collapse of the people's trust in its country's politicians, institutions and financial system."

In her column in the Guardian, Alda Sigmundsdottir describes how this trial lets everyone understand exactly what happened that led up to the financial crisis.

As an Icelander, I found it chilling to watch the trial of my country's ex-prime minister Geir Haarde get under way. Haarde was PM of Iceland during and leading up to its economic meltdown in 2008, and is the first national leader to face charges over the global financial crisis....

Yet this trial is necessary. The Icelandic collapse was not just an economic collapse – it was also a moral collapse. It was a collapse of the people's trust in its country's politicians, institutions and financial system. It revealed to the vast majority of us that we'd had no idea of the extent of the political corruption and neglect that had lurked beneath the surface of our society for decades.

This trial is not about Haarde.... No, this trial is about transparency and democracy. It is about the right of the people to hear from their highest elected representative about what really happened in the months and years leading up to the greatest man-made disaster this country has known....

We want to know what happened. A vast amount of information and data has been collected and analysed for this trial. That information contains answers to many of the burning questions that the Icelandic people need the answers to if we are to put the shock and trauma of the economic collapse behind us.

At the beginning of the year, the current leader of the Independence party introduced a motion in parliament to have the charges against Haarde dismissed. Late last week, lawmakers voted by a narrow margin to press ahead with the trial. Had the vote gone the other way, the information and documents that will presumably surface during the trial might have been closed to the Icelandic people for decades to come.

Indeed, the Independence party's vehement opposition to the trial did nothing but raise suspicion that there was something in those documents that the power elite wanted to keep hidden. With any luck, that suspicion will be eliminated.

Haarde's trial is a victory for transparency and democracy – those ideological concepts that are sweeping the world on the back of movements like the Arab spring and Occupy.

His guilt or innocence is not the issue; his trial is a stepping-stone to a more open and just society. As to whether other nations should follow Iceland's example, I can only respond with a resounding yes. Let transparency, justice and truth guide the way to a new world order.

Why isn't Romney for breaking up the big banks?

2012-03-05T13:05:00.000-05:00

In a post on the American Enterprise Institute's online magazine, James Pethokoukis asks "why isn't Romney for breaking up the big banks?"

Because he has already put forth his solution to the financial crisis and that is to adopt the Swedish model and require banks to recognize all the losses currently hidden on and off their balance sheets.

In an earlier post, Mr. Romney was quoted as saying,

We're just so overleveraged, so much debt in our society, and some of the institutions that hold it aren't willing to write it off and say they made a mistake, they loaned too much, we're overextended, write those down and start over. They keep on trying to harangue and pretend what they have on their books is still what it's worth.

In some cases, if the debt is not in something you can service, it's like you have to move on and start over away from those debts. It's helpful if you get an institution that's willing to work with you, but if you don't you have no other option.

The banks are scared to death, of course, because they think they're going to go out of business... They're afraid that if they write all these loans off, they're going to go broke. And so they're feeling the same thing you're feeling. They just want to pretend all of this is going to get paid someday so they don't have to write it off and potentially go out of business themselves."

This is cascading throughout our system and in some respects government is trying to just hold things in place, hoping things get better... My own view is you recognize the distress, you take the loss and let people reset. Let people start over again, let the banks start over again. Those that are prudent will be able to restart, those that aren't will go out of business. This effort to try and exact the burden of their mistakes on homeowners and commercial property owners, I think, is a mistake.

Based on his proposed solution, Mr. Romney does not see a need for breaking up the Too Big to Fail banks. These banks will only be allowed to restart if they are prudent.

And the way that the market will know if they are prudent is they will be required to disclose on an on-going basis their current asset, liability and off-balance sheet exposure details. With this data, market participants will be able to assess whether management is prudent or not.

Banks clash with Fed over release of stress test details

2012-03-05T11:28:00.000-05:00

In yet another example of Wall Street's Opacity Protection Team in action, the Wall Street Journal ran an article on how banks are lobbying the Fed not to release the details of the current round of stress tests.

As regular readers know, the results and details of the stress tests themselves are meaningless.

The reason they are meaningless is that since the adoption of regulatory forbearance and the end of mark-to-market accounting at the start of the financial crisis bank financial statements and individual items on them like book capital have been a fiction.

Despite the simple fact that the stress tests and financial statements are meaningless, Wall Street has to fight against anything that might threaten to lift the veil of opacity even a little bit.

After all, the Fed might release some out of date exposure data and analysts would run with this data and rediscover just how much risk these banks are carrying and how insolvent they really are.

Some very large banks are clashing with the Federal Reserve over how much detail the central bank will reveal about them when it releases the results of its latest stress test.

The 19 biggest U.S. banks in January submitted reams of data in response to regulators' questions, outlining how they would perform in a severe downturn. Now, citing competitive concerns, bankers are pressing the Fed to limit its release of information—expected as early as next week—to what was published after the first test of big banks in 2009.

Three years ago, as the financial crisis was abating, the Fed published potential loan losses and how much capital each institution would need to raise to absorb them. This time around, the Fed has pledged to release a wider array of information, including annual revenue and net income under a so-called stress scenario in which the economy would contract and unemployment would rise sharply.

Talk about completely meaningless data.

The stress test from three years ago produced results that said this is what happens when there is regulatory forbearance and banks are never required to address the bad loans on their balance sheet. The significant information released with these stress tests was that US Treasury Secretary Tim Geithner reaffirmed that the US government stood behind the banks and offered a blanket guarantee for depositors, debt holders and share holders.

The Clearing House Association, a lobbying group owned by units of companies such as J.P. Morgan Chase & Co., Bank of America Corp. and Wells Fargo & Co., warned in a letter this month to the Fed that making the additional information public "could have unanticipated and potentially unwarranted and negative consequences to covered companies and U.S. financial markets."

Making additional information public could also have unanticipated and positive consequences.

Government officials aren't backing down from their plan to publish detailed projections of how the biggest lenders would fare in a steep economic downturn lasting two years.

Regulators view full disclosure as critical to assuaging investor concerns about banks' capacity to withstand a market shock or economic setback.

"The disclosure of stress-test results allows investors and other counterparties to better understand the profiles of each institution," Fed Governor Daniel Tarullo, the central bank's lead official on supervisory matters, said in a speech last November....

Apparently the regulators agree with your humble blogger that full disclosure is critical to restoring confidence.

Where there is a vast gap is the definition of full disclosure.

Your humble blogger thinks in terms of ultra transparency where banks provide on an ongoing basis their current asset, liability and off-balace sheet exposure details. With this data, market participants can run their own stress tests as part of assessing the risk of each bank. It is the ability to independently assess the data that restores confidence.

The Fed thinks in terms of disclosing the results and not the underlying data.

Regular readers know that there are several reasons that thinking in terms of disclosing results is flawed:

It substitutes the Fed's analytical ability for the market's. Are the 100+ economists at the Fed who did not see and prevent the financial crisis from occurring in the first place really better than the market at analyzing the data?

It tries to make the market's assessment of the risk of each bank reliant on the Fed for properly performing the stress tests. A reliance that we know is misplaced because the starting point for the stress tests is the banks' fictional financial statements. Given that the results of the test are meaningless, it is hard to see how trying to make meaningless tests a significant factor in market participants' assessment of risk is a positive.

It morally commits the US government to stand behind and guarantee all depositors, bond holders and equity investors in the stress tested banks. It is hard not to bailout the bond holders and equity investors after saying that the banks are solvent!

Finally, regular readers know that the stress tests are simply an exercise by the Fed in reminding the market that it has an information monopoly on all the useful, relevant bank information and that it reserves the right to gamble with financial stability.

Fed officials are assuring banks they won't release data that rivals could mine for clues to future acquisitions or other moves. In one concession, the Fed told banks it doesn't intend to break out projected losses on a quarterly basis....

An assurance that guarantees no useful, relevant data will be disclosed to market participants.

The biggest U.S. lenders have been raising capital over the past year, and most institutions are expected to receive approval for dividend increases or share buybacks. Bankers believe those moves will boost their appeal with investors at a time when many financial stocks are trading below book value, a measure of net worth.

The reason that these banks trade below book value is the lack of disclosure. As the Bank of England's Andrew Haldane observed, banks are 'black boxes'.

Given regulatory forbearance and lack of mark-to-market, there is no reason for market participants not to believe that all of the big banks are insolvent --- the market value of their assets is less than the book value of their liabilities -- and hence, just like the opaque, toxic subprime mortgage backed securities, investors are only willing to gamble that a fraction of book value is what the banks are worth.

This believe is confirmed every time that Wall Street's Opacity Protection Team springs into action to object to disclosure.

After all, if there were nothing to hide, then banks would be willing to disclose!!!

Keep in mind that throughout history, the sign of a bank that could stand on its own two feet was a bank that disclosed all of its current asset, liability and off-balance sheet exposure details.

Even so, regulators are walking a fine line with the latest test. If banks look ill-equipped, markets could be spooked, adding to the stress on firms already struggling with the low interest rates, soft growth and new rules that led banking-industry revenue to fall last year for just the second time in 74 years.

Shares of the biggest banks fell as much as 58% in 2011 amid questions about the industry's profit outlook and the impact of the European debt crisis.

If regulators are viewed as too pliant, the tests will fall short of their basic confidence-building purpose, possibly undermining a market recovery that pushed the Dow Jones Industrial Average above 13000 for the first time in four years and pushed the KBW index of commercial bank stocks up 16%.

Similar tests administered by regulators in the European Union were denounced for giving passing grades to some lenders that later required taxpayer bailouts.

This perceived need to walk a fine line is another reason that your humble blogger says that the Fed should run its stress tests as mandated by Dodd-Frank and never leak a word about them.

For example, everyone knows that the Fed is going to let the grossly undercapitalized banking industry pay dividends and increase the exposure of the taxpayer to the losses hidden on and off the banks' balance sheets.

The Fed should quit being offensive and publicly tying the results of the stress tests to permitting dividends to be paid.

Soon after the Fed said last November that the results would be made public, the debate began about how much the Fed should disclose.

More than a dozen bank holding companies subject to the stress tests—all with at least $50 billion in assets—met with Federal Reserve staff in late December to discuss what the Fed might say, according to disclosures on the Fed's website.

The meetings were at the Fed's invitation, and Fed staff said they were still considering the timing, scope and level of detail of the data they will publish, according to a summary of the meetings posted by the Fed.

Officials from Metlife Inc., Bank of America, J.P. Morgan Chase, Goldman Sachs Group Inc. and other financial institutions also discussed with Fed staff the implications, including competitive issues, of making the results public.

Bankers say it is unfair for the Fed to release more information than it did during the initial 2009 stress tests.

The reason: The Fed is still in the middle of writing a rule establishing what information it will make public in future stress tests, as required by the Dodd-Frank financial law passed in 2010.

The only thing the Fed should say is that it conducted stress tests.

Last year the Fed didn't make any aspect of its stress test public, leaving disclosure to institutions, many of which then released some results. Some bankers warn they may put out their own figures if they disagree with the Fed's calculations.

"They could just publish something that has nothing to do with reality," said one top executive at a major bank.

Absolute true as anything that the Fed says about the stress tests has absolutely nothing to do with reality since the tests themselves have absolutely nothing to do with reality!

Why are taxpayers bailing out unsecured bank creditors?

2012-03-04T18:03:00.000-05:00

Edward Harrison wrote an interesting post on his blog, Credit Writedowns, that lays out why bank "bailouts are bad, defaults are good" is not as black and white an issue as it is made out to be.

Regular readers know that your humble blogger doesn't look at the issue as bank 'bailouts are bad, defaults are good', but rather that bank bailouts are completely unnecessary.

They are unnecessary because banks can continue with no interruption in their day to day business with negative book capital. Between government guarantees of their deposits and unlimited access to the central bank for liquidity, banks can address any concerns over a run on the bank.

Mr. Harrison starts by asking the question of "why are taxpayers bailing out unsecured bank creditors".

Back in early 2010, I recounted how Matt Taibbi, Barry Ritholtz and I each felt that the Swedish model was the right one, instead of the all bailout all the time approach that is standard fare right now.

Clearly, the Obama people didn’t want this solution because they are captured by the financial services industry. That’s why the U.S. is going the Japanese route of bailouts and accounting dodges.

Nice to see the he favors a Swedish model over the Japanese model for how to handle a bank solvency led financial crisis.

So, what is the right thing to do. Politically, it seems nigh impossible to allow bondholders to take the haircuts they deserve. Nowhere is this happening now.

Bond investors made calculated capital allocation decisions. They misjudged the risk and must face the consequences. To bail them out is a moral hazard which encourages the misallocation of capital.

And in Ireland’s case, and in Europe more generally, there is the question of economic nationalism to boot because the periphery’s creditors are foreign institutions. It’s not like the Irish government bailing out Irish creditors or the Greek government bailing out Greek creditors but more Irish and Greek governments imposing depression and huge debt burdens on Irish people to bail out foreign creditors. That’s some seriously combustible stuff.

But there is the systemic risk dilemma:

My problem here is that the holders of bank liabilities – depositors and creditors – have other options. They can always withdraw their support from an institution that they feel will fail – creating a self-fulfilling prophecy. This means that taking too much of a haircut on bondholders, especially senior bondholders, will undermine confidence in the system.

In the Swedish example from the 1990s, this was recognized and a blanket guarantee was given to all depositors and creditors of institutions deemed to be solvent…

This is a solution that was geared to address the ‘Bear Stearns problem’, where lines of credit are pulled and a firm goes under before it is clear that said firm is actually insolvent…

However unpalatable a senior debt guarantee might be, it seems a wise option to consider...

Under this blog's blueprint for saving the financial system, existing bondholders receive a blanket guarantee.

My reasoning is slightly different from Mr. Harrison's. He makes the case that bondholders should take a loss because they misjudged the risk of the banks. I don't think they misjudged the risk because they never had the data they needed to correctly analyze the risk in the first place!

Furthermore and more importantly, the bondholders did not have any information that would cause them to question the financial regulators' representation over the years leading up to the financial crisis that the banks were solvent and low risk.

Bottom-line: in the absence of disclosure of the information needed to assess each bank's risk, governments had and have a moral obligation to guarantee all depositors and debt holders.

Please note, that under this blog's blueprint, there is a natural end to this blanket guarantee. Under the blueprint, banks are required to provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details. Hence, risk can be assessed and market participants can adjust the pricing of unsecured debt accordingly.

Six months after each bank starts providing ultra transparency the blanket guarantee ends and any unsecured debt issued after this is subject to haircuts based on the bank's future performance.

Six months provides market participants with enough time to independently analyze the data and determine the price they need to receive to take on this unsecured debt.

The issue is separating liquidity and solvency. In a systemic crisis, the illiquid can be rendered insolvent. So, a credible senior bondholder guarantee can underpin the capital structure of a solvent organization and induce investors to roll over debt.

That’s why the Swedes guaranteed senior bondholders in the 1990s. As I put it then: "To my mind, this all speaks to the overriding need for policy makers to ascertain who is illiquid and who is insolvent and to as demonstrably as possible subject the insolvent and the solvent to the most differential treatment one can muster."

Bank solvency is a measure at a point in time. By definition, a bank is solvent if the market value of its assets exceeds the book value of its liabilities.

Under the blueprint for saving the financial system, whether a bank is solvent or not, it receives liquidity.

With ultra transparency, it is the market that determines which financial institutions have a franchise that is capable of restoring a bank to solvency through rebuilding its book capital accounts through future retained earnings after absorbing all the losses the bank faces and which financial institutions do not.

Those banks that the market does not believe have a strong enough franchise should be resolved by the financial regulators. Any losses after the resolution process can be subsequently recouped from the banking industry as part of the cost of the deposit guarantee.

John Kay's review of equity markets and reporting

2012-03-04T11:16:00.000-05:00

Led by Economist John Kay, the UK is undertaking a review of its equity markets looking at how to improve their performance. Specifically, rebalancing the markets from their current bias towards short-term gratification and more towards long-term performance.

In her Guardian column, Heather Stewart discussed that old canard that transparency, as shown by quarterly reporting, is really the driver towards short-term gratification and that less frequent reporting might be beneficial.

When MPs call on shareholders to rein in runaway executive pay, and the public wonders in exasperation why investors in RBS didn't tame Fred Goodwin's overweening ambition ... they probably imagine a group of enlightened owners carefully shepherding the firms they control.

The reality of today's equity markets is very different. Deep-seated structural forces favour hands-off ownership, short-term myopic decision-making and quick sell-outs....

According to Kay, there was a striking consensus among the hundreds of experts who responded to his review about the kind of role shareholders ought to play in UK plc – and similarly strong agreement that we are a very long way away from it.

To start her column, Ms. Stewart links the failure of RBS to the failure of the equity markets to take a long-term view. In doing this, she and the interim report issued by Mr. Kay conveniently leave out the role played by the Board of Directors.

The Board of Directors exists to act as the group of enlightened owners carefully shepherding the firm.

It is their responsibility to oversee the selection and implementation of the firm's long-term business strategy. It is their responsibility to be sure that management and employees are compensated in ways that create long-term value for the firm.

In theory, the Board of Directors is responsive to shareholders as shareholders can vote to replace them if the shareholders are dissatisfied with the performance of the firm.

In practice, this tends to not occur because many dissatisfied shareholders elect to sell their stock instead and invest in firms where they think long-term value is being created.

Ms. Stewart then moves on to lay out the case for why less frequent reporting might be beneficial.

The second, perhaps even more cherished, principle that Kay appears willing to ditch is quarterly reporting: the idea that companies, and the asset managers who buy and sell many of their shares, must produce a deluge of information every three months about their financial performance.

In theory, quarterly reporting enhances transparency and focuses bosses' minds on the sacred idea of "shareholder value"....

In theory, quarterly reporting enhances transparency.

In practice, as the Bank of England's Andrew Haldane has observed by describing banks as 'black boxes', it does not.

Ms. Stewart then asserts that reporting is suppose to focus bosses' minds.

This is not true. The reason that there is reporting is so that market participants will have access to all the useful, relevant information in an appropriate, timely manner so they can independently assess the risk of each business and adjust the amount and price of their exposures accordingly.

The question that needs to be asked is does the current reporting achieve this goal. Clearly, in the case of financial institutions, it does not.

If current reporting does not achieve this goal, then what would achieve this goal?

For financial institutions, what is needed is they must provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details. It is only with this data that market participants can truly independently assess the risk of each firm.

Please note, reporting that provides ultra transparency for a utility (electric, gas,...) is likely to be different than for financial institutions as the utility business has different characteristics. Fortunately, market participants are flexible enough to handle ultra transparency as it applies to different industries.

The tyranny of chasing the quarterly numbers can cloud more considered strategic thinking, and has helped to spawn the byzantine executive pay schemes that claim to align bosses' interests with those of the shareholders but can end up rewarding them handsomely for meaningless financial engineering, for instance tarting a firm up for sale to a ruthless foreign predator, or for driving their company to the edge of a cliff and baling out just in time.

All of these are a symptom of the failure of Boards of Directors to do their job.

Even Jack Welch, the legendary GE boss regarded as the father of the idea of "shareholder value", has since disowned his offspring, telling theFT three years ago that he now regarded chasing quarterly returns as "the dumbest idea in the world".

"Shareholder value is a result, not a strategy," he said. "Your main constituencies are your employees, your customers and your products."

However, that did not stop him, with the blessing of his Board of Directors, from putting out a quarterly earnings target that GE managed to consistently beat by 1 to 3 cents per share.

Please note, ultra transparency for GE would involve GE Capital and its corporate treasury disclosing on an on-going basis its current asset, liability and off-balance sheet exposure details.

Abandoning quarterly reporting would seem like a backward step if you assume that more information must always be a good thing; but short-term targets will inevitably distort decision-making.

Actually, abandoning quarterly reporting is not a step backward if, and only if, what replaces it is reporting that meets the goal of providing market participants with all the useful, relevant information in an appropriate, timely manner.

Commodity trading sheds light on how Wall Street gains proprietary trading edge

2012-03-03T12:31:00.000-05:00

Reuters ran an interesting article discussing the struggle between Wall Street's biggest banks and the Federal Reserve over Wall Street being able to retain their investment in warehouses, storage tanks and other hard assets.

Why is Wall Street fighting so hard to retain and expand their physical commodity operations?

For the same reason that they purchased mortgage origination and servicing operations in the years leading up to the financial crisis -- information.

Not just any type of information, but information that is the equivalent of having tomorrow's news today.

For example, mortgage originators provide information on both the mortgages they fund and the mortgages they decline and someone else funds. It is useful to know who funded loans that did not meet your credit standards if you would like to short the market and not use mortgages you originated.

For example, mortgage servicers provide current information on mortgages because their data reflects all observable events that have occurred with the mortgages through the close of business yesterday. This data provides an informational advantage when investors access to this same data lags by several days.

"The truth of it is that having access to the physical markets is about optimization and knowledge - it gives you the visibility of the market to make far more successful proprietary trading decisions in both physical and financial markets," said Jason Schenker, President and Chief Economist at Prestige Economics in Austin, Texas.

"That's why for many years the most successful traders had access to both markets, and why we've seen little sign they're moving quickly to divest these assets now. It's trading with material non-public information - the difference compared with equity markets is that it's perfectly legal."

Mr. Schenker's point bears repeating. There are markets like structured finance securities and commodities where it is legal for Wall Street to trade with material non-public information.

In the case of structured finance, there is a simple solution for leveling the playing field. The solution is to require all structured finance securities to disclose all observable events involving their underlying collateral one hour before the beginning of the business day following the business day on which the observable event occurred.

In the case of commodities, there is a simple solution for leveling the playing field. The solution is to require the banks to provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details. This way, market participants could see what these firm's trading positions are and adjust their exposures based on their assessment of these trading positions.

How to end panics and impose market discipline

2012-03-02T08:18:00.000-05:00

William Isaac and Richard Kovacevich wrote an interesting column in the Financial Times offering their solution on how to end panics and impose market discipline. They propose that banks issue debt at least once per year and carry a combination of long term, subordinated debt and equity equal to 20% of assets that can be used to cover any 'reasonably conceivable loss'.

Market discipline will come from the credit markets that will link higher returns to higher risk.

Their solution naturally reflects their background as former regulator and former bank CEO respectively. It is inconceivable to either of them given their long history of promoting and protecting opacity in the financial system that the simple solution is to require the banks to provide ultra transparency.

Without ultra transparency, how exactly do they expect market participants in the credit markets to be able to determine how risky a 'black box' bank is?

Their solution also assumes that regulators will close banks as soon as the banks are unable to access the long term and subordinated debt markets. By this definition, given that both the interbank lending and unsecured bank debt markets are frozen in the Eurozone, all of the banks in the Eurozone should be closed.

The US has suffered three severe financial crises in the past 40 years, each driven by excessive risk taking, particularly in real estate. Regulators had plenty of authority to rein in the abuses but failed to do so....

A simple statement of the facts.

But even if we had the ideal regulatory structure, we could not rely on regulation alone to control excesses in the financial industry that too often lead to crises.

Even with an ideal regulatory structure, your humble blogger has argued that we should not rely on regulation alone to control excesses in the financial industry because it leaves financial stability dependent on a single point of failure.

There is no reason to gamble on financial stability by making it dependent on the regulators always performing their role perfectly.

To end the boom-bust cycles and accompanying panics, we do need smarter, more effective and less politicised regulation – but it is also critically important to impose stronger marketplace discipline on financial institutions, particularly the largest that were previously regarded as too big to fail....

The only way to bring market discipline is if the big financial institutions are required to provide ultra transparency and disclose on an on-going basis their current asset, liability and off balance sheet exposure details.

This is the data that market participants need if they are going to be able to assess the risk of a financial institution.

[Currently, regulators have access to this data through their examination function. Presumably they use this data to assess risk at each bank. Since regulators have access to this data and market participants do not, market participants rely on regulators to properly assess and communicate the risk of each bank. Effectively, the regulators monopoly on this data makes independent market discipline impossible.]

When regulators finally gather the information needed to understand the biggest institutions, they must develop a plan to ensure these are structured and operated in a way that will allow them to be re-organised or to fail without creating panics that cripple the economy. The plan must be simple, practical and credible to convince markets it will be employed when needed.

Actually, ultra transparency addresses the issue of allowing the biggest institutions to be re-organized or fail without creating panics or crippling the economy. Ultra transparency eliminates panics because market participants can see the build up of risk and adjust their exposure well before the biggest institution needs to be re-organized or fails.

Even better, ultra transparency is simple, practical and credible because it allows the market participants to see that the regulators are doing their job to re-organize or resolve the biggest institutions when they fail. Since market participants can see the regulators doing their job, it eliminates the regulators' default position of bailing out the banks under a Japanese model for handling a bank solvency led financial crisis.

Requiring big institutions to increase their common equity capital to breathtaking levels – say above 9 per cent of assets – is not the answer. It lowers returns on equity to a point where banks will not be able to raise enough capital and will shrink their balance sheets, impeding growth – as is happening in Europe.

Moreover, equity holders, even when they perceive the risks to be excessive, cannot impose the same discipline on management as creditors. Finally, equity holders may gain from taking risks and so are more tolerant of risk than creditors.

Without ultra transparency, neither creditors nor equity holders can enforce market discipline as they cannot assess the risk of each bank. Instead, they do what they are currently doing and that is go on a buyers' strike as seen in the freezing of the Eurozone interbank lending and unsecured bank debt markets.

A more effective form of market discipline would be to require large financial institutions to issue, at least annually, both long-term senior and subordinated debt. The total long-term debt should be more than enough, when coupled with a bank’s equity and reserves, to cover any reasonably conceivable losses the institution might incur.

If the institution faced insolvency, the FDIC would put the institution into a “bridge bank” that would operate under FDIC control with new management and directors. The bridge bank would continue to serve depositors and borrowers, leaving the equity and long-term debt behind in a receivership with no guarantee of recovery. The bridge bank would be privatised as soon as possible.

If total equity and long-term debt were set at 20 per cent of assets, it is hard to imagine the FDIC, much less taxpayers, ever incurring losses on the failure. If a bigger cushion were desired, a 5 or 10 per cent hold-back on uninsured depositors could also be imposed.

Who knows how much in the way of losses is being hidden on and off bank balance sheets today.

Let's look at potential sources of losses: opaque, toxic subprime mortgage backed securities; second mortgages; commercial real estate mortgages; and sovereign debt. This is before we consider off balance sheet derivative exposures to banks that may be insolvent.

This plan would not only protect the FDIC and taxpayers against losses in the event of failure, it would also impose discipline making failure much less likely. A bank would be required to issue senior and subordinated long term debt on a regular basis. A risky bank would have to pay higher interest and ultimately might not be able to issue debt, which would curtail growth and force it to adopt a new strategy.

For this plan to work, creditors need to be provided with ultra transparency so they can independently assess how risky each bank is and adjust the price and amount of their exposure according to this assessment.

Financial crisis amnesia

2012-03-01T22:50:00.001-05:00

Once again, US Treasury Secretary Tim Geithner has taken to the op-ed pages of the Wall Street Journal. This time he wants to remind everyone why in the aftermath of the financial crisis we needed to reform the financial system.

Regular readers know that financial reform as represented by the Dodd-Frank Act was pushed through before the Financial Crisis Inquiry Commission had submitted its work explaining what were the causes of the financial crisis.

Whether you agree with the Commission's conclusions or not, the simple fact is that Dodd-Frank does not address them.

For example, the Commission concluded that opacity in the financial system played a significant role in the financial crisis. The Commission went further and defined by example that it was valuation opacity and not price opacity they were talking about.

The example the Commission gave was the opacity of banks that made it impossible to tell which banks were solvent (the market value of their assets exceeded the book value of their liabilities) and which were insolvent.

Dodd-Frank does nothing to address the absence of valuation transparency for banks or, much more remarkably, the opaque, toxic structured finance securities. [valuation transparency refers to the disclosure to market participants of all the useful, relevant information in an appropriate, timely manner so they can independently assess risk before making a buy, hold, or sell decision at the prices shown to them by Wall Street.]

Four years ago, on an evening in March 2008, I received a call from the CEO of Bear Stearns informing me that they planned to file for bankruptcy in the morning.

Bear Stearns was the smallest of the major Wall Street institutions, but it was deeply entwined in financial markets and had the perfect mix of vulnerabilities. It took on too much risk. It relied on billions of dollars of risky short-term financing. And it held thousands of derivative contracts with thousands of companies.

And no one in the market had access to its current asset, liability and off-balance sheet exposure details so that they could properly assess its risk and adjust both the amount and price of their exposure based on this risk assessment.

Instead, market participants had to rely on the financial regulators to assess this data and to convey just how much risk they found.

Based on how much risk Bear Stearns had at the time of its failure, it is doubtful that the amount of risk was successfully conveyed to market participants.

These weaknesses made Bear Stearns the most important initial casualty in what would become the worst financial crisis since the Great Depression.

Not exactly a high hurdle given that we had not had a major financial crisis since the Great Depression!

But as we saw in the summer and fall of 2008, these weaknesses were not unique to that firm.

In the spring of 2008, more Americans were starting to face higher mortgage payments as teaser interest rates reset and they could no longer refinance out of them because the value of their homes stopped rising—the leading edge of a wave of foreclosures and a terrible fall in house prices. By the time Bear Stearns failed, the recession was then already several months old, but it would of course get much worse in coming months.

These problems were partly the result of amnesia. There was no memory of extreme crisis, no memory of what can happen when a nation allows huge amounts of risk to build up outside of the safeguards all economies require.

Actually, all of this risk build up was the result of the regulators having amnesia and failing to require banks and structured finance securities to disclose all their useful, relevant information in an appropriate, timely manner. Without this information, market participants were not able to properly assess risk of either the banks or the structured finance securities nor were they able to exert market discipline.

This crisis represented a huge failure of the regulatory system. It was the regulators who failed to remember the lessons of the Great Depression. The leading lesson of the Great Depression being the need for transparency (see creation of SEC as Exhibit I).

When the CEO of Bear Stearns called that night, it was not because I was his firm's supervisor or regulator, but because I was then the head of the Federal Reserve Bank of New York, which serves as the fire department for the financial system.

The financial safeguards in the law at that moment were tragically antiquated and weak.

Neither the Fed, nor any other federal agency, had the necessary comprehensive authority over investment firms like Bear Stearns, insurance companies like AIG, or the government-sponsored mortgage giants Fannie Mae and Freddie Mac.

Regulators did not have the authority they needed to oversee and impose prudent limits on overall risk and leverage on large nonbank financial institutions. And they had no authority to put these firms, or bank holding companies, through a managed bankruptcy that wound them down in an orderly way or to otherwise adequately contain the damage caused by their failure....

What regulators did have was the authority to make sure that there was no opacity in the financial system. They had all the authority they need to require all of these financial institutions to disclose all their useful, relevant information in an appropriate, timely manner.

Had regulators done this leading up to the financial crisis, the market would have exerted discipline and reigned in the risk taking behavior of these financial institutions.

However, by letting opacity run wild in the financial system, the regulators effectively neutered market discipline. Precisely at the time that they had made the internal decision to rely on market discipline as being more effective than regulation.

A large shadow banking system had developed without meaningful regulation, using trillions of dollars in short-term debt to fund inherently risky financial activity.

The derivatives markets grew to more than $600 trillion, with little transparency ...

The reason it is referred to as a 'shadow' banking system is because it is opaque and provides no valuation transparency.

The failure to modernize the financial oversight system sooner is the most important reason why this crisis was more severe than any since the Great Depression, and why it was so hard to put out the fires of the crisis.

The failure to reform sooner is why the crisis caused gross domestic product to fall at an annual rate of 9% in the last quarter of 2008; why millions of Americans lost their jobs, homes, businesses and savings; why the housing market is still so far from recovery; and why our national debt has grown so significantly....

Outside of Washington, nobody believes it was the failure to modernize oversight of the financial system that was responsible for the fact that the fires of the crisis have still not been put out.

Market participants have the common sense to know that valuing opaque structured finance securities is the same as blindly guessing the value of the contents of a brown paper bag. As a result, market participants know it was the failure of the regulators to require ultra transparency and not antiquated oversight that is responsible.

Market participants also know that it was the choice by the Obama administration to pursue the Japanese model for handling a bank solvency led financial crisis. As a result, the administration championed preserving meaningless bank book capital and banker bonuses over protecting Main Street from damage from the excesses in the financial system.

Had the administration not listened to the regulators who were responsible for the crisis in the first place and instead adopted the Swedish model for handling a bank solvency led financial crisis, Wall Street and the banks would have rescued Main Street and we would have significantly less national debt and a better economy.

Remember the crisis when you hear complaints about financial reform—complaints about limits on risk-taking or requirements for transparency and disclosure....

Given that Wall Street's Opacity Protection Team helped to write Dodd-Frank, there aren't many complaints about transparency and disclosure as it only relates to price and not valuation.

Are the costs of reform too high? Certainly not relative to the costs of another financial crisis....

Hence the reason that the mother of all financial databases should be built so that all market participants have access to the current asset, liability and off-balance sheet exposure details for every bank and structured finance security.

Are these reforms complex? No more complex than the problems they are designed to solve....

Ultra transparency is the simplest reform and could be written in less than three pages. There is no ambiguity about updating disclosure daily for all observable events that occurred with the bank's or structured finance security's exposures.

These reforms are not perfect, and they will not prevent all future financial crises. But if these reforms had been in place a decade ago, then the rise in debt and leverage would have been less dangerous, consumers would not have been nearly as vulnerable to predation and abuse, and the government would have been able to limit the damage that a financial crisis could have on the broader economy....

It is absolutely true that the reforms included in Dodd-Frank are not perfect and that they rely on regulators to be perfect. Since one of the major lesson of the financial crisis is that regulators are not perfect, it seems that relying on them to be perfect is simply gambling with financial stability.

Instead, regulators could focus all of their attention on making sure that they eliminate opacity where ever it may be in the financial system.

This does not require that the regulators are perfect in their analysis. This simply requires that regulators ask themselves is their information that market participants might find useful.

We cannot afford to forget the lessons of the crisis and the damage it caused to millions of Americans. Amnesia is what causes financial crises.

Which is why we need the mother of all financial databases. So that the next time the regulators forget and let Wall Street try to introduce opacity through financial innovation, there will be an entity in the financial system who sees it as its responsibility to insure that market participants have access to all the useful, relevant information in an appropriate, timely manner.

Jeremy Warner highlights need for a solution to solvency crisis

2012-03-01T20:20:00.000-05:00

In his Telegraph column, Jeremy Warner discussed how by itself the ECB's Long Term Refinancing Operation is not going to solve the Eurozone's problems. Rather it is going to buying time in which the problems can be solved. He then observes that what is now needed is a solution to the crisis.

Regular readers know that this blog is unique in its focus on presenting the solution to the bank solvency led financial crisis as well as documenting its proven effectiveness.

The solution is to implement a variation of the Swedish model for handling a bank solvency led financial crisis. Under this variation, Wall Street and the banks rescue Main Street.

When something looks dangerous, it generally is. And few things look quite so high-wire right now as the European Central Bank’s efforts to hold the euro together by flooding the banking system with free money....

When Mario Draghi, the new ECB president, embarked on the programme shortly before Christmas, it was hailed as a masterstroke which had saved the eurozone from financial and economic calamity. Even the Jeremiahs of Germany’s Bundesbank, proud keepers of the sacred flame of monetary conservatism, were stunned into grudging acquiescence by the evident seriousness of the crisis. But now the doubts are beginning to set in, and with good reason.

The measures adopted are so extreme that it is no longer possible to know where they might lead, or what their eventual consequences might be. There is no precedent or road map for this kind of thing. All we do know is that they fail to provide any kind of lasting solution to the single currency’s underlying difficulties, which are still largely unrecognised and unaddressed.

If Draghi’s intention was to buy time, it’s not being well used.

It might be argued, of course, that a sticking-plaster solution is better than no solution....

What [Quantitative Easing and the LTRO] try to do is stop the contraction of the money supply threatened by very rapid deleveraging in the banking sector. As banks shrink their balance sheets, by writing off bad debts or refusing credit, the supply of money also shrinks. If unaddressed, this will cause economic collapse, as during the Great Depression....

I am not sure that the supply of money shrinks when banks write off their bad debts.

As I recall and it has been over 30 years since I worked at the Federal Reserve in the area that produced the monetary aggregates, bank equity is not included in the money supply. Bank deposits yes. Bank equity and other forms of bank capital, no.

Refusing to supply credit contributes directly to economic collapse. However, the reason that Eurozone banks are refusing to provide credit is the requirement by the financial regulators that they achieve a 9% Tier I capital ratio by the end of June.

Much of the Mediterranean rim is already in a depression, with disastrous levels of unemployment, contracting output, and a collapsing money supply.

What was going on prior to the first tranche of LTROs was a banking run similar to that which culminated in the collapse of Lehman Brothers, as money was withdrawn from the troubled periphery and redeposited in the more solvent core.

A bank run that this blog has been documenting for the last year.

In addition, the sticking-plaster solution that is the LTRO is also there to deal with the fact that interbank lending and unsecured bank debt markets are frozen. Without funding from the ECB, many Eurozone banks would not have the funds they need to redeem the interbank loans and unsecured bank debt as it matures throughout 2012.

The ECB’s actions have succeeded in easing these difficulties, and removing the immediate threat of cascading insolvency throughout the European banking system.

But they have also stored up big problems for the future. To get the cheap funding, banks must lodge their better-quality collateral with the ECB.

My understanding is that the ECB was willing to take really dodgy collateral under the LTRO. To a certain extent as banks consolidate their ECB borrowing under the LTRO, this frees up the better-quality collateral that had been previously pledged to the ECB under different programs.

The effect is to dilute the quality of their remaining balance sheet, making it even more difficult to get funding from the markets as normal.

As previously noted, even with better-quality collateral, the interbank lending and unsecured bank debt markets are frozen. This is a result of the simple fact that no market participant has access to the data they need so that they can assess the risk of any bank (there is a reason the Bank of England's Andrew Haldane refers to banks as 'black boxes').

What market participants learned at the beginning of the credit crisis when they lost trillions on opaque, toxic structured finance securities is not to invest in black boxes.

As a result, European banking is becoming ever more dependent on ECB life-support, with no obvious way off it....

This is where my version of the Swedish model under which Wall Street and the banks rescue Main Street comes in. Under the blueprint, Wall Street and the bank recognize the losses today on all the excesses in the financial system. Then, they rebuild their book capital through retention of future earnings and proceeds from newly issued stock.

To insure that they recognize the losses on and off their balance sheets and do not gamble on redemption, financial institutions will have to provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details.

The ECB’s activities also create huge potential liabilities for the more solvent countries that ultimately – through their national central banks – provide the funding for all this. What is in essence happening is that the banking risks of the European periphery are being progressively foisted onto the taxpayers of the more solvent core. Once people in those countries actually realise what’s going on, they’re going to hit the roof.

By requiring the banks in the periphery to recognize their losses and provide ultra transparency, the taxpayers of the more solvent core are able to limit their exposure and put in place a mechanism for winding down their exposure (the mechanism the rebuilding of the bank balance sheets).

Taken as a whole, the sophistry of the process is breathtaking. The ECB is in effect being used as a mechanism for making fiscal transfers between countries, which can only legitimately be agreed by elected governments.

To save the politicians’ blushes, the transfers are being executed via an unelected monetary authority.

It’s another example of how legal and democratic niceties seem to have been abandoned in the scramble to save the euro.

The fiscal compact, almost certainly illegal within the wider framework of the European Union, is not the paving stone to fiscal federalism it pretends to be, but a form of economic dictatorship which seems to condemn much of the periphery to permanent depression.

The more policy-makers dig, the deeper into the mire they sink....

Europe has no strategy for growth, no strategy for jobs, and in truth, no strategy for saving the euro. The project is broken beyond repair.

Your humble blogger's solution offers many additional benefits.

First, it does not require legal and democratic niceties to be set aside to preserve bank book capital.

Second, it does not require an unelected monetary authority to make fiscal transfers that only elected governments should make as it requires no fiscal transfers.

Third, it ends the policy-makers sinking into the mire and allows them to focus their resources on how to grow the Eurozone.

Banks should learn to go it alone

2012-03-01T11:10:00.000-05:00

In his Financial Times column, former ECB executive board member Lorenzo Bini Smaghi identifies the fundamental problem with the Japanese model for handling a bank solvency led financial crisis: eventually banks have to go it alone.

Since the beginning of the financial crisis, banks have been protected at significant cost to society.

The latest example is the ECB's Long Term Refinancing Operation. It was needed as a direct result of the freezing of the interbank lending and unsecured debt markets. Simply put, banks needed the access to funds or they would be unable to pay their maturing debts.

Interestingly, central bankers are describing the resulting increase in the ECB's balance sheet from LTRO as reflecting "a change in the composition of financial market participants' portfolios towards less-risky assets"and "the prevention of deflation".

This benign description glosses over a very important point. As the Bank of England's Andrew Haldane observed about current disclosure practices and banks, banks are 'black boxes'.

The interpretation of investor behavior changes when the fact that banks are black boxes is taken into account. The refusal to invest reflects a buyers' strike and an unwillingness to blindly gamble on the contents of a black box.

The lesson investors learned through trillions of dollars of losses on opaque, toxic structured finance securities is not to gamble on the contents of a black box.

When investor behavior is interpreted in this way, the solution for ending the buyers' strike and letting banks go it alone becomes apparent. Require banks to provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details.

With this information, market participants can assess the risk of each bank and adjust the amount and price of their exposure based on this assessment.

Requiring ultra transparency also ends implementation of the Japanese model and adoption of the Swedish model for handling a bank solvency led financial crisis. Market discipline will force the banks to recognize their losses. While this is bad for bank book capital today, it is good for society as banks can rebuild their book capital through retention of future earnings.

With the €530bn lent to banks through its latest three-year longer-term refinancing operation, the size of the European Central Bank’s balance sheet has increased to unprecedented levels, raising three separate concerns. Not all are justified....

If the increase in central bank money helps commercial banks to finance additional private or public consumption and investment, over and above the economy’s productive potential, it may indeed fuel inflation.

If, instead, the demand for central bank money reflects a change in the composition of financial market participants’ portfolios, towards less-risky assets, the increase in central bank money is not inflationary. It contributes instead to preventing deflation.

The data show that market participants’ current demand for central bank money does not reflect an intention to increase their balance sheets but rather their difficulty in accessing financial markets – the result of a generalised increase in risk aversion. Replacing market financing with central bank funding has prevented a sharp contraction in banks’ liabilities, which would have induced a drastic deleveraging and possibly a credit crunch....

Of course, all of this could have been avoided if banks were not black boxes and instead offered ultra transparency.

The large amount of liquidity will, of course, have to be mopped up once financial markets have recovered, to avoid fuelling inflationary pressures.

The process will be partly endogenous, as commercial banks in the eurozone will request less central bank money as risk aversion subsides, or will reimburse existing loans in advance, as the three-year LTROs allow. The ECB can hasten this process, if needed, by raising the refinancing rate, by increasing the spread between the refinancing and the deposit rate, by adopting variable rather than fixed-rate tenders for its operations, or by issuing term deposits or certificates of deposit.

In the absence of ultra transparency, there is no reason for risk aversion to subside. Buyers are on strike and unwilling to gamble on the contents of a black box.

Despite the central banks' best efforts, buyers still have alternatives to invest in other than banks (or structured finance securities).

The second concern relates to the overall risk a large balance sheet may create for the central bank and its shareholders. This concern is mitigated by the fact that the ECB lends against collateral. For a loss to materialise, the counterparty has to be insolvent and the collateral must be sold at a price lower than the central bank’s valuation (market price minus a haircut). These events are unlikely to occur simultaneously.

In fact, markets are concerned about the opposite issue – that the ECB has de facto acquired preferred creditor status. The recent Greek bonds swap, which allowed the ECB to avoid loss, has confirmed this status.

Under these circumstances, the larger the central bank balance sheet, the larger the risk shifted to the remaining unsecured bondholders, who might be more and more discouraged from lending to banks as they would find it harder to return to market financing.

Increasing subordination might contribute to keeping the interbank lending and unsecured debt markets frozen, but it is not what caused them to freeze in the first place.

The cause is no market participant, other than the bank regulators, has access to the information needed to assess the risk of any bank. So long as banks are black boxes, this will be true. Hence the reason that investors are taking back their principal at maturity and investing elsewhere.

What is required to unfreeze the interbank lending and unsecured debt markets is ultra transparency.

This raises a third, more serious concern: that cheap three-year funding creates a disincentive for eurozone commercial banks to restructure their balance sheets and strengthen their capital base, as they must to stand on their own feet once the crisis is over. Banks may become addicted to easy central bank financing and delay the adjustment indefinitely.

This can be prevented only if supervisors put sufficient pressure on bank managers and shareholders to continue adjustment, and to use central bank funds only as a temporary, exceptional source of financing. However, supervision in the eurozone is implemented at national level, with little incentive to pursue these objectives rigorously and on a level playing field.

This will only occur if the Eurozone policymakers agree to end the implementation of the failed Japanese model and adopt the Swedish model for handling the current bank solvency led financial crisis.

There is one major barrier to this occurring: bankers are going to fight this to preserve their bonuses.

Standard Chartered's Peter Sands identifies systemic risk

2012-02-29T14:25:00.000-05:00

In discussing his bank's financial results, a Telegraph article reports that Peter Sands observed

that he was worried that international regulators were fixated on preventing another collapse like Lehman Brothers and not looking at the risks created by the expansion of central bank balance sheets.

Please re-read the highlighted text because Mr. Sands has identified the largest systemic risk in the financial system.

Just like structured finance securities and bank balance sheets are 'black boxes', so too is a central bank's balance sheet.

While a central bank can always fund its balance sheet by printing more money, there is a risk from the expansion in the central bank balance sheets that the public loses confidence.

As Morgan Stanley said (hat tip Zero Hedge):

What happens when the public loses confidence in central bank liabilities?

A: A run on the fiat money systemIn response to the seismic shift in private sector risk-aversion the financial crisis brought about, central banks have deployed their balance sheets to cushion the blow to the economy.

Actually, the private sector is no longer willing to buy opaque products including structured finance securities and bank liabilities that are not guaranteed.

The central banks are using their balance sheet to fill this hole.

Should the central banks want to stop using their balance sheets, they should require the end of opacity in the financial system.

They have done so by taking the unwanted risk off the private sector balance sheet and replacing it with safe as well as liquid assets: central banks’ own liabilities.

This is, in essence, a confidence trick. It works for as long as the private sector is willing to hold these liabilities – i.e., for as long as they are considered safe, which in turn depends on them being considered safe by everyone else.

A central bank will, of course, never default on its liabilities – they can, after all, create unlimited amounts of it.

But the ‘safety’ property also depends on whether this asset is seen as a store of value, i.e., likely to maintain its real value – its value in terms of goods and services.

So, while there is no technical limit to the expansion of central bank balance sheets, there is a limit nonetheless: the public’s confidence in the real value of such liabilities – and government liabilities more generally. The more such liabilities are created, the more we approach this point.

How would such a loss of confidence unfold?

If the supply of central bank liabilities – call it ‘liquidity’ – exceeds the public’s liquidity preference, then the latter will seek to substitute away from it. The public will then buy goods and real assets. The result is self-fulfilling inflation – inflation will rise essentially because the public has lost confidence in the ability of central bank liabilities to maintain their real value.

We are probably very far from such an outcome – far enough that it can be considered a tail risk. Yet, the risk in question is nothing less than a wholesale run on the fiat money system.

ECB's bazooka has not stopped money collapse in Greece, Italy, Portugal and Spain

2012-02-29T14:03:00.000-05:00

In his column, Ambrose Evans-Pritchard discusses the ECB's Long Term Refinancing Operation and notes that it has not stopped the collapse of M1 deposits in Greece, Italy, Portugal and Spain.

Readers know that the collapse in deposits in these countries is related to the run on the banks going on in these countries.

Specifically, there is a run on the banks going on because not only are there questions about the solvency of the banks, but there are also questions about the ability of the sovereign to make good on its bank deposit guarantee.

As for deposit growth in the North, particularly Germany, this is not surprising because the deposits have to go somewhere. The alternative is a mattress.

So the Draghi Bazooka II will be just under €530bn: Goldilocks, if you like that kind of liquidity. Not too high, not too low. Instant thoughts:

This is about €330bn of new money once you strip out roll-overs of shorter maturities. The last one in December was a net €200bn, so it is a nice shot in the arm for French, Italian, and Spanish banks, and their sovereigns.

They can borrow at 1pc for three years to buy Club Med bonds at over 5pc, the Sarko "carry trade". It is certainly a game-changer for the South, heading off the near-certain disaster that was unfolding before Mario Draghi took over the European Central Bank.

While it will boost the income of the Club Med banks, it is not clear that it will restore them to solvency.

As this blog has said repeatedly, it is time to adopt the Swedish model under which Wall Street/the Banks rescue Main Street. Banks need to recognize all their losses and provide ultra transparency to prove it.

Combining this with the Draghi Bazooka then puts the banks on the path to restoring their book capital and providing the funds the local economies need to grow.

But be careful. It is in essence a Martingale play, a doubling up of a very risky strategy. Prof Charles Wyplosz from Geneva University said the ECB is taking a trillion-euro bet.

The weakest banks in the weakest countries are gobbling up ever more sovereign debt, concentrating systemic risk. If it all goes wrong, the ECB itself will be in grave trouble with ever expanding junk collateral.

The ECB action is leading to structural subordination of all other creditors, degrading the bonds of weaker banks – some of which will soon be reduced to junk status. The Draghi LTRO reduces the likelihood of defaults, but increases the losses should it happen.

As previously discussed, the unsecured debt and interbank lending markets are frozen. As a result, the ECB funds are replacing the unsecured debt and interbank loans as they mature.

Should these markets remain frozen, subordination is a moot point as they will no longer have any exposure in the banking system.

It is double-edged, and whether it ultimately works will depend on the monetary transmission channels. The data from January showed that the eurozone’s broad M3 money supply has recovered slightly, but narrow M1 is flat and lending to business is still deep in the doldrums.

It is not yet enough to save the South.

What few economists picked up – because there are almost no monetarists left – was the monetary break-down by country. Simon Ward from Henderson Global said the collapse of real M1 deposits is continuing at terrifying speeds in Europe’s arc of depression. The vortex is actually getting worse.

The six-month fall was 12.9pc in Greece, 9.2pc in Ireland, 9pc in Portugal, 8pc in Italy, and 1.5pc in Spain (there are special technical reasons for the Spain’s better profile). On an annual basis these rates would be twice as high. These are 1931-1932 rates of decline. Indeed they are worse than the worst year of the Great Depression.

Meanwhile, real M1 deposits are recovering in the North. The gap is widening again.

ECB's cheap money preserves zombie banks

2012-02-29T11:39:00.000-05:00

In a Telegraph article, Harry Wilson looks at the impact of the ECB's Long Term Refinancing Program and concludes that it kicks the problem of banks recognizing their losses on toxic assets into the future.

Actually, it is not the ECB's funding that kicks the problem into the future, but rather the choice by the Eurozone policymakers and financial regulators of implementing the Japanese model for handling a bank solvency based financial crisis.

What Mr. Wilson discovered is that unless financial regulators require banks to recognize their losses, they will not do so. Why should they given the impact of these losses on their bonuses?

Under the Japanese model, not only are the Eurozone financial regulators not requiring the recognition of losses, but they are actively blessing banks hiding their losses on and off their balance sheets (see RBS's Stephen Hester's confession).

Last year a well-known senior former investment banker travelled around southern Europe’s troubled banks offering them a simple trade.

He knew their balance sheets were stuffed with billions of euros of toxic loans. He also knew the banks could neither afford to finance these assets any longer, nor had enough capital to recognise the full-scale of the losses they would have to take to sell them.

Meeting with the banks he offered to buy not the odd loan here and there, but their entire toxic portfolios. The catch: well he wouldn’t offer them the face value of the loans, not even close, but he’d pay enough that it would be at a level where the bank could take a manageable loss.

Everything was going well until December when the ECB launched the first three-year long-term refinancing operation, or LTRO, which saw eurozone lenders borrow €489bn (£414bn) from the central bank at a 1pc interest rate.

Almost immediately the banker’s calls stopped being returned and meetings were cancelled.

Buoyed by the ECB’s cheap money, the impetus for the previously cash-strapped banks to offload their toxic assets was removed and they were now in a position to adopt a wait and see approach.

I do not expect many people to feel too sorry for the banker, but what his story demonstrates is the profound effect the ECB’s LTRO borrowing programme, which today has lent a further €530bn to eurozone banks, has had on the recipients behaviour.

Losses that might have been recognised sooner will now be taken later. Problems that were on the cusp of being dealt with have been bought off for at least the next three years....

Across Europe hundreds of banks open their doors every day only because of Mr Draghi’s intervention. These lenders may look like banks, call themselves banks, and, to their customers, feel like banks, but they are in reality wards of the ECB, going through the motions of banking.

These banks can make little impact on the real economy, and their main purpose in life is merely to survive and maintain the status-quo. They cannot afford to make loans and be the agents of Europe’s economic recovery as they remain too bloated with toxic debt and are, to all intents and purposes, insolvent.

Actually, Mr. Wilson is wrong here. As shown by the US Savings and Loans in the late 1980s, banks that are for all intents and purposes insolvent can continue to make loans. Call it gambling on redemption. In the case of the Savings and Loans, they invested heavily in commercial real estate and junk bonds and had a significant impact on the economy.

In Italy, Spain, Portugal and many other European countries, small and medium-size lenders, and many larger banks too, have tens of trillions of toxic debt still on their balance sheets.

The ECB loans have bought time to begin fixing these problems, but it is not a cure in and of itself.

Unpalatable as it may be, the European banking system’s toxic debt burden will not begin to be solved until lenders are forced to make the scale of writedowns that banks in Britain and the US have done over the last four years.

Actually, as Stephen Hester confessed, the banks in Britain have not been require to take the write-downs necessary to solve the problem.

Be under no doubts, the European banking system remains broken at its core. The LTRO is merely the full body plaster cast hiding the cadaver inside.

Is Sir Mervyn King about to champion ultra transparency? [update]

2012-02-29T11:10:00.001-05:00

As a Telegraph article says, Sir Mervyn King 'loses his cool' when it comes to talking about what should have happened with the banks as a result of the financial crisis.

My only question is will Sir Mervyn King now step forward and lead the charge to require banks to provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details?

Given what he told the Treasury Select Committee he wants, requiring ultra transparency is the most direct and fastest way to achieve it as it brings market discipline to the banking system. Unlike politicians, markets are not influenced by lobbyists, but rather by the actual risk and performance of the banks.

Sir Mervyn King, Governor of the Bank of England, made a remarkable statement in front of the Treasury Select Committee this morning. I’ll include his whole quote below, but let me sum it up.

Andrew Large, a Labour MP on the committee, accused the Governor of being “relaxed” about the current economic situation, which provoked a surprisingly angry reaction from the Governor.

First, he said he is far from “complacent” .... Then he launched into a fierce attack on the banks, the weakness of politicians in the face of the forceful bank lobby, and the Labour Government....

Politicians did back down in the face of the bank lobby when it came to regulating the banks.

However, that was only after these same politicians had been advised by their nation's financial regulators to adopt the Japanese model for handling a bank solvency led financial crisis.

The regulatory blessing of hiding losses on and off the banks' balance sheets gives the banks tremendous negotiating leverage that bankers are uniquely qualified to take advantage of.

Had the Swedish model for handling a bank solvency led financial crisis been adopted, politicians would not have backed down in the face of the bank lobby.

Sir Mervyn opened by claiming the banks should have been recapitalised far more than they were (in all it was close to £100bn). In the case of RBS, that would have probably meant full nationalisation.

Readers know that between deposit guarantees and access to liquidity through a central bank banks can continue to operate indefinitely and therefore there is no reason for governments to ever recapitalize a bank.

Readers also know that banks are the safety valve between the excesses in the financial markets and the real economy. Banks perform this safety valve function by absorbing the losses on the excesses in the financial markets today and rebuilding their book capital through the retention of future earnings and equity issuance.

Finally, readers know that banks must be required to provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details. With this disclosure, market participants can confirm that the banks have recognized all their losses and that the banks are not gambling on redemption in their efforts to rebuild their book capital.

Then he claimed Labour had been feeble in its attempts to ensure the banks lent to small businesses, something he claimed to have had concerns about from the start of the financial crisis.

Gathering a head of steam, he proceeded to turn his guns on the way banks are currently behaving – suggesting they are even trying to profit at taxpayers’ expense.

Why exactly does he find the banks' behavior shocking?

The UK government adopted the Japanese model for handling a bank solvency lead financial crisis. Having made bank book capital a sacred number, the government then had to bailout the banks on terms that were favorable to the banks.

Having benefitted so much from the bailout at taxpayer expense, why should he be surprised that the banks expect to continue to profit at taxpayer expense?

He claimed they are proving an obstacle to the Chancellor’s efforts to establish a “credit easing” programme to help lending to small business.

The banks, he said, want to hand over to the taxpayer the dud loans that will make losses while keeping the profitable ones for themselves.

This behavior is no different than what banks had been engaged in leading up to the financial crisis. Then, the banks simply put the dud loans into opaque, toxic structured finance securities.

Having slammed the self-interested banks, he turned his ire on Labour’s years in power and, seemingly, Alistair Darling. In Labour's years, he suggested, banks more or less set public policy. The government negotiated with them and then adopted their proposals, he claimed. In all, it was quite a remarkable tirade.

Again, by adopting the Japanese model, the government choose to let banks set public policy.

Here’s the quote:

“I’ve consistently and publicly been dissatisfied with what has been done. I said to the previous government that the scale of the recapitalisation of the banks was inadequate and their actions in making sure banks lend to SMEs was also inadequate. I made that very clear.

“In terms of asking banks to put together pieces of paper that are claims on SME loans, I will tell you exactly what would happen. The pieces of paper given to us [taxpayers] would be the worst of the loans, not the good ones. And I’ll tell you why. Because in discussing with the present Government a scheme to lend to SMEs, the banks were unhappy about the idea of a scheme in which the Government would participate in all SME lending.

“Why? Because they didn’t want to share the fruits of the most profitable loans to small businesses. We’d [the taxpayer again] end up being left with the bad ones. That’s why we’ve [the Bank] been very clear on this with Government.

“I’m not relaxed about it at all. I’m the person who put forward proposals for how this might be done. They are not proposals that banks find in favour. I’m disappointed that the government you supported before [Labour] was unwilling to take on the banks on this issue.

“They negotiated with the banks, and if the banks didn’t like it, that was what came out. That doesn’t seem to be a very strong public policy. So, I’m far from relaxed or complacent, Mr Large. I am actually rather concerned about it. I want to see something that makes sense economically, not something which is just a gesture.

“Unless there’s an element that tries to prevent the banks picking and choosing which SME loans they share with Government, and which not, there is a risk of adverse selection and taxpayer gets a bad deal.”

Sir Mervyn King's issues with the banks could be cured by abandoning the Japanese model and adopting the Swedish model for handling a bank solvency led financial crisis.

Requiring banks to recognize their losses and provide ultra transparency to prove it would dramatically change the financial system for the better.

Economic models versus financial system reality

2012-02-29T10:37:00.001-05:00

Since your humble blogger began talking about the need for transparency/disclosure in the financial system almost two decades ago, I keep finding out that transparency/disclosure is an idea that is easy to understand at a purely theoretical level, but is very hard to understand at the implementation level.

Cathy O'Neil provides a wonderful example on her Naked Capitalism post: economists don't understand the financial system.

What I felt then and what I still feel is that these super influential economists are so high on their clean, simple economic models of the world (about the only variables of which are GDP, stimulus, and tax rates) that they focus on the model to the exclusion of the secondary issues.

Sometimes you get important results this way: simplifying models can be really useful. But sometimes it’s really truly misleading to do so, and I believe this is one of those cases.

I’m left thinking that they (the economists) are so entranced with their simplified world view that still don’t understand what actually fucked up the world in 2007 and 2008, namely the CDO market’s implosion.

Message to Krugman: this is not exactly like other financial crises, because it’s partly caused by complexity, and nobody seems to have the balls to fix it. The problem is that the financial system has been allowed to get so complicated and so rigged in favor of the people with information, that normal people, including homeowners, credit card users, politicians, and regulators have been left in the dark, and many of the little guys are still stuck in ludicrous contracts left over from the outrageous securitizations that took place in the CDO market.

Apparently I am not the only one who wonders how the policies that have been adopted to deal with a crisis that started with opaque, toxic securities has never explicitly deal with the opaque, toxic securities or opacity in the system.

What is especially enraging is how these same economists are still the experts that people turn to to help figure out how to get out of this mess, when they don’t actually understand the mess itself.

A point that the Queen of England made when she asked how the economics profession managed not to warn of the crisis in advance.

Confession: it has always been a sore point with your humble blogger that he predicted the financial crisis and laid out what had to be done to moderate its impact and, since the beginning of the financial crisis, has not been turned to for help in getting us out of the mess.

Why else would a large audience be willing to pay $25 a piece to hear them talk about this? Why else would Obama be considering Larry Summers to lead the World Bank?

As an aside: please, Mr. President, do not let Summers lead the World Bank. He does not understand the system well enough to lead it. And he is too arrogant to admit what he doesn’t know.

Doesn't this apply to the economists in general?

After all, when you did not predict the financial crisis isn't that a sign that you do not understand the system.

It most clearly is a sign of arrogance that after not predicting the financial crisis economists feel free to pontificate on how to solve the problem created by the financial crisis. Hello, what insight do you have exactly?

I can introduce you to a bunch of people that may be less imposing but are more informed, more ethical, and wiser. Give me a call any time and we can chat and form a short list of candidates.

Hopefully Cathy, I am on the short list.

Why did I say that transparency/disclosure is easy to understand at the theoretical level, but very hard to understand at the implementation level?

As Yves Smith discussed in her book, ECONNED.

The scientific pretenses of economics got a considerable boost in 1953, with the publication of what is arguably the most influential work in the economics literature, a paper by Kenneth Arrow and Gérard Debreu (both later Nobel Prize winners), the so-called Arrow-Debreu theorem.

Many see this proof as confirmation of Adam Smith’s invisible hand. It demonstrates what Walras sought through his successive auction process of tâtonnement, that there is a set of prices at which all goods can be bought and sold at a particular point in time. Recall that the shorthand for this outcome is that “markets clear,” or that there is a “market clearing price,” leaving no buyers with unfilled orders or vendors with unsold goods.

However, the conditions of the Arrow-Debreu theorem are highly restrictive. For instance, Arrow and Debreu assume perfectly competitive markets (all buyers and sellers have perfect information, no buyer or seller is big enough to influence prices), and separate markets for different locations (butter in Chicago is a different market than butter in Sydney). So far, this isn’t all that unusual a set of requirements in econ-land....

this paper is celebrated as one of the crowning achievements of economics.

The idea of perfect information and hence perfect transparency/disclosure is an assumption that underpins economics.

If you look at the Nobel prizes that have been awarded, you will find a couple of them have been awarded that call into question this assumption of perfect information by looking in the area of transparency/disclosure.

Specifically, Joseph Stiglitz for his work on information asymmetry and Robert Akerlof for his work on accounting control fraud. The fact that both of these are of interest to financial market participants highlights the simple fact that there is not perfect transparency/disclosure (or as I like to call it ultra transparency) in the financial markets.

If banks were required to provide ultra transparency and disclose their current asset, liability and off-balance sheet exposure details, it would be very difficult for management to engage in accounting control fraud. Accounting control fraud requires that banks be able to take on greater risk without market participants being able to see the increase in risk and adjusting the pricing of their exposures to reflect this higher risk.

If structured finance securities were required to provide information on the underlying assets as observable events with these assets occur, it would be very difficult for Wall Street to profit from an information asymmetry. Information asymmetry requires that Wall Street owns the servicers of the underlying assets so that it has tomorrow's news today and disclosure of observable events on the underlying assets is delayed to market participants.

These are just a couple of examples that illustrate the gap between theory and implementation.

More importantly, it makes one ask why do economists stop by awarding Nobel prizes for illustrating the gap between theory and implementation on transparency/disclosure and not offer it up as a solution to a financial crisis that featured opaque, toxic securities?

Bank of England's Chris Salmon: Three principals for successful financial sector reform

2012-02-28T20:47:00.000-05:00

The Bank of England's Chris Salmon, Executive Director of Banking Services and Chief Cashier, gave a speech titled: Three principals for successful financial sector reform.

Principal one:

First, in general it is better to manage the costs of change by having a long-transition period to achieve the preferred outcome, than it is to water down the reform so that change can be implemented more quickly...

There is one area the Bank has tended to be less persuaded by the benefits of transition periods: transparency.

The costs of producing information are obviously much less than those associated with
changing balance sheet structures, and lack of transparency was an important factor in the run up to and during the crisis.

To give a specific example where a relatively speedy move to greater transparency may help, the FPC has recommended that banks publish leverage ratios from the start of 2013, ahead of the Basel III timetables. These would act as a backstop to capital ratios, which are affected by the risk weights applied to bank assets.

In making this recommendation the FPC drew on market intelligence which suggested that the
opacity of the methods used to calculate risk weights has dented confidence in the published data.

Manipulating the calculation of risk weighted assets is one of two reasons that bank capital ratios are meaningless.

The primary reason that bank capital ratios are meaningless is that the Japanese model for handling a bank solvency crisis was adopted at the beginning of the financial crisis and regulators have blessed banks hiding losses on and off their balance sheets (see RBS's Stephen Hester's confession). As a result, bank book capital has no relation to reality.

The Bank hears multiple arguments against producing data like leverage ratios, ranging from the idea that investors will have difficulty interpreting the data, so disclosure could be destabilising, to the suggestion that investors could calculate simple ratios like this themselves, so they add little value. And sometimes both arguments are put forward at the same time!

The 'investors are stupid and would have difficulty interpreting the data, so disclosure would be destabilizing' is one of the favorite arguments put forth for retaining opacity by the Wall Street Opacity Protection Team.

In the Bank’s view investors need to be presented with a range of information, which allows them to build their own picture of a firm. Some of these may be less sophisticated investors than others, but if we are to reduce the dependence on ratings agencies, more data, must in general be a good thing.

At the high end of the 'range of information', Mr. Salmon appears to recognize the need for ultra transparency and having the banks disclose on an on-going basis their current asset, liability and off-balance sheet exposure information.

In his own words, there are investors who are "sophisticated" and this disclosure would "allow them to build their own picture of a firm".

An example of these sophisticated investors would be banking competitors who currently have a tendency to freeze the interbank lending market because they do not have the data to build their own picture of a firm and assess its risks and the probability of repayment.

Financial innovation and the financial infrastructure [update]

2012-02-28T18:39:00.001-05:00

As part of its series on financial innovation, the Economist magazine carried an article in which it discussed the role of financial infrastructure.

FAILURE IN THE financial crisis had many fathers. There were failures of regulators, bankers, shareholders, borrowers and economists. But two in particular were closely tied to the way financial innovations work. One was a failure of plumbing—the infrastructure of the markets and the back offices of financial firms. The other was a failure of the imagination.

Actually, the failure of the plumbing and the failure of imagination are linked. It is the back office that has the information that is needed so that risk can be assessed.

As Yves Smith observed on Naked Capitalism, nobody on Wall Street was compensated for creating transparent, low margin products. To the extent that the back office lags financial innovation, it creates the opportunity for opaque products to be developed and sold.

Infrastructure often lags when an innovation takes off. Remember how markets move over time from being customised to becoming more standardised. When products are standardised and demand is high, finance’s manufacturing, sales and distribution channels can pump out a vast supply....

Looked at from the perspective of the back office, products move from customized, where it is tracked in an excel spreadsheet, to standardized, where it is tracked in a relational database.

In an ideal world, as the product moves from customized to standardized and sales volume takes off, the relational database is there at the moment of standardization to support the growth.

In the real world, the relational database for tracking all the product information, like terms, trails the growth in volume because it must be designed and built. As a result, significant growth occurs and is supported by the customized spreadsheet.

[Some] argue that having a bigger haystack of data makes it harder to find the really important needles. Others want a lot more information.

Given 21st century information technology, it is better to error on the side of providing a lot more information. Unless all market participants know in advance what the really important needles are in the haystack, it is better to take the whole haystack and let the market participants subsequently discard what they think are the unimportant needles.

Each market participant can easily find what they think are the important needles using modern database technology. For example, they can drilldown into the data.

No national regulator can see all of the financial system: an American regulator can see the CDS exposures of American banks to French banks, for instance, but is not allowed to see the counterparty risks of the French lenders in turn....

Given concerns about financial contagion, this is wholly unacceptable.

This is a problem that is easily solved by requiring each bank to provide ultra transparency and disclose on an on-going basis its current asset, liability and off-balance sheet exposure details.

Then all market participants, not just the national regulator, could see not just the CDS exposures of American banks to French banks, but also the counterparty risks of the French lender in turn.

“Margining and technical policy and back-office monitoring of positions against collateral are unsexy but it is the stuff to be focused on,” says Mohamed Norat of the IMF.

This is particularly true when it comes to innovations that pledge to transfer or reduce risk.

Many of the instruments and techniques that were most lauded before the crisis were designed to package risk and shift it away from people who did not want it towards those who did.

More transparency might have made it clear that risk was simply being concentrated somewhere else, or was not really leaving banks’ balance-sheets at all.

Or, more transparency might have allowed the market participants who supposedly wanted the risk the information they needed so that they could accurately assess and price the risk.

This weakness in infrastructure compounded a behavioural one. Finance is at its most dangerous when it is perceived to be safe. One element in the financial crisis was a failure to understand the risks inherent in various products until it was too late...

Investors do not necessarily think through all the risks embedded in these new instruments (for example, that a national housing bust would render the tranching within CDOs useless) and buy them enthusiastically. When those risks materialise, there is a destabilising flight to safety.

“The standard argument for financial innovation is that there are gains from trade, but that model crumbles if you suppose that people do not fully understand the risks,” says Mr Shleifer....

Why was there a failure to properly assess the risks in various products? Because as Yves Smith said it was the intention of Wall Street from the get go to innovate opaque products that hid the risk.

This analysis rings true of much of finance: people are liable to forget about the risks of products that have already blown up as well as misjudge those that have been newly created.

The euro zone’s debt crisis has shown that risks even in long-established instruments like government bonds can be underestimated.

These are problems with the practice of risk management and not just a consequence of financial innovation.

But innovations are particularly susceptible to the problem of self-delusion. If they go wrong early enough, they are unlikely to get off the ground. But once they reach a sufficient scale without a big blow-up, nobody believes that they might be flawed.

Given Wall Street's incentives, it is a bad assumption to believe that because a product has not had problems that all the risks of the product are known and that it will not have problems in the future.

Update
In a Naked Capitalism post, Satyajit Das reviews the Economist magazine's series on financial innovation. He observes

There is no acknowledgement [in the series] that much of what is called financial innovation is economic rent extraction, exploiting lack of transparency as well as information and knowledge asymmetries.

There is no discussion of the destructive bonus culture which encourages certain behaviours in financial institutions. Thomas Philippon and Ariel Reshef have estimated that around 30-50% of the extra pay bankers received compared to similar professionals is attributable to economic rents.

In a January 2009 speech, Lord Adair Turner, chairman of UK’s Financial Services Authority, observed that: “Much of the structuring and trading activity involved in the complex version of securitized credit was not required to deliver credit intermediation efficiently, but achieved an economic rent extraction made possible by the opacity of margins and the asymmetry of information and knowledge between…users of financial services and producers…financial innovation which delivers no fundamental economic benefit, can for a time flourish and earn for the individuals and institutions which innovated very large returns.”

The unpalatable reality that few, self interested industry participants and their cheerleaders are prepared to admit is that much of what passes for financial innovation is specifically designed to conceal risk, obfuscate investors and reduce transparency.

The process is entirely deliberate. Efficiency and transparency is not consistent with the high profit margins on Wall Street and the City. Financial products need to be opaque and priced inefficiently to produce excessive profits. The Report does not canvas this issue.

Mr. Das has nicely summarized why financial regulators must error on the side of too much transparency.

Europe's banks are addicted to ECB's money

2012-02-28T11:12:00.001-05:00

Der Spiegel carried an interesting article that identifies the lack of trust in the financial system as the cause of many of the symptoms, like frozen interbank lending markets and bank runs, that exist today. It observes that while the ECB can provide enough money to replace the normal money markets, this does not address the issue of restoring trust.

The article confirms what your humble blogger has been saying since the beginning of the financial crisis.

The only way to restore trust in banks or structured finance securities is if they provide ultra transparency. For banks, this means disclosing on an on-going basis their current asset, liability and off-balance sheet exposure details. For structured finance securities, this means disclosing on an observable event basis what is happening with the underlying collateral.

It is only with this disclosure that market participants have the information they need to independently assess the risk of the banks or structured finance securities. Based on this analysis, market participants can adjust the amount and price of their exposure and make buy, hold, sell decisions based on the prices shown to them by Wall Street.

For Kleanthis Papadopoulos, chairman of Greece's TT Hellenic Postbank, the situation is not looking good. "I can't give any new credits," he admits soberly.

Many Greeks are withdrawing their euros from the country's banks. To make matters worse, insurance companies and other financial institutions have long since stopped giving any money to Greek banks. As a result, the country is simply running out of cash...

Greeks say that anyone intending to withdraw several thousand euros in cash from their bank would be well advised to warn them in advance.

For months, this blog has been documenting the run on the Greek banks.

This dearth of money will prompt the European Central Bank (ECB) to once again open its seemingly bottomless coffers this week and grant generous loans....

The fact is that so long as a central bank is willing to provide liquidity, banks can remain in business.

What drives the run on the Greek banks is not just questions about their solvency, but also questions about whether the government can perform on its deposit guarantee. The Eurozone could have ended the bank run by backstopping the deposit guarantee.

When asked how long such a policy could be successfully pursued, ECB President Mario Draghi said that it was only "temporary." In his view, the financial system faces an emergency situation -- and therefore requires emergency aid.

But when does an emergency become business as usual? And how big is the danger that Europe's banks will simply forget how to stand on their own two feet if they are continuously being propped up?

It's been years since the banks were last able to easily access money.

"Before the Lehman Brothers collapse, liquidity was simply there," says Stefan Best, an analyst at the rating agency Standard & Poor's. At the time, banks readily lent each other billions at low interest rates -- overnight as well as for longer periods. It was an era of widespread trust.

Please re-read the highlighted text and recall that before deposit insurance the sign of a bank that could stand on its own two feet was a bank that provided ultra transparency!

The issue is not just that banks are addicted to central bank funding and government bailouts, but that there is no policy in place that restores trust. Without trust, there is no possibility of ending bank reliance on central bank funding and government bailouts and replacing this funding with money from the markets.

There was such an abundance of money that banks became less and less reliant on customer deposits.

[Until] the 1990s, banks primarily recapitalized using funds that individuals and companies had squirreled away on their accounts. In 1997, the gap between deposits and loans granted within the euro zone was only €44 billion.

During the 10 years that followed, this disparity increased to €1.3 trillion.

The banks easily plugged the hole using funds that they acquired on the financial markets....

A hole that the ECB has to fill if financial markets are unwilling to lend to banks.

The fact that this situation changed dramatically is thanks to managers like Richard Fuld and Georg Funke, the former CEOs of the US investment bank Lehman Brothers and Germany's Hypo Real Estate (HRE) respectively.

They invested money which they borrowed short-term at low interest rates in risky and protracted mortgage deals. As long as the profits continued to flow, nobody asked about the risks.

Actually, market participants relied on the regulators since the regulators had ultra transparency into the banks exposure details (think bank examiners) and the market participants did not.

More importantly, market participants assumed that the regulators knew how to assess this exposure detail and understand its implication for the risks the firms were taking.

Finally, market participants assumed that the regulators would convey their assessment of risk to the market in a timely manner or take steps to keep the risk the banks were taking in line with regulatory pronouncements. After all, who can forget Alan Greenspan's comments on how financial innovation had made the banks less risky.

But after the collapse of Lehman Brothers and HRE in the fall of 2008, the financial industry's trust was shattered.

Trust was shattered not only in the banks, but in the regulators! Subsequent actions by the regulators, like the stress tests, have only confirmed why the regulators' assessment should not be trusted (recall that European banks have failed within weeks of the last two stress tests).

Market participants have reacted by going on a "buyer's strike" until such time as they are provided with ultra transparency so they can independently assess the risk of each bank for themselves.

The interbank lending market dried up...

Predictably because the data was not available to assess the risk of making the loans.

Under the Japanese model for handling a bank solvency based financial crisis, regulators blessed banks hiding losses on and off their balance sheets. Each bank knows what it is hiding and as a result is reluctant to lend to another bank.

[Central] bankers ... became paramedics who eagerly rushed to the aid of ailing banks with each new crisis -- continuously increasing the dosage in the meantime.

Today, euro-zone banks owe the ECB some €796 billion.

"The ECB's cash injections have significantly reduced the danger of refinancing bottlenecks and a credit crunch," says Stefan Best, the Standard & Poor's analyst.

But how long can this policy of almost free money continue to work?

In Japan, they have been pursuing this policy of almost free money for 2+ decades.

ECB President Draghi is hoping that the situation will resolve itself on its own.

Since the beginning of the year, he says, the banks have again been increasingly borrowing via their normal financing channels....

There is no reason to believe that the situation will resolve itself on its own. The lesson of the financial crisis is the need for market participants to do their own homework (a point that US Treasury Secretary Hank Paulson made).

Without ultra transparency, it is impossible to do the homework.

Citing an increase in borrowing via normal financing channels is a bit misleading given the dependence of the financial system on life support programs like the ECB's Long Term Refinancing Operation. Perhaps access to these financing channels is simply investors reasoning that the ECB will provide funds in the future to repay them at maturity.

With the latest round of three-year loans granted by the ECB, the central bank is charging a rock-bottom interest rate of just 1.0 percent. Critics argue that this is like distributing free heroin to junkies.

"If the ECB continues in this vein, we'll soon be able to shut down the normal money markets," says Hans-Werner Sinn, head of Germany's influential Ifo economic think tank.

The normal money markets have been shut down since the start of the financial crisis. The only way to reopen them is requiring ultra transparency.

There is a long list of possible risks and side effects.

Draghi's cheap money is also keeping financial institutions afloat that simply don't earn enough to cover their financing costs.

The ECB's money is even paving the way for deals that in reality are too risky. However, the price for such risks is blurred when a central bank continuously maintains artificially low interest rates.

By definition, central banks maintaining artificially low interest rates (think zero interest rate policies) distorts the pricing of risk.

Central banks hope that this mis-pricing of risk leads to economic activity.

This is a case of hope triumphing over experience. As shown by Japan which has followed artificially low interest rate policies, their GDP was lower in 2010 than it was in 1995 (Wikipedia - Economy of Japan).

Draghi's prescription for the crisis is also "a recipe for a new speculative bubble," says Uwe Burkert, head of credit analysis at Landesbank Baden-Württemberg, a state-owned regional German bank.

In Germany, for instance, rates on real-estate financing loans are about as low as they have ever been. In its most recent monthly report, the German central bank, the Bundesbank, noted a "marked price reaction on the housing markets."...

Interest rate expert Uwe Burkert points to an additional risk that concerns the general public: Interest payments on life insurance policies are already declining from year to year.

"The ongoing low interest rates are insidiously eating away at people's pensions," he argues. Since money is no longer circulating normally, the entire economic system is going off the rails....

Apparently Uwe Burkert was channeling his inner Walter Bagehot and seeing interest rates below 2% as causing a problem with the entire economic system.

It is important to note that the low interest rate policies in the Eurozone that are feeding a real estate bubble in Germany (and Sweden too) are still higher than in the US, UK or Japan.

In any case, Draghi is convinced that it's all been worth it. He's also convinced that it's now time to stop. "We have done enough," he told the FAZ, adding that, in future, the focus would be on "tightening the requirements again."

But there are many bankers who suspect that he won't find it that easy to slip out of the role of Europe's bankroller. Indeed, it will be difficult to wean the banks off cheap and generous loans from the ECB.

In fact, a number of banks would again find themselves in trouble if that happened, because investors are even more loath to lend them money after years of dependency on the ECB.

In many regions, the economy would simply run out of money -- as is the case in Greece.
For TT Hellenic Postbank chairman Kleanthis Papadopoulos, the situation in his country is clear. "Greek banks are dependent on the ECB for their funding," he says.

As I have said since the beginning of the financial crisis, there is only one way to exit all of the central bank funding programs and government bailouts and that is to provide ultra transparency.

With ultra transparency comes adoption of a Swedish model for handling a bank solvency based financial crisis, because, even if the regulators do not require the banks to recognize the losses on and off their balance sheets, the market will.

HSBC confirms need for banks to provide ultra transparency

2012-02-27T16:10:00.001-05:00

In its review of HSBC's financial results, the Telegraph focused on the dramatic increase in funds HSBC has parked at central banks.

Why given the demand for funds from banks looking to borrow in the interbank lending market?

As the review noted, HSBC was right not to lend it to its weaker rivals at the risk of not getting it back.

Readers know that banks are in the business of making credit judgements. There is always some chance that a loan will not be repaid.

The reason that the interbank loan market froze and banks like HSBC are not lending is that they do not have access to the information that is needed to assess the risk of not being repaid.

Specifically, banks do not have access to ultra transparency from the borrowing bank so that they can evaluate the borrowing bank's asset, liability and off-balance sheet exposure detail to assess the probability of repayment.

One of the most eye-catching of HSBC’s 2011 figures was how much money it has on deposit at central banks. The figure’s shot up from $57.4bn (£36.3bn) to almost $130bn – a sure sign of risk aversion, if ever.

Before the crisis in 2007, that number was $22bn.

But chief executive Stuart Gulliver is rightly loth to lend depositors’ cash to weaker rivals at the risk of not getting it back, while noting wryly that: “The only people you want to lend it don’t need to borrow it.”

Such prudence hits net interest income but explains why HSBC has coped with a crisis that has decked profligate competitors, not least Royal Bank of Scotland and Lloyds Banking Group.

G-20 answers how large are the losses hidden in Eurozone financial system

2012-02-27T14:31:00.001-05:00

Regular readers know that under the Japanese model for handling a bank solvency based financial crisis banks, with regulatory approval, hide the true extent of their on and off balance sheet losses (see RBS's Stephen Hester confession).

Naturally, your humble blogger is curious as to just how big the losses are that are being hidden.

The G-20 provided an estimate for the Eurozone sovereign debt related losses. From an article in the Telegraph, the figure appears to be about $1.5 trillion.

This also happens to be the amount of money the G-20 is requiring the Eurozone to put into its financial firewall before non-Eurozone countries would be willing to provide any financial support.

There is a logic behind the G-20s request for $1.5 trillion.

Remember, each member of the G-20 has also adopted the Japanese model. As a result, they have some knowledge of the size of the losses that their own banking system is hiding. It is a simple matter to take these losses and scale them assuming that the Eurozone is hiding similar losses.

Then, having estimated the size of the losses hiding in the Eurozone, it makes sense to require the Eurozone to cover these losses before providing any financial support. Otherwise, the G-20 countries would be covering the Eurozone losses.

In an interview with Sky News, Mr Osborne said: "We are prepared to consider IMF resources but only once we see colour of eurozone money and we have not seen this.

"While at this G20 conference there are a lot of things to discuss, I don't think you're going to see any extra resources committed here because eurozone countries have not committed additional resources themselves, and I think that quid pro quo will be clearly established here in Mexico City."

Pressure to mount a large enough financial firewall to head off eurozone sovereign debt concerns has been mounting this weekend, after America, Brazil, and the Organisation for Economic Cooperation and Development all pushed for a funding increase.

Angel Gurria, the head of the OECD, set the tone at the conference on Saturday, calling for about $1.5 trillion in "firewall" funds aimed at restoring confidence in European countries' debt....

Guido Mantega, the finance minister of Brazil, said "there is a very strongly shared opinion that first, the European countries should strengthen their firewall."...

US Treasury Secretary Timothy Geithner said: "I hope we´re going to see, and expect we´ll see, continued efforts by Europeans to put in place a stronger and more credible firewall."

ECB's unlimited loans are no panacea for banks

2012-02-27T10:18:00.001-05:00

A Bloomberg article discusses how the ECB's Long Term Refinancing Operation (LTRO) temporarily ends concerns over Eurozone banks failing for lack of liquidity, but it does nothing to address the underlying problem of the bad debt on and off their balance sheets.

Regular readers know that your humble blogger sees the LTRO as a useful program to have in place to support my version of the Swedish model for handling a bank solvency based financial crisis (aka, Wall Street rescues Main Street blueprint).

Under the Wall Street rescues Main Street blueprint, the Eurozone banks would be required to recognize the losses on the bad debt on and off their balance sheets. They would also be required to provide ultra transparence and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details so that market participants could verify the losses were recognized.

Over the weekend, the G-20 asked the EU to enhance its firewall against financial contagion. As this blog has repeatedly said, the best way to enhance the firewall is to realize that bank book capital is there to absorb losses and not something to be protected as banks have the capacity to generate book capital in the future through retention of earnings and stock issuance.

This is a very important point and needs to be repeated. Under the Wall Street rescues Main Street blueprint, existing bank capital and future earnings and stock issuance are the primary contributors to the firewall between the excesses in the financial system and the real economy.

It is only under the failed Japanese model for handling a bank solvency based financial crisis that governments are called on to use their creditworthiness to bailout the banks or erect a firewall against financial contagion.

European Central Bank President Mario Draghi’s success in quelling a bond-market rout across the euro region’s periphery masks a failure by the region’s banks to bolster their capital.

The ECB will offer a second round of unlimited three-year funds on Feb. 29. Firms will seek 470 billion euros ($629 billion), approaching the 489 billion euro take-up by 500 banks at the first long-term refinancing operation on Dec. 21, the median estimate of 28 analysts surveyed by Bloomberg show.

“The worry is it may act to keep afloat institutions that aren’t exactly viable,” said Stewart Robertson, chief European economist at Aviva Investors in London, which manages more than $425 billion. “This buys time for banks, but does it really provide them with an incentive to sort out their books? The worry is it doesn’t.”

This is the reason that a Swedish model like the Wall Street rescues Main Street blueprint must be explicitly adopted.

The Frankfurt-based central bank is flooding the market with cheap money to head off a credit crunch, boost lending to companies and consumers, and spur demand for unsecured bank debt....

“Providing money so cheaply, for so long, against what is now effectively any collateral whatever, leaves the ECB in a position no central bank would choose to be in,” UBS AG analysts led by London-based Alastair Ryan said in a Feb. 22 note to clients. “It cannot control the credit risk coming onto its books, or at least onto the books of its national central banks. Worse, the success of its interventions risks encouraging politicians to avoid making necessary but difficult decisions.”...

Specifically that the banks their country hosts be required to recognize their losses and disclose their current exposure details.

“This will ease credit flows but won’t stop the great deleveraging,” Huw van Steenis, an analyst at Morgan Stanley in London, wrote in a note to clients. “LTRO is important but not a panacea. While the LTRO should materially ease the euro zone deleveraging process, credit conditions appear likely to remain fairly tight in Spain, Italy and central and eastern Europe.”...

After all, banks are still deleveraging in order to achieve the 9% Tier I capital ratio that bank regulators are requiring.

Of course, if the Swedish model is adopted, regulators would have to abandon the capital ratio target in the near term so there are no impediments to losses being realized -- over the long term, regulators could require banks to achieve the capital ratio target.

A benefit of abandoning the 9% Tier I capital ratio in the near term is it would end the credit crunch regulators precipitated as a result of adopting this target in the first place.

Mortgage plan seeks single securities platform

2012-02-26T13:44:00.000-05:00

The Financial Times wrote an article about the push by the Federal Housing Finance Agency (FHFA) to create a data warehouse for mortgage backed securities.

Regular readers know that your humble blogger has been advocating for the creation of this data warehouse since before the financial crisis (full disclosure: I have a US patent that may cover this data warehouse; however, patent or no patent, a data warehouse is needed if a new model for mortgage backed securities is to emerge that doesn't have the problems that exist with the current model).

The US may create a public utility to process all mortgage securitisations in the future after the main regulator of housing finance said it wants to invest in a single platform.

In a strategic plan published on Tuesday, the Federal Housing Finance Agency said that it aims to build a single securitisation platform for Fannie Mae and Freddie Mac, the two housing finance agencies that guarantee and bundle most US mortgages.

The plan points to a revolutionary future for the $8,500bn US mortgage-backed securities market, in which all public and private issuers use a single platform to process and track payments from mortgage borrowers through to MBS investors, and Fannie and Freddie may no longer exist.

The platform should track and provide reports on the mortgages on an observable event basis. An observable event for a mortgage includes, but is not limited to, a payment, delinquency, default, bankruptcy of borrower, or modification.

By tracking and reporting on an observable event basis, users of the data always have current information on the performance of the underlying mortgages.

Fortunately, observable event based data is obtainable from the mortgage servicers because this is the way their loan databases are designed -- they already track and report observable events for each mortgage.

“Right now, Fannie and Freddie each have their own proprietary systems,” said Edward DeMarco, acting director of the FHFA. He said it made little sense for taxpayers to keep investing in two different platforms when they could instead build a single system that could be used regardless of whether Congress keeps Fannie and Freddie or scraps them.

“It’s about building out an infrastructure for the secondary mortgage market but doing so in a way that is not dependent on any particular policy path,” said Mr DeMarco. In the medium-term, such an infrastructure could mean a single agency MBS, instead of different Fannie and Freddie securities....

The role of the state-backed US mortgage originators has come under the microscope.

Politicians across the spectrum in the US want to scale back the government’s role in guaranteeing mortgages but Congress has not yet decided whether to keep Fannie and Freddie or scrap them. ...

“We want to gradually shift some of the mortgage credit risk that Fannie and Freddie are taking on today back to the private market,” said Mr DeMarco....

The data warehouse is the key to bringing back the private market for mortgage backed securities. With observable event based reporting, market participants can actually independently value these securities. This is the first step in making an investment decision.

IceCap Asset Management discusses Japanese model and resulting monetary policy

2012-02-26T11:19:00.000-05:00

IceCap Asset Management wrote a very interesting investment letter in which it discusses the Japanese model for handling a bank solvency driven financial crisis and the resulting monetary policy (h/t ZeroHedge).

Today, future economic historians are lucky enough to both see and experience what will happen as Europe (lead by Germany), Japan, Great Britain and the United States fully engage in the biggest, coordinated, money printing experiment in the history of the Universe.

In its simplest form, only three scenarios are possible:

1) Money printing has absolutely no impact on prices rising or falling
2) Money printing results in a return to the 1922 German experience
3) Money printing results in a return to the modern day Japan experience

No worries though - the very competent hands of today ’s central bankers, on the surface at least, appear quite confident that their money printing games will successfully engineer a very serene road to prosperity. The mere mention of the probability of scenarios 2 or 3 occurring are casually dismissed as easily as an offering of a third espresso.

However, what should make you a little concerned is that central bankers in both 1922 Germany and 1990 Japan came to the very same conclusion before they commenced their devastating money printing strategies.

Any investment manager worth their salt these days will tell you that the probability of scenario 1 occurring is lower than the real odds of England winning the next World Cup.

The elimination of scenario 1, naturally leaves us with a tug of war between a hyper-inflationary World or a deflationary World. Both outcomes are certainly extreme, yet what else could you expect when we have the World’s biggest central banks implementing extreme monetary policies in the form of money printing?...

The 1922 German hyperinflation experience was undoubtedly propelled by printing massive amounts of money. Yet, the Japanese money printing experience has had no impact whatsoever on inflation.

Here we are in 2012, and the World’s four main central banks (USA, Britain, Europe and Japan) continue to print gobs of money. Will the outcome be 1922 Germany or 1990 Japan?

An important point to understand is whether the printed money actually flows through to the economy. In the 1922 German case – yes, it definitely did. The printed money circulated in the economy causing the German Mark to plummet against other currencies which resulted in extreme inflation.

Today, trillions of Dollars, Yen, Euros and Pounds are being printed – yet this new money is certainly not being distributed into the economy. Instead, big banks everywhere are hoarding the newly minted cash for a rainy day. In economic parlance, this is referred to as a “liquidity trap” meaning there is plenty of cash available, however the cash remains trapped and is not being used. This makes today’s situation, perilously closer to the Japanese experience.

Chart 1 ... shows the amount of money not being distributed into the economy by the very big American banks. Once this money is eventually released (via loans) into the economy, the cost of things could rise very quickly – similar to 1922 Germany.

We (and many, many others) have been very critical of the American, European and British central banks. We freely admit that these people all have very good intentions – they truly do want the World’s economy to return to normal.

So is that why they adopted the Japanese model for handling a bank solvency based financial crisis and engage in misrepresentation about the condition of the banks? Is that why they adopt extreme policies that negatively impact the vast majority of their society?

Yet in our opinion, it is their analysis of the problem that is leading them to make a very big mistake.

Your humble blogger agrees with this observation whole heartedly.

There are two problems with their analysis.

First, they assume that banks cannot operate with negative book capital! This is absolutely not true.

Second, they assume that the economy cannot 'recover' from all the excesses in the financial system being recognized. Iceland, which followed the success of Sweden, has shown that this is not true.

The central banks fully believe that the World is currently suffering from what they would call – an aggregate demand problem. They believe growth is slow around the World because people and companies are not spending as much money as they normally would.

To many of the big banks, stock brokers and mutual fund sales people, this “aggregate demand problem” sounds no different than any other economic slow down – it’s a part of a normal business cycle. And during a normal business cycle, the solution to encourage people and companies to spend more money has always been 1) lower interest rates and 2) increased government spending. And if the situation becomes untenable as it is today, you can add 3) money printing to the list.

The reason this combination isn’t working today is due to the flawed belief that all of this extra money sloshing around in the economy will naturally entice people and companies to spend their hard earned (and borrowed) money again.

As this blog has documented, zero interest rate policies actually create a headwind to spending. Both retirees and savers reduce demand to make up for the loss in income on their savings.

With trillions in freshly printed money, sub 2% growth, widening government deficits and continued bailouts to banks, it has become crystal clear that the central banks’ money printing strategies are not working.

The reason it isn’t working is simply due to the fact that all of this free money being provided to the banks, is not being distributed back into the economy. US and European banks are hoarding this free money and as a result - the transfer mechanism is broken.

The reason for hoarding free money has to do with the banks' solvency problem. Since all banks are hiding losses on and off their balance sheets, the interbank loan market is frozen as it is impossible for banks to determine which banks are solvent and which are not.

At the same time, zero interest rate policies are suppressing aggregate demand and with the reduction in aggregate demand comes a reduction in the demand for new loans.

Finally, banks have the risk free option to make money on the free money they have been given by keeping it in an interest earning account at the central bank.

Is there any truth to bank earnings presentations when banks use 'Alice in Wonderland' accounting?

2012-02-25T11:33:00.000-05:00

In a Telegraph article, RBS chief Stephen Hester confessed that bank regulators have blessed RBS hiding losses on and off its balance sheet and only recognizing these losses as RBS generates the earnings to absorb them (an example of the Japanese model for handling a bank solvency based financial crisis).

One result of this is what Mr. Hester refers to as 'Alice in Wonderland' accounting.

The RBS chief admitted that since its £45bn bailout in 2008, the lender had taken losses when it could "afford" to and used profits to "finesse" its results.

"We have to finesse it with our own profits as we go through. Each year we have, in a sense, a budget for making losses for clean-up – and the better or worse our profits are, the better or worse that budget is and the faster or slower that we can go," said Mr Hester, adding that the bank had "never" had sufficient capital to recognise all its losses upfront.

The question is, with regulator blessed 'Alice in Wonderland' accounting, is there any truth to bank earnings presentations?

In a column in the Guardian, Rob Taylor looks for an answer by asserting "the truth is in Lloyd's latest results presentation....somewhere".

This is the fourth year we have watched banks claim improvements in their core areas – and then turn round and tell us there is still garbage inside their businesses that needs to be written off.

This just happens to coincide with the start of the financial crisis and the regulatory blessing of and bank adoption of Alice in Wonderland accounting.

For the layman, operating profits are key indicators of the health of a business. As long as a company has the income to cover one-off losses – or sufficient capital tucked away to absorb these losses – the business can, in theory, continue to run another year and make more money.

Of course, chief executives and boards don't like to have to tell shareholders they need to write down high levels of legal liabilities and restructuring charges, let alone do so for several years in a row.

The strategy for most new chief executives is to fully audit and find the rubbish lurking in their businesses – then clear it off their books as soon as possible.

This strategy runs counter to the Japanese model of delaying recognition of the losses until the bank has the capacity to absorb them through earnings.

Under the Japanese model, loss recognition is balanced against the fact that management doesn't like reporting write downs and restructuring charges for several years in a row. The result is that banks report earnings while they are still hiding additional losses.

In the case of Horta-Osório, he announced early in his tenure that he would write-off PPI repayments and the restructuring charges one assumes were necessary for his longer-term growth strategy.

RBS's chief executive, Steven Hester, has had several years to find the bad bits and rid his bank of its financial liabilities.

Of course, banks will have to write down some sort of unanticipated expense most years. But let's just hope that Hester and Horta-Osório have finally got these big charges out of the way.

There is no reason for market participants to trust the bank's financial statements since they reflect Alice in Wonderland accounting and may or may not be hiding significant additional losses. This has directly contributed to the interbank lending market freezing as each bank knows what it is hiding through Alice in Wonderland accounting and assumes that other banks are also hiding losses.

Without ultra transparency under which banks disclose their current asset, liability and off balance sheet exposure details, there is no way of knowing if the banks have gotten the big charges out of the way.

Finally, so long as regulators pursue the Japanese model for handling a bank solvency based financial crisis and bless Alice in Wonderland accounting, regulators will be undermining confidence in the financial markets.

Since the 1930s, confidence in the financial markets has come from the idea that market participants are able to access all the useful, relevant information in an appropriate, timely manner and independently assess this information prior to making their investment decisions.

When regulators deliberately bless the withholding of all the useful, relevant information in an appropriate, timely manner, they undermine confidence (and this is before the question of is it legal is raised -- see IndyMac and its regulator, OTS)

Hedge Fund Manager Paul Singer renews call for transparency

2012-02-24T20:58:00.000-05:00

Approximately one year ago, this blog carried a post on hege fund manager Paul Singer, who like your humble blogger was publicly recognized as predicting the financial crisis.

At that time, Mr. Singer was critical of the Dodd-Frank Act for its failure to bring transparency to the financial system and its reliance on regulators to effectively monitor the Too Big to Fail banks.

Mr. Singer is back with a letter to investors in his Elliott Management funds which once again sounds themes that are very familiar to regular readers.

In a NY Times Dealbook article on the letter, Mr. Singer observes:

A great deal of stupidity has chipped away at the massive advantages of Western civilization, which could terminally decline if it remains on the current path. But these problems can be solved — and swiftly ....

This observation confirms the long term economic impact of the Japanese model for handling a bank solvency based financial crisis (preserve bank capital and only recognize losses as banks generate earnings to absorb them). The US, UK and EU policies since the beginning of the financial crisis reflect this model.

As shown by Japan, the impact of the Japanese model and its supporting fiscal and monetary policies is long term economic decline. In Japan's case, its economy has shrunk over the last 15 years.

This observation also supports the idea that adopting the Swedish model for handling a bank solvency based financial crisis and requiring banks to recognize all of their losses today will bring a quick end to the global financial crisis.

Mr. Singer is generous with his ire, directing it at the United States, the European Union and Japan, and offering a critical assessment of the sorry state of affairs in the world marketplace.

Here is a current snapshot of the U.S., Europe and Japan: the financial sector is overleveraged and opaque. Fiscal, tax, and regulatory policies are unsound and not oriented toward growth and efficiency. On a long-term balance sheet basis, these countries are insolvent, with no hope of paying presently promised benefits regardless of the level of growth achieved or tax rates charges. Monetary policy is extreme and experimental. None of these assertions is refutable...

The financial sector is opaque and, with the blessing of regulators, hiding losses.

He goes a step further, too, arguing that “the epoch of investor confidence in money backed by nothing is coming to an end.”

As he often has in recent letters, Mr. Singer spends pages railing against the Federal Reserve for buying bonds, printing cash and keeping interest rates at or near zero percent.

“This policy is arrant idiocy and is likely to ultimately lead to serious inflation, a risk that governments continue to ignore at their peril,” he writes.

Whether it leads to serious inflation or not, Mr. Singer joins Bill Gross, Charles Schwab and Walter Bagehot in thinking that the zero bound for monetary policy is at an interest rate greater than zero and more like Mr. Bagehot 2%.

Mr. Singer spells out a clear casualty of pursuing a zero interest rate monetary policy: investor confidence in money backed by nothing.

The peril he spells out for Europe, meanwhile, is much more immediate. He points out the circle of codependency between the nations and their banks: the nations support the banks to keep them from falling prey to markets, but the banks support the nations, too, by buying their debt.

In the next global trading crisis, characterized (as it may well be) by the cascading transmission of losses from one opaque, overleveraged institution to another, the survival of any given commercial or investment bank (or group of such institutions) is likely to depend more on the perception of the creditworthiness of the sovereigns which stand behind them (and the sovereigns’ willingness to actually do so) than on any analysis of the fundamentals of the afflicted institutions....

By adopting the Japanese model, nations have to stand behind their banks to inject capital should a bank's book value fall. As a result, there is a circle of codependency between banks and sovereign.

Under the Japanese model with its emphasis on protecting the level of capital at the banks, opacity is a policy requirement. For example, regulators have given RBS's Stephen Hester permission to hide the losses on and off the RBS balance sheet and only recognize them as RBS has earnings to absorb them.

If the Swedish model were adopted, nations would only stand behind the bank depositors. This breaks the circle of codependency.

Under the Swedish model with its emphasis on protecting Main Street and requiring banks to recognize the losses on and off their balance sheet, transparency is a policy requirement. If banks disclose their current asset, liability and off balance sheet exposure details, market participants could see that all their losses have been recognized.

Back home, a bevy of regulation in the wake of the financial crisis has done little to shelter the system from risk, address leverage or puncture the veil of secrecy at large financial institutions, he writes.

The argument is context to his real point, however, about impending regulation of hedge funds: “It is worse than pointless.”...

“We wonder if the Securities and Exchange Commission, the regulatory body tasked with policing hedge funds in the U.S., has the sophistication and resources to sniff out issues related to the myriad of complicated trades, strategies and securities that these firms manage,” he writes, before throwing some salt on a particularly sensitive wound at the agency. “Hopefully this new crop of regulators will be more astute than those who ignored a 15-page detailed analysis of the Madoff fraud that was handed to them on a platter years before his unmasking.”

If every financial institution over a certain size were required to provide ultra transparency, the regulators could enlist the resources of the market to help them understand each firm and the risks it poses to the system.

For example, JP Morgan could help the regulators in their analysis of Citi and BofA. Likewise, these firms could help in the analysis of JP Morgan.

Europe's banks bleed from Greek debt crisis

2012-02-24T14:27:00.000-05:00

A Reuter's article discussed the previously hidden losses that Eurozone banks were forced to recognize as a result of the Greek debt restructuring.

The scars of Greece's debt crisis were laid bare in heavy losses from a string of European banks on Thursday, and bosses warned the region's precarious finances would continue to threaten economic growth and earnings.

This warning of a threat to economic growth is entirely self serving for the bank bosses. Even though no linkage actually exists, the threat ties together the level of bank earnings and economic growth.

This blog has documented several examples of financial institutions incurring losses, having negative book capital and continuing to make loans to support economic growth. These examples include the US Savings and Loans in the mid-1980s.

From France to Germany, Britain to Belgium, four of the region's biggest banks lined up to reveal they lost more than 8 billion euros last year from their Greek bonds holdings.

"We are in the worst economic crisis since 1929," Credit Agricole chief executive Jean-Paul Chifflet said...

According to the NY Fed, the solution that the FDR Administration came up with for breaking the back of the economic crisis that began in 1929 was to force banks to stop hiding and recognize their losses.

Europe's banks have already written down billions of euros from losses on Greek government bonds and loans, and a deal agreed this week with its creditors will inflict losses of 74 percent on bondholders.

"We can't say that the writedowns are over," said Franklin Pichard, director at Barclays France. "Even if some can say that the worst is over, we are only at a new stage in terms of provisioning and not necessarily at the end."...

Problems in Europe's banking sector are far wider than Greece....

The region's banks are still repairing the damage of the financial crisis and shrinking their assets. They must also find 115 billion euros by the middle of this year to shore up their balance sheets against future shocks. But any weakening in the economy will hit earnings and make that harder to achieve....

As this blog has repeatedly observed, requiring banks to build up their book capital before they have been required to recognize all of the losses hidden on and off their balance sheet is bad policy.

It does not restore confidence in the banking system.

It does reduce the availability of credit as banks restrict the amount of new lending consistent with achieving higher Tier I capital ratios.

European governments are hoping to avoid more state bailouts to prop up the banking sector, and to limit the fallout should any bank collapse.

As has been shown since the adoption of the Japanese model at the start of the bank solvency crisis, bailouts are a frequent occurrence. Take Dexia as the latest example.

It is in fact the Japanese model that links the book capital level of the banks to sovereign debt.

Under the Japanese model, bank book capital levels are protected. This introduces the notion that if bank book capital drops below a certain level the state must invest funds to boost the book capital level.

Under the Swedish model, European government would not have to do any more state bailouts.

The Swedish model recognizes that between deposit insurance and access to liquidity through the central bank, depositors do not need to worry about getting their funds back. As a result, banks with negative book capital can remain in business until regulators close them down --- see US Savings and Loan example above.

Since banks with negative book capital can remain in business, there is no need for state bailouts.

Just how sizable are the losses being hidden by banks?

2012-02-24T10:32:00.000-05:00

Following the confession by RBS's Stephen Hester that with permission from the regulators his bank is hiding losses on and off its balance sheet, the logical follow up questions are:

How sizable are the losses being hidden at each bank, throughout the UK, Eurozone and global banking system?

How long will it take to work through the hidden losses?

A Bloomberg article provides some insight for the size of the losses from the European commercial property market and how long it might take for the Eurozone banking system to work its way through these losses.

European landlords have 582.7 billion euros ($779 billion) of commercial property debt maturing by the end of 2013 at the same time regulators are urging banks to shrink their balance sheets.

The maturing loans could trigger writedowns for banks that need to meet stricter capital standards under international accords and as the region’s sovereign debt crisis threatens to dent lender balance sheets.

If banks demand repayment, it may lead to a surge in foreclosures and restrain economic growth in Europe.

That’s why regulators are instead encouraging gradual sales of the loans to private-equity firms including Blackstone Group LP (BX) and Dallas-based Lone Star Funds....

European lenders can both avoid writing down the loans and shrink their balance sheets at the same time.

For non-performing loans that the banks want to continue to hide, they simply rollover the loans at maturity.

For performing loans, the banks either demand repayment or sell the loan. Either way, the banks' reported risk adjusted assets decline and their Tier 1 capital ratio improves.

As this blog has said before, by not requiring the banks to realize their losses before they increase their capital ratios, the numbers reported by the banks are meaningless. What is meaningful is that to achieve these meaningless numbers, banks are cutting back on extending credit to the real economy (the regulator driven credit crunch) and restraining economic growth.

Most European real-estate debt originated before markets plunged in 2007 is being held on bank balance sheets at 90 percent or more of face value, according to Conor Downey, a partner specializing in real estate and financial reform at law firm Paul Hastings. Potential buyers value them at 50 percent to 60 percent, he said.

If we say the value is 50 percent, then, based on the 582.7 billion euro exposure, banks are sitting on roughly 291 billion euros of unrecognized, hidden losses.

A substantial “rebound in capital values appears to be at best delayed with no immediate prospects for any strong growth, so I think the banks are probably feeling fairly uncomfortable at the moment,” said Colin Lizieri, a real estate finance professor at Cambridge University.

So much for the gamble on redemption.

European commercial property prices rose 5.3 percent in 2010, according to data from Investment Property Databank Ltd., the latest available. That followed declines of 15.9 percent in 2008 and 2.2 percent in 2009 that left borrowers struggling to repay loans and banks trying to sell soured assets.

New regulatory requirements mean banks have to increase core capital to 9 percent by June, which may restrict lending. That’s “not a very fortunate plan,” given current market conditions, European Central Bank Governing Council member Ewald Nowotny said last month....

It is worse than a not very fortunate plan. It is a deliberate action by regulators that is causing significant damage to the real economy.

While relative yields on European commercial mortgage debt packaged into securities narrowed in the last two months, the spreads are wider than a year ago and five times the level in November 2007, according to JPMorgan Chase & Co. (JPM) data.

Investors demand 505 basis points, or 5.05 percentage points, above lending benchmarks to hold the securities, down from 575 basis points at the end of 2011. The spread has widened from 365 basis points a year ago, the data show.

European banks hold most of their loans on their books with just 112 billion euros, or 6 percent, securitized at the end of 2010, according to the latest figures from DTZ Research.

Banks sold 20 billion euros of real-estate loans across Europe and the Middle East last year and a further 13 billion euros is on the market, CBRE Group Inc. said Feb. 21. A total of 20 billion euros will probably be sold this year, according to the broker.

Most of the property debt owned by European banks is secured against properties in unfavorable condition or unattractive locations.

Suggesting that a 50% loss rate might be optimistic.

In the U.K., two thirds of the properties financed by banks are secured against non-prime property, according to a Dec. 30 report published by the Bank of England.

Potential acquirers are instead focusing on prime assets, Natale Giostra, CBRE’s European head of debt advisory, said in December.

Banks may add to the problem if they foreclose on borrowers because more inferior real estate would come onto the market and push down values, said Lizieri at Cambridge University.

Banks that historically bundled property debt for sale are being discouraged by new rules that mean securitizations require higher levels of capital. Instead, they’re seeking to team up with other banks to package their loans into funds that can be sold.

Funds “diversify - and therefore improve - each investors’ risk position,” Simon Gleeson, a lawyer at Clifford Chance LLP in London specializing in markets and regulation, said in an e- mail. “You need quite a large number of banks involved, and they need to trust each other only to put in assets of the specified quality. Building that trust may take time.”

Regulatory arbitrage to try to get rid of non-performing assets.

Banks are being “nudged” by regulators toward recognizing bad real estate loans, “but it’s going to end slowly,” said Bob Penn, a partner at Allen & Overy LLP in London. “Regulators report to their political masters and are sensitive to their wishes. They don’t want to drive economic growth off a cliff and they don’t want to trigger another crisis.”

So the blame for not adopting the Swedish model and requiring banks to recognize all of their losses up front is really on the politicians who were adamant that the banks hide their losses and fiscal and monetary policies be adopted that maximized the destruction of the real economy.

Honestly, the regulators pushed for the banks to hide their losses. As this blog has previously stated, having financial institutions hide losses is the regulators default position. Example of this abound including the US Savings and Loans.

Private-equity firms are seeking to pick up some of the slack. Royal Bank of Scotland Group Plc sold 1.36 billion pounds ($2.14 billion) of commercial real-estate loans to a Blackstone fund in December at about 29 percent less than face value, two people with knowledge of the talks said, who declined to be identified because the deal was private....

Lloyds Banking Group Plc (LLOY), Britain’s second-biggest government-aided bank, sold more than 900 million pounds of mortgage-backed loans to Lone Star Funds in December. The loans may have been bought at a 40 percent discount, two people familiar with the matter said.

For assets like non-prime shopping malls in Spain, “there’s virtually no buyers or at least there’s none unless there’s significantly lower prices,” said Harm Meijer, an analyst at JPMorgan in London. The investment bank expects “falling property prices or at best a flattish market for a long time” across Europe, according to a Jan. 11 note to investors.

Banks will put more distressed real estate up for sale in some parts of Europe this year, Meijer said, and Dutch offices and secondary U.K. properties will be among the assets sold.

U.K. banks would have to write off billions of pounds if they “seriously attacked” their commercial property loan books through sales, Michael Marx, chief executive officer of Development Securities Plc, (DSC) said by e-mail. RBS said yesterday that its non-core division’s commercial real estate assets were impaired by 3.4 billion pounds in 2011.

Germany, the largest economy in Europe, is not immune, based on the performance of commercial mortgage backed securities issued there. Only 22 percent of German CMBS loans were repaid when they matured last year, compared with 74 percent in France and 38 percent in the U.K., Standard & Poor’s said in a January report....

PwC said that it will take 10 years for banks to sell up to 3 trillion euros of assets and expect a similar timeframe for their troubled real estate loans.

That echoes earlier crises, said Meijer of JPMorgan. “We’ve heard from bankers in Germany that they only worked out the last of their problem loans from the 1970s in recent weeks.”

Please re-read the previous two comments about how long it will take to work out from under the commercial property exposure.

There is a reason that Japan has been pursuing the monetary and fiscal policies it has been for the last 2+ decades. The reason is it takes forever for the banking system to generate enough capital to absorb the losses.

RBS' Stephen Hester ends the myth of bank capital being there to absorb losses

2012-02-23T16:56:00.001-05:00

In this blog's discussion of the Japanese model for handling a bank solvency crisis, your humble blogger noted that the central element of this model is banks only recognize losses as they generate the capital to absorb them.

As a result, bank book capital is not available to absorb losses on the excesses in the financial system and save Main Street and the real economy.

Never did I expect to read an article in which a banker confirms a) that regulators have adopted the Japanese model and b) that there are losses hidden on and off his bank's balance sheet.

Mr Hester said [RBS], which is 83pc owned by the state, had been "spooked" by the severity of the eurozone crisis into taking "an extra £1bn" of losses for 2011.

"We got spooked by the dangers of the eurozone so we deliberately spent an extra £1bn that we hadn't planned on in losses to go even faster than we had planned in reducing risk.

"You can say to me it's a slight Alice in Wonderland world, where extra losses is a good thing and I completely appreciate the difficulty in the communication of that, but those are the facts," said Mr Hester.

The RBS chief admitted that since its £45bn bailout in 2008, the lender had taken losses when it could "afford" to and used profits to "finesse" its results.

"We have to finesse it with our own profits as we go through. Each year we have, in a sense, a budget for making losses for clean-up – and the better or worse our profits are, the better or worse that budget is and the faster or slower that we can go," said Mr Hester, adding that the bank had "never" had sufficient capital to recognise all its losses upfront.

Please re-read Mr. Hester's comments as they confirm the UK's adoption of the Japanese model for handling bank solvency and the simple fact that regulators do not use bank capital to absorb losses.

The Volcker Rule: Insights into Wall Street's Opacity Protection Team

2012-02-23T16:03:00.001-05:00

This blog has written a number of posts on the Volcker Rule (see here, here, here, and here) to provide some insight into how Wall Street's Proprietary Trading Protection Team operates and what this implies for how Wall Street's Opacity Protection Team is trying to prevent the adoption of ultra transparency.

In a NY Times Dealbook article, Jessie Eisinger looks at the current condition of the Volcker Rule and declares it as good as dead.

The Volcker Rule, named after Paul A. Volcker, former chairman of the Federal Reserve, is meant to bar financial institutions that are protected and subsidized by the federal government from trading for their own accounts. That is, it’s pretty simple: Traders shouldn’t speculate for their own personal gain...

Actually, as simple as this statement of the Volcker Rule is, it is more complicated than ultra transparency. Under ultra transparency, banks disclose all of their current exposure details.

Under the Volcker Rule, there is a question of is a trader speculating or not. Under ultra transparency, if a bank has an exposure the bank discloses all the information it has on the exposure consistent with protecting individual borrower privacy consistent with HIPAA patient privacy standards and corporate privacy as it relates to projections of future performance.

Yet bank lobbyists with complicit regulators and legislators took a simple concept and bloated it into a 530-page monstrosity of hopeless complexity and vagueness.

Besides Wall Street, the members of the Protection Team include lobbyists, complicit regulators and legislators.

They couldn’t kill the rule. Instead, they are getting Congress and regulators to render it morbidly obese and bedridden.

Of course, that is no accident. The biggest banks, which are in business today only because taxpayers bailed them out, want to protect their valuable franchises.

“Most of the length, complexity and questions are in there because of industry lobbying,” said Dennis Kelleher ... The rule is “the bastard child of the lobbying industry,” he said. “You can’t demand and insist and lobby for all these rules and exemptions and then complain that it’s too long and complex.”

The banks are making sure the rule stays incapacitated.

By redefining the Volcker Rule so that it is now complex, the Protection Team makes it vulnerable to being squashed.

Fortunately, in its expanded form, ultra transparency still fits on one sheet of paper.

By Mr. Kelleher’s count, of the substantive responses, 13 were pro-reform, compared with 300 from the industry.

Based on your humble blogger's personal experience dealing with comments made on the Article 122a of the European Capital Requirements Directive (this article requires commercial and investment banks, broadly defined, to know what they own when buying a structured finance security), this proportion of responses pro versus against reform is typical.

Unfortunately, as the Committee of European Bank Supervisors showed, regulators favor the preponderance of responses even when the responses were created using the same Word document and printed on different letterhead.

The regulators and legislators deserve some sympathy against such an onslaught. But only so much. Responsibility for the gross inadequacy of the Volcker Rule lies with them. They added the loopholes and exceptions.

Regulators did so out of vanity. They are confident they will be smart enough to navigate all the complexities.

Regulators have already testified that they wanted to carry out the rule in a nuanced fashion.

They aspire to distinguish intentional proprietary trading from unintentional cases, a standard that is tantamount to pre-emptive surrender. That will make enforcement all but impossible without a trader stupidly putting something incriminating in an e-mail.

When it comes to ultra transparency, regulators are acting in a similar fashion.

For example, the Federal Reserve believes that putting over 100 of its PhD economists on the bank stress test exercise means it will be smart enough to catch all the ways that the banks can game the stress tests and determine which banks are solvent and which are not.

Hmmm...100 PhD economist versus the thousands of experts, including from the global banking competitors, the market could bring to bear doing stress tests on the data disclosed under ultra transparency. Which one does common sense says will do a better job (hint: PhD economists all believe that for markets to be good at pricing they have to be better at analysis than a group of economists)?

Even at this late hour, regulators still have a choice. The final rule is not in place. They could radically simplify it. The law could merely state that prop trading is illegal at banks backed by the government, and not explain what the inevitable exceptions and exemptions would be....

Second-best is to introduce some bright-line rules into this monstrosity. Then Volcker would not be hostage to whichever heavily lobbied regulators happen to be on staff at any given moment....

The regulators' choice should be to require banks to provide ultra transparency and comply with the simple description of the Volcker Rule used at the beginning of the article. Market participants will exert discipline to reduce proprietary trading.

In all their pages of concerns, what is the anti-Volcker crowd most worried about? Nothing convincing.

Actually, what the anti-Volcker and anti-ultra transparency crowd is most worried about is their paycheck. It is much harder to make money when you no longer have the benefit of opacity.

RBS: 'the biggest balance sheet time bomb in history'

2012-02-23T14:27:00.000-05:00

In a Guardian column, RBS boss Stephen Hester says that he took over 'the biggest balance sheet time bomb in history' and that the losses that have been taken are to defuse this time bomb.

Of course this raises the question of how will any outsider ever know if the bomb has been defused?

Because Mr. Hester or the government says so?

Sorry, market participants learned at the start of the financial crisis the importance of independent confirmation of the contents of a black box.

Ultimately, if Mr. Hester thinks he has successfully defused the balance sheet time bomb, he will be willing to provide ultra transparency and disclose on an on-going basis the current asset, liability and off-balance sheet exposure details so that market participants can independently confirm this for themselves.

Draghi's bazooka: subordinating or bailing out unsecured Eurozone bank debt holders

2012-02-23T12:57:00.001-05:00

By re-affirming its right to avoid a write-down on its Greek sovereign debt holdings, the ECB has triggered a long second look at Mario Draghi's bazooka, also known as the Long Term Refinancing Operation (LTRO).

In his Telegraph column, Ambrose Evans-Pritchard observed

ECB boss Mario Draghi has sparked a blistering rally in global asset markets by lending banks as much as they want for three years at 1pc, but bond experts say the side-effects are toxic and the benefits are wearing off.

"It's a sugar rush," said Alberto Gallo, European credit chief at RBS. "It lowers the risk of defaults, but also lowers recovery rates if things go wrong."

Lenders must provide the ECB with collateral, at a haircut of up to 65pc, using up ever more of their balance sheets. The ECB has first claim on these assets, pushing other creditors down the pecking order. The longer it goes on, the worse it gets.

"There is no such thing as a free lunch. Liquidity today comes at the price of subordination tomorrow," said Mr Gallo, warning that BBVA, BNP, Commerzbank, Intesa, Santander and Unicredit are all vulnerable....

I am not sure that I accept Mr. Gallo's analysis.

Remember that the event that triggered the need for the LTRO program was the freezing of both the interbank lending market and the unsecured bank debt market. These markets froze because no one can evaluate the solvency or risk of any of the Eurozone banks.

The freezing of these markets was important, because the Eurozone banks have billions of euros of interbank loans and unsecured debt maturing.

The primary use of funds from the LTRO is to replace the maturing interbank loans and unsecured debt.

Clearly, as a senior secured lender, the ECB has a higher priority in a bankruptcy proceeding than the unsecured debt. As Mr. Gallo observed, the unsecured debt holder has been subordinated.

However, this is a short term concern. So long as the interbank and unsecured debt markets remain frozen, banks will continue to increase their LTRO exposure and pay off the maturing debt. In the medium to long term, it is not too difficult to imagine the situation where the banks will have replaced all their interbank loans and unsecured debt with LTRO funds.

In addition, the concern over subordination assumes that each bank is solvent (the book value of each bank's liabilities minus the market value of each bank's assets does exceed the current book value of its equity).

If the banks are not solvent, subordination is not a problem as the banks do not have the capacity to repay the unsecured debt holders if the banks were liquidated instead.

Said a slightly different way, the unsecured debt holders are holding positions that are worth less than the par value they receive as a result of the LTRO funding. In this case, the LTRO is actually a bailout of the unsecured Eurozone bank debt holders.

Back to the Telegraph column.

Mr Gallo said the LTRO has badly eroded the capital structure of banks, pushing many over the edge towards junk status....

In the absence of ultra transparency, it is not clear that the capital structure of the Eurozone banks is not already junk. That is what the frozen interbank lending and unsecured debt markets are telling us.

Huw Van Steenis, Morgan Stanley's bank strategist, said the bazooka is no panacea even though it has averted a shock as lenders slash loan books in a frantic rush to meet core tier one capital ratios of 9pc by June. "The LTRO will not stop the Great Deleveraging," he said.

WSJ confirms regulatory policy driven credit crunch in Eurozone

2012-02-23T10:19:00.000-05:00

As the dust settles over the latest Greek bailout proposal, market participants are beginning to look at what the implications are for Eurozone banks.

Specifically, they are looking at how much more in the way of assets the banks are going to have to dispose of to still reach a 9% Tier I capital ratio by June given the hit to their Tier I capital caused by writing down Greek sovereign debt.

Regular readers know that bank book capital was rendered meaningless at the beginning of the financial crisis when regulators adopted the policy of regulatory forbearance and mark-to-market accounting was suspended.

Since bank book capital is currently meaningless, a regulatory policy of requiring the banks to reach a 9% Tier I capital ratio is meaningless for restoring confidence in the banks, but is meaningful in terms of the credit crunch it precipitates.

Frankly, Eurozone banks are not capable of internally generating capital quickly enough to offset the losses on the Greek debt or the future losses on the debt of Portugal, Spain and maybe Italy.

At the same time, due to a lack of disclosure, investors are unwilling to invest in the banks. Would you invest in a black box and hope to see both return on and return of your capital?

What all this means for the Eurozone banks is that they have to cut back on lending.

A WSJ article confirms this regulatory policy driven credit crunch in the Eurozone

World financial markets may have breathed a collective sigh of relief over the rescue package for Greece, but European bank stocks have fallen since the announcement Tuesday.

After a fourth quarter in which many of the Continent's banking institutions wrote down tens of millions of euros on their exposure to Greece, 2012 is likely to be a year of retrenchment as they work to meet strict capital requirements....

The €130 billion ($172.3 billion) Greek package, agreed upon on Tuesday, calls for private investors to take a 53.5% haircut, more than the 50% agreed on in October. Real losses will be as much as 70% after factoring in lower interest rates paid on new debt investors will receive in exchange for their existing Greek bonds.

Analysts now expect banks to stay in defensive mode, hoarding cash and cutting back on their reliance on debt. Lending is likely to be limited to domestic markets.

"Top-tier euro-zone banks are building up stocks of short-term liquidity, paring down risk assets to meet tougher regulatory standards for capital adequacy, and tightening credit standards," Standard & Poor's said in a recent note.

The so-called Basel III rules, agreed upon by the Basel Committee on Banking Supervision, call for international banks to hold core Tier 1 capital ratios—a measure of their ability to absorb losses—of at least 7%. The rules also impose new requirements for bank liquidity and leverage.

The European Banking Authority requires European banks to reach a core Tier 1 ratio of 9% by June 2012.

PIMCO to quit structured finance trade group

2012-02-22T18:54:00.000-05:00

According to a Bloomberg article, PIMCO is going to quit the American Securitization Forum (ASF), a structured finance trade group, because it does not fairly represent the opinions of investors.

This is not surprising given that ASF was created by the sell side's lobbying group Securities Industry and Financial Markets Association (SIFMA).

As PIMCO has undoubtedly experience through its participation in the ECB's ABS data warehouse initiative, the Association for Financial Markets in Europe (AFME, another offspring of SIFMA and the former European Securitisation Forum) is just like ASF.

Based on the contributions that I have seen made by ASF, AFME and SIFMA to restarting the structured finance industry, it is clear that they are fighting to retain the current level of opacity in structured finance securities and the sell side's informational advantage.

For the last four years, your humble blogger has used a brown paper bag to show the current level of opacity exhibited by structured finance securities. Simply put, market participants do not have access to current data on the performance of the underlying collateral. Without this data, they are not investing, but gambling on the contents of a brown paper bag.

My solution has been to require all structured finance securities to provide observable event based disclosure. An observable event for the underlying assets includes a payment, delinquency, default, bankruptcy or restructuring. The day an observable event occurs, it is disclosed. As a result, market participants always have access to current data on the performance of the underlying collateral and can value the structured finance security.

Pacific Investment Management Co. is quitting the American Securitization Forum (0150170D) after the trade group declined to issue a statement about investors’ views on the nationwide foreclosure settlement this month by five banks, two people with knowledge of the matter said.

Pimco, manager of the world’s biggest bond fund, informed ASF Executive Director Tom Deutsch of its decision in early February, said the people, who requested anonymity because the talks were private.

The episode underscored Pimco’s concern that the trade group doesn’t advocate for debt buyers as well as banks that underwrite mortgages, the people said....

This is not surprising because the lineage and heritage of ASF and AFME is as a direct descendent of the sell-side lobbying effort, SIFMA.

The ASF, which counted Pimco Managing Director Daniel Ivascyn as a board member, was founded in 2002 as part of the Securities Industry and Financial Markets Association, Wall Street’s biggest lobbying group. In 2010, the New York-based ASF decided to become independent of Sifma.

Bondholders asked the ASF to publish a press release on their views of the pending foreclosure settlement after being denied last month by Sifma, which cited the “potential legal issues involving the commercial interests of many of our members.” Both organizations include banks that sell, underwrite, service and trade debt.

U.S. Housing and Urban Development Secretary Shaun Donovan told reporters Feb. 9 that “a relatively small share, in the range of 15 percent, of the principal reduction” for homeowners resulting from the settlement will come from investor-owned loans.

“Nothing in it requires any trustee or servicer to reduce principal where it’s not allowed legally by the underlying documents,” Donovan said. “The misunderstanding somehow that investors will be paying the banks’ share is just false.”

The ASF is among groups vying to influence policy makers amid the largest financial regulatory overhaul since the 1930s and following a crisis triggered partly by securitization, the packaging of assets such as mortgages into bonds.

The organization helped spur industry-led reforms meant to revive the almost-frozen market for home-loan securities that aren’t backed by the government. In August, for example, its “Project Restart” initiative offered suggested best practices for new mortgage-bond contracts to aid in dealing with claims of faulty loans....

Based on my experience, there is a gap between actual best practices and what the trade groups claim are best practices.

For example, best practice for tracking a loan portfolio is observable event based reporting and monitoring. It is what banks do internally and it is how loan databases are designed to operate.

However, the trade groups represent that once per month disclosure is best practice (this is the frequency of disclosure for opaque, toxic subprime mortgage backed securities). Clearly it is not because the supporting information systems are capable of reporting on an observable event basis.

To regular readers, it appears that the trade groups are trying to retain opacity in structured finance and protect Wall Street's informational advantage.

RMBS data warehouse needed if private investors are to replace Fannie and Freddie

2012-02-22T09:36:00.000-05:00

Four years after the beginning of the financial crisis, the US government is finally taking the first steps towards addressing the issue of opaque residential mortgage backed securities.

Specifically, as discussed in a Bloomberg article, the Federal Housing Finance Agency (FHFA) has realized that an RMBS data warehouse must be constructed if investors are going to end their buyers' strike.

It is impossible to shrink Fannie Mae and Freddie Mac without these investors.

The only way that these investors are going to be willing to end their buyers' strike is if they are provided with all the useful, relevant information on the underlying collateral performance in an appropriate, timely manner.

For RMBS deals, this information is observable event based disclosure where an observable event with the underlying collateral that causes the information to market participants to be updated includes, but is not limited to, a payment, delinquency, default or bankruptcy.

It is only with observable event based disclosure that market participants have current information on the assets backing the security.

Without this information, market participants are left with the disclosure practices that exist for opaque, toxic mortgage backed securities. We know how that turned out.

With no plan from Congress or the Obama administration to shutter Fannie Mae and Freddie Mac, the companies’ regulator told Congress today it will expand its oversight with a strategic plan to develop new systems and standards for home loans.

The companies, which own or guarantee most of the nation’s mortgages, exist in an extended policy limbo that poses new risks to taxpayers and the housing market, said Edward J. DeMarco, acting director of the Federal Housing Finance Agency.

The mandate to protect taxpayers must be balanced with the need to invest in staff and infrastructure, he said.

“Conservatorship can’t go on forever,” DeMarco said today in a telephone interview. “If we want to have a secondary mortgage market in the future without Fannie and Freddie we have to start investing.”

The companies are “complex financial institutions with complex business processes, information technology structures and important human capital,” he said.

FHFA urges creation of a single utility-like platform for selling mortgages to investors

2012-02-21T22:06:00.001-05:00

In a letter to Congress, the Federal Housing Finance Agency (FHFA), which oversees Fannie and Freddie, called for the creation of a single utility-like platform for selling mortgages to investors. Combined with efforts to standardize data, the platform could pave the way for restarting mortgage securitization and reducing government exposure to mortgages.

At the beginning of the financial crisis, your humble blogger proposed creating this mortgage database (it is a subset of the Mother of all Financial databases).

[Full disclosure: your humble blogger has a patent that would cover the database being talked about by FHFA.]

FHFA identifies three strategic goals for the next phase of the conservatorships:
 Build. Build a new infrastructure for the secondary mortgage market;
 Contract. Gradually contract the Enterprises’ dominant presence in the marketplace while simplifying and shrinking their operations; and
 Maintain. Maintain foreclosure prevention activities and credit availability for new and refinanced mortgages.
“With the conservatorships operating for more than three years and no near-term resolution in
sight, it is time to update and extend the goals and directions of the conservatorships,”
DeMarco wrote.

“FHFA is contemplating next steps to build an infrastructure for the secondary mortgage market that is consistent with existing policy proposals and will support any outcome of the leading legislative proposals. FHFA looks forward to working with Congress and the Administration on a resolution of the conservatorships and a comprehensive review of the nation’s housing finance system,” said DeMarco.

To pay its bankers' bonuses, HSBC to sell new shares

2012-02-21T20:54:00.000-05:00

A Telegraph article discusses how HSBC is going to pay it bankers' bonuses by issuing new shares.

This confirms yet another element of the Wall Street rescues Main Street blueprint. Specifically, it confirms that it is acceptable to the banking industry to pay bonuses in shares.

This is important, because it speeds up the pace of rebuilding bank book capital after a bank recognizes all the losses hidden on and off its balance sheet.

Under a new pay structure designed in consultation with the British authorities, HSBC will sell new shares to pay the non-deferred component of bonuses worth more than £50,000.

The pay deal has been agreed with the Financial Services Authority, which likes the structure as it views it as a way for banks to bolster their capital base at the same time as continuing to pay staff bonuses.

The amount of new shares issued will cause a "miniscule" amount of dilution, according to one source with knowledge of the pay deal, who said it would equal less than 0.1pc of the bank's outstanding share capital.

Under the arrangement, an executive director HSBC employee earning worth £1m will receive 60pc of the payout in the form of share deferred over three years. The £400,000 non-deferred component will be paid for by HSBC selling shares worth an equivalent amount with the proceeds handed on to the employee.

Staff bonuses worth less than £50,000 will be paid entirely in cash.

While other British banks such as Barclays and Royal Bank of Scotland have put in place cash bonus caps of £65,000 and £2,000 respectively, they are also understood to be using similar share proceeds arrangements to pay their staff....

In the wake of the financial crisis UK authorities have been pushing banks to come up with new ways to pay their staff after widespread criticism of industry practices in the lead up to the downturn.

Caps on cash bonuses have become routine at many major banks since the crisis. However, several large Wall Street banks, including Citigroup, JP Morgan and Goldman Sachs, have continued to pay a large proportion of staff bonuses in cash.

S&P finds Eurozone banks deleveraging despite ECB loans

2012-02-21T19:00:00.000-05:00

A Telegraph article reports that S&P has discovered that Eurozone banks are deleveraging so as to reach the 9% Tier I capital ratio target and using the loans from the ECB for liability management.

Regular readers are not surprised as this confirms your humble blogger's predictions of a financial regulator created credit crunch and that higher capital ratios would not unfreeze the interbank or private funding markets.

In a report published on Tuesday, S&P analysts warned that "deleveraging" by European banks was one of the industry's "defining" issues and that the €859bn borrowed by lenders from the ECB had not stopped credit availability from shrinking.

S&P points out that loans to eurozone residents shrank by 1.2pc year-on-year for the 12 months to the end of December, with Ireland, Spain, Portugal and Belgium among the countries showing a decline in loan growth.

The declines come despite the ECB pumping €489bn into eurozone banks in December as part of a new three-year lending facility, which took the total borrowed to more than €800bn....

At the end of this month, the ECB will allow banks to borrow three-year money for a second time, with most analysts expecting lenders to borrow at least a further €500bn.

However, S&P said this was only a form of "emergency relief" providing "breathing room" for banks struggling to find private sources of funding.

"The pace and scope of deleveraging will be one of the defining issues of the eurozone banking industry in the years to come. Although the very large amount of loans from the ECB may slow down this process, we believe banks in Europe will use them more for liability management, namely, paying off maturing wholesale debts that fund assets already on the balance sheet," said S&P.

12 Eurozone leaders call for allowing banks to fail

2012-02-21T13:19:00.001-05:00

According to a Washington Post article, a dozen Eurozone leaders have called for ending the implied guarantee of banks and allowing banks to fail.

Regular readers know there is one simple way of accomplishing this: requiring banks to provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details.

Combining this information with existing deposit guarantees and access to central bank funding when pledging good collateral, banks can be held fully responsible for bearing the costs of the risks they take.

“We meet in Brussels at a perilous moment for economies across Europe,” the leaders said. “Growth has stalled. Unemployment is rising. Citizens and businesses are facing their toughest conditions for years. “

The letter urges European nations to deregulate their service, research and energy sectors, forge trade ties with growing markets including China, Russia and South America — and even contemplate a free trade agreement with the United States....

It also suggested that faltering banks could be allowed to fail.

“Implicit guarantees to always rescue banks, which distort the single market, should be reduced,” the letter said. “Banks, not taxpayers, should be responsible for bearing the costs of the risks they take.”

Please look at who signed the letter!

The letter is signed by the leaders of Britain, Ireland, the Netherlands, Italy, Spain, Estonia, Latvia, Finland, Sweden, Poland, the Czech Republic and Slovakia.

Eurozone Greek bailout repeats errors in handling banks [update]

2012-02-21T10:06:00.002-05:00

Eurozone policy makers appear to have avoided the lessons from the experience of Sweden or Iceland when it comes to dealing with a solvency crisis.

According to a Telegraph article, once again BlackRock has been paid a significant amount of money for what is effectively Kentucky windage -- in this case, they concluded from their diagnostic exercise that recapitalization of Greek banks might require 50 billion euros rather than 40 billion euros.

Based on this analysis, bailout money is going to be injected into the Greek banks.

Compounding this mistake, the Greek banks are going to be required to hit a meaningless 9% Tier I capital ratio in September and a 10% Tier I capital ratio in June.

As has already been shown throughout the Eurozone with the 9% Tier I capital ratio target, the result of this requirement is that the banks a) delay recognition of their troubled assets for as long as possible, b) shed performing assets and c) minimize new lending to the real economy as they try to hit the meaningless Tier I capital ratio targets.

With regards to the Greek banks, the Eurozone bailout appears to be working against the goal of stabilizing Greece and putting it on a path towards economic recovery.

Rather, the Eurozone bailout appears to be once again be putting the interest of bankers ahead of society.

Regular readers know that there is a far better solution.

First, require the Greek banks to provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details. With this information, the market and not BlackRock will determine the shortfall between the market value of the assets and the book value of the liabilities.

Second, require that Greek banks write-down the value of their assets to market value.

Third, require that Greek banks retain all future earnings until such time as they have restored their book capital to 10% Tier I capital ratio. Bonuses can continue to be paid, but they have to be paid in stock.

Fourth, have the EFSF and the ESM backstop the Greek government and guarantee the deposits in the Greek banks. This additional guarantee will alleviate any concerns with runs on the Greek banks.

Fifth, use the money that would have gone into recapitalizing the banks today for programs that will improve the prospects for economic growth in Greece.

Update

According to a column in Der Spiegel,

Greece is bankrupt and will need a 100 percent debt cut to get back on its feet. The bailout package about to be agreed by the euro finance ministers will help Greece's creditors more than the country itself. EU leaders should channel the aid into rebuilding the economy rather than rewarding financial speculators for their high-risk deals....

In truth, Greece has of course been bankrupt for a long time. The country doesn't need debt forgiveness of 70 percent, it needs a 100 percent debt cut if it is ever to recover....

Most of the countless officials dealing with the Greek problem in the euro zone are well aware of this simple truth. Some of them, including people in the German government, privately admit that the €130 billion won't solve the problem. It's only about buying time, they say. Time until the financial markets have stabilized to such an extent that they can weather a Greek default without a disastrous chain reaction. Without bank insolvencies, without domino effects through credit default swaps and without an explosion of bond yields in the euro zone's other ailing economies.

But when will that moment be reached if not now?

As previously discussed on this blog, the Japan model for handling a solvency crisis is to buy time. Time which in theory the banks use to generate earnings so they can recognize the losses hidden on and off their balance sheet.

Unfortunately, buying time is expensive.

Since last autumn, the European Central Bank has been showering banks with liquidity. Spain and Italy, the two wobbling giants of the euro zone, have new government leaders who have made credible pledges to reduce debt. Most of the other EU states are similarly committed to budget discipline through the EU's fiscal compact. And the problem with the credit default swaps isn't as serious as the banking lobby keeps claiming.

If the European politicians have a shred of faith in all the work they've done in the two years since the breakout of the euro crisis, they should now admit what everyone already knows: Greece is bankrupt and all the country's debts should be forgiven.

This is the problem with the Japan model for handling a solvency crisis: there is no easy way out as the same politicians and regulators who made the decision to buy time in the first place are now required to make a different decision.

Compounding the problem is the simple fact that the cost of buying time exponentially increases the cost of the initial insolvency.

Ultimately, the only way out is to adopt the Swedish model and force the banks to recognize the losses in the financial system.

Greece should nevertheless get the €130 billion. But the money should be paid in another form. Instead of rewarding financial speculators for their high-risk deals, the money should flow into the reconstruction of the Greek economy. A new Marshall Plan is needed, rather than a manic insistence on debt repayments.

Do Greek banks need to be recapitalized?

2012-02-20T19:06:00.001-05:00

As Eurozone policy makers try to figure out how to make the second rescue of Greece work, one of the main sticking points to emerge is how much funding is needed to recapitalize the Greek banks.

Is the figure 30 billion euros? 50 billion euros? More?

Regular readers know that the answer is zero funds are needed to recapitalize the Greek banks today.

Policy makers should not inject any funds into the Greek banking system today. Rather, they should use the EFSF and the ESM to guarantee the deposits in the Greek banks. By guaranteeing the deposits, they end the risk of a run on the Greek banking system.

In addition, Eurozone policy makers should require that the Greek banks provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details. With this information, market participants can assess the risk of the banks.

Finally, the Greek banks should be required to retain future earnings to rebuild their book capital until they are in compliance with the Basel III capital requirements. By having the banks provide ultra transparency, market participants can exert discipline to ensure that the management of the Greek banks do not gamble on redemption.

Big banks in EU rush for safety

2012-02-20T17:26:00.000-05:00

The Wall Street Journal ran an article discussing how the largest banks in the Eurozone are depositing record amounts of funds with the global central banks. The article theorizes that this is being done for liquidity purposes.

Regular readers know this is not being done for liquidity purposes but rather because the interbank lending market is frozen.

The interbank lending market froze because none of these banks can evaluate the solvency of any of the other banks. In addition, each bank knows that it is hiding losses on and off its balance sheet, so it wonders just how big are the losses that the other banks are hiding.

Top European banks, responding to new regulations and wary of lending, are stashing increasingly large sums of money at central banks around the world in a collective flight to safety.

The eight giant European banks that have disclosed their annual results in recent weeks reported holding a total of about $816 billion in cash and deposits at central banks as of Dec. 31, according to calculations by The Wall Street Journal. That is up 50% from a year earlier, when the same banks were holding roughly $543 billion.

The stockpiling, which occurred over the course of last year, represented a collective response to the growing pressures on the European financial system.

By storing funds at central banks in Europe, the U.S. and elsewhere, banks ensure that their money is safe. And they appease nervous regulators who want to guarantee that banks will have easy access to funds in a pinch.

But the strategy has a downside. Banks are depositing money at central banks instead of lending it to individuals, businesses or governments, which has the potential to exacerbate a Europewide lending drought. In addition, central banks pay paltry interest rates on the deposits, squeezing bank profits.

Hard-hit French banks were at the vanguard of the trend. Last year, Société Générale SA more than tripled the amount of money it was placing at central banks world-wide, to €44 billion ($57.8 billion). BNP Paribas SA's central-bank deposits soared 74% to €58 billion. More than half of BNP's deposits are parked at the Federal Reserve, with the remainder at the European Central Bank, the Bank of Japan and other central banks.

"We have faced a huge crisis in the second half of last year. And so we reacted as fast as possible in order to be on the safe side," BNP Chief Executive Jean-Laurent Bonnafe said last week.

In addition to BNP and Société Générale, the six other banks included in the tally are Spain's Banco Santander SA andBanco Bilbao Vizcaya Argentaria SA; Switzerland's UBS AG and Credit Suisse Group AG; Germany's Deutsche Bank AG; and the U.K.'s Barclays PLC. Each reported holding more cash and central-bank deposits at the end of 2011 than a year earlier....

"It's a symptom of where the markets are right now and how people feel safer putting their money at central banks," said an official at a top Spanish bank....

Some European banks acted at the behest of individual regulators. Spain's Santander—which increased the amount it deposited at central banks to €97 billion at the end of December, up 58% from June 2010—said the rise was partly due to tougher liquidity rules in the U.K. and Brazil, where it has major operations....

It is unclear whether the deposit levels will remain elevated for the foreseeable future. Some bank executives say it is likely a long-term phenomenon as banks adapt to new regulations.

Others say banks might find better uses for the funds once market conditions improve.

"There is no need to keep such a huge buffer once things would stabilize and calm down," said BNP's Mr. Bonnafe. "So this is something we are going to manage in order to try and optimize between security and cost."

David Paul: The world of finance is indeed a rigged game

2012-02-20T17:07:00.000-05:00

David Paul wrote an interesting Huffington Post column in which he observed that 'the world of finance is indeed a rigged game' and since the beginning of the financial crisis the banks have been able to fend off all efforts to control them.

This is the direct result of global policy makers and regulators adopting the Japan model (banks only recognize their losses as they generate the income to absorb them) for dealing with the financial crisis.

It is virtually impossible on the one hand to provide cover for the banks so that they can hide their losses on and off their balance sheet and on the other hand to exert any discipline over these same banks.

The world of finance is indeed a rigged game. As the world of finance came crashing down four years ago, aggregate losses on Wall Street and in the banking sector totaled in the trillions, exceeding the combined profitability of the industry over the previous century.

That the Fed made over $7 trillion available to restore our financial system, as tabulated by Bloomberg, was only made more obscene by the fact that billions were restored to the balance sheets of our banks -- including Goldman and Morgan Stanley who essentially became banks just so they could benefit from Fed largesse -- filtered through a risk-free carry trade from which massive bonuses were deducted before flowing to bank capital accounts.

Americans are not stupid. They know a rigged game when they see it. But if the past four years have proven nothing else, it is that the tightly interwoven relationship between Washington and Wall Street has survived the collapse as strong as ever.

From the outset of the crisis -- when within weeks of the first passage of the $700 billion TARP program banks succeeded in stonewalling the sale of toxic assets because they didn't like the proposed pricing and succeeded instead in getting the public dollars for free -- the major banks have succeeded at almost every turn in defending their interests.

Four years later, the industry is more concentrated than ever, trillions of dollars of derivatives trading remains opaque and the industry culture of privatized profits and socialized risk has been codified into law.

Like the Cioffi-Tannin case, last week's "settlement" with mortgage brokers, whose patent fraud contributed to the housing bubble and ensuing collapse, was embarrassing -- whether one believes it was supposed to constitute compensation for damages, restitution for conduct, or deterrence against future abuse. That settlement, approved by 49 participating states' attorneys general, was one more example of a resurgent finance industry that has walked away largely unscathed from the havoc it wrought.

Late last year, another U.S. District Judge, Jed Rakoff, stood up for the dignity of society -- someone had to -- when he rejected a Securities and Exchange Commission settlement with Citigroup.

It was one of those many cases floating around these days where one of our leading banks sold bundles of mortgage-backed securities to investors, while secretly betting against those same securities. Rakoff rejected the proposed settlement as "pocket change," and "neither fair, nor reasonable, nor adequate, nor in the public interest." But the real source of Rakoff's wrath, like Block's this week, was that the Citi settlement included no admission of wrongdoing.

And so the game goes on. No one admits to any wrongdoing, and four years later almost nothing has changed....

This week, our finance industry is on the attack again.

The industry target now is the Volcker rule -- the proposed rule that would limit the ability of banks to trade for their own account. Leading the attack has been JPMorgan CEO Jamie Dimon, who has turned to thinly veiled derision of Paul Volcker, as Dimon continues to make the case for scale and opacity in banking....

As regular readers know, the leading casualty of adopting the Japan model and facilitating banks hiding their losses on and off their balance sheet is transparency.

It is transparency that ends the tightly interwoven relationship between Wall Street and Washington.

When banks are required to provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details, market participants know exactly what the banks are hiding. More importantly, market participants can assess the risk that the banks are taking either in their lending or capital market business and adjust the amount and price of their exposure to each bank to reflect this risk.

Concentration and risk in the banking system has grown steadily since Clinton-era deregulation, and only increased since 2008. Today, the four largest U.S. banks hold over 50 percent of the assets of the banking system and the four banks most active in the largely unregulated and opaque derivatives market hold 94 percent of the $250 trillion volume of financial derivatives in the U.S. banking system.

Dimon is taking on Volcker because he can. A towering figure in the finance world, Volcker's support brought great credibility to Barack Obama as a candidate. But since Obama took office, Volcker has been marginalized, and replaced by advisors more closely aligned with the banking industry.

Since the financial collapse, the industry has won nearly every round as it has sought to protect its privileges and power.

While many might complain about the dizzying complexity of Dodd-Frank legislation, the truth is that the industry beat back the most substantive restrictions on derivatives trading as well as any constraints on size or leverage.

The industry beat back all attempts at valuation transparency.

Valuation transparency is disclosure that provides market participants with all the useful, relevant information that they need in an appropriate, timely manner so they can independently value a security. This independent valuation is used to compare against the price shown by Wall Street to make buy, hold and sell investment management decisions.

One area where the banks beat back valuation transparency was structured finance. Here we had opaque toxic securities that blew up the global financial system and government could not bring itself to require these securities to provide valuation transparency by disclosing observable event based reporting for the underlying collateral.

If it can minimize the effect of the Volcker rule, the industry will have protected the two greatest sources of profitability for the big banks -- derivatives and proprietary trading -- despite those being the greatest sources of risk to the public and the farthest away from the public purpose of the banking system.

This Friday, in an assault on the Volcker rule that might on the surface seem to have been in support of Dimon, the Wall Street Journal editorial board ... rightly argued that Dodd-Frank promotes the illusion that an increasingly complex regulatory apparatus can prevent systemic failure.

It is simply not reasonable to imagine that regulators can begin to track and monitor, much less regulate, the complex risks embedded on bank balance sheets -- hidden away in collateral rules, language arbitrage and collateral valuation.

This is why banks must provide ultra transparency.

As the Bank of England's Andrew Haldane observed, regulators are not up to the task of assessing the detailed exposure data.

Fortunately, there are a number of market participants who are capable of turning the data disclosed under ultra transparency into useful information. The list of market participants includes competitors and experts.

Iceland shows that forcing banks to take losses works to end financial crisis

2012-02-20T09:58:00.000-05:00

For the last several days, your humble blogger has been writing a number of posts on the Japan model and the Swedish model for handling a financial crisis.

Under the Japan model, governments do everything they can to protect the meaningless bank book capital values. This includes allowing the banks to recognize losses as banks generate earnings to absorb the losses, shielding the banks from market discipline by providing an implied guarantee when regulators proclaim that stress tests show the banks are solvent, and adopting zero interest rate policies.

The Japan model puts the interest of the banks ahead of the interests of society.

Under the Swedish model, governments require the banks to recognize the losses on the excesses in the financial system today. Banks then rebuild their book capital through future retained earnings and equity issuance.

The Swedish model puts the interests of society ahead of the interests of the banks.

Today, I would like to focus on two interesting data points. First, Japan has been following the Japan model for 2+ decades since its credit bubble burst with no end in sight. Second, Iceland has been following the Swedish model for 3 years since its credit bubble burst, the financial crisis is effectively over and it has returned to investment grade.

Which model appears to work better: bend over for the bankers or kick them in the backside?

So why exactly has the US, UK and Eurozone chosen the Japan model?

Bloomberg ran an article on Iceland and the victory of the Swedish model for handling financial crisis.

Icelanders who pelted parliament with rocks in 2009 demanding their leaders and bankers answer for the country’s economic and financial collapse are reaping the benefits of their anger.

Since the end of 2008, the island’s banks have forgiven loans equivalent to 13 percent of gross domestic product, easing the debt burdens of more than a quarter of the population, according to a report published this month by the Icelandic Financial Services Association.

“You could safely say that Iceland holds the world record in household debt relief,” said Lars Christensen, chief emerging markets economist at Danske Bank A/S in Copenhagen. “Iceland followed the textbook example of what is required in a crisis. Any economist would agree with that.”...

“The lesson to be learned from Iceland’s crisis is that if other countries think it’s necessary to write down debts, they should look at how successful the 110 percent agreement was here,” said Thorolfur Matthiasson, an economics professor at theUniversity of Iceland in Reykjavik, in an interview. “It’s the broadest agreement that’s been undertaken.”

Without the relief, homeowners would have buckled under the weight of their loans after the ratio of debt to incomes surged to 240 percent in 2008, Matthiasson said....

Iceland’s approach to dealing with the meltdown has put the needs of its population ahead of the markets at every turn.

An observation that your humble blogger has made a number of times.

Once it became clear back in October 2008 that the island’s banks were beyond saving, the government stepped in, ring-fenced the domestic accounts, and left international creditors in the lurch. The central bank imposed capital controls to halt the ensuing sell-off of the krona and new state-controlled banks were created from the remnants of the lenders that failed.

Activists say the banks should go even further in their debt relief. Andrea J. Olafsdottir, chairman of the Icelandic Homes Coalition, said she doubts the numbers provided by the banks are reliable.

“There are indications that some of the financial institutions in question haven’t lost a penny with the measures that they’ve undertaken,” she said.

According to Kristjan Kristjansson, a spokesman for Landsbankinn hf, the amount written off by the banks is probably larger than the 196.4 billion kronur ($1.6 billion) that the Financial Services Association estimates, since that figure only includes debt relief required by the courts or the government.

“There are still a lot of people facing difficulties; at the same time there are a lot of people doing fine,” Kristjansson said. “It’s nearly impossible to say when enough is enough; alongside every measure that is taken, there are fresh demands for further action.”...

According to Christensen at Danske Bank, “the bottom line is that if households are insolvent, then the banks just have to go along with it, regardless of the interests of the banks.”

Andy Haldane's regulatory reform litmus test: would it be used to wage a financial crisis war

2012-02-19T17:52:00.000-05:00

In a Telegraph article about bail-in bonds (a form of contingent convertible debt that absorbs losses after shareholders are wiped out), the Bank of England's Andy Haldane lays out the litmus test for all financial regulatory reform.

Having debtors assume pain is fine on paper. But crisis wars are not waged on paper.

Debt instruments which had bail-in style properties in the 2008 meltdown were not triggered, he pointed out, "because [bank management] feared scaring creditors and making a bad situation worse".

Policy by regulators has been no different, he said, adding: "Pre-crisis, deposit and liquidity insurance were enshrined in a well-defined regime. But in the teeth of crisis, these regimes were abandoned."

His litmus test for any regulatory reform is not does it look fine on paper, but rather would regulators actually use it to fight a financial crisis.

What a great litmus test! [Full disclosure, your humble blogger happens to think very highly of Mr. Haldane and his work.]

To see how this litmus test works, let's apply it to bank capital. The theory behind bank capital is that it is there to absorb losses.

As a result, a significant amount of regulatory time and energy since the beginning of the solvency crisis has gone into crafting the Basel III capital rules including the requirement that systemically important financial institutions carry an additional capital buffer.

As Mr. Haldane would say, all of that is fine on paper. The litmus test is would financial regulators actually use bank capital to fight a financial crisis.

Unfortunately, history shows that just like the well-defined pre-crisis deposit and liquidity insurance regime, using bank capital to absorb losses was also abandoned in the teeth of the crisis.

Bank capital is not the only area where regulatory reform fails Mr. Haldane's litmus test. I invite readers to comment on additional reforms, virtually all of the Dodd-Frank Act is fair game, that look fine on paper, but will do nothing to help in the battle against the next financial crisis.

Does the Japanese model work for Greece, Portugal, Spain and Italy

2012-02-19T16:44:00.000-05:00

[Please forgive the following. I thought you might find it interesting as your humble blogger wrestles with the implications of the Japan and Swedish models of dealing with a bank solvency crisis.]

As Iceland basks in the glow of returning to investment grade status in three years as a result of adopting the Swedish model for dealing with bank solvency, it raises the question of whether continuing to pursue the Japanese model will work for Greece, Portugal, Spain and Italy.

The Japanese model is built around recognizing losses on the excesses in the financial system only as quickly as banks are able to generate the earnings to absorb them (ie, meaningless bank book capital is preserved at all costs).

So the question is, can Greece, Portugal, Spain and Italy continue to delay loss recognition?

To answer this question, we have to look at those countries which have adopted the Japanese model - Japan, the US and the UK - and achieved a degree of financial stability. How have they managed to achieve this degree of financial stability?

Each has a fiscal authority that issues unlimited quantities of debt that is purchased by both its captive central bank and its banking system.

This is a very important point. There is no limit to how much debt these countries can issue because there is a captive market for the debt. These countries' policy makers talk about capitalism, but when it comes to issuing debt they prefer a 'captive' market.

Please note, this is done at great cost to the real economy of these countries. Look at where Japan's economy is now versus 15 years ago ... it has shrunk!

A shrinking real economy is not surprising because the central banks pursue a policy to minimize the cost of debt to the fiscal authorities. A casualty of this interest rate policy is consumer demand, consumers save more to offset the lost earnings on their savings, and business investment, without growing demand for their products, business don't invest.

I made the point that these countries have achieved a degree of financial stability. Rather than have a brief, but intense decline in the economy as the banks absorb the losses on the financial excesses as they would under the Swedish model, these countries have adopted the Japan model and locked in permanent long term decline.

How long is the long term? Despite its aging population, I don't see any reason that Japan's economy cannot continue to gradually decline for the foreseeable future.

There is a degree of stability in this decline in that the government can prevent any precipitous economic decline because it can keep borrowing from the central bank and the banking system and keep spending. An inconvenient fact that delays the investment returns for the hedge fund managers that are shorting Japan.

I can hear an objection already: the economies in the US and UK are growing. This too happened in Japan for the first few years after the credit bubble burst and zero interest rate policies were adopted.

The decline really set in as consumers and businesses came to realize that there is no easy exit from the Japan model. If there were an easy exit, you would have thought the Japan would have done so.

Economists talk about growth in income as the solution to repay the debt taken on during the credit bubble. Why did this not work for Japan as Japan was unable to tap into the significant global growth in income that occurred after its credit bubble burst and exit from the Japan model?

The problem that Greece, Portugal, Spain and Italy face is that while they have a fiscal authority and a banking system, they do not have a captive central bank.

As a result, it appears that they have a limited to how much sovereign debt they can issue.

Given that having unlimited ability to issue sovereign debt is a necessary condition for the Japan model to prevent losses from being recognized faster than the banking system can generate earnings, it appears these countries will have to abandon the Japan model sooner or later.

When they abandon the Japan model with its delayed recognition of losses, they will end up with the Swedish model and recognizing all the losses in the financial system today. This promises to be ugly simply because the total size of the losses was increased by delaying their recognition.

Irish banks tell troubled borrowers to cut health care insurance

2012-02-19T13:04:00.000-05:00

The Independent carried an article in which it described how Irish banks are telling troubled borrowers to cut their health care insurance.

The fact that banks which were bailed out by the government feel they have the right to make this request of borrowers demonstrates the banks do not expect any meaningful consequences from their bad behavior.

Your humble blogger refers to the bank behavior as bad because there are very well known rules of thumb for what is the maximum percentage of a family's budget that should go to housing while allowing them to maintain a reasonable standard of living.

In the US, the maximum housing expenditure percentage adopted by the Obama Administration is 31% of gross income before tax. There is no reason that a similar maximum percentage does not exist in Ireland.

Once everyone knows what the maximum housing percentage is, a level the Irish government should set if it hasn't already, there is no reason to discuss how the borrower spends the rest of their money.

Banks are behaving badly, when they try to get the borrower to cut back on their spending above the maximum percentage and requiring the borrower to hand over this money to the bank.

BANKS are telling thousands of families struggling to restructure mortgages they will have to cut back on health insurance, private education, groceries and Sky Sports before any deal can be done.

Around 1,300 families a month are now getting their mortgage payments reduced -- with the Government admitting last night that more were likely following yesterday's revelation that one in seven homeloans is in trouble.

The banks have been accused of putting the boot into homeowners who are unable to meet their existing mortgage repayments.

An Irish Independent investigation can reveal how banks will only agree to change the existing conditions if homeowners:
- Shop in discount stores like Aldi or Lidl instead of local shops or supermarket chains seen as more expensive.
- Change health insurance provider or drop down to a cheaper plan.
- Cut out extra sports or movie packages from their satellite or cable television services.
- Secure a reduction in other loan repayments before coming to the bank for help.
- Take children out of private, fee-paying schools....

Homeowners seeking to modify their mortgage repayments must fill out a 12-page financial statement.

This lists all household spending and income, providing the bank with bank and credit card statements going back three months, according to financial consultant Michael Dowling, who is a member of the Independent Mortgage Advisers Federation.

The form details spending on everything from phone bills, fuel and groceries, to gym memberships, salons and sports events.

Mr Dowling, who helps households secure a deal from their banks, said pressure from lenders on homeowners in south Dublin to take children out of private schools was leading to bitter arguments.

“People get very vocal when they are told to take their children out of a fee-paying school and send them to one that does not charge fees,” he said. Demands from banks that people change health insurer or drop down to a cheaper plan were also leading to huge rows, he said.

David Hall of New Beginning, a group of lawyers who represent mortgage holders in danger of having their homes repossessed, said lenders were challenging households paying for Sky Sports or UPC movie packages, telling them to change to basic TV packages. “Banks should not be telling people how to live in the absence of long-term solutions for mortgage problems,” he added....

A spokesman for the Irish Banking Federation said banks were trying to be as fair as possible.

He said that some people were willing to compromise on certain items of expenditure while others were not.

“Each situation is dealt with on a case-by-case basis. It is about working out what people can afford to pay on their mortgage and what they need to maintain a reasonable standard of living.”

Germany pushing for Greece to default raises question of who is holding losses

2012-02-18T22:31:00.000-05:00

In a Telegraph article by Bruno Waterfield, he discusses how Germany is pushing for Greece to default. This of course raises the interesting question of who is holding onto the losses on the Greek debt and related CDS (credit default swaps).

The answer to who is holding the losses is that nobody knows.

By pushing for Greece to default, Germany is betting on market participants having adjusted their exposure to Greece bonds and CDS over the last two years to what they can afford to lose.

The fact that nobody knows if market participants did adjust their exposure means that pushing for Greece to default is gambling with financial stability. There is some chance that some unexpected market participant is over exposed and this could trigger systemic problems.

Regular readers know that if there were ultra transparency, all market participants would know who was holding the losses. As a result, there would be less chance of an unexpected surprise from a Greek default.

The German finance ministry is actively pushing for Greece to declare itself bankrupt and to agree a "haircut" on the bulk of its debts held by banks, a move that would be classed as a default by financial markets.

Eurozone finance ministers meet on Monday to approve the next tranche of loans from the EU and the International Monetary Fund, designed to stave off national bankruptcy while the new Greek government puts the country's finances in order.

But the severe austerity measures being demanded have caused such fury in Greece, and the cuts required are so deep, that Wolfgang Schäuble, the German finance minister, does not believe that any government would be able to implement them....

"He just thinks the Greeks cannot do what needs to be done. And even if by some miracle they did what has been promised, he - and a growing group - are convinced it will not pull Greece out the hole," said a eurozone official.

"The idea instead is that the Greek government should officially declare itself bankrupt and begin negotiating an even bigger cut with its creditors. For Schäuble, it is more a question of when, not if." ...

With Greek morale at rock bottom, the national mood darkened yet further after armed thieves looted a museum on Friday in Olympia, birthplace of the Olympic Games, and stole bronze and pottery artefacts - just weeks after the country's National Gallery was burgled.

One Greek newspaper suggested the state could no longer properly look after the nation's immense cultural heritage. "The Greek state has gone bankrupt, let's face it," the conservative daily Kathimerini said in an editorial.

"If the state cannot guard the country's great cultural heritage for financial or other reasons it must find other ways to do it."...

Mr Schäuble's pessimism .... is not yet fully shared by Angela Merkel, who is said still to be determined to prevent Greece's financial collapse. "She thinks Greece going bust could cause a shock wave that buries other countries - with Spain and Italy among them. It could break apart the entire monetary union," said an official.

But it has support from Austria and Finland - holding the prospect that a eurozone meeting tomorrow will fail to agree the next set of EU-IMF payments for Greece....

Rumours are already circulating in Wall Street that banks are preparing for a "credit event" - a technical term used by credit agencies to mean a default - in the days immediately following March 20, as Greece looks likely to be unable to meet its debts....

Mr Schäuble maintains that since Greece is already regarded by the financial world as bankrupt, a formal bankruptcy would have no negative consequences for other euro members.

Ultra transparency and Citigroup's mortgage origination practices

2012-02-18T11:42:00.000-05:00

A Bloomberg article on Citigroup's settlement of a whistle-blower suit over its mortgage origination practices highlighted its broken mortgage processing system.

As regular readers know, with ultra transparency the current performance of the Citigroup originated mortgages is easy to monitor and compare against other mortgage originators.

This allows market participants to perform two simple analysis to identify a broken mortgage processing system.

If the percentage of mortgages originated that subsequently become delinquent is excessive relative to the representation of the quality of the mortgage at the time of origination; and

If the percentage of mortgages originated that subsequently become delinquent is excessive relative to peer group performance.

More importantly, as a result of this analysis, market participants will exert discipline by paying less for Citigroup's mortgages knowing that they are riskier than they are represented.

Four years after rotten mortgages helped trigger a global financial crisis, Sherry Hunt said her Citigroup Inc. quality-control team was still finding flaws in new loans that included altered tax forms, straw buyers and borrowers who listed fictitious employers.

Instead of reporting the defects to the Federal Housing Administration, the bank saddled the agency with losses by falsely declaring the loans fit for its federal insurance program, according to a complaint filed yesterday by the U.S. Attorney’s Office in Manhattan. Citigroup agreed to pay $158.3 million to settle the claims, and admitted that it certified loans for FHA backing that didn’t qualify.

Iceland confirms that Swedish model for bank solvency crisis works

2012-02-17T14:37:00.000-05:00

According to a Guardian article, Fitch has raised the credit rating on Iceland so that it is now investment grade again. The rating agency sees Iceland as relatively unaffected by the European sovereign debt crisis and unlikely to slip back into recession.

As regular readers know, Iceland adopted the Swedish model for dealing with a bank solvency crisis. Specifically, Iceland forced its banks to recognizes the losses on the financial excesses.

As a result, the real economy has been able to recover to such an extent that Iceland has become investment grade again.