Europe rejects Geithner's failed bailout strategies

As was broadly reported (for example, this Telegraph article), the European finance ministers firmly rejected the bailout strategies proposed by US Treasury Secretary Geithner.

There could be a number of explanations for this rejection.

• They could have rejected the idea because they knew that the countries that would be required to fund the bailout would not do so.  This is a tad simplistic because what countries like Germany have ruled out is an endless stream of bailouts that do not solve the underlying problem.

• They could have rejected the proposal because they could see that it transfers vast quantities of wealth to individual bankers and elite traders while saddling the sovereign with a tremendous debt load and failing to restore confidence in the banking system.

• They could have rejected the idea because they resented being advised to adopt a solution where the speaker would not put his country's money where his mouth is.  After all, when pushed on the question of would the US help to fund the bailouts, Mr. Geithner said absolutely not.

My preferred explanation is that because they have a monopoly on all the useful, relevant information about the European banks, the European policy makers rejected the suggestion because the facts did not show it was required. [I like this much better than they have the facts and are in denial.]

Remember, the regulators just conducted stress tests on these banks.  Presumably, these stress tests were based on all the facts, particularly since the previous stress tests which avoided any inconvenient facts failed so miserably.

Facts that BNP Paribas and Societe Generale confirmed with their recent disclosures.

What Mr. Geithner came to discuss was an analysis that was short on facts and long on fear driven assumptions.

In fairness to Mr. Geithner, since he was part of the US stress tests, he knows that the results of stress tests can easily misrepresent the true condition of the banks.  This blog has pointed to the possibility of Bank of America needing upwards of $200 billion in additional capital despite being required to raise a fraction of this under the first stress test as an example of the potential for intentional or inadvertent misrepresentation.

Your humble blogger has said that the path forward for Europe is for the policy makers and regulators to disclose the facts.  First, through a statement.  Second, through the promise and implementation of 'utter transparency' in terms of setting up a data warehouse to provide on-going disclosure of each bank's current asset and liability-level data.

By disclosing the facts, policy makers and regulators can reframe the discussion of bank and sovereign solvency so that everyone is using the same information.  

By promising and implementing disclosure, policy makers and regulators can address the existing fear driven assumptions.  After all, policy makers and regulators would not disclose the information if it were going to show that the situation was worse than they described in their statement.

Fear driven assumptions must be addressed because in any leveraged financial system there is not enough equity to support the system in the face of these assumptions.

It is only by returning the conversation to the facts, that assumptions are constrained by the facts and not emotions like fear.

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?

With the focus on Europe, US regulators looking at bank values for home-equity loans

With Treasury Secretary Geithner off to tell the Europeans to recapitalize their banking system, could a recapitalization of US banks be coming too?  According to a Bloomberg article, US regulators have begun looking at how US banks are valuing home-equity loans including second-lien mortgages.

What are these loans really worth?

This is an important question because the balance sheets of the largest banks in the US hold enough of these loans to threaten their solvency.

Clearly, investors would like to be able to analyze the loan-level data.  This is particularly true because recently banks have been increasing their earnings by cutting reserves despite high unemployment and decline home prices.

U.S. regulators are examining whether the nation’s home lenders have accurately valued $845 billion of home-equity and other second-lien mortgages, according to seven people with direct knowledge of the matter...

A slowing economy has cast doubt on the value of second mortgages, whose collateral can be wiped out when home prices decline. The S&P/Case-Shiller index covering 20 U.S. cities has dropped 32 percent from its July 2006 peak, and the jobless rate, stuck above 9 percent, makes it harder for borrowers to keep up with payments.  

Bank of America Corp. (BAC) and JPMorgan Chase & Co. (JPM) are among the largest holders of second liens.... 

Second mortgages allow borrowers to get extra cash by using the equity in their home as collateral for a loan. When the borrower stops paying or goes bankrupt, the holder of the primary mortgage has first claim on the assets. If the home’s value has fallen since the loan was made, the holder of the second mortgage may be left with little or no collateral to cover losses.

Regulators are focusing on individual loans where borrowers are already overdue on their first mortgages, or where the value of the home has dropped below the size of the loans, according to the people. ... With banks cutting reserves as overall defaults decrease, regulators want to ensure the firms still have enough to cover second liens that go sour, the person said...

Second mortgages soared in popularity during the housing bubble as homeowners sought to tap growing equity values. The balance of home-equity loans and other second mortgages held by lenders rose from $327.6 billion in 2000 to a peak of $1.14 trillion in 2007, according to Inside Mortgage Finance, a trade publication. The total fell to $845.3 billion in the first quarter of 2011. 

Home-equity lines of credit made up the largest second-lien category with unpaid balances of $666.5 billion in the first quarter, the data show. 

Investors are skeptical about the true worth of assets held by U.S. lenders, with the KBW Bank Index (BKX) selling at about 75 percent of stated book value for the 24 companies represented. Bank of America, based in Charlotte, North Carolina, has been pummeled by speculation that it needed a bigger capital cushion to protect against unexpected losses. The stock has lost almost 50 percent this year and sells for about a third of book value.

Bank of America, the biggest U.S. lender by assets, holds the largest second-lien portfolio, with $129.3 billion in unpaid balances, according to first-quarter data from Inside Mortgage Finance. San Francisco-based Wells Fargo is second with $114.4 billion, and New York-based JPMorgan Chase & Co. is third, with $101.6 billion. New York’s Citigroup Inc. (C) had $46 billion and PNC Financial Services Group Inc. (PNC), based in Pittsburgh, had $30.1 billion. Spokesmen for the lenders declined to comment on the examination. 

John Walsh, the acting comptroller, said in testimony before the Senate Banking Committee last December that examiners were looking into situations where banks had resisted offering loan modifications to distressed homeowners on first mortgages where the bank also held a second mortgage. Modifying the first loan could include an acknowledgement that that the home’s value had dropped, forcing the lender to take a loss or complete write-off of the second mortgage.

“A conflict of interest could arise if the second-lien holder were trying to overstate the second lien’s carrying value (and under-allocate loan-loss reserves) for a troubled borrower,” Walsh said. The comptroller had required that banks take all such risks into consideration in their valuations, even if the second mortgages are performing, Walsh said. 

The American Bankers Association reported delinquent closed-end home-equity loans rose to 4.12 percent in the first quarter from 4.05 percent in 2010’s final quarter. For open-end home-equity lines of credit, delinquencies rose to 1.8 percent from 1.73 percent. Closed-end loans are for a fixed amount with a fixed repayment period. Open-end loans come with a fixed amount of available credit, with the actual balance fluctuating based on usage.

Regulators and lawmakers have been sounding alarms since at least 2009 about the value of second mortgages. The Federal Deposit Insurance Corp. sent a letter to banks in August 2009 asking them to consider boosting reserves for second liens, citing the impact of overdue first mortgages. Barney Frank, then the chairman of the House Financial Services Committee, sent a letter to banks in March 2010 urging them to recognize more losses because “large numbers of these second liens have no real economic value.” 

Bankers have responded that American borrowers tend to meet their obligations and pay their bills as long as they are able, regardless of whether the value of their homes has declined. Customers keep paying because they want to keep access to the account and draw on the unused portion of their credit lines, according to a paper last December by staff members of the Federal Reserve Bank of Philadelphia. 

The study found that 31 percent of borrowers who were 90 days or more in default on first mortgages remained current on their second liens, and 20 percent of borrowers in foreclosure on first mortgages still made payments on their seconds. 

Even if second-lien payments are current, the delinquency on the first loan means the default risk has grown and banks may need to set aside more reserves, two of the people said. 

The conflict between first and second mortgages may become more acute as banks resume foreclosures, said Guy Cecala, publisher of Inside Mortgage Finance. Lenders halted or slowed the process after accusations that homes had been seized using legal shortcuts and forged documents. Those delays are ending, Cecala said. 

Default notices sent to overdue U.S. homeowners surged 33 percent in August from the previous month, and total foreclosure filings increased 7 percent from a four-year low, according to a report today from RealtyTrac Inc., the Irvine, California-based data seller.
“When you see those foreclosures pick up, which you will, then the losses on the seconds will really start to come in,” he said.

Larry Fink: Regulators Broke Europe; TYI: Regulators can fix Europe

A Wall Street Journal blog summarized BlackRock Chairman and CEO Larry Fink's speech on the European financial crisis succinctly as regulators broke Europe.

The finger of blame is pointing all over the globe when it comes to the European sovereign-debt crisis. BlackRock CEO Larry Fink knows exactly who is at fault. 

“You could argue this was created by regulators,” Fink said of the Eurozone crisis at today’s “Delivering Alpha” conference. “This was not an accident. This was a very visible action by banks and regulators are aware of it. And now we’re sitting with some deep exposures to sovereign credits….

Mr. Fink has gone further than say that regulators are a source of financial instability.  He has specifically said that regulators are a cause of financial instability.

How exactly did the regulators cause Europe's current sovereign debt and banking crisis?  He attributes it to the regulators being aware of what the banks were doing and not taking action.

Why is this the regulators' fault and not a failure of market discipline given that buying sovereign credits "was a very visible action by banks"?  Because the regulators had a monopoly on all the useful, relevant information about bank sovereign debt exposures.

It was only with the latest stress tests that banks were required to disclose this information.

Since then, lead by BNP Paribas, the French banks have been moving towards 'utter transparency' and disclosure of the 'hard facts'.

To me it’s going to require similar actions to what we did in ’08 and ’09 to stabilize.” 

Memories are short, Fink said, and investors are uncertain of what the policy response could look like. “Until we have greater comfort that government is going to do the right thing, it’s pretty binary.”

These actions presumably include the European version of TARP and PPIP.

Regular readers know that taking "similar actions to what we did in '08 and '09" is the absolutely wrong strategy and would waste a considerable quantity of taxpayer money.  Rather than address the problem, these actions address the symptoms.

The issue the market is dealing with is trying to answer the question of which banks are solvent and which are not (including the impact of restructuring government debt).  The only way this issue can be addressed directly is with disclosure that provides 'utter transparency'.

It is only with this information that the market can determine which banks are solvent and which are not.  It is only with this information that the market can determine which of the insolvent banks is capable of earning its way back to solvency and which need to be recapitalized or closed.

It is only by going through the steps of disclosure, analysis and then action that the problem of solvency can be addressed.

When I proposed this solution to the US Treasury in 2008, they agreed with me that addressing the issue of solvency required going in order through these steps, but they felt they needed to "buy" time as disclosure and analysis was not going to happen over night.

The rest is history.  The Great Reprieve from the financial crisis that began in 2007 was bought at large cost to the taxpayers.  Unfortunately, the time of the Great Reprieve was not used to bring disclosure and address the global solvency issue.

Today, the global solvency issues have returned and Europe no longer has access to a charge card for buying time.  The German public has sent the clear message that taxpayer money has to be spent on addressing the underlying solvency problem and not on an unending stream of bailouts.

Fortunately, Europe has an alternative for buying time that will allow it to take the steps of disclosure, analysis and then action.

The alternative is a statement by the regulators.  This statement has two parts.

• The first part includes a reminder that the regulators have access to all the useful, relevant information that other market participants do not have.  The statement then goes on to honestly lay out what the situation really is for the European banks on a bank by bank basis. 
• This is not a statement of how each bank performed on the stress tests.  The results of the stress test are a combination of a bank's current position and assumptions made by regulators about the future.  
• This is a statement of each bank's current condition.  It is the starting point off of which all other market participants should and will base their analysis of a bank's solvency.

• The second part is to implement 'utter transparency' under which banks will disclose their current asset and liability-level data. 
• The US Treasury is right that this will not happen over night.  A much more realistic time period is 36 - 48 months for implementing disclosure through a data warehouse. [by way of background, I have designed and patented information technology for collecting, standardizing, and disseminating loan-level information through a data warehouse.]

This statement sends a very powerful message.  It asks the market to trust the regulators.  Perhaps more importantly, it tells the market that it is going to receive the information necessary to verify that what the regulators said is the situation is in fact what is happening.

Trust but Verify.

This is a very powerful combination that will provide Europe with the time it needs to implement disclosure.

Trust but Verify: Tracking data from banks takes diligence

The NY Times' Dealbook published an article by Jesse Eisinger in which he makes the point that the numbers being provided by the banks make it hard to for outsiders to understand what is actually happening at the banks.

For individual banks, the numbers change between the call reports, the annual reports and investor presentations.  Not only does this make it very hard to understand the individual bank, it also makes it very difficult to compare between banks.

His conclusion is outsiders should continue to Trust but Verify by exercising diligence in looking at the data.

Under the FDR Framework, governments are responsible for ensuring that market participants have access to all the useful, relevant information in an appropriate, timely manner.  The article highlights many of the ways data is currently disclosed that could be improved.

If you really want to give your brain a workout to stave off the ravages of mental decline, I recommend trying to read bank financial statements.... 

To be fair, banks do file mountain ranges of disclosure documents. They report to the S.E.C. (which protects investors), the Federal Deposit Insurance Corporation (which insures borrowers), the O.C.C. (which regulates banks) and the Federal Reserve (which also regulates banks with slightly different responsibilities). 

Day after day, they push out news releases that run dozens of pages. They prepare reams of special presentations for investors, the most recent of which from Wells ran 51 pages, on top of a 41-page news release. The S.E.C. filing from the quarter was 162 pages. 

The numbers and presentation differ slightly in all of them and often differ from other banks’ presentations, stirring a struggle among outsiders to compare apples and bananas. No professional admits this publicly, but many investors and analysts privately acknowledge that they can’t fully track the data gushing each quarter from the nation’s banks. 

Even if they could somehow reconcile all the numbers, analysts would still be significantly in the dark. In many instances, banks’ financial disclosures are drawn from estimates that only management teams are privy to. Even the simplest of concepts — how much capital a bank has — is a number based on countless calculations that, let’s face it, are not much better than guesswork. 

Why should analysts have to be in the dark?  If banks were required to disclose their current asset and liability-level data, analysts could know what was going on.

As Mr. Eisinger observes, bank capital is an accounting construct based on countless calculations drawn from management estimates that are not much better than guesswork.  This is not a ringing endorsement of capital ratios as being a reliable indicator of the solvency of a bank.

So it is all the more important that we trust bank management and regulators to make sure the numbers we see truly reflect their financial condition....  

A Wells Fargo representative told me that the bank’s disclosure was “best in class” and listed the enormous amount that it provides. 

The bank still falls short of other big banks in disclosure, according to investors and analysts I’ve spoken with. It doesn’t break out the reserves it has made by asset class, unlike Bank of America, making it particularly difficult to understand how much it is reserving for bad residential real estate loans. It doesn’t separate its business lines in the detail that the other banks do. 

Then there are its nonperforming loans. For its residential mortgages, it doesn’t classify them as nonaccrual until they are 120 days past due, instead of the more typical 90 days. The effect is to make the numbers look better. 

The crucial figure, over time, is the loss rate, the bank representative said. And since the Wells portfolio — not counting the bad Wachovia loans — has been performing consistently well for many years now, investors should believe that the bank is doing something right, and better than its competitors with its mortgage portfolio. 

Yet housing prices continue to fall, the economy is weaker than expected, and we are flirting with another financial crisis, as Europe gets its revenge on us for having exported our calamity to their continent in 2008. Wells isn’t likely to remain immune to that. “Trust but verify,” Ronald Reagan used to say of the Soviet Union. Not a bad idea. 

'Rogue' trading and disclosure

The WSJ ran an interesting article on the UBS rogue trading debacle titled: "What do you call a 'rogue' trader who makes $2 billion?  A Managing Director".

One of the major points made in the article is how bringing more disclosure into the trading operations would reduce both the amount of trading activity and the losses from trading.

As previously discussed, it would have been a lot harder for Wall Street to short sub-prime securities if their clients saw what they were doing.

UBS AG apparently is the latest bank to suffer at the hands of a “rogue.” British police arrested a man on suspicion of fraud Thursday after UBS’ exchange-traded fund desk said a trader had racked up $2 billion in losses. 

Trading on Wall Street, of course, is a thinly controlled game of dice. Traders put their firm’s capital at risk, but must do so with authorization. As this latest scandal shows, authorization is either easy to come by or circumvent. And as nearly every “rogue” has said in their defense, there were winners making unauthorized trades, too. The difference: they were winners.... 

So, why is trading beyond internal limits allowed? Because of the winners. 

Enter Philipp Meyer, a former UBS derivatives trader who left the business a few years ago and wrote about the excess of the business for The Independent. To be clear, Meyer never said he made unauthorized trades, but he did offer this observation about trading. ” It was pretty clear what The Market didn’t like. It didn’t like being closely watched. It didn’t like rules that governed its behavior.” 

... Ultimately, the difference between trading floor rogues and royalty is how their bets pay off, not whether they take extreme risks. As Leeson said, there’s no excuse for not catching rogue trading today or even 18 years ago: “a very simple check would have exposed it.”

S&P discovers that collateral backing covered bonds is important

Tracy Alloway at the Financial Times wrote an article on S&P cautioning investors to distinguish between covered bonds based on the loans supporting them.

Regular readers know that your humble blogger introduced this idea several months ago while discussing the problems with covered bonds.  The solution is to provide market participants with current loan-level performance data so they have the ability to analyze the supporting loans.

Covered bonds are not the universally safe assets that some investors think they are, rating agency Standard & Poor’s has warned in a new report. 

“There remains a tendency for investors to treat all covered bonds as alike in credit terms, which we believe is not the case,” S&P’s Karen Naylor said. The report, called ‘Never underestimate credit risk in mortgage bonds’, argues that the riskiness of the loans underlying the bonds can vary significantly from deal to deal. 

Sales of covered bonds have boomed in recent months, with about €1,000bn of the debt now outstanding in Europe alone. The bonds are gaining in importance since, for many European banks, they remain the only source of funding amid eurozone turmoil. Unsecured debt issuance, traditionally the biggest funding tool for Europe’s banks, has dried up since July, leaving covered bonds to plug some of the gap... 

Many investors consider the bonds “super-safe” because, if the underlying assets sour, they also have a claim on the issuing bank. However, in the report, S&P warns that “the common perception of mortgage covered bonds as a homogeneous and universally low-risk product is misleading. In fact, the characteristics of individual mortgage covered bonds are not only diverse, but can change over time.” 

Covered bonds are typically backed by either mortgages or government-related loans, the analysts explained. The bonds remain on issuing banks’ balance sheets, unlike other forms of structured finance such as mortgage-backed securities. Moreover, the issuer must “top up” the bonds if underlying loans go bad, meaning the assets backing the debt can vary, within certain legal boundaries. 

In covered bonds comprised only of mortgages, for instance, there may be a mix of residential and commercial loans. In covered bonds backed by public sector debt, there may be a mix of exposure to different governments, S&P said. 

Investors in what appears to be staid public sector Pfandbriefs, as German covered bonds are known, may be surprised, for example, to find the bond also contains loans to civil servants in Greece. Barclays Capital estimated last year that 10 per cent of the assets in public sector Pfandbriefs are exposed to European peripherals, though that figure is likely to have altered significantly since then. 

The report comes just as the covered bond industry grapples with record issuance and a wider international roll-out. The Association of German Pfandbrief Banks, for instance, has warned that new proposals for covered bonds in the US, which may use student or car loans as collateral, will damage the debt’s reputation.

European bank run continues: deposit flight at European banks raises risks

For several months, this blog has predicted and documented the ongoing run on the European banks.  Today, Bloomberg ran an article which confirms this deposit flight.

This deposit flight is occurring despite three plus years of implementing the best ideas of the global financial regulatory community, Wall Street sell-side and buy-side firms, global consulting firms, and economists.

Despite hundreds of millions in fees, the on-going deposit flight confirms that all these ideas have failed to restore investor confidence.

It is time to turn to and implement ideas from a different source.

Besides predicting and documenting this deposit flight, your humble blogger has also been discussing what it will take to stop this modern version of a "run on the bank".

The only way to restore investor confidence and halt this deposit flight is for financial institutions to provide 'utter transparency' by disclosing their current asset and liability-level data.  It is only after market participants have analyzed this data and know who is solvent and who is insolvent that confidence can return and the run on the banks stopped.

European banks are losing deposits as savers and money funds spooked by the region’s debt crisis search for havens, a trend that could worsen economic and financial conditions. 

Retail and institutional deposits at Greek banks fell 19 percent in the past year and almost 40 percent at Irish lenders in 18 months. Meanwhile, European Union financial firms are lending less to one another and U.S. money-market funds have reduced their investments in German, French and Spanish banks. 

While the European Central Bank has picked up some of the slack, providing about 500 billion euros ($685 billion) of temporary financing, banks are cutting lending, which could slow growth in their home countries. They’re also paying more to keep and attract deposits -- or, in the case of Italy, selling bonds to retail customers for five times the interest they offer on savings accounts -- which will erode profitability. 

“All of this is symptomatic of a lot of fear in the European financial sector,” said Kash Mansori, senior economist at Experis Finance in Charlotte, North Carolina, which advises U.S. and European companies. “It shows that even European banks don’t trust each other anymore, so they’re taking their money out of the EU system. It’s similar to the distrust that happened worldwide in 2008.”

Regular readers know this because the question of who is solvent and who is insolvent has not been addressed.

Deposits by financial institutions in Greek banks, which make up 21 percent of the total, have fallen by one-third since the beginning of 2010, while those by non-financial firms and residents dropped 9 percent, according to Bank of Greece data. 

In Germany, deposits by financial institutions, which account for one-third the total, declined 12 percent over the same period and 24 percent since the September 2008 collapse of Lehman Brothers Holdings Inc., ECB figures show. 

In France, where the erosion started last year, the same type of deposits, which make up half the total, are down 6 percent since June 2010. 

They have fallen 14 percent since May 2010 at Spanish banks, where they account for one-fifth of the total....

While retail deposits at Italian banks have fallen only 1 percent in the past year, the outflow of money from financial institutions has exceeded $100 billion, a 13 percent decline, according to Bank of Italy and ECB data.

Some of the retail deposits have been invested in bank bonds sold directly to retail clients that pay as much as 5 percent, compared with an average interest rate on deposits of 0.88 percent....

In Portugal, where banks raised the interest rates they pay savers, non-residents have reduced deposits by 19 percent since March 2010. 

The eight largest U.S. money-market funds halved their lending to German, French and U.K. banks over the past 12 months and stopped financing Italian and Spanish financial firms, according to data compiled by Bloomberg from investment reports. 

A survey by Fitch Ratings showed that U.S. money-market funds reduced their lending to European banks by 20 percent from the end of May through July. The funds cut investments in Spanish and Italian lenders by 97 percent, to German firms by 42 percent and to French ones by 18 percent, Fitch said. The Aug. 22 survey covers almost half the $1.53 trillion assets held by money funds in the U.S.

The banks in every European country have seen a significant outflow of deposits.

...[F]irms are leaning on the ECB for short-term funding. Borrowing by Italian lenders from the central bank more than doubled to 85 billion euros between June and August. Greek and Irish banks each took about 100 billion euros from the ECB in August. Irish lenders also got 56 billion euros from their domestic central bank. Portuguese banks borrowed about 46 billion euros from the ECB, while Spanish banks took 52 billion euros in July. 

By accepting those countries’ bonds as collateral in exchange for funds, the ECB is piling up risk, ... “If there are sovereign defaults, the ECB will be left with garbage that has been accepted as collateral,” said Lachman. “It’s putting EU taxpayers’ money at risk in a very non-transparent way. But there’s no alternative. The ECB is the only game in town.”

... ECB President Jean-Claude Trichet has defended his institution’s actions. European banks have more collateral that they can place with the ECB in exchange for additional financing if they need it, he said Sept. 8 in Frankfurt. 

“We stand ready to provide liquidity as we have done in the past,” Trichet said. 

In theory, when providing liquidity, central banks are suppose to lend only against good collateral.   With the lack of information on bank's current asset-level data, it is impossible for market participants to know if the ECB is lending only against good collateral or not.

The outflow of deposits is a measure of eroding trust in the region’s financial system. 

... Irish banks have been the hardest hit. Losses on the collapsing real-estate market and a government guarantee of bank liabilities forced the nation to seek EU assistance in November. 

The money started flowing out in early 2010 as confidence in the government’s ability to support the banks waned, and it accelerated later that year after Ireland’s rescue by the EU led multinational companies to move deposits out of the country. 

Ireland took control of five lenders and is winding down two of them. Even Bank of Ireland, which wasn’t nationalized because its losses weren’t as catastrophic, saw deposits dwindle by 20 billion euros, or 23 percent, last year. 

At Allied Irish Banks Plc (ALBK), Ireland’s second-largest lender, deposits declined 37 percent over the past 18 months. The bank said July 25 that most of the drop occurred at the end of 2010 and in the first quarter of this year as companies pulled money amid sovereign and bank downgrades. Deposits since the end of the first half have been “broadly stable,” said Alan Kelly, the lender’s director of corporate affairs and marketing, who declined further comment.

While “the rate of outflow is falling,” Finance Minister Michael Noonan said on Sept. 1 in Dublin, that hasn’t soothed savers such as Phil Carey, an 86-year-old mother of eight from Galway in western Ireland. 

“I wouldn’t trust the banks,” said Carey, who keeps her savings at credit unions. “I’d be afraid of them. Look at the money they gave to the builders and the terrible situation we’re in now.” 

It isn’t easy for retail depositors such as Carey to move funds abroad. In Ireland, there has been some shift to units of foreign banks operating in the country. RaboDirect, the Irish online-banking unit of Utrecht, Netherlands-based Rabobank Group, saw deposits rise about 40 percent in 18 months, according to General Manager Roel van Veggel.

Clearly, that hiring BlackRock Solutions, Barclay Capital and Boston Consulting to run stress tests and advise on reorganizing the banking system did not, as predicted here before the fact, restore depositor confidence.

... European lenders are also moving money out of the region. The cash that foreign banks keep at the U.S. Federal Reserve has more than doubled to $979 billion at the end of August from $443 billion at the end of February, according to Fed data. The increase in bank deposits at the ECB has been smaller, suggesting that healthy European firms are putting money in the Fed instead of lending to weaker banks, according to economist Mansori, who also writes a blog called “Street Light.” 

“Do you want to keep your money at the Fed, which you know will pay you back, or at the ECB, which has lots of periphery euro zone country debt?” said Mansori. 

The reluctance of European banks to lend to one another has been on display since last month. The spread between Euribor and the overnight indexed swap rate, which reflects the higher risk of lending euros for three months versus overnight, widened to 0.85 percentage point on Sept. 13. The rate compares with 0.36 percentage point at the beginning of August.
Banks can’t continue to rely on the ECB for funding because that’s a sign of being on “life support,” so they’ll have to shrink their balance sheets, said KBW’s Ramirez. That means reduced lending in countries where growth is stagnant....

While banks say higher capital requirements will curb lending and economic growth, it’s the lack of capital in the European banking system that’s spooking depositors and other creditors, said Lachman of the American Enterprise Institute. That’s why the International Monetary Fund is pushing for recapitalization of the region’s banks, he said. 

Paying more for deposits to prevent them from leaving, as banks in Ireland, Spain and Portugal are doing, will hurt banks’ chances of rebuilding capital through earnings. Offering higher interest rates for retail bonds as Italian lenders have done will cut into interest margins.

“It’s not sustainable for this type of pricing strategy to continue,” Rabobank’s Van Veggel said about the high rates Irish banks are offering for deposits. “But I don’t think rates will start to come down until nervousness about European, and indeed global, issues calm down.” 

German and French banks are losing funds because they hold the most debt linked to troubled euro zone countries, according to Mark Schaltuper, an analyst at Business Monitor International, a London-based consulting group. Investors and creditors worry that German and French lenders will face losses on their holdings in the event of a default, he said. 

“European policy makers are kicking the can down the road, waiting for banks to recapitalize slowly so they can take these losses over time,” said Schaltuper, the firm’s chief European analyst. “Until the debt situation in the periphery is sorted out, these funding troubles won’t end.”

Andrew Ross Sorkin and the IMF's Chief change of tune on bank capital

Andrew Ross Sorkin wrote a column in the NY Time's Dealbook on how Christine Lagarde's change in roles from French bank regulator to Chief of the IMF appears to have influenced her position on the adequacy of European bank capital.

He roundly praises her for coming clean about the need for more capital and asks if she can bring the rest of the European financial regulatory community with her.

Regular readers would like to know why he thinks she should stop there.  If Bank of America has shown anything over the last few weeks, it is that the US financial regulators are every bit as guilty when it comes to hiding what is going on.  Is it credible that the 2009 stress tests missed what many analysts today believe is a $200 billion hole in BofA's balance sheet?

If he truly believed in what he wrote, he would become an advocate of the FDR Framework.

Under this framework, 21st century information technology is harnessed to ensure that market participants have access to all the useful, relevant information in an appropriate, timely manner.  For banks, this is their current asset and liability-level dat which the financial regulators currently have a monopoly on.

Over the weekend, Christine Lagarde, the managing director of the International Monetary Fund, was desperately trying to back-pedal. A report had surfaced citing an internal I.M.F. document estimating that Europe’s banks were woefully short of capital — by a whopping $273.2 billion....

While Ms. Lagarde acted as if she was surprised by the number — and tried to play it down — she shouldn’t be. And in truth, she wasn’t. 

Changing her tune seems to be a theme for Ms. Lagarde, which may explain her feigned sense of shock. 

Ms. Lagarde sounded alarm bells last month about what she called the need for an “urgent recapitalization” of European banks, and was roundly criticized for it. 

“Developments this summer have indicated we are in a dangerous new phase,” she said then. Her refreshingly honest remarks had been so honest — apparently, too honest — that some bankers blamed her for further undermining confidence in European banks. 

Yes, Ms. Lagarde had broken the secret code of silence among Europe’s top bankers — a silence she herself had kept for far too long when she was a politician. 

It is this code of silence about what is actually going on with the banks that is a major source of financial instability.

As BNP Paribas Chairman Michel Pebereau observed, 'utter transparency' is needed.

Just this summer,... Ms. Lagarde was trying to will the world into believing that the French banks, the ones she oversaw as France’s Minister of Economic Affairs, Finances and Industry, and the ones which are now in the headlines every day — BNP Paribas and Société Générale, among them — were sound....

In an interview even before the results of this summer’s stress tests of European banks, she told The Economist: “As far as my banks are concerned, the French banks, I am very confident about the results; and No. 2 and probably more importantly, from what I have seen of the criteria, and the kind of tests that are applied to the 91 banks in Europe, it’s a very tough standard that is applied. And I’m saying that because I have seen here and there some, you know, allegations, little hints, and, and, various comments, analysts saying ‘Oooh, not so sure about the tests.’ Well, let’s go down to the details, the tests are really, really hard.” 

... Europe’s central bankers continue to defend the fictional stress test. 

Even as late as last week, they somehow argued that “individual disclosures of sovereign exposures were an essential component of the exercise and a great enhancement in terms of transparency” despite disbelief in the markets.

The markets disbelief was in the stress tests themselves which have been subsequently shown as not very credible.

It is an undisputed fact that the individual disclosures of sovereign exposures were a significant enhancement in terms of transparency.

We often blame United States politicians and regulators for not owning up to our economic problems until it is too late. But the Europeans have tried to keep up the fiction of their economic strength for much longer....

While the United States was injecting capital in banks, guaranteeing debt and trying to increase capital requirements, European regulators were fighting behind the scenes to keep capital requirements low.

Perhaps my memory is hazy, but I think that France injected capital into its banks and, following the example set by the US, let the banks repay this capital.

The US policy of guaranteeing financial institution debt was and is a major contributor to moral hazard.

On the other hand, this blog has argued that the US should guarantee the debt if the regulators are going to have a monopoly on the information that market participants need to assess the risk of investing in the debt.

Furthermore, when regulators say that the banks are solvent (see stress tests above), they are explicitly offering investment advice.  Given that the information monopoly makes market participants dependent on the regulators for analysis of the information, if the regulators fail to properly assess the risk, the government should pick up the loss.

Instead, European regulators, including Ms. Lagarde, jumped on the banker compensation bandwagon, which might have won her political points, but appears now to have also kept the public eye off the bigger issue: Europe’s banks were woefully undercapitalized and every regulator knew it. 

Why does anyone not think the same about US banks and what their regulators knew?

Recently, a considerable amount of attention has been focused on Bank of America and analysts' estimates that it is undercapitalized by $200 billion.  Is it believable that US regulators did not know about this capital shortfall when they conducted their 2009 stress tests?  What are we to make of the representation by the regulators that accompanied the 2009 stress tests that BoA would be adequately capitalized if it raised less than a fifth of this estimated shortfall?

... Europe’s economic problems won’t be solved until the banks — and their regulators — accept that they need more capital and a solution is reached about the structure of the European Union. (It probably has to happen in that order.) 

Actually, what has to happen first is that the banks need to disclose their current asset and liability-level data.  Market participants can use this data to determine which banks are solvent and which banks are insolvent and the amount of capital needed to restore each insolvent bank to solvency.

Some of the insolvent banks will be able retain earnings and restore their solvency.  Other banks will need to be recapitalized.  Private investors are likely to participate in this recapitalization because they will know what they are buying.  Other banks will have to be closed.

The question, of course, is now that Ms. Lagarde has broken her code of silence, can she persuade the rest of her European counterparts to come clean too?

Can she persuade the rest of the global financial regulator to come clean too?

Now that the code of silence has been broken, there is no excuse for not implementing 'utter transparency' across all financial institutions.

BNP Paribas Chairman Michel Pebereau reaches time for 'utter transparency'

In a great irony, BNP Paribas which fired the Guns of August on August 9, 2007 and signaled the beginning of the financial crisis when it announced that it could no longer value sub-prime structured finance securities now finds the market is unable to value BNP Paribas.

The WSJ ran an article by Nicolas Lecaussin citing an anonymous executive on the condition of BNP Paribas.  Naturally, BNP Paribas issued a statement claiming the executive was wrong.

Why should market participants believe BNP Paribas?  If 'utter transparency', disclosing its current asset and liability-level data would show that it is right, it ought to disclose this information.

The failure to provide 'utter transparency' and disclose its current asset and liability-level data is a public admission BNP Paribas has something to hide and its anonymous executive is right.

If BNP Paribas would like help with the mechanics of offer 'utter transparency', your humber blogger is ready to assist them.

"We can no longer borrow dollars. U.S. money-market funds are not lending to us anymore," a bank executive for BNP Paribas, who declines to be named, told me last week. "Since we don't have access to dollars anymore, we're creating a market in euros. This is a first. . . . we hope it will work, otherwise the downward spiral will be hell. We will no longer be trusted at all and no one will lend to us anymore." 

He's not the only one worried. Société Générale has lost 22.5% of its value since the beginning of the summer. In early September, BNP released a statement—in English, which is highly unusual—explaining that it has abundant dollar liquidity and that BNP has nothing to worry about, unlike other banks. France's three biggest banks have been the subject of whisper campaigns about their solvency throughout the summer. 

On the surface at least, the concerns are hardly groundless. BNP, Société Générale and Crédit Agricole together hold nearly $57 billion in Greek sovereign and private debt, versus $34 billion held by the largest German banks and $14 billion at British banks. And then there is Spain and Italy. French banks held more than €140 billion in total Spanish debt and almost €400 billion in Italian debt as of December, according to the latest figures from the Bank for International Settlements. If either of these governments were to default on their debts, their banking systems could collapse and take the French system along with them. BNP, Société Générale and Credit Agricole all say that their finances are in order and the market worries are unfounded. 

But it's difficult for the BNP executive to hide his concern. "Look at the French banks' debt holdings versus those of U.S. banks," he continues. "The total debt of the three big U.S. banks (Bank of America, JP Morgan and Citigroup) is $5.86 trillion, or 39% of GDP, while the debts of BNP, Crédit Agricole and Société Générale come to €4.7 trillion, or 250% of French GDP."... 

Whether the market's worst fears are realized or not, French banks certainly maintain an all too close relationship to the state. This opaque system doesn't offer outsiders much visibility, save for the knowledge that indebted banks and an indebted French state intend to continue to cover each other, no matter the cost and on taxpayers' backs if they must.  If U.S. money-market managers no longer trust the French system, this is a glaring reason why. The fastest way to regain their trust would be to end this system.

This is true of the relationship between the banks, governments and regulators in the US, UK and the rest of Europe too (See the Nyberg Report on Irish Financial Crisis for confirmation of this fact).

The way to end this system would be to provide utter transparency as recommended under the FDR Framework.