US Covered Bond Act of 2011: A Fundamentally Flawed Proposal

Recently, the United States Covered Bond Act of 2011 was proposed in Congress.  Passage of this Act would be the equivalent of Congress offering large subsidies for building nuclear power plants in areas prone to frequent earthquakes.

Covered bonds are bonds issued by financial institutions.  These bonds are backed by pools of loans.  The performance of these loans and hence the performance of these bonds is guaranteed by the financial institution.  If a loan becomes delinquent by 60 days, it must be replaced with either cash or a new performing loan.

In the event of bankruptcy of the issuing financial institution, these bonds have priority to the cash flow from the loans in the pool.  More importantly, as proposed in the Act, these bonds also have priority over the FDIC claim to the cash flow of the failed financial institution.

The bonds are therefore effectively guaranteed by the US government.

The authors of the Act recognized this.  They also recognized that it would increase the losses incurred by the FDIC in resolving financial institutions that had outstanding covered bonds.  To protect the US taxpayer, they instructed the FDIC to increase its deposit insurance premium to cover any losses incurred as a result of the covered bonds.

Would the US taxpayer be protected?

Imagine that private label residential mortgage backed securities did not exist.  Instead, as allowed under the Act, financial institutions issue $2 trillion of covered bonds backed by sub-prime mortgages.  Unfortunately, as they are prone to do, the sub-prime mortgages stop performing.

As the hundreds of billions of non-performing sub-prime mortgages are taken out of the covered loan pool, the issuing financial institutions are required to recognize the loss in value from the impairment of these mortgages.  Bottom-line, the financial institutions do not have the capital to absorb the losses and the financial institutions themselves require an FDIC resolution.

Is it realistic that the FDIC could increase its deposit insurance premium on the surviving banks enough to cover $1 trillion in covered bond related losses?  No!

The US taxpayer is fully on the hook for the losses under the US Covered Bond Act of 2011.  This design flaw is so obvious that even the Administration commented on it in the following article by Reuters [if this legislation progresses, a subsequent post will address another major design flaw:  the lack of information on the underlying loan performance],

Treasury Secretary Timothy Geithner on Tuesday backed efforts by U.S. lawmakers to create a new market for financing mortgages that would help wean the $10.6 trillion U.S. mortgage market from government support. 

Geithner said he backed efforts to create a market for covered bonds, which are securities issued by banks and backed by pools of loans. The loans underlying covered bonds remain on the issuer's balance sheet. 

That is different from the the current U.S. mortgage system, where lenders sell many of the loans they make to Fannie Mae and Freddie Mac, which then repackage them as securities for investors. 

"We would support legislation that would help create better conditions for a covered bond market," Geithner told the Senate Banking Committee in response to a question from Senator Charles Schumer. 

Republican Representative Scott Garrett, a strong proponent of covered bonds, last week called advocates to testify to a House panel heads to push the idea. He thinks a covered bond market could lessen the role of Fannie Mae and Freddie Mac. 

Schumer, a Democrat, said he was considering introducing a Senate version of Garrett's bill. 

... In Europe, covered bonds have long been in use. But they have failed to catch on in the United States. 

In a covered bond system, banks can borrow against the value of the underlying mortgages to obtain fresh capital to extend further loans. The bond investors have the right to those underlying assets in the case of a bank default. 

The Federal Deposit Insurance Corporation has warned a covered bond system could put its bank deposit insurance fund at increased risk for losses because the investors would have seniority over the agency in the event of default. 

Geithner said the FDIC concerns are legitimate and would have to be worked out. 

"For this to work, you would be putting the taxpayer in some sense behind private investors, and that has its own consequences, but that is something we can work through and I think it can play a greater role in our system," Geithner said. 

The White House and Congress are in the midst of a major policy debate on how to overhaul the finance system for buying U.S. homes, which collapsed in 2008. 

The Obama administration last month announced several steps to make those government-backed mortgages more expensive in a bid to lure private capital back to the mortgage market. 

Highlight of Euro Stress Test II: Disclosure of Data

Reuters carried an article in which analysts said that the major positive they expected from the second round of European bank stress tests is the release of some bank data.  Analysts plan to use this data to run their own independent stress tests.

As regular readers of this blog know, this is exactly what the FDR Framework would predict would be the reaction of the market - give us the data and let us do our own homework.

The only question that is outstanding about the stress tests is how far short of full transparency they will fall.  We know that the regulators are not going to provide full transparency and release each bank's current asset-level data.  The question is will they release enough data so that the stress tests run by investors can actually provide useful information.

Investors hoping for clarity from this year's European stress tests can expect at best to be given enough data to run their own assessment. 

The problem is that the new regulator running the exercise is unable to challenge EU policy that simply will not accept any of its member countries could default, even theoretically. 

"They have to go for the second-best solution, which is giving transparency of banks' sovereign exposures so that investors can calculate the implications of this particular stress factor themselves," said Nicolas Veron, senior fellow at Bruegel, a Brussels-based think-tank. 

The aim of the tests is to restore confidence in the region's banking sector after last year's health check was widely criticised for lack of transparency and credibility. 

Only seven banks failed last year's tests and needed to raise just 3.5 billion euros, far less than expected. All of Ireland's banks passed, yet months later Dublin needed an 85 billion euro bailout and all its lenders had to be rescued. 

Though the 2011 exercise is being run by the new European Banking Authority (EBA), under pressure to prove its own credibility as a regulator, it will still be flawed by the same inability to force banks to show a loss on assets held in their long-term "banking book," where they park sovereign bonds.  

... "Provided you get the disclosures for the market to run its own stress tests I don't think it's a fatal problem that the banking book isn't stress tested," said Mike Harrison, analyst at Barclays Capital. 

...To run your own test, however, you need to know that the capital being tested across countries is of roughly the same quality, not an easy task without full transparency. 

Last year banks had to meet a Tier 1 capital requirement of 6 percent to pass. This refers to a broad measure of a bank's resilience to shocks, but lenders can pad it with lower quality assets which obscure exactly how much cash is available to tap. 

Analysts would have preferred to use a stricter 'core' Tier 1 benchmark comprising shareholders' capital and retained earnings, possibly with a 5 percent pass rate. That is opposed by some countries as it would make the test harder to pass. 

Germany, for example, wants to include the debt-equity hybrids known as "silent participations" commonly held by its banks, sources familiar with the matter have said. This form of capital has been criticised because it cannot absorb losses while the bank is still in business. 

The solution could be to stick with Tier 1 capital, but include a detailed breakdown of what it contains. 

Another proposed improvement is to highlight the banks that nearly miss the stress tests requirements, in order to pressure them to recapitalise. 

The test also looks set to apply higher funding costs and greater losses from a fall in property prices. It should also ensure that economic stress scenarios are consistently applied under similar accounting rules. 

Regulators are also sticking their necks out politically by insisting that governments have a plan in place to top up capital at banks that fail, unlike last year. 

Germany, in particular, needs to show how it would recapitalise its landesbanks, critics say. 

... Regulators say greater transparency means investors and analysts can run their own tests or add elements if they don't think the EBA is being tough enough. 

Asset-level Disclosure Makes Markets Work Better at Low Cost

In a recent column in the NY Times, Richard Thaler puts to rest the idea that the market would in any way, shape or form not be up to the task of transforming all the data in the 'Mother of all Databases' into useful information.

He looks at what market participants do with non-financial databases where there are limited financial rewards from transforming the data into information.  Now, just imagine what they would do with access to all the financial data in the 'Mother of all Databases' where there are potentially huge financial rewards from transforming the data to information!

GOVERNMENTS have learned a cheap new way to improve people’s lives. Here is the basic recipe: 

Take data that you and I have already paid a government agency to collect, and post it online in a way that computer programmers can easily use. Then wait a few months. Voilà! 

The private sector gets busy, creating Web sites and smartphone apps that reformat the information in ways that are helpful to consumers, workers and companies. 

... Another example involves weather data produced by the National Oceanographic and Atmospheric Administration. The forecasts you find on the Weather Channel, or on the evening news or online, use the agency’s information. 

Again, the government produces and releases raw data, and the private sector transforms it into something useful for the public. 

... Now the administration is pushing to use this concept as a tool for regulation, and as a method of avoiding more heavy-handed rule making. The idea is that making things more transparent can immediately turn consumers into better shoppers and make markets work better. 

One might think that such an initiative would receive nearly universal support — after all, who could be against openness and transparency? But it turns out that some people are. 

Two cases... 

First, the Department of Transportation is considering a new rule requiring airlines to make all of their prices public and immediately available online. The postings would include both ticket prices and the fees for “extras” like baggage, movies, food and beverages. The data would then be accessible to travel Web sites, and thus to all shoppers. 

The airlines would retain the right to decide how and where to sell their products and services. But many of them are insisting that they should be able to decide where and how to display these extra fees.

Electronic disclosure of all fees can make it much easier for consumers to figure out what a trip really costs, and thus make markets more efficient, without requiring new rules and regulations.   [every industry that thinks it benefits from a lack of transparency by being able to sell their products at a higher price will be like the airlines and object to openness and transparency]

Another initiative has been proposed by the Consumer Product Safety Commission. In 2008, Congress overwhelmingly passed and President George W. Bush signed legislation mandating an online database of reported safety issues in products, at saferproducts.gov.  

... If we want to reduce the cost of government regulation, this is exactly the kind of effort we should be applauding and expanding. Compared with the tiny costs [$3 million per year], the benefits of this program could be enormous. 

Thirteen years ago, two of my dear friends ... were called at work ... and told that their 18-month-old son had died in a crib accident. Imagine their anguish when they later learned that other children had died in this model of crib, and that still others had died in cribs with similar design. ... If this program could reduce that number even slightly, the cost would seem amply justified. 

Moving the government into the 21st century should be applauded. [see here] 

Banks Are Still Unable to Assess Competitors' Solvency

The key concern for markets and regulators was that they weren't sure they understood the extent of toxic assets on the balance sheets of financial institutions - so they couldn't be sure which banks were really solvent.  [Financial Crisis Inquiry Commission Report summary of the role of contagion in the credit crisis, page 373 pdf]

The ability to assess the risk and solvency of the large, global financial institutions has still not been addressed.

Until banks are required to disclose current asset-level data so competitors can actually do their own analysis to determine a bank's risk and solvency, competitors are forced to rely on one-off solutions like risk-adjusted capital ratios.

A column in the Wall Street Journal highlights the problem with relying on risk-adjusted capital ratios that are not being consistently calculated across the too big to fail.

Bank strength still is very much in the eye of the beholder. 

... firms can rely on differing definitions of Tier 1 capital, a key measure of bank strength. 

That debate comes as worries rise in the U.S. that varying approaches in the calculation of Tier 1 ratios will put big American institutions at a competitive disadvantage to European rivals. 

Risk weightings of assets measure the threat of loss posed by different holdings. So, a government bond will receive a lower risk weighting than a "junk" bond. A lower risk weighting for a bank's total assets may allow it to hold less capital. That can help boost returns and profit. 

J.P. Morgan Chase CEO James Dimon recently fired a broadside over that issue. He questioned differences in models other banks use to calculate risk-weighted assets that help determine Tier 1 ratios. 

A comparison of J.P. Morgan's risk-weighted assets to peers suggests their approach "can't be accurate," Mr. Dimon said at his bank's investor-day conference last month. "I mean, obviously, someone's using far more aggressive models." Although Mr. Dimon didn't single out particular institutions, it appears he was pointing a finger at Europe. 

Determining risk weightings relies on complex calculations and judgments. In the U.S., banks calculate them based on an older, restrictive version of international capital standards. European banks use an updated version allowing wider discretion through management's use of internally devised risk models. 

... But the danger mightn't be so much that U.S. banks face competitive constraints as it is that European banks, by using higher leverage, or borrowed money, are courting greater risk. 

For investors, the answer is to cast a skeptical eye on regulatory measures of bank strength.

Wall Street's Winning Financial Reform Battle May Change

According to a post by Henry Blodget on Yahoo, 'Wall Street Won! Nothing to Prevent Another Crisis, says Former FDIC Chairman Bill Isaac'.

Crisis may create opportunity, but Congress completely flubbed its opportunity to enact meaningful financial reform in the aftermath of the worst crisis since the Great Depression, says the former chairman of the FDIC, Bill Isaac. 

The Dodd-Frank reform bill--the one major piece of legislation to emerge since the financial crisis--is mostly meaningless, says Isaac, who is also the chairman of regional bank Fifth Third.  Dodd-Frank does nothing to address the root causes of the financial crisis, Isaac says, and it won't prevent the next one. 

 According to an article by Floyd Norris in the NY Times, the 'Crisis is Over, But Where's the Fix?'

... the International Monetary Fund ... researchers this week concluded that the rescues “only treated the symptoms of the global financial meltdown.” 

The researchers, Stijn Claessens and Ceyla Pazarbasioglu, warned that “a rare opportunity is being thrown away to tackle the underlying causes. Without restructuring financial institutions’ balance sheets and their operations, as well as their assets — loans to over-indebted households and enterprises — the economic recovery will suffer, and the seeds will be sown for the next crisis.” 

Clearly, Wall Street has been winning the financial reform battles.  In seeking to explain why Wall Street is winning, Mr. Norris highlights two facts.

[1]... “If we ask [the banks] for more capital, and they are too big to fail, they can take even more risk” after they raise additional capital, Y. Venugopal Reddy, a former governor of India’s central bank, argued at an economic conference sponsored by the I.M.F. this week. 

[2]  He added that he was worried about institutions that were “too powerful to regulate.”

Mr. Norris then points out what needs to be fixed:

... there is also the fact that the financial system did not accomplish what it was supposed to do. “At the core of these functions is the ability to find and set the right price, including the extent to which it reflects risk,”Antonio Borges, an I.M.F. official and former vice chairman of Goldman Sachs International, told the conference. “This is not really a question of financial sophistication, of complex products or greedy bankers. It is a question of getting the prices wrong.” 

He added, “It is unbelievable how wrong they were.” 

There is general agreement that many of the assumptions economists and others made before the crisis — about the rationality of markets, about their ability to measure risks and about the proper role of monetary policy — were largely wrong, or at best oversimplified. 

But there is far less unanimity about what to do about it. International cooperation was impressive in dealing with the immediate crisis. Now it is splintering, and banks are threatening to move operations to areas they deem friendlier to them. 

As regular readers of this blog know, the FDR Framework provides the fix that Mr. Norris is looking for.  It answers the question of why prices and the assumptions made about how the markets operate were wrong.

Simply put, the FDR Framework predicted and the credit crisis showed that prices will be wrong and markets will not function if investors do not have access to all the useful, relevant information in an appropriate, timely manner.

Mr. Norris concludes by focusing on a potential flaw in any regulatory system.

... regulatory failures may be inevitable. If multimillion-dollar bank bosses do not see a crisis looming before it is too late, can we be sure regulators who work for far less will be more prescient? 

Markets clearly did a horrid job of allocating capital, but there is no particular reason to think governments would do better. 

Even if regulators somehow did design a perfect regulatory system, it would not last, simply because clever bankers would eventually find ways around it, just as people find ways to evade taxes, forcing tax law writers to constantly make changes. 

“Every decade or so,” said Paul Romer, a senior fellow at the Institute for Economic Policy Research at Stanford and now a visiting professor at New York University, “any finite system of financial regulation will lead to systemic financial crisis.” 

If he is right, it is all the more important that ways be found to assure that the costs of the next financial crisis — in failed institutions and lost economic growth, not to mention government borrowing — will be far lower. It is hard to conclude much progress has been made in accomplishing that goal.

Fortunately, legislation passed in the US and Europe has effectively eliminated this flaw and is driving the US and Europe to an FDR Framework based regulatory system.

In the US, the legislation took the form of requiring the removal of the rating agencies from all regulations.  Without ratings to rely on, investors are forced to do their own homework.  The only way this can be done is if they have access to all useful, relevant information in an appropriate, timely manner.

In Europe, the legislation took the form of requiring financial institution investors, both commercial and investment banks, to know what they own.  Again, the only way for these institutions to show they know what they own is if they can access all useful, relevant information in an appropriate, timely manner.

It Takes Current Asset-Level Data to Convince Investors

A Bloomberg article discussed how the Spanish banks that are now looking for capital must convince investors to invest.

As predicted by the FDR Framework, there is only one way that investors can be convinced that the potential reward from investing offsets the risks of these banks.  That way is for investors to see the current asset-level data so they can independently analyze and value both the real estate exposure and the banks.

There are two methods for letting investors see the current asset-level data.

• Invite in a select group of potential investors.  There are several problems with doing this that were previously discussed in the first part of the Looting of the Irish posts.  These problems include that the investors might not use the information as intended.  As Naked Capitalism has documented with CDOs, sometimes an investor buys the equity in a deal so that they can also purchase a short position.

• Disclose to the entire market.

The Spanish government should insist that the cajas choose to fully disclose the current asset-level data to the market.

Spanish banks that together need as much as 15.2 billion euros ($21 billion) to meet minimum capital levels now must persuade investors that their battered balance sheets offer the potential return to match the risk. 

... Yesterday’s announcement sets in motion a timetable that gives lenders as long as a year to raise funds or risk being taken over by a government bailout fund. 

Investors may be skeptical that the Bank of Spain’s estimates of how much capital the banks need fully reflect losses hidden on balance sheets, putting the onus on them find investors quickly, said Inigo Lecubarri, a fund manager at Abaco Financials Fund in London. 

“At this stage, I don’t think anyone will be really convinced by anything,” said Lecubarri, who helps manage about $200 million at Abaco. “People will only be convinced when someone credible comes and puts some money on the table to invest.” 

Spain’s credit rating was cut to Aa2 by Moody’s Investors Service yesterday, which said the cost of shoring up the banking industry will eclipse government estimates. 

Moody’s said Spanish lenders may need as much as 50 billion euros to meet new capital requirements. The Bank of Spain said its estimate of 15.2 billion euros may end up lower as some savings banks opt for stock listings that will reduce the amount of capital they need under Spain’s new rules imposed last month. 

“The number from the Bank of Spain comes at the lower end of the range that analysts have been estimating for the capital needs of the Spanish banks,” said Luis de Guindos, a former deputy finance minister in the government of Jose Maria Aznar and a professor at IE business school in Madrid. 

... “My opinion is that capital needs are not the main issue,” said de Guindos. “I think the best way to convince investors is to have full clarity and transparency on real- estate exposure of the savings banks.” 

The exposure of Spanish savings banks to the real-estate and building industry amounts to 217 billion euros, the Bank of Spain said Feb. 21. About 100 billion euros of that is already classified as “potentially problematic,” of which 38 percent is covered with provisions, the regulator said.

Spain's Sovereign Debt Crisis is Avoidable

Despite the recent history of the Irish debt crisis, the Spanish government is insisting on pursuing the same flawed strategies that resulted in a loss of confidence in the Irish banking system and the solvency of its government.  As predicted previously on this blog, these flawed strategies are producing the same results for Spain.

Spain could avoid a sovereign debt crisis by abandoning these flawed strategies and adopting strategies that are consistent with the FDR Framework.

Specifically, the Spanish government should stop trying to convince the market.

Instead, it should require its financial system to provide current asset-level data to the market.  Market participants will analyze this data to determine who is solvent and who is not solvent.  If a financial institution is not solvent, the market participants will determine how much capital is needed to restore solvency.  The financial institution can either raise this capital from private investors or turn to the Spanish government.  The Spanish government can either inject the funds or resolve the financial institution.

If the total amount of capital needed to restore solvency exceeds what is available from the private markets and the Spanish government, the Spanish government can turn to the European Financial Stability Facility (EFSF) for additional resources.

This strategy is the only way to avoid a sovereign debt crisis as it allows market participants to trust and verify that the issue of bank solvency has been addressed.

Strategies that are based on trying to convince the market are doomed from the start.  At best, the actual performance of the underlying bank assets performs in line with the Spanish government's assumptions.

Much more likely, and this is what happened in Ireland, is that the underlying bank assets perform worse.  Since the government staked its credibility on better performance, the government's credibility collapses as the assets perform worse than it expected.  With the loss of the government's credibility, the sovereign debt crisis becomes unavoidable.

A Bloomberg article on Spain reported how investors are telling the Spanish government to abandon the flawed 'convince the market' strategy and instead adopt the 'provide the current asset-level data' strategy.

The Bank of Spain will tell lenders today how much capital they need to raise to meet new rules as the nation tries to convince investors that the cost of rescuing its banks won’t sink public finances. 

The Bank of Spain will publish each lender’s capital shortfall and the overall amount, which the regulator has already estimated won’t exceed 20 billion euros ($28 billion), or 2 percent of Spanish gross domestic product. The government wants most of that to be raised privately even as central bank Governor Miguel Angel Fernandez Ordonez said Feb. 21 that some lenders will ask the state-rescue fund for help. 

Spain, whose credit rating was cut by Moody’s Investors Service today, is trying to stem contagion as investors increase bets that Portugal will need a bailout and Greece lobbies to renegotiate its rescue deal. 

Prime Minister Jose Luis Rodriguez Zapatero’s government is seeking to show that Spanish lenders can weather a fourth year of economic slump and a jobless rate of 20 percent, as bond yields on peripheral euro-area nations surged this week. 

“It’s like a mini-stress test in the type of data we’ll get and any greater transparency is to be welcomed,” said Claire Kane, an analyst at MF Global in London. “What will be clearer is how they come to the 20 billion-euro estimate and from there we can make our own assumptions.” 

Moody’s cut Spain’s credit rating one notch to Aa2 with a negative outlook today, saying the costs of shoring up the banking system will be greater than the government forecasts. 

The overall amount, including funds that may be raised privately, will be 40 billion euros to 50 billion euros, the company estimates. 

...  Spanish banks, mostly savings institutes called “cajas,” have recognized losses equivalent to 9 percent of GDP since 2008, the Bank of Spain said on Feb. 21. 

Cajas’ exposure to the real-estate and building industry amounts to 217 billion euros. About 100 billion euros of that is already classified as “potentially problematic,” of which 38 percent is covered with provisions, the regulator said.

“At the moment, solutions are being found to many of the problems in the financial system,” said Jose Nieto, chief executive officer of Banca March, a bank controlled by the billionaire March family that closed 2010 with a core capital ratio above 22 percent. “All this is good and if it occurs sooner rather than later, all the better.” 

As part of efforts to rein in its borrowing costs, the government approved the new capital requirements on Feb. 18 and said lenders that fail to meet them risk partial nationalization via the purchase of ordinary shares by the FROB bank-rescue fund. 

That facility, created with 9 billion euros and the capacity to take on as much as 90 billion euros of debt, has already committed about 11 billion euros through the purchase of preferred shares. 

“The issue is, how much are the assets worth?” Javier Diaz-Gimenez, a professor at IESE business school in Madrid, said in a telephone interview. “Do you value them at market value, or purchase value or something in between, which is fair value: and what is fair value?” 

... The new rules, which say an independent expert will value the lenders that the FROB buys into, were approved by decree last month and are due to be ratified by parliament today. 

Listed banks must have core capital of 8 percent, while lenders that aren’t at least 20 percent-owned by private shareholders and depend on wholesale financing are required to reach 10 percent. They have until September to meet the new requirements and can seek an extension until the first quarter of 2012 if they commit to listing shares.

Barclays Bob Diamond Wants Financial Markets That Only the FDR Framework Can Deliver

The Daily Telegraph published an article based on an interview with Barclays Bob Diamond.  In this interview he said,

You shouldn't be trying to create a system where no bank fails but you should be creating one that catches a bank and allows it to fail without impacting the financial markets.

This is exactly the result that would be achieved with adherence to the FDR Framework and especially insuring that market participants have access to all the useful, relevant information in an appropriate, timely manner.

With the data made available under the FDR Framework, each bank could analyze its competitors.  Using the results of this analysis, each bank could determine how much exposure to another bank they were willing to have.  In addition, each bank could properly price this exposure based on the other bank's risk.

Since each bank has the ability to analyze the solvency of every other bank and adjust its exposure well ahead of solvency becoming a critical issue at an individual bank, the problem of contagion is minimized.  As a result, banks can once again fail.

Mr. Diamond was also concerned with

Finding the balance between making financial institutions safe and secure and also fostering economic growth and job creation is what we need. We need tough supervision and monitoring of these rules so that we don't run into the situation again where banks fail. Capital is at the right levels but people shouldn't believe that no banks ever fail.

The strength of the FDR Framework is that it does a superior job of balancing making financial institutions safe and secure while also fostering economic growth than do capital requirements by themselves.

It does this by expanding of the supervision and monitoring of banks beyond the regulators to the peer banks.  This brings market discipline to the banking industry.

At the same time, it supports the creation of properly priced credit.  If credit is underpriced, the risk of the bank increases and so does its cost of funds.

RBS Crisis: Regulators did not know how much capital was needed

As part of its analysis of the RBS crisis, the Telegraph wrote an article on how the regulators did not understand how much capital was needed at RBS or throughout the UK banking system to restore solvency.

Regular readers of this blog know, that one of the benefits of adhering to the FDR Framework is that the regulators and the market are looking at the same information.  As a result, regulators do not have to rely only on their internal assessment of the situation.  They can ask independent experts as well as competitors for their assessment of the situation.

Another benefit is that it supports functioning structured finance markets and allows these securities to be valued.  This is important when the issue of bank solvency arises as solvency is defined as the market value of the bank's assets exceeding the bank's liabilities.  If the markets are not functioning, it is harder to determine if the market value of the assets exceeds the liabilities.

The Financial Services Authority (FSA) was in denial about the scale of the banking crisis right up to the week of the historic multi-billion-pound bailout in October, 2008, an investigation by The Telegraph has found. 

Just days before the rescue, FSA officials, under chief executive Hector Sants, believed the most the banking system would require in emergency equity was £20bn and insisted that their problems were to do with a lack of liquidity rather than low levels of loss-bearing capital. In fact by the time the crisis was over, the total equity raised by the banking sector came to around £100bn. 

The City watchdog’s failure to identify the key cause of the financial crisis was the culmination of more than a year’s lax governance of banks’ capital levels. 

... In the week of the rescue, while the FSA was claiming £20bn would be enough, the Bank was arguing for a recapitalisation of £75bn-£100bn. 

On October 8, the Treasury outlined a £25bn-£50bn industry-wide recapitalisation plan. Days later Royal Bank of Scotland (RBS) alone was forced into a £20bn equity injection from taxpayers, while HBOS was made to take £11.5bn and Lloyds TSB £5.5bn. By the crisis’s end, the total figure was £100bn. 

The FSA delivered its £20bn estimate to Treasury and Bank officials between October 3 and October 6 2008, based on a worst-case projection for the banks. However, under pressure from officials, it subsequently conducted a second set of tests with more pessimistic inputs and on October 9 decided that RBS alone required £20bn. “There was definitely a big move at the FSA,” one senior source involved in the bailouts said. 

RBS’s collapse was in large part due to billions of pounds being withdrawn by large companies. However, one former manager said the regulator had never required it to stress-test its business for such an eventuality. 

The RBS Failure was Preventable

The failure of RBS was preventable. As documented by the Telegraph, there were numerous times where adherence to the FDR Framework, specifically insuring that market participants had access to all the useful, relevant information in an appropriate, timely manner, would have prevented the failure of RBS.

... In the new year, 2006, [Sir Fred Goodwin, RBS chief executive,] made an immediate change. He responded to shareholders’ demands for better returns in the only way he considered possible – to release RBS’s until then relatively slow-growing investment bank. 

Global Banking & Markets (GBM) and UK Corporate Banking would grow their combined balance sheet over the next two years, increasing its assets from £500bn to £830bn. In 2008, excluding the distorting effects of the ABN Amro acquisition, GBM alone would account for almost half the group’s total risk-weighted assets – £195bn of a total £482bn. 

Put simply, Sir Fred had bet the bank on GBM even before he doubled down with the calamitous acquisition of ABN Amro.

This is the first time that adherence to the FDR Framework would have saved RBS.

Had RBS been required to disclose its current asset-level data, the market would have seen exactly what GBM was putting on to the balance sheet.  With this data, market participants could have analyzed the risk of these assets and the solvency of RBS given its changing risk profile.  Market participants then could have adjusted both the amount and cost of their investment in RBS debt and equity.

As risk on RBS balance sheet increased, so too would have the cost of funds to RBS.  This feedback loop is the mechanism for the market to exert discipline on financial firms and would have constrained both the profitability and the risk of this strategy.

In short, RBS would have added many fewer assets to its balance sheet as the cost of funding these assets would have exceeded the financial return on these assets.

... The expansion of a commercial and retail bank into investment banking was in keeping with the fashion of the times. Barclays was already well on the way to becoming a vehicle for the ambitions of its investment bank, Barclays Capital . And at the summit stood investment banking thoroughbreds like Goldman Sachs and Lehman Brothers, which seemed to offer those with the guts and capital to copy their models the chance to make the kind of money in a year retail banks would take decades to earn.

This is the second time that adherence to the FDR Framework would have saved RBS.

As Warren Buffett would be happy to point out, disclosure of current asset-level data on each position in the trading and investment portfolios at the end of each business day would have dramatically squash the potential profitability of this business model.

A number of years ago, he negotiated with the SEC and received permission to delay disclosure for his investment positions.

Why would he have wanted to delay disclosure?

If he was buying, he wanted to delay disclosure to minimize the price he paid for his entire position.  By not filing, he does not have to compete with investors who piggyback on his reputation and ideas. These investors would have increased the cost of his position by driving up the price of stock with their buying.

If he was selling, he wanted to delay disclosure to maximize the price he received for his entire position.  By not filing, he does not have to compete with investors who piggyback on his reputation.  These investors would have decreased his sale proceeds by driving the price of the stock down with their selling.

Clearly, there are advantages to having opacity when it comes to buying and selling securities.

Eliminating opacity in the trading and investment portfolios also has another advantage for regulators.  Regulators can now turn to other market participants, like portfolio managers and competitors, for help in analyzing what are the risk of an individual firm's trading and investment portfolio.

RBS’s fate may have hinged on that one decision over Christmas 2005, but to understand the bank’s downfall properly one has to go back to its greatest accomplishment – the NatWest takeover. To this day, the deal is considered among the greatest acquisitions in UK deal making. 

... The work that went into RBS’s offer was exhausting. Endless public documents were produced to justify the deal to a sceptical audience. Synergies and costs were verified by the accountants Deloitte. Full strategy documents were disclosed. 

... The deal may have been Sir George’s brainchild, but it was the making of Sir Fred. “Fred was very good at delivery. He did the integration planning. His rigorous nagging saw the deal through. We truly delivered £3bn of synergies, it was not just an accounting trick,” another director said.

Proof that the adherence to the FDR Framework works.

How ironic that to convince the market of the merits of acquiring NatWest, RBS should resort to providing the market with a significant degree of transparency.  RBS had direct experience that adherence to the FDR Framework works.

... At the height of his powers, Sir Fred was able to do pretty much as he pleased such was the support that he gained with the remarkable NatWest deal.

Then, in April 2002, in a deal brimming with ego, he demonstrated just how far he felt he could go. 

There is no obvious synergy between a mass market car dealership and a global bank but that did not stop Sir Fred – a renowned motor enthusiast – buying Dixon Motors in a £110m deal. 

“Financially, it was below the radar. But it was completely mad,” the director said. 

With hindsight the deal exposed a subtle cultural shift at the bank. First, Sir Fred’s unquestioned command and, second, RBS’s pliant board. Both came to the fore in RBS’s worst deal before its calamitous takeover of ABN Amro in 2007, that involving Charter One. 

The deal broke all the lessons learned from NatWest. Due diligence and transparency on the Charter One deal were poor. Compared with NatWest, the detail provided was so scant the numbers could barely be tested properly by analysts, let alone accountants. No one filled the role Deloitte had played with NatWest. 

“It was all done on the back of an envelope,” the director said. “If you stop reporting transparently externally, you can start fudging it internally.”

This is the third time that adherence to the FDR Framework would have saved RBS.

The difference between NatWest and Charter One was that adherence to the FDR Framework was voluntary.  This is why disclosure of current asset-level data needs to be a requirement.  There is precious little room to fudge an exposure.

By making it a requirement, it also allows accounting firms to perform a function for which they are well suited.  In this case, the firms can attest that all of the positions have been disclosed.

It is up to the market to analyze this data and turn it into useful information.

... Doubts may have been raised about his leadership but Sir Fred Goodwin was still very much in charge of RBS as 2007 began. 

Weeks earlier his advisers from Merrill Lynch had briefed the bank’s board on an audacious plan that would see RBS at the head of a consortium bid for ABN Amro that would end in the largest cross-border banking takeover in European history. 

... [UBS Banker, John] Cryan had been against RBS buying ABN from the start and had warned Sir Fred against doing the deal, telling him he was “extremely concerned” about the impact it would have on the bank, particularly its capital ratios. 

In one note, Cryan wrote to Goodwin warning him about ABN’s exposure to subprime mortgages: “There is stuff in here we can’t even value.” Goodwin replied saying: “Stop being such a bean counter”. 

This is the fourth time that adherence to the FDR Framework would have saved RBS.

Disclosing all the useful, relevant information in an appropriate, timely manner to market participants is not restricted just to financial institution balance sheets.  It also applies to structured finance securities.

Had the SEC, through Regulation AB, required that structured finance securities disclose the performance of the underlying collateral on an observable event basis, the subprime mortgage-backed securities could have been valued.

... [Johnny] Cameron [chairman of RBS global banking and markets] regularly met his opposite number at ABN, Wilko Jiskoot. However, there were limits to how much help ABN could offer as the consortium’s bid remained a hostile offer. RBS, Fortis and Santander were prevented from performing full due diligence on the bank – unlike Barclays, which had full access to the books. 

“It is always a gamble when you take on something but if you are taking on a large bank it is always useful, you would have thought, to have some knowledge of what you have bought,” Alistair Darling, the Chancellor at the time of the bail-out, said. 

This is the fifth time that adherence to the FDR Framework would have saved RBS.

With all financial institutions having to disclose their current asset-level data, RBS would have been able to perform a full due diligence and known exactly what they were buying.  As a result, they would not have overpaid for their portion of ABN.

... The lack of celebration was quickly justified as RBS bankers got their first detailed look at what the bank had bought. There was immediate concern as it appeared that Cryan’s warnings at the state of the division’s assets appeared justified. 

“Once you started to look around ABN’s trading books you realised that a lot of their businesses, particularly what you would call model businesses where valuations were based on assumptions, were based on forecasts that were super aggressive,” said one senior former RBS trader. 

... In contrast to NatWest, which had been the dream integration, RBS managers now found themselves dealing with a nightmare situation of trying to value ABN’s assets amid a “freefall” in valuations, while dealing with ABN staff who, if not downright hostile, were disengaged at best. 

This demonstrates why adherence to the FDR Framework is necessary for functioning financial markets.

The reason that there was a free-fall in valuations was that there was no current information on the underlying collateral performance.  If the market had access to the underlying asset-level data, it would have been factoring in the deterioration of the underlying assets sooner and reigning in the super aggressive forecasts.

Access to the underlying asset-level data would also have anchored the price movement on the securities.  Every market participant would have known how the underlying assets were currently performing and used this as the starting point in their valuation of the securities.  This would have reduced the volatility in the price movements by narrowing the gap between buyer and seller valuations.

As the months dragged by in 2008, arguments between RBS and Fortis managers became more open as the two sides disagreed more frequently on how the separation should proceed. The strain in the relationship was not helped by Fortis’s financial difficulties as it became clear the Belgian bank was facing its own funding crunch. 

... Two days later the bank was partially nationalised, with the Netherlands, Belgium and Luxembourg authorities injecting a total of €11.2bn to prop it up. 

On Monday, Fortis staff turning up for work at the ABN headquarters in Amsterdam were barred from entering the building as the bank was forced to sell its stake in the ABN acquisition vehicle. ABN was a busted flush and RBS was left holding a whole load of nothing. The question was, could the bank survive such a hole in its balance sheet. Or would one of the world’s largest banks actually have to turn to the ultimate backstop – the Government and by implication the UK’s millions of tax payers. 

This is the sixth time that adherence to the FDR Framework would have save RBS.

RBS faced a question about its solvency.  In the absence of disclosure of current asset-level data, market participants were left to guess whether the market value of the assets on its balance sheet exceeds its liabilities.  Because investors did not know if RBS was solvent, it was susceptible to a run on the bank.

Over the summer of 2007 as the battle raged for ABN Amro very strange things were happening in the credit markets. 

Back in February, HSBC had been the first bank to openly signal the problems it was having in the US subprime market and had fired the head of its US mortgage business as losses hit $10.5bn. 

Investors had to guess the value of the subprime securities and their related CDOs on RBS's book.

... The main area of worry for RBS was its huge leveraged finance and commercial real estate lending businesses. The market for leveraged debt had already shut and what the managers did not contemplate was what would happen if they were unable to fund the lending books. 

Add in leveraged finance and commercial real estate lending.

In early September the ABN in-house funding team held a conference call to discuss the increasing difficulty the bank was having in securing financing and were surprised when they realised they were financing themselves at a lower rate than their soon to be new owner, RBS. In plain English, it meant RBS was having a harder time sourcing funding than they were. 

And they were in real trouble. Like all investment banking businesses, ABN and RBS’s wholesale banking arms were funded in large part through a mixture of short-term loans, often overnight borrowing from other banks, and corporate deposits and the cost of these was rising daily. 

... Even without the problems in the credit markets, funding such a large balance sheet would have been a major headache for RBS, but as the wholesale businesses were combined, the bank began to breach the risk limits of many of its corporate depositors, leading to a steady outflow of increasingly scarce funds. 

The cost of attracting new funds was rising and combined with the losses the bank was now facing on many of its wholesale banking assets, RBS’s core tier 1 capital, already taken to the dangerously low level of 4pc through the acquisition, was entering emergency territory.

With the problems on its balance sheet, corporate depositors had even more reason to withdraw funds.

[Gordon] Brown, who valued Vadera’s knowledge of finance industry, asked her to begin thinking about solutions to the problems that were appearing and said he thought it was important that banks become more open about declaring their losses. 

“In December and January it was becoming clear that the system was clogging up and that people were sitting on huge losses,” one Whitehall source said. “There was a fear that no-one could really test what was on each others’ books.” 

Such a lack of information astonished the Government. “The situation raised important questions,” Darling said. 

“One of the things that was a real problem was that neither the FSA nor the Bank nor any of their American or European counterparts could pull out a file and say 'here’s a health check on such-and-such a bank’. It did surprise me. But looking back now three years later, what is equally surprising is that there wasn’t a sheet that could be pulled out by RBS. 

“If you look at the FSA – the emphasis over its first few years of operation was consumer protection and that is what it occupied itself with. And if you look at the Bank of England it was monetary policy and it wasn’t financial security for which it always had responsibility.” 

Until disclosure under the FDR Framework is required, the financial system still faces this problem.

Without current asset-level disclosure, it is impossible for banks to know what the true financial condition of their competitors are.

This is why Jamie Dimon, Peter Sands and Bob Diamond highlighted the need for this information to be disclosed at Davos.

... Cameron realised the funding of the wholesale business was becoming critical. Over the summer a decision was taken to put most of the division’s product sales staff on to deposit gathering duties with bottles of champagne now handed out for landing large deposits in the same way they had once been for hitting sales targets. 

“We literally had a taskforce out there trying to convince corporates not to take their money away,” says one former senior RBS investment banker. 

Had there been current asset-level disclosure, there would have been no need to convince corporates not to take their money away.  They could have seen for themselves or hired independent third parties to do the analysis for them whether RBS was solvent or not.

In the absence of disclosure, these corporate depositors had a strong incentive to avoid loss and withdraw their money.

Treasurers at rival banks were also alarmed by what they were seeing happening at RBS as overnight borrowings increased day by day and the bank was forced to replace deposits with short-term funds. 

“It was like you could see this wall of water coming towards you. We had a meeting internally about pulling back our risk limits on RBS because there was clearly something going horribly wrong,” said one head of treasury at a major UK bank. 

Naturally, knowing what they knew about their own exposure to subprime mortgage-backed securities, leveraged lending and commercial real estate, banks did not want to lend to each other.

.... Crisis landed at Royal Bank of Scotland on Tuesday October 7, 2008. One day earlier, a giant oil group had taken billions of pounds out of the bank in a single transaction. It was the biggest withdrawal RBS had suffered in recent memory and foreshadowed the disaster that would cripple the bank. Unlike Northern Rock, where queues formed at branches that trailed around the street, RBS was suffering a “virtual” run by its corporate customers. 

On that Tuesday morning, RBS shares crashed 20pc as what little confidence remaining evaporated on rumours of a run. 

In the absence of data showing RBS to be solvent, it succumbed to the fear that it was not.

From the very beginning, had current asset-level data been available, the result for RBS would have been different.