JP Morgan report on trading losses offers illusion of transparency

In his Bloomberg column, Jonathan Weil examines many of the ways that the JP Morgan report on it CDS trading losses overs the illusion of transparency while firmly protecting the veil of opacity that surrounds the bank.

For example,

Another example: During an April 13 call with analysts, about a month before JPMorgan began acknowledging the magnitude of its losses, Douglas Braunstein, JPMorgan’s since-demoted chief financial officer, said “those positions are fully transparent to the regulators” and that the bank’s regulators “get the information on those positions on a regular and recurring basis as part of our normalized reporting.” ...

True, the positions are fully transparent to the regulators and to no one else in the market.

However, it is not the regulators' job to value the positions or to approve JP Morgan's valuation of the positions.

It is the role of JP Morgan's accounting firm to agree or disagree with how JP Morgan values its positions as this valuation directly effects the question of "does JP Morgan's financial statements provide an accurate picture of its financial condition".

The report also included this bizarre disclaimer: “This report sets out the facts that the task force believes are most relevant to understanding the causes of the losses. It reflects the task force’s view of the facts. Others (including regulators conducting their own investigations) may have a different view of the facts, or may focus on facts not described in this report, and may also draw different conclusions regarding the facts and issues.” In other words, we haven’t been told the whole story. 

You have to like Mr. Weil's summary of JP Morgan's disclaimer about exactly what is in the report.

Sure, there were colorful anecdotes, like this: “April 10 was the first trading day in London after the ‘London Whale’ articles were published. When U.S. markets opened (i.e., towards the middle of the London trading day), one of the traders informed another that he was estimating a loss of approximately $700 million for the day. The latter reported this information to a more senior team member, who became angry and accused the third trader of undermining his credibility at JPMorgan. 

“At 7:02 p.m. GMT on April 10, the trader with responsibility for the P&L Predict circulated a P&L Predict indicating a $5 million loss for the day; according to one of the traders, the trader who circulated this P&L Predict did so at the direction of another trader. 

After a confrontation between the other two traders, the same trader sent an updated P&L Predict at 8:30 p.m. GMT the same day, this time showing an estimated loss of approximately $400 million. He explained to one of the other traders that the market had improved and that the $400 million figure was an accurate reflection.” 

Who were those masked traders? How could JPMorgan employees be so willing to manipulate their numbers to achieve an outcome at odds with the facts? And how does a day’s loss go from $5 million to $400 million? Nothing is very clear, which seems to have been by design.

Mr. Weil has just highlighted why banks must be required to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

Among its many benefits, ultra transparency ends banks manipulating their valuation numbers.

Update
In its usual concise style, ZeroHedge nails how the JP Morgan report highlights the problem with opaque banks as the loss at JP Morgan goes from $5 million to $700 million and back to $400 million.

And this is the opacity that one gets when a firm sets off to expose what should otherwise be perfectly public information in the first place. 

One does start to wonder: if America's banks go to such great lengths to mask how ugly the behind the scenes truth really is, is thetrue undercapitalization of the US banking sector in the trillions... Or tens of trillions?

Does Pandit's departure signify that Citigroup has cleaned up the 'casino' portion of the bank?

With the abrupt resignation of Vikram Pandit and John Havens, the top two officials at Citigroup, everyone is asking what this means.

My question is does this signify that Citigroup has cleaned up the 'casino' portion of the bank or is the Board of Directors so fed up with the lack of progress that it dumped these officials?

Unlike Sheila Bair who had concerns over Pandit's lack of commercial banking experience, I thought that someone with Pandit's experience in 'casino banking' was appropriate if he was serious about cleaning up the casino portion of the bank.

We will never know if he cleaned up the casino because Citigroup never embraced ultra transparency and the disclosure on an ongoing basis of its current global asset, liability and off-balance sheet exposure details to show that he did.

Ed Milibrand shows how the Blob huffs and puffs and does nothing to reform banks

As reported by the Guardian, UK Labour leader Ed Milibrand says he would push through the modern day equivalent of Glass-Steagall and separate the 'casino' operations from the retail operations.

"Either they can do it themselves – which frankly is not what has happened over the past year – or the next Labour government will, by law, break up retail and investment banks. 

"The banks and the government can change direction and say they are going to implement the spirit and principle of Vickers to the full. That means the hard ringfence between retail and investment banking. We need real separation, real culture change. Or we will legislate."

Mr. Milibrand said he was sincere about pursuing this policy.

Critics of such a policy argue it would lead the banks to abandon the UK as their base. 

The Labour leader told BBC1's Andrew Marr show he did not believe that would happen but said that, if it did, he was ready to face them down. 

"I think what the British people want is a prime minister that will do the right thing for the country," he said. "Do you want somebody who will stand up to the powerful vested interests in our country or not? 

This whole position would be great except for one small problem:  ring-fencing is a solution endorsed by the Blob (aka, financial regulators, bankers and their lobbyists).

No less an authority than Paul Volcker has already said that it will not work in a time of financial crisis.

Regular readers know that ring-fencing is simply another way of substituting complex regulations and regulatory oversight for transparency and market discipline.

Without requiring both 'casino' and retail banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details, how can any market participant independently assess how much risk is being taken?

Ring-fencing doesn't help in the assessment of risk and ultimately, as Mr. Volcker observed, breaks down at a time of crisis.

The one area where ring-fencing is helpful is drawing attention away from the fact that ultra transparency is needed to truly reform banks.

JP Morgan's trading loss highlights need for disclosure

Bloomberg reports on how JP Morgan's silence about its trading loss and risk models has brought even more attention to the inadequacy of its disclosures.

Regular readers know that if JP Morgan were required to provide ultra transparency and disclose its current asset, liability and off-balance sheet exposure details, then market participants could independently assess and model its risk.

JPMorgan Chase & Co. (JPM)’s multibillion- dollar trading loss exposed an industry practice that U.S. regulators are now likely to clamp down on: Banks keep investors in the dark about how they calculate trading risks.

The U.S. Securities and Exchange Commission is probing JPMorgan’s belated May 10 disclosure that a change to its mathematical model for gauging trading risk helped fuel the loss in its chief investment office. 

While the SEC would have to prove that the biggest U.S. bank improperly kept important information from investors, regulators probably will press Wall Street firms to tell more about the risks they’re taking, three former SEC lawyers said....

JP Morgan did keep important information from the investors.  The important information was the actual trades.  Without the exposure details, investors could not possibly assess the risk of JP Morgan.

JP Morgan's trading models are just like the management commentary at the beginning of an annual report.  Designed to show that everything is wonderful.

The only important information is the actual trades.  With this information, market participants can use their own models to assess the risk.

“It was exceedingly difficult for third-party analysts to diagnose the magnitude of JPMorgan’s CIO hedging portfolio risk buildup based on bank-provided disclosures,” David Hendler, an analyst at CreditSights Inc., wrote in a June 18 report. Only “on-the-ground” hedge funds trading credit derivatives could discern the buildup, he wrote.

Confirmation that it is only the actual trades that are important information.

Banks typically disclose only changes to the broadest parameters of their risk models. In 2008, for example, JPMorgan switched its VaR formula to use the 95 percent “confidence level” from 99 percent, according to the bank’s annual report for that year. The move, which reduced the bank’s year-end VaR to $286 million from $317 million, was intended to “provide a more stable measure,” the bank said.

And confirms that trading models are just another form of opacity.  A bank would rather disclose the result of its trading models than the positions it is actually taking.

If the position loses a lot of money like JP Morgan's did, oops, the model was wrong.  The bank promises to fix the model and continues taking proprietary bets.

With actual trades disclosed, the opacity of the models goes away and everyone can see what the bank is actually doing.

A review of the Bank of England's Financial Policy Committee performance after one year

Regular readers know that your humble blogger was not optimistic about the contribution that the Bank of England's Financial Policy Committee would make to promoting financial stability and, as a result, set the bar for success at "do no damage".

The reason for this low standard is the composition of the membership of the FPC.  It is long individuals with a PhD in Economics.

In addition, there is no one on the FPC who publicly predicted our current financial crisis.  I felt this might be a problem because in the absence of anyone who understood why the financial crisis occurred it was highly unlikely the FPC had the expertise to do anything to moderate the current crisis or prevent the next crisis.

Recall that the Queen also predicted that this was a problem when she asked the economic profession why it hadn't seen the current crisis coming.  The very question suggests that perhaps by training economists are very poorly suited for understanding the financial system and what might cause a crisis.

At its one year anniversary, I am sadden to report that the FPC could not get over the 'do no harm' standard.

Here is the performance of the FPC as described by external board member Robert Jenkins in a Telegraph column.

The financial policy committee of the Bank of England is now one year old. Its purpose is to identify and, where possible, mitigate threats to the British financial system. Financial stability is the goal.

Over the past 12 months, systemic fragility and troubles in the eurozone have been the key threats. 

Restoring confidence in the British banking system has been the priority.

Given this priority, has the FPC done the only thing that restores confidence in a financial system and called for banks to provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details?  No.

Regular readers know that transparency restores confidence as it allows market participants to independently assess each bank.  Confidence is restored because market participants trust their own analysis (whether they do it themselves or they hire a third party to do it for them).

That banks should build balance sheet strength has been the primary recommendation and today the country's banking system is among the better capitalised and funded.

However, as everyone except the economists and other members of the FPC knows, bank capital is meaningless.  This is not just your humble blogger's opinion, but an opinion expressed by the OECD.

The reasons why bank capital is meaningless are extremely well known.

First, we have suspended mark-to-market accounting.  As a result, all those opaque, toxic securities and government bonds that still reside on and off the bank balance sheets have not been properly marked-to-market.  This results in an overstatement of bank book capital levels.

Second, bank regulators have engaged in regulatory forbearance that has allowed the banks to keep zombie borrowers alive using 'extend and pretend'.  Again, the banks have not taken losses and this too results in an overstatement of bank book capital levels.

So the primary recommendation for restoring confidence was to focus on a meaningless number as oppose to requiring the banks to provide ultra transparency and actually restore confidence.

Unfortunately, the primary recommendation to boost bank book capital also carried with it a well known and fully predictable  toxic side effect for the real economy:  a financial regulator induced credit crunch.

Since no investor is dumb enough to buy newly issued capital in a bank with large, undisclosed losses, to reach the higher capital ratios the FPC endorsed, banks had to shrink their balance sheets.  The number one place to shrink a bank balance sheet and get the most bang for the activity is by reducing loans.

The toxic side effect of the FPC's primary recommendation was to support a financial regulator induced credit crunch.  The FPC managed to take a situation where it was difficult for credit worthy borrowers to access bank credit and make it virtually impossible.  As a result, the real economy has been starved for credit to support it.  A clear violation of the "do no harm" standard.

Financial stability requires a healthy economy and a healthy economy requires financial stability.....

Is this true?

Couldn't we have financial stability in a recession (I would think a recession qualifies as a 'sick' economy)?

committee members have questioned whether there might be a trade-off between the strengthening of bank balance sheets on the one hand, and ensuring sufficient credit availability on the other.

In other words, was there a choice to be made between safer banks and a stronger economy? 

The discussion continues. To date, the following facts have informed the committee's recommendations: 

• Confidence must be maintained in our banks without which the banking system will cease to function. Loss of confidence in the banking system is the single biggest threat to lending. The strengthening of bank capital and liquidity has been critical to restoring confidence. 

Every part of the highlighted text is not a fact, but is rather something that only economists believe! (Of course. they are encouraged in this belief by bankers who tell them it is true as the bankers are looking to be paid their bonuses.)


It is a belief that results in the incredibly destructive policies adopted under the Japanese model for handling a bank solvency led financial crisis.


Regular readers know that under the Japanese model, bank book capital levels are protected at all costs.  This involves deception by the regulators and the adoption of policies like suspension of mark-to-market accounting and regulatory forbearance.


The result of these policies is that an accounting construct is held constant and the damage from excess debt in the financial system is forced onto the real economy.  This burden is more than the real economy can support and results in contraction of the real economy.


As your humble blogger has said many, many, many times, the combination of deposit insurance and access to central bank funding forever ended depositors' concerns about the book capital level or liquidity of a bank.  


(Let me give you two leading indicators of this simple fact.  First, to date, no economist I have asked what is the capital or liquidity level of the bank they have their checking account at as of the end of last quarter has known the answer to the question. Second, every economist I have asked that has helped a child open a banking account has answer the child's question of how do they know they will get their money back from the bank by saying the government guarantees the child will get their money back.)


Deposit insurance shifts the concern to the issue of can the government make good on its deposit guarantee.  If you live in Japan, the UK or the US, by definition the answer is yes because the government can always 'sell' bonds to the banks who can use these bonds as 'collateral' at their central banks to access funds that can be given to the depositor.


In the EU, until the politicians threatened to kick countries out and force them onto a new currency, depositors continued to believe that their governments would make good on their deposit guarantees.  By introducing re-denomination risk, the EU politicians have lowered the value of the deposit guarantee (you still get your 'money', it is just paid back in a currency worth significantly less than the euro).


What everyone, except the economics profession, learned during the Savings and Loan Crisis in the late 1980s is that bankers will continue to lend even when there is little confidence in the solvency of their institution.  Based on the commercial real estate boom that resulted from this lending, the link between 'solvency' and lending has been shown not to exist in the real world.


Our current crisis shows that bankers will also continue to gamble in the securities casino even when there is little confidence in the solvency of their institution.  In short, since bankers are compensated for gambling and lending they will continue these activities regardless of the solvency of their institution unless the financial regulators intervene with policies like higher capital ratios.

• The balance sheets of Britain's major banks total some £6 trillion. The aggregate of British lending to small and medium sized enterprises is below £200bn. The committee is concerned about that portion of SME lending which seeks and merits credit. It is also concerned about the loss-absorbing buffers needed to support the other £5.8 trillion. 

Leading up the financial crisis, the structured finance market was a significant source of funds for the SMEs.  The structured finance market is a fraction of its former size. This is a direct result of current disclosure practices that do not provide investors with the timely performance information on the underlying collateral that they need to know what they own.

Investors prefer not to blindly bet and instead are investing in asset classes that provide transparency.

To attract investors back to structured finance and reinvigorate SME lending will require that each security provide observable event based reporting.  Under observable event based reporting, every activity, like a payment or default, that occurs with the underlying collateral is reported to all market participants before the beginning of the next business day.

With current information, investors can know what they own and prospective buyers can independently assess the value of the security.

• There is a difference between capital levels and capital ratios. Higher capital levels absorb loss, inspire confidence and support lending. By contrast capital ratios can be "improved" by reducing lending without increasing capital. 

There is a difference between bank capital that is used to protect the real economy from the excesses in the financial system and bank book capital levels that are meaningless.

Bank book capital levels that are used to protect the real economy vary over time.  In times when there are excesses in the financial system, bank book capital levels decline dramatically as the losses on the excesses are absorb today.  If the losses are large enough, bank book capital levels can become negative.

Bank book capital levels that are meaningless tend to increase during a financial crisis.  This increase is a sure sign that the losses on the excesses in the financial system are being shifted onto the real economy and that there is a financial regulator induced credit crunch.

• Capital is not something locked away in the vault. An incremental pound of capital can fund an incremental pound of loans. And given current bank leverage, each £1 of additional capital can support £20 of additional small business lending – provided, of course, that the liquidity funding is available. Alternatively, some portion of incremental equity could support new lending with the remainder used to build buffers and reduce leverage. 

Of course, once again this focus on capital is irrelevant as it implies a link between lending and capital that does not exist.

What is well known to everyone except perhaps the FPC is that banks make loans when the opportunity arises and then look for how to fund the loans.

While many people think that structured finance was the original originate to distribute banking model, it wasn't.

For decades before structured finance became significant in size, banks would sell participations in their loans or the whole loans themselves to other banks, insurance companies and pension funds.  This was a classic way for smaller banks to diversify their loan portfolio by geography and industry.  It also resulted in matching loans to deposit funding already in the system.

• Allowing capital ratios to fall might lead to new real economy lending – but it might not. It might merely fuel intra-financial risk-taking with little positive impact on small business requests. 

• And even if lower ratios did lead to new business lending, to which businesses would the loans go: to a manufacturer in Manchester or a shoe factory in Shenzen?....

Of all the financial regulators, the FPC should know that it is not the job of regulators to approve or disapprove of individual positions taken by banks.  Doing so explicitly substitutes the regulators for the market in the allocation of capital.

Recently the Chancellor announced that the committee would add an economic growth objective to that of stability. 

How disappointing as it would have been far better for the UK and global financial stability if the Chancellor had put the FPC out of existence so that it could do no further harm to the real economy.

Bank of England warns UK banks need more capital

The Telegraph reports that the Bank of England's Financial Policy Committee would like to see banks increase both their book capital levels and their lending.

Sorry, but it is not going to happen.

What banker is dumb enough to make new loans given all of the zombie loans sitting on and off their balance sheet?

Sorry, but it is not going to happen.

What investor is going to invest in a bank given that bank reporting leaves bank's resembling a 'black box'?  A black box that everyone knows holds the zombie loans as well as government bonds and structured finance securities of little value.  In case that isn't enough, of course there is also the potential for losses on the tsunami of lawsuits related to Libor manipulation.

Sorry, but it is not going to happen.

Every banker knows that capital ratios are higher gambling with securities in the casino than making new loans.

Sorry, but it is not going to happen.

The UK government realizes that banks are not going to make loans they have to hold on their balance sheet and set aside capital for, so the UK government is putting up 80 billion pounds in a "Funding for Lending" program.

Britain's banks do not have enough capital to withstand an escalation in the eurozone crisis, the Bank of England has warned. 

Members of the Financial Policy Committee (FPC), the Bank’s risk regulator, “judged that the overall capitalisation of the banking system was unlikely to be sufficient for stability to be assured” if there were “severe but plausible” developments in the sovereign debt crisis, according to minutes of last month’s meeting.

Since the advent of deposit guarantees and access to central bank funding for liquidity, bank book capital levels have been simply an accounting construct.  Nobody, but regulators pursuing harmful policies, cares about them.

Everyone, except for PhDs in Economics, knows that book capital is there to protect the real economy from harm by absorbing the losses on the excesses in the financial system.

The committee was also sufficiently concerned about weak lending in the UK to consider suspending the rules governing how much banks must hold in cash and other liquid assets to get credit flowing again. The rules may have “pushed up the pricing of loans” and, by relaxing them, funds “supporting liquid assets could potentially be used instead to finance lending”, the minutes said.

Free at last, free at last, the bankers cried, free at last to increase our gambling in the casino!

Both issues were addressed in last week’s Financial Stability Report, when banks were told to continue building up their capital levels and liquidity regulations were relaxed slightly instead of suspended. 

Analysis of the report showed that easing the liquidity rules could release as much as £150bn for lending to small businesses and households.

Or multiples of this for speculative investments.

Banks had been hoping for the capital rules to be loosened as well, but the FPC decided the risks to financial stability and the economy were too great, even though UK lenders are “reasonably well placed” to meet new standards that begin coming into effect next year.

The same 9% Tier I capital ratios that the OECD called meaningless since policies were adopted to suspend mark to market accounting and regulatory forbearance was embraced so that banks could keep zombie borrowers alive with 'extend and pretend'?

“The committee was concerned that in especially severe, but plausible, adverse scenarios in the euro area some UK banks could face large losses,” the FPC said. Although “the position of individual institutions varied significantly”, the overall health of the banks was too weak and threatened “the supply of financial services to the economy”....

We have known since the Less Developed Country Loan Crisis in the mid-1980s and the Saving and Loan Crisis in the late 1980s that banks can operate with negative book capital levels and supply financial services.

The only threat to the supply of financial services to the economy is that bankers won't get their bonuses.

Banks have increased their capital levels by £90bn since the crisis but they have been broadly flat since last year. 

To boost their capital, the FPC said banks now need to issue equity or contingent capital because “the weak profit outlook for banks would make it difficult to raise sufficient additional capital solely by limiting cash dividends and compensation”. Debt-for-equity swaps should also be considered, it said, which could raise £8bn.

As stated above, there are no investors other than governments (who don't have to because of the design of a modern banking system) that are dumb enough to buy any form of capital in the banks.  

Some of the extra capital could also be used to “support lending immediately” but the bulk would be to “enhance market perceptions of resilience and reduce funding costs”.

Bank book capital levels do absolutely nothing to enhance market perceptions of resilience or reduce funding costs!

Investors are not muppets.  They are smart enough to know that the UK banks would all probably show negative book capital levels if not for the regulators blessing the deceptions in each bank's current financial disclosure.

If there were one bank CEO that truly believed that his bank had positive book capital, he would immediately embrace ultra transparency and disclose on an on-going basis his bank's current asset, liability and off-balance sheet exposure details.

He would do this knowing that the market could independently assess that his bank could stand on its own two feet and would rush to a) buy his bank's stock and b) provide his bank with low cost funds.

He would do this because he knows that any bank that doesn't provide ultra transparency is sending a very easily understood message that they have something to hide.  Investors understand that banks that are hiding something should be rewarded with low stock prices and high costs of funds.

Families should not accept share of blame for Britain's woes

In a Telegraph article, a senior UK cabinet member said that families had to accept responsibility for taking on bigger loans than they could afford to repay.

This is fundamentally wrong.

Banks are not in the business of granting a loan to anyone for any amount of money that they would like to borrow.

Rather, banks are in the business of providing loans based on an assessment of the borrower's capacity to repay.  This assessment of the borrower's capacity to repay caps the amount of the loan the bank is willing to provide.

Assessing a borrower's capacity to repay a loan is a core competence of banks.

As a result, it is 100% the bank's responsibility to not provide a bigger loan than the borrower can repay.

British households that borrowed too much money must “accept responsibility” for their role in the current economic troubles... 

Philip Hammond, the Defence Secretary, said that banks were not solely responsible for the financial crisis as “they had to lend to someone”. 

The minister, who played a key role in drawing up David Cameron’s economic strategy in opposition, also claimed that people who took out loans were “consenting adults” who, in some cases, were now be seeking to blame others for their actions. 

Mr Hammond made the comments after Sir Mervyn King, the Governor of the Bank of England, ... criticised the delay by Gordon Brown’s government in bailing out the banks; remarks that prompted calls for an official inquiry into the role of regulators, the Bank and ministers in the financial collapse. 

Mr Hammond, speaking to The Daily Telegraph on an official visit to Germany, said that households must also accept that they played a role in the decisions that led to the crisis.

“People say to me, 'it was the banks’. I say, 'hang on, the banks had to lend to someone’,” he said. “People feel in a sense that someone else is responsible for the decisions they made. Of course, if banks don’t offer credit, people can’t take it. [But] there were two consenting adults in all these transactions, a borrower and a lender, and they may both have made wrong calls. 

“Some people are unwilling to accept responsibility for the consequences of their own choices.” 

He added that individuals, companies and governments were all guilty of excessive borrowing. We allowed our expectations to run away with us,” Mr Hammond said. “We started living a lifestyle both in private consumption and in public consumption that we could not afford. We borrowed to top it up … now the day of reckoning has come and we are adjusting. 

“Households were spending more than they earned. That’s why household debt rose.” 

The attempt to persuade indebted households that they should share responsibility for the crisis is a risky strategy at a time when Conservative ministers are facing accusations that they are out of touch with ordinary Britons. 

Mr Hammond was a successful businessman before entering politics, amassing a multi-million-pound fortune from interests including property development. But he insisted it was right to highlight the role played by household borrowing, including mortgages. 

“It is a tough message but we are still, by some margin, the most indebted nation on earth in terms of household debt,” he said.... 

Last night, Mr Hammond made it clear that he was not telling people how to arrange their finances, although he did point out that consumers were clearing debts rather than spending — a factor in the lacklustre economic recovery. 

“People are dealing with that [their indebtedness],” the Defence Secretary said. “That is what households are doing. Running down debt. Households are very rational. 

“Governments can pontificate all they like but its individual decisions that matter. Millions of households are deciding they are uncomfortable with their levels of debt and they are going to tighten their belts and squeeze down their levels of debt. I prefer to trust millions of households to make their own decisions rather than try to impose them from the centre.”

Wall Street's Opacity Protection Team meets Judge Rakoff [update]

In a MarketWatch article, A new era of Wall Street transparency, U.S. District Judge Jed Rakoff takes on Wall Street's Opacity Protection Team.

“In any case like this that touches on the transparency of financial markets whose gyrations have so depressed our economy and debilitated our lives, there is an overriding public interest in knowing the truth. In much of the world, propaganda reigns, and truth is confined to secretive, fearful whispers,” the judge wrote. 

“Even in our nation, apologists for suppressing or obscuring the truth may always be found.

Judge Rakoff calls out Wall Street's Opacity Protection Team.

But the SEC, of all agencies, has a duty, inherent in its statutory mission, to see that the truth emerges; and if fails to do so, this Court must not, in the name of deference or convenience, grant judicial enforcement to the agency’s contrivances.”

It is the SEC that was set up to ensure that market participants have access to all the useful, relevant information in an appropriate, timely manner so that the risk of any investment can be fully assessed prior to making the investment decision.

The SEC defended the settlement it reached with the bank....

In defending its actions, the SEC confirms the late Mark Pittman's observation that the regulators are members of Wall Street's Opacity Protection Team.

“The court’s criticism that the settlement does not require an ‘admission’ to wrongful conduct disregards the fact that obtaining disgorgement, monetary penalties, and mandatory business reforms may significantly outweigh the absence of an admission when that relief is obtained promptly and without the risks, delay, and resources required at trial....”

The SEC focuses on what is essentially a cost of doing business for a Wall Street firm.  It ignores the fact that the SEC had reached prior settlements with the bank that included mandatory business reforms that, if implemented, would have prevented the sale of the security which gave rise to the proposed settlement.

Rakoff’s ruling is likely to have far-reaching ramifications on Wall Street and at the SEC. 

The consent judgment settlement reached between Citi and the regulatory body, in which Citi had the ability to neither admit to any wrongdoing nor deny the allegations held against it, was a common one that the SEC typically reached with firms that it accused of wrongdoing.... 

The fact that this type of settlement is commonly used by the SEC does not mean that it is a good practice.

In fact, using it frequently makes this type of settlement look like the equivalent of a parking ticket.  As everyone knows, parking tickets are at best a nuisance and do not change people's behavior.

If Rakoff’s ruling proves to be popular in the public sphere, then it is possible that other judges might start scrutinizing settlements between the SEC and Wall Street firms more closely, and the SEC would also be compelled to be stricter in its discipline of firms who flout rules.

I can only hope that the ruling is extremely popular in the public sphere.

This ruling shows the degree of regulatory capture that has occurred at the SEC.  The SEC needs to be compelled to be stricter in its discipline of firms who flout its rules.

As Adam Sorensen of Time magazine notes: 

“Rakoff’s ruling is one small dose of exactly what Wall Street’s critics have been hankering for. 

The conflict ... is basically over whether securitization fraud cases will get swept under the rug. 

And you’d be hard pressed to find a realistic outcome more appealing to protesters hoisting ‘Jail the Banksters’ signs in Zuccotti Park than a public fraud trial for a major Wall Street institution and a rebuke to what Occupiers see as an overly sympathetic federal government. 

Judge Rakoff just gave them both of those things.”

That being said, it is still unlikely that the facts of the Citi fraud case will be uncovered, even though a trial date of July 16, 2012 has been set.

Of course, Citi will just agree to pay a bigger fine for its parking ticket.  There is precedence for paying a bigger fine and that is why SEC settlements are simply a cost of doing business as opposed to being a tool to bring about changes in the conduct of business.

In 2009, the SEC sued Bank of America (NYSE:BAC) , claiming that the bank had lied to shareholders about bonuses paid out to Merrill Lynch executives when it sought approval to acquire the troubled firm. The agency reached a $33 million settlement, which Rakoff first rejected. However, the judge later relented and approved a $150 million settlement in February 2010, even though he said the agreement was “half-baked justice at best.” 

If history is to repeat itself, what will probably happen is that the SEC will increase the penalty Citi has to pay — perhaps an amount closer to the $550 million Goldman coughed up — and Rakoff will approve the new settlement. 

Then again, populist anger toward big banks has grown since the SEC-Bank of America settlement last year, as exemplified by the nationwide Occupy movement, and perhaps Rakoff, augmented by the pro-transparency public sentiment and a growing public profile as a take-no-nonsense judge, will insist on holding the SEC and Citi accountable to the public this time around.

Clearly, this is what it is going to take if Wall Street's Opacity Protection Team is ever going to be defeated.

Update
Jesse Eisinger wrote an article in ProPublica that also addressed how Wall Street views fines from regulators.

I asked Richard Kramer, who used to work as a technology analyst at Goldman Sachs until he got fed up with how it did business and now runs his own firm, Arete Research, what was going wrong. He sees it as part of the business model. 

“There have been repeated fines and malfeasance at literally all the investment banks, but it doesn’t seem to affect their behavior much,” he said. “So I have to conclude it is part of strategy as simple cost/benefit analysis, that fines and legal costs are a small price to pay for the profits.”

Always nice to get confirmation of my analysis and the need for transparency as the solution.

MF Global highlights need for disclosing asset, liability and off-balance sheet exposure details

A Bloomberg article discusses the role played by the Board of Directors and complicated disclosure in MF Global's demise.

Regular readers know that market participants need financial firms to disclose on an on-going basis their current asset, liability and off-balance sheet exposures if the market participants are going to be able to assess the risk of the financial firm.

Rather than offer ultra transparency, the article describes how MF Global's disclosure failed to lift any of the opacity surrounding the trades.

MF Global’s regulatory filings don’t give dollar amounts for the gross purchases of European sovereign debt or for the hedges. Instead, the investments are shown as percentages of a bigger base of assets, leaving investors to calculate the numbers themselves. Those assets are reported on a market-value basis. 

The firm in filings and an October investor presentation disclosed the net amount at risk from its European bonds after hedges. Neither the presentation nor regulatory filings explained that the hedges matured before the bonds and thus would have to periodically be renewed....

MF Global disclosed in a May 20 filing that its net holdings among the five European countries consisted of $6.3 billion in debt at the end of March that had an average maturity of April 2012. 

The company said in the Aug. 3 filing that its European sovereign portfolio had risen to $6.4 billion of debt with an average maturity of October 2012. 

In both instances, MF Global said the figures were “net of hedging transactions the company has undertaken to mitigate issuer risk.” 

While reporting its net holdings had increased 2 percent, MF Global had expanded its bets to $11.5 billion as of June 30 from $7.64 billion as of March 31, according to data contained in the SEC filings. The firm didn’t quantify its holdings at the end of 2010. 

The firm’s hedges, known as reverse repurchase agreements, jumped to $4.93 billion at June 30 from $1.08 billion as of March 31, the data show. 

Revenue from the European sovereign trades was about $47 million during the fiscal fourth quarter ended March 31, or 16 percent of net revenue, and $38 million, or 12 percent, in the following quarter, according to an October investor presentation.

This lack of useful disclosure meant that MF Global's management was not constrained by market discipline -- market discipline would have taken the form of investors reducing their exposure to the firm and increasing the cost of funds to the firm as MF Global increased its risk.

Instead, MF Global was dependent on its Board of Directors.

Although the trades didn’t require pre-approval by the board, directors (MF) later questioned Corzine’s investment, according to a person familiar with the discussions. 

After challenging the size of the bets and the concentration on a small number of countries, the board set dollar limits on the amount of sovereign debt its chairman could buy. 

Corzine came back to the board at least once to get the ceiling raised. 

At multiple meetings, Corzine reassured directors that the trades would work out, said the person, who asked not to be identified because the discussions were private. 

Corzine said the European countries he selected wouldn’t default before the bonds matured, and that the market was mis-pricing the debt, according to the person. Underpinning Corzine’s view was the euro zone’s European Financial Stability Facility, which could backstop government short-term debt through June 30, 2013. 

Some risk managers and traders at MF Global shared the directors’ concerns, according to a former employee with knowledge of the matter. The risk-management department began asking for daily prices of credit-default swaps on sovereign debt to keep track of how the market viewed the underlying bonds, a second person said. 

The demise of MF Global, which was spun off from fund manager Man Group Plc in 2007, shows how Corzine’s stature made it hard for the board or underlings to oppose him, even as the crisis in Europe deepened. 

Directors believed that rejecting the trades would have been an affront to the veteran trader and would have been tantamount to firing him, said the person familiar with the board’s deliberations. 

The trades could have been rejected had there been market discipline.  Investors selling the stock as MF Global's risk increased would have been the equivalent of firing Corzine.

“This was a board that could not possibly have been more expert in exposure to risk, a board with at least as much, if not more, expertise than the CEO,” said Jeffrey Sonnenfeld, senior associate dean at the Yale University School of Management in New Haven, Connecticut, and founder of a nonprofit educational and research institute focused on CEO leadership and corporate governance. “This was an example of people not having the courage to stand up to the CEO.”

The failure to stand up to the CEO would not have been a problem if there had been ultra transparency as that would have permitted the market to exert market discipline on the CEO.

Why not pull the trigger on Greek credit default swaps? Authorities fear contagion.

A NY Times Dealbook article asks the question of why not pull the trigger on Greek credit default swaps.  The simple answer is fear of the unknown in the form of contagion.

Since financial regulators have not required that banks disclose their current asset, liability and off-balance sheet exposure details on an on-going basis, they have no idea who would win or who would lose if the credit default swaps payout.

This lack of disclosure creates the potential for surprises and the financial regulators are trying to avoid this.

Far better that the financial regulators should have required ultra transparency so everyone could see what the impact would be.

The really important issue here centers on why the European Union cares so much about not setting off credit-default swap triggers in this exchange offer. The absurd lengths European leaders are going to in order to make this “voluntary” does raise a few eyebrows. And I have no really compelling explanations. 

Still, would it be so hard to imagine that the Eurpean Union wants to avoid setting off the swaps because of aggregate exposure among European banks to Greek and other European sovereign debt? For example, what if European banks have all been hedging their sovereign credit-default swaps with each other. If that proves to be the case, a German bank with seemingly modest net exposure to sovereign debts, for example, could really be heavily exposed because the hedge is with a French bank? 

And let us stop with the “Greek C.D.S. market is small” argument. Yes, the publicly acknowledged market is small. What about the bespoke market? 

Moreover, what would the collateral posting requirements be for European banks if non-Greek sovereign debt was downgraded after the triggering of Greek credit-default swaps? What if we also add collateral posting requirements that result from European banks being downgraded?

What is the contribution of the financial sector?

The Bank of England's Andy Haldane and Vasileios Madouros published an interesting column on VoxEU in which they asked "what is the contribution of the financial sector?"

Specifically, they focus on the distinction between risk-taking and risk management.

They observe that if risk-taking were a value-added activity,

Russian roulette players would contribute disproportionately to global welfare.

Risk-management, on the other hand, is a value-added activity.

The financial system provides a number of services to the wider economy, including payment and transaction services to depositors and borrowers; intermediation services by transforming deposits into funding for households, companies or governments; and risk transfer and insurance services. 

In doing so, financial intermediaries take on risk. For example, when they finance long-term loans to companies using short-term deposits from households, banks assume liquidity risk. And when they extend mortgages to households, they take on credit risk. 

But bearing risk is not, by itself, a productive activity. The act of investing capital in a risky asset is a fundamental feature of capital markets. For example, a retail investor that purchases bonds issued by a company is bearing risk, but not contributing so much as a cent to measured economic activity. Similarly, a household that decides to use all of its liquid deposits to purchase a house, instead of borrowing some money from the bank and keeping some of its deposits with the bank, is bearing liquidity risk....

What is a demonstrably productive economic activity is the management of risk. Banks use labour and capital to screen borrowers, assess their creditworthiness and monitor them. And they spend resources to assess their vulnerability to liquidity shocks arising from the maturity mismatches on their balance sheets. Customers, in turn, remunerate banks for these productive services.

Risk management is not solely the province of banks.  All market participants are suppose to manage their risks.

The key to managing risk is access to all the useful, relevant information in an appropriate, timely manner.

Without this data, there is no way to assess the risk of a given exposure.

Regular readers know that the current level of opacity engulfing structured finance securities and banks is similar to not seeing the bullet chambers while playing Russian Roulette.  Buying these securities is not investing, but rather blindly taking risk.

Risk management is like playing Russian Roulette, but being able to see if there is a bullet in the chamber and stopping before the trigger is pulled.

Naomi Prins on banks and disclosure

In her post on ZeroHedge, Naomi Prins takes aim at the willingness of the media to believe anything that Wall Street's Opacity Protection Team says and the issue of banks and disclosure.

Please note, with ultra transparency it is game over for banks engaging in speculative behavior.

Most of the media goes along with the notion that US banks exposed to the ‘euro-contagion’ will hurt our (nonexistent) recovery. US Banks assure us, they don't have much exposure - it's all hedged. (Like it was all AAA.) 

The press doesn't tend to question the global harm caused by never having smacked US banks into place, cutting off their money supply, splitting them into commercial and speculative parts ala Glass-Steagall and letting the speculative parts that should have died, die, rather than enjoy public subsidization and the ability to go globe-hopping for more destructive opportunity, alongside some of the mega-global bank partners. 

Today, the stock prices of the largest US banks are about as low as they were in the early part of 2009, not because of euro-contagion or Super-committee super-incompetence (a useless distraction anyway) but because of the ongoing transparency void surrouding the biggest banks amidst their central-bank-covered risks, and the political hot potato of how many emergency loans are required to keep them afloat at any given moment.  

Because investors don’t know their true exposures, any more than in early 2009. 

Because US banks catalyzed the global crisis that is currently manifesting itself in Europe. Because there never was a separate US housing crisis and European debt crisis. Instead, there is a worldwide, systemic, unregulated, uncontained,  rapacious need for the most powerful banks and financial institutions to leverage whatever could be leveraged in whatever forms it could be leveraged in. 

So, now we’re just barely in the second quarter of the game of thrones, where the big banks are the kings, the ECB, IMF and the Fed are the money supply, and the populations are the powerless serfs.

US banks say they have little exposure to Europe, MF Global and its derivative bet indicate otherwise

Gretchen Morgenson had a very interesting column on how Europe's problems are likely to be problems for US banks.

The column discusses the simple fact that because of a lack of disclosure market participants do not know what any individual firm's exposure to derivatives is.  Without this information, it is impossible to assess the risk of any firm.

As a result, the markets are dependent on the financial regulators to properly analyze the risk of each firm's derivative exposure.  However, what MF Global suggests, is that the regulators are not up to the task.

WHO are you going to believe — me, or your own lying eyes? 

That old line from the Marx Brothers came to mind last week as MF Global, the brokerage firm run by Jon S. Corzine, was felled by over-the-top leverage and bad derivative bets on debt-weakened European countries. 

Suddenly, all of those claims that American financial institutions have little to no exposure to Europe rang hollow. 

You can understand why Wall Street wants to play down the threats from Europe....

If market participants actually knew their exposures, they would not be able to gamble with derivatives.

Market participants would exert market discipline by increasing the banks' cost of funds and decreasing their access to funds to dissuade banks from taking on excessive risk.

But MF Global provides two lessons. The first is that our financial institutions are not impervious to Euro-shocks. The second is that when those problems reach our shores, they usually ride in on a wave of derivatives. 

“The problems that we’ve had since the inception of the credit derivatives market have never been solved in any meaningful way,” said Janet Tavakoli, president of Tavakoli Structured Finance and an authority on these instruments. “How many times do we want to live through this?” 

MF Global’s debacle was a result of complex swaps deals it had struck with trading partners. 

While those partners owned the underlying assets — in this case, government debt — MF Global held the risk relating to both market price and default. 

These arrangements at MF Global underscore two big problems in the credit derivatives market: risks that can be hidden from view, and risks that are not backed by adequate postings of collateral....

Both of these problems are cured with detailed disclosure.

Detailed disclosure eliminates the ability to hide risks from view.

Market discipline, which results from being able to see the risks being taken, works to prevent financial firms from taking on more risk than they can absorb.

Consider an investment vehicle known as a credit-linked note. In these deals, investors buy a note issued by a special-purpose vehicle that contains a credit default swap referencing a debt issuer, like a government. That swap provides credit insurance to the party buying the protection, meaning that the holder of the note is responsible for losses in a so-called credit event, like a default. 

Credit-linked notes are very popular and have been issued extensively by European banks. Many are governed by I.S.D.A. contracts, which define the terms of a credit event and require a ruling by the association on whether such an event has occurred. 

But some deals have different definitions or contractual language overriding the I.S.D.A. agreement. 

“The people writing these contracts may say, ‘I would like to be paid if there is a voluntary restructuring of debt, or if Greece goes back to the drachma, or if Greece goes to war with Cyprus,’ ” Ms. Tavakoli said. “I can declare a credit event where I am entitled to get paid if any of those events happen.” 

Cash calls can also be generated by declines in the market price of the notes or increases in the cost of insuring the underlying sovereign debt issue, according to credit-linked note prospectuses. 

The other party has to agree to these terms up front. 

But, given the nature of these so-called bespoke deals, we don’t know the full extent of the insurance that investors have written on troubled nations or the circumstances under which the insurance must be paid. Neither do we know who may be facing severe collateral calls or demands for termination payments on the contracts. 

When those collateral calls start coming, market values assigned to the securities that have been provided as backup can decline significantly. And when a company’s credit rating is downgraded, as MF Global’s was in late October, cash demands from skittish trading partners become even greater. 

“At this late date we still don’t know the risks that are out there,” Ms. Tavakoli said. “This market is opaque, bespoke, and the regulators don’t know what they’re doing.” 

At least regulators didn’t deem MF Global too big to fail. That’s a plus. But given the billions at stake in these markets, more transparency is needed about market participants, their financial soundness and their ability to withstand liquidity crises like the one that wiped out MF Global.

Thank You UBS: 'mess has uncanny historical echoes'

To paraphrase Martin Wolf:  I could not have asked for a better illustration of the costs of opacity than Thursday’s announcement by UBS of a loss of $2 billion in “unauthorised trading”.  No sane country can allow taxpayers to stand behind the costs of opacity. That is the kernel of the case for providing disclosure recommended under the FDR Framework.

Or as Gillian Tett, who warned in May 2011 that ETFs were headed for a scandal, said it so well in her column,

[W]hen regulators eventually unpick this $2bn mess, I would hazard that one culprit will turn out to be a pernicious cocktail of opacity, complexity and naive enthusiasm for innovation. 

Sounds exactly like what your humble blogger has been saying since the beginning of the financial crisis.

For what has happened in the ETF world in recent years has some uncanny echoes of what took place with collateralised debt products last decade; and the fact that it was those CDOs which caused such terrible damage for UBS in 2007 just reinforces the historical echoes. And the bitter irony. 

Consider the parallels. On paper, ETFs (just like CDOs) look like a wonderful idea; they are vehicles that enable investors to gain exposure easily to a diverse range of different asset classes, without having to pay the ridiculously high fees demanded by the active fund management industry – or engage in stock picking, say, on their own. 

So, unsurprisingly, the sector has exploded: annual growth over the past decade has been 40 per cent on average, as banks have marketed these products to their client base as a “safe” investment. Indeed, if you look at the charts tracking ETF growth in the past three years, they look extraordinarily similar to the CDOs charts back in 2005: the lines all point to the sky. 

But, as with CDOs, this growth has come at a cost. Although the first generation of ETFs were very stodgy – composed of cash equities, say – more recently banks have started creating more exotic structures to boost returns. In Europe, for example, so-called “synthetic” ETFs, or packages of derivatives, have become very hot and now account for almost half of all ETFs. 

As Yves Smith at NakedCapitalism likes to point out, nobody on Wall Street gets paid for creating low margin, transparent products.

With that in mind, it is no surprise that the financial engineers stepped in to make the product both opaque and high margin for the street.

Worse still, potential conflicts of interest have emerged within the banks too: not only do banks sell ETFs to their clients, but they also manage the trading flows that occur when the portfolios are hedged and rebalanced. 

Or, as the Financial Stability Board observed in a brilliantly prescient report earlier this year: “the dual role of some banks as ETF provider and derivative counterparty” creates dangerously close ties.  

And the industry is marred by opacity too. As far as individual investors are concerned, individual ETFs seem pretty transparent; after all, their price can be monitored on an exchange (which is why they are often presented as “safe”). 

Price transparency is not the same as valuation transparency.  Price transparency refers to the ease with which an investor can look up a quote.  Valuation transparency refers to the ease with which an investor can access all the useful, relevant information on the assets backing the ETF.

But what is often opaque is the way that banks manage the funds, particularly since many banks use black boxes to determine how to hedge and rebalance these portfolios (via so-called “equilibrating” mechanisms). It is impossible for outsiders to track the vast quantity of trading flows that occur around the ETF industry, as this hedging occurs, particularly since these flows often blur the banks’ own “proprietary” trading and “client” trading.  

Of course, in theory, senior bank managers should be able to monitor this.

If senior bank managers can monitor this, then it is something that can and should be disclosed.

But, as ever, cultural and structural problems have sometimes prompted them to look away: precisely because ETFs have been labelled as “safe” and “transparent” by the industry, they have not featured as a danger spot on risk managers’ radar screens. 

Once again, there may be echoes of those CDOs: one reason why UBS racked up such vast losses in 2007 on CDOs, for example, was that AAA-rated CDOs were classified as safe and profitable in internal risk management reports – and nobody felt any need to probe. (Check out the 2008 UBS shareholder report for a fantastic, highly detailed account of this). 

All of this, of course, may end up raising big questions about UBS’s management (did anybody, I wonder, actually read that 2008 shareholder report?). It also poses challenges for the regulators. Earlier this year, partly at the prompting of the Bank of England, the Financial Stability Board started delving into the issue. The International Monetary Fund and Bank of International Settlements have written reports too. But this does not appear to have produced any rapid action so far, partly because the release of these reports prompted a veritable army of bankers to start lobbying against any clampdown. 

Hopefully, though, the story of UBS should now put more fire in the regulators’ belly. If so, it may have actually done the financial industry a favour; after all, as I noted above, in its basic (vanilla) form, the ETF idea is a sensible one and very useful for investors. But if the sector is to flourish again, it needs to go back to its roots, and become more simple and transparent. 

This is exactly the same recommendation that I gave to the structured finance industry at the beginning of the credit crisis.

Rather, in fact, like the credit markets after 2007. Anybody know how to translate “déjà vu” into Swiss German?

Ring-fencing and disclosure

As expected, the Independent Commission on Banking in the UK issued its report and recommended that the core retail deposit taking bank be separated by a ring-fence from the casino investment bank.

This recommendation puts a premium on requiring disclosure of all current asset and liability-level data.  Without this data, who would invest in the casino bank?