Thursday, October 30, 2008


On the day we wake up to the most negative US Federal Reserve base rates ever remembered ('negative' after inflation, about 150bp-350bp less than the rate of inflation depending on how you calculate it) that so reminds us of Japan's response to its crisis of the early '90s (see essays below from much earlier) and as the Bank of England decides whether to drop the base rate by 150bp or more - but not so far that if the US $ now falls a bit sterling won't rise) our news media continues to bellow back-seat driver advice on matters that surely deserve whole academic theses. Lord Lawson says tax cuts are not the solution; it is too late for a Keynesian fiscal boost, best just to drop the UK's 4.5% bank rate. The Daily Telegraph opines that the Bank of England's MPC in the driving seat "but didn't know the Highway Code!" and "Bank of England acted too slowly" to cut interest rates. yet, somewhere we all know these rate cuts are not proportionately passed through to household and corporate borrowing rates. Government is meanwhile using a mix of carrot and stick to tell the banks as firmly as can be done not to accelerate foreclosures. What they do not appreciate is that they are talking to computer systems that are hard, maybe impossible, to readjust to new policy or changing strategy? Human judgment has mostly gone from the heart of traditional banking.
Elsewhere in the forest of crashing newsprint, few articles attracted as many comments in the FT site as Willem Buiter's "Making monetary policy in the UK has become simpler, in no small part thanks to Gordon Brown" (26 October), which proceeds to heap blame on the Prime Minister when he was in charge of the country's finances. Most comments continue in this orduring tone, plus laying additional blame on transatlantic cheap money and Basel II regulation of banks (for being either weakly or ineptly implemented). I agree with the last point and know what I’m talking about in painful detail (I’ve just been looking at a bank were £billions of transactions were not risk-accounted because the accounting system had only a fraction of the headings and data fields required. The failed data was sent to people who no longer worked at the bank and so nothing was done!) A banker and trader called AJGS in the FT from one of the UK clearing banks castigates accountants and risk managers for incompetence. On this, I repeat my view Basel II is conceptually competent and comprehensive, far more so perhaps than we deserve or than banks are capable of digesting; it was only half implemented when crisis struck. The bits that had not been done required economists to become involved. Until a year ago the prevailing fear among top bankers (accountants) was that if they gave way to economists they’d take over the running of the banks. What accountants had not appreciated is that banking was being taken over by mathematicians! Consequently, none, I repeat none, of the major banks succeeded in building adequate economic capital models whereby they could model for economic shocks, which is the hard-core central objective of Basel II regulation! Mathematical risk models now appear discredited and bankers, however fearfully, are forced to give economists their due - maybe?
As for cheap money, between dollar and Euro base rates in a period of subdued consumer price inflation, what choice was there for the sterling? If the UK led in experiencing recession before the EU (current GDP also estimated officially as negative) that is entirely because of how closely tied it is to the USA economy and financial services. When someone called J.L. in the FT site says Gordon Brown “ploughed his own furrow” that is not so; he followed all the prevailing theories of the day (privatisation, central bank so-called ‘independence’, long term non-inflationary growth, whatever was the fashion in the US and among New Keynesians so-called). As for the Euro, the European Commission’s own economists knew in the late '90s it would be a disaster for at least the first five years until 2005 or so, but a similar disaster if they did not do it or postponed doing it, so they decided to proceed in the hope that we'd all learn something and do better after 2006. US and UK recovery after 2001 was faster than expected largely because the Euro zone remained weak (fiscal tightening to squeeze 10 currencies into the Euro toothpaste tube knocked about $500bn off growth and cost 5 million jobs against trend). There was not a sustainable economic argument from the UK’s point of view that joining the Euro would have been good in the medium term. That said, arguments either way only offer marginal benefits net of gains and losses. Gordon took the entirely sensible view that unless there is unquestionably significant benefit for the UK, worthy of all the trouble and cost, there’s no point in joining.
Back to where we are today - whatever the UK did in credit boosting the economy with fast rising house prices, running historically high trade deficits and paying for this by selling mortgage backed securities to foreign investors, was also followed by Ireland, Greece, Spain, Netherlands and others. France and especially Germany shied away from similarly boosting domestic demand hoping instead to rely on export-led growth, which can also be a chimera. The most prudent economy of all by far, however, was Italy with the least expansion of bank credit. This did not stop it from being the first into recession! Case dismissed; Gordon reprieved for lack of compelling evidence?

Tuesday, October 28, 2008


I hope readers notice the fashion forward timeliness of topics chosen here. Today's is illustrated by Heironymus Bosch.
We have a morality in financial accounting that is double-entry book-keeping whereby we expect both sides of balance sheets to add up the same, that is when counting up income and expenditure where the balancing item is profit or loss. For assets and loan accounts, which are not part of income and expenditure, there is no obvious balancing until we insert equity value. Below-the-line or off-balance sheet items of economies (which by convention we only measure for size in terms of income and expenditure) are confusing to the unenlightened, even the generality of accountants and, dare I say it, to many economists, never mind our importuning bankers.
When television, radio, newspaper and web media discussions conflate in the same breathlessness recession and falling asset values, what is happening to both INCOME (GDP = national output = earnings + net profits) and to WEALTH (Net Assets = equity and property, plus lending & borrowing) one has to issue a warning that ‘Income’ and ‘Assets’ are not linked in ways that are intuitively obvious (except for the fact that less net wealth means less collateral for borrowing or lending and more reliance on income for security, and a fall in income means less ability to maintain consumer spending while also keeping up mortgage and interest payments, about which Governments can intervene by lowering bank base rates, increase transfers from rich to poor and lower tax rates relative to wage and consumer price inflation - if that can be called intuitive?)
If these matters of income and assets are casually inter-mingled, this is confusing to the General Public who may imagine that all the reported stock market falls and asset writedowns translate directly into, for example, a 3% fall in GDP (Jeffrey Sachs, FT, October 28) or into 1% fall (Martin Wolf, FT, October 29) this quarter and next, or that world GDP in the current quarter is falling globally by about 1% but will be just about 1% positive in 2009 (JP Morgan Chase).
Martin reports Nouriel Roubini’s gleeful sarcasm how every few weeks or days banks feel obliged to shave chunks off their previously over-bullish forecasts. Roubini’s moralistic tone like that of the general public and media vilification of irresponsible lending by banks is stunning to most bankers. They believed in their own prudence and simply do not know why it is that they did not know whatever it is they should have known better?
The Bank of England reports today that the world’s banks and other financial institutions have lost (written down for now so far) $2.8 trillions (nearly 5% in ratio to world GDP and actually part of GDP only when fully translated into profit/loss ) while neglecting to remind us of the bigger picture of all stock market capitalisations and property falls of somewhere in the region of a 66% ratio to world GDP. The fact is that we do not have a logical economic calculus, a closed double-entry system of a standard accounting model, within which to place all the much bigger (sometimes astronomical) financial numbers that are outside of world GDP (globally about $60 trillions net of inflation), numbers such as world real estate, financial assets and debt values ($200, $100 and $100 trillions), derivatives outstanding ($550 trillions nominal), annual financial cash market turnovers $1,500 trillions single-counted), or global velocity of money (interbank transactions $7,500 trillions single-counted).
Jeffrey Sachs, who advises the UN Secretary-General, took as a working assumption that if wealth has fallen by $15 trillions in the US (whose size is one quarter of the world’s economy), then this may mean a fall in spending of 10% ratio to this loss, which is how he gets to a 3% fall in world GDP, which all governments must do something to mitigate or compensate for. Jeffrey should look at the global economic model of the UN DP International Poverty Centre. His numbers (like mine) are finger-in-air, back-of-fag-packet models and our typical economists’ shorthand on all this must leave public and politicians rabbit-in-headlights confused. Bankers, we know, are already floating powerless like stunned fish weakly tail-flopping having lost all oxygen out of their familiar dark pools. Thank goodness Keynesian responses are somehow hard-wired into Governments’ tacit reflexes and not all economic history 101 forgotten. Stephen Roach (FT October 28), Chairman of Morgan Stanley Asia, recommends that The Federal Reserve be given explicit responsibility for financial stability? But, the Fed, like all central banks (including globally BIS and IMF) have always had that. Indeed, the Fed has it in full measure with the Comptroller of the National Currency, the FDIC and other tactical supports. Stephen writes very sensibly, but his argument is evidence for the fact that he like most top bankers neglected to study central banks’ financial stability reports, which claim goes to the heart of our present crisis; whatever warnings central banks issued year after year have been ignored by the very people that the usually very prescient and quite timely information was designed for!
The fact is banks’ write-downs wiped out the world’s banks capital reserves (though not equally). The fact is too that this much is normal in a severe recession, but this time the recession has some way to go yet and banks’ worldwide capital reserves will need replenishing again before recovery is upon us. It will be about 6 years before asset values recover their 2006 prices (my contribution to gloomy forecasting). World GDP will meanwhile stumble and then re-grow modestly.
The traditional job of central banks is to do all they can to ensure the financial system muddles through until then without causing longer term damage to itself or others. The traditional job of governments is to ensure the damage to the most vulnerable in society is compensated and that everyone is spring-cushioned sufficiently to bounce back.
Let’s agree that much.

You can't spend your way out of a recession, or can you?

In this week's press there is much being made of the Conservative attack by David Cameron et al on spendthrift Labour, as if its mismanagement should now be obvious to all. The political attack exploits the present crisis by pretending it is as much or more national than global and goes straight for Gordon Brown's jugular by seeking to expose his long and hard-won reputation for prudence and stability. The message is "You can't spend your way out of a recession!" 16 Hayekian or Friedmanite or Monetarist or New Keynesian or Neo-liberal economists wrote to the Sunday Telegraph saying "Occasional slowdowns are natural and necessary features of the market economy." Thus far I agree with them. They go on to say laissez-faire is the best policy and if something has to be done "which is highly disputable" then "taxes should be cut" i.e. George Bush's policy on entering office in the 2001 recession or the Geoffrey Howe fiscal and monetary stance of 1981, which cut spending and sent unemployment off the scale of all economists models to over 3 millions. The economists include Tim Congdon, Alan Peacock, Ruth Lea and the Chief Economists of Lloyds TSB and Cazenove. They want Government to provide tax cuts while remaining within 4% budget deficit and 40% ratio to GDP of National Debt. I think this stance is political and ideological and unwarranted. Conservatives have failed to notice it seems that the FT's economists and leading commentators are all now sounding convincingly Keynesian who recognise that the Government can and must spend our way out of recession. They recognise the unprecedented scale of problems this time, possibly by being more closely aware of the dangers of severe systemic problems in the financial system just as we enter recession.
The more died (sic) in the wool Conservative 16 are not getting it, even if Tim Congdon (FT 22 October) went so far as to advocate an unlimited long term repo liquidity window by a better capitalised Bank of England, only because he otherwise fears a "rapacious and hostile" Government. The not so sweet 16 want to discredit Gordon Brown in the Mais lecture tomorrow when in his Iron Chancellor style he tells us what we already know that the National debt will grow to exceed 40% (temporarily). His unfortunate iron (he doesn't do ironic) style is one of wooden assurrances (that repeat like a stuck-record, whichj Polly Toynbee in today's Guardian unkindly describes as "unable to stop saying things so blindingly untrue that you wonder how he gets the words out" that "as hammer blows rain down day after day" he can still reassert that Britain is better placed than other economies to weather recession). I answer some of the questions and make pointed statements below about Gordon Brown’s stewardship of the economy about which I have somewhere written a short history.
1. Government’s role is not as commanding as that of a company’s board and CEO, so let’s not exaggerate.
2. In Labour’s first term Gordon Brown kept to conservative budget forecasts inherited from Ken Clark, his Conservative predecessor whose Keynesian walk belied his Monetarist talk and who sensibly never remained within his own deficit projections. Gordon did, however, and went even further by repaying £15bn of National Debt almost immediately (on Martin Wheale’s advice from the NIESR when he really did not need to that - Martin was really surprised at being taken so literally when all his own forecasts were rarely close to accurate). Gordon embraced the idea as further political signal of his prudence to the markets (while at the same time the UK generously left Hong Kong endowed with $50 billions of foreign reserves that it could just as easily have raided to balance the UK Government's budget and boost spending).
3. When recession and bust arrived in 2001, Gordon by chance or by foresight (jury's still out) anticipated this by raising public spending ahead of time sufficiently to keep GDP growth positive when the US went into recession (and EU Eurozone growth was flat and low with 3 times UK unemployment rates). Consequently, UK property price growth barely stumbled. This one time Gordon really did ban boom & bust, but has never resorted to owning up to that; the truth that the UK economy is tied so tightly to that of the US has never been publicly admitted. Please note too that even New Labour’s distancing from old Labour’s so-called tax and spend profligacy was greatly exaggerated for political effect; there was only ever one year when Labour spent outside of Maastricht criteria even though these had not yet been invented! Labour’s budgets in the distant past, even by today’s prudential standards, were always conservative, marginal tax rates notwithstanding.
4. The UK in the last 14 good years has experienced improving and high employment (mostly under New labour), strong currency (whereby UK firms bought foreign firms and other assets cheaply), attracting massive foreign investment inflows (greater than China’s such that a quarter of UK industrial production received much higher investment and productivity growth than would otherwise have happened) and aggregate prosperity was high. 5. The government’s real share of the economy (not the budget’s ratio to GDP) was lower than the US (at about 18%) and the UK became for a few years the world’s 4th largest economy.
6. The trade deficit-gap grew too large (funded by selling financial assets) and property rose too fast depriving UK manufacturing of investment finance from banks, and yet industry performed better than in the ’80s. Public house building was abandoned absolutely (big mistake) and local government and agencies' powers, social and legal responsibilities continued to be squeezed financially under New Labour as had been begun under preceding Tory Governments. New Labour was too slow in repairing the damage done to Health and Education, and, in its first term especially, entirely ignored its employment responsibilities in the Public Sector as it did its responsibilities to pensioners. These are financial and economic engines of the economy that New Labour conservatively mistrusted and neglected.
7. Finance and professional services prospered at twice the rate of the rest of the economy, but no-one knew whether to, or how to, contain the most global of economic sectors on which much of 'trickle-down' economic 'feel-good' theory was based!
8. Inflation, bank rate, growth, national debt and budget deficits were kept within practical bounds. Despite households having the highest debt to GDP ratio in the EU, relative to household assets net debt was at EU average and considered safe.
9. Gordon’s crimes include allowing public pensions to drop to half of what they should be. Doubling the state pension to restore the value prevailing in the 1950s would have been eminently affordable as growing taxes paid by wealthy pensioners pay for all of state pensions and more. Poverty and old-age health provision could and should have become much better. Instead they deteriorated and continue to fester badly. A promise to double the state pension will win the next election for whichever party has the good sense to see that.
10. Inefficient housekeeping precepts (inherited from the Tories in the ’80s) led to failure to relate tax income directly and indirectly to public spending so that opportunities to economise on net cost to taxpayers of public spending were regularly missed and this led too to rotten accounting of public-private partnership schemes and inability to see the economic growth benefits of more and better targeted social welfare and infrastructure spending. In 1979 Thatcher and Neave banned the Treasury from ever again informing Cabinet of the difference between the gross cost and net after-tax cost of any item of public expenditure. This ban was not overturned since then.
In conclusion, there was little in the last 3 years say that Gordon or Alistair Darling failed to do that could have very significantly softened the impact of the present crisis whose risk factors are predominantly global, not even tightening the economy sooner by setting aside more room for borrowing within the Government’s own Golden Rule. Darling is sensibly trying to bring forward medium term spending plans and to speed up current spending so as to have a more timely counter-cyclical effect on top of the normal automatic stabilisers. The Conservative opposition's rhetoric about the Government not having a plan only an overdraft is knowingly simple-minded to exploit the general public’s naivete. It is beneath the intellect of many on the opposition front benches, but is spin-doctor inspired by Margaret Thatcher’s principled (but in practise unknowingly hypocritical) rhetoric of the early ’80s about being a good housekeeper of the public purse, when 365 well-educated economists published a joint letter of protest at the time arguing that present policy was patently absurd! It says a lot for the Opposition's case that it can today only muster 16 economists

Monday, October 27, 2008

Gordon Brown's Basel II haircut or hairshirt?

Willem Buiter in the FT (today, 27 October) has issued a long and damning indictment of Gordon brown and of Basel II banking regulation. My equally ex-cathedra response (also posted in the FT) follows:
The Basel II accord did not permit banks to "skimp on capital in exchange for better risk management and market discipline". Basel II has not yet been fully implemented and was only half-way complete by the time the credit crunch struck. Reliance on banks’ internal risk models (something Buiter is angered about) never happened, and in any case all internal models overwhelmingly continued to rely on external ratings agency data. All that internal models could do that marking-to-market could not was risk assess loan collateral and haircuts, and again those tasks use external ratings. One major problem in this was that the external ratings models of CDOs were spectacularly wrong (see blog below "Ratings agencies: the smoking gun" and "protecting Assets like a junk-yard dog" and "B2 or not B2? - another long essay"! Market discipline may be inversely proportional to the degree of euphoria in the market, but Basel II is specifically designed to address this, especially in its Pillar II stress testing and scenario modelling for extreme shocks. It was this aspect that all banks struggled with a failed at. But that was an intellectual as well as a management failure. And the lack of involvement of macro-economists and poverty of academic treatises on the subject are also very much to blame.Basel II did not introduce “vulnerabilities” in what banks knew about risks; they were already there. Basel II and IFRS, when fully implemented, will mean that senior managements of banks cannot be blind-sided on excessive risks - as many have claimed in their hairshirt defence; that they only knew what was in their conventionally audited accounts. No bankers have blamed Basel II for not knowing their true positions!
It is a dilemma to insist on mark-to-market valuations when these depend on ratings agencies errors. Banks and other CDO investors were misled and need time (over the next 5-6 years) to work their way out of current m2m losses in CDOs until actual economic losses are realised, when they will be considerably lesser by about half. Spreading losses over time also reduces those losses and this is what central bank support aims to achieve, to win more time for the banks. Strict mark-to-market principles invite the danger that banks act severely pro-cyclically. Systemic stability may be best served by banks publishing under Basel II Pillar III both m2m and hold-to-maturity values with a strategy for getting from one to the other. There should not be an obstacle in the way of banks taking assets underlying their originated CDOs back on banking book balance sheet, at least the equity and mezzanine tranches. There is no official global relaxation of constraints on bank balance sheet reporting, not yet.
It seems mistaken to blame Gordon Brown as Chancellor of the Exchequer, for encouraging “self-regulation wherever conceivable for banks and other highly leveraged institutions.” That has obviously been led by repeal of Glass-Steagal and other measures including a hands- off de-regulation by SEC and stock exchanges regarding quality of market issues, and decades of tolerance of OTC fixed income markets. Basel II is absolutely not “light-touch regulation” neither does it represent any less than a “strengthening of the global coordination of national financial regulatory regimes”. The cross-border rights of regulators and their coordination and agreement to all sing from the same hymn sheet in risk and accounting standards is clearly defined and operating even as the Basel II edifice is only half-built and only in its first-version implementations. No bank has passed muster in Basel II Pillar I without major issues being spotted by regulators and penalties threatened and imposed including cancelling banking licenses (e.g. Fortis Netherlands). Brown accepted FSA’s membership of C-ebs and opposed EU alignment of tax rates and fiscal stance (via Euro membership), but remained fully aware of the competitive pressures pushing for this as well as good arguments for opposing. A question of optimal balance. Does Willem think all this was wrong? The idea of a regulatory race to the bottom in the face of Sarbanes Oxley, Basel II and IFRS seems much exaggerated. Market euphoria is hard to iron out. In any case a good dose of cyclical experience from time to time is good for the soul of capitalism.
If Brown deemed it advisable to be a devoted disciple of Alan Greenspan, he was in good company and it must have seemed confidence-building politically. But, I am quite unaware of Greenspan having personally diluted Basel II or IFRS or Sarbanes-Oxley, even if he did oppose CDS regulation and trusted too much in the banks. But the banks were not the sole problem. The question of CDS is also the question of unregulated OTC markets and that has a history stretching back long before Greenspan. He flip-flopped less on regulation than Christopher Cox at the SEC, and let’s not forget that market values were for most of Greenspan’s tenure patently cyclical and then still in recovery upturn from 2001 when he vacated his throne. And yes, “Mr. Greenspan, much to his credit, has the intellectual honesty to admit that he was wrong.” Though he is wrong to say, “The whole intellectual edifice, however, collapsed in the summer of last year because the data inputted into the risk management models generally covered only the past two decades, a period of euphoria.“ The fact is, as Moody’s admitted, key historical data was not updated after 2003 by ratings agencies, if we accept that what Moody’s did was true of S&P and Fitch? And, let’s not neglect just how ubiquitous the ratings agencies’ data (and commission services) were and are to the business of commercial as well as investment banking!
Willem says, “The day you hear a political figure say: ‘I am sorry; I made a mistake because I had the wrong understanding of how the world works’ is the day we will be skating in hell on natural ice.” Politicians are in power because they at least know how democratic politics works, what we pay them for. Anything else is up to other professionals like Willem! And we (if I may count in myself with him) have to politically and intellectually win our war of ideas and policy prescriptions. We are mandarins of banking economics. Where are our mea culpas?
Describing Brown’s relentlessly expansionary fiscal policy in New Labour’s second term as”pro-cyclical” is interesting, even Keynesian, but GDP rates were close to or below the so-called long term non-inflationary growth rates. He was wedded to long term stability. The criticism should be that he did not act firmly enough to balance the external account while welcoming FDI inflows bigger than China’s, and certainly should have succeeded better in cooling the property market. But, were there votes in that? Are our intelligent chattering class property investors not also blame-worthy? And, what would have been the media or public response to reviving public sector house-building or raising stamp duty further? In any case, our economy is tied to the US so closely that we are forced to either ride with, or use the lag of 2 quarters to try and actively cushion the UK economy against, the US cycles. Boosting public spending seemed a solution for the latter, one that worked a few years ago at the end of New Labour’s first term picking up on similar deficit spending boosts that Ken Clark employed to climb out of the ‘92 recession and again in ‘95 when growth suddenly faltered (due to severe winter weather in the US and the US budget sign-off crisis), as it was faltering again (led by falling US property prices) leading into the credit crunch of ‘07. The very sound point has been made in the FT by Gillian Tett, that governments have been racing to save the banks in order to try and out-run recession and ensure banks have some part to play in acting counting-cyclically, however marginal compared to what governments will do, and are doing, as the economy’s main counter-cyclical pedalist. In that regard, Gordon Brown’s taking the lead globally has much to be said for it as Willem no doubt agrees. [for more see comment]

Sunday, October 26, 2008

Protecting assets like a junk-yard dog?

Today, the UK experienced a small quake that the BBC reports merely rattled the crockery on kitchen sideboards, nothing compared to the quakes and after-shocks rattling stock market investors. I feel flabbergasted at the insouciance (blithe unconcern or faith in honest doubt) with which exchanges and regulators view the short-selling tremors in stock markets without serious challenge that politicians are stridently (anxiously and angrily) calling for? We have had not very effective bans on 'naked short-selling' but it now seems that SEC and FSA believe it is enough to insist on short-sellers reporting only when their short positions exceed 3% of a stock? This is fantastical. From the data just this year we can see that all the thousands of short-sellers added together borrow in total less than 10%, usually less than 5%, of a stock. And we can see this is easily sufficient to pull down the share price for narrow speculative reasons i.e. greed (unless you ideologically believe short-selling is merely derivative style self-protection and healthy competition transferring money from failing firms to superior more successful ones; our dog eat dog banks shorting of each other in a Darwinian race to see who falls furthest - a giant game of chicken?)
Are we expected to believe three quarters to one third of the shares loaned out could all have been borrowed by only one short-seller with 3% or more of the target's stock? The answer is no and therefore the FSA's short-selling reporting proposal will result in zero reporting of short positions. And since this should be obvious to any professionals, it makes a complete farce of the welcome given to this 3% idea by financial industry bodies representing institutional investors!
The media is also happily reporting that hedge funds (who are not the only short-sellers, but undoubtedly the dominant players) had a 9.9% loss in the year to end September, and are now experiencing 10% withdrawals, plus Nouriel Roubini's claim (widely reported) that 500 hedge funds will fold in the next few weeks. I take the view that these news items will serve Hedge Funds very nicely by helping in efforts to dissuade regulators from restoring or extending short-selling bans or making new laws to gain more transparency and make hedge funds subject to stricter regulation on a par with the regulation of mutual funds or even that of banks. The reported average losses of hedge funds is a good performance. It is only the aggregate; many funds have made strong gains. That 500 funds (out of over 40,000 hedge funds) will close is an easy prediction and probably a conservative one. More than 1,000 hedge funds closed in 2004/5, though 1,500 new ones opened at the same time; birth rate may be more interesting therefore than death rate of hedge funds. That investors in hedge funds are withdrawing 10% of funds (an estimate by Credit Suisse/Tremont) is also an easy call, neither surprising nor unprecedented (in fact the least one can expect in a currently cash-strapped world). The sum involved is $170-300bn. Reuters continue to refer to “the $1.7 trillion hedge fund industry.” That may be the US share. Others believe the global figure is $3 trillions. Institutional Investor News estimated total industry assets at $2.68tn by Q3 2007. The fact is that we do not know. We need to know. Many investors will withdraw to shift out of some hedge funds now (it takes time) only to invest in other hedge funds later or build their own hedge funds for the rich fees (1-2% management fee plus up to 20% of gains). There is no official public guidance to choke off stock lending on which much short-selling depends! Of course, supposedly, it is up to the good sense of stock-holders to be sensible and not lend stock they know will only get dumped to drag down market prices. But owners of shares do not always know when their shares have been lent. Some stock owners may themselves be derivative-shorting the market anyway via puts, and are happy to earn a small additional 200-500bp margin by renting shares they have already hedged. Many holders of stock cannot sell if they manage index-tracking funds (traditionally over half of mutual, insurance and pension funds' equity holdings). Furthermore, stock exchanges like the LSE are doing their best to attract short-sellers (CFD – contracts for difference) simply because these drive a large % of transaction volumes and transaction volumes are factored into stock exchanges' own share price valuations. Exchanges are happiest to have stocks churned and seem indifferent to price quality issues. Exchanges appear blithely indifferent to the growing imbalance between extreme speculators and long term investors.
Some long term investors like Berkshire Hathaway's Warren Buffet are happy about short-selling for now. He is now shifting massively into US equities and will buy somewhere around the floor of current prices (Dow at 7,500, FTSE at 3,000?). Warren Buffet 's personal investment account until recently comprised only US government bonds. According to this weekend's FT, his 'net worth' will soon be 100% invested in US equities! Motto: “Be fearful when others are greedy and greedy when others are fearful.” Buffet is little-invested outside the US and actually he will be investing in US equities just as globally everyone is piling into a rising US $, and where better than US equities just as they may be about to bounce off both a short term and a long term bottom? In this respect he is anticipating where greed risk-takers are going next. Motto: “follow the high net worth money.”
The FSA (FSA) said on Wednesday it does not see the need for new regulation of hedge funds because they are performing relatively better than others. The latter point is true but does not directly relate to whether or not hedge funds should be subject to new laws, an issue that concerns the so-called 'shadow-banking' sector. Hector sants, FSA CEO said at Hedge 2008 "I ... recognise there is pressure for more regulation in a rather general way... I don't particularly think more regulation is needed, but I do think more effective regulation is needed... Hedge fund managers in general are weathering the market turmoil pretty well in the circumstances, certainly versus other components of the financial services industry", adding that he expects more funds to fail.
Recently it has been claimed that a third of hedge funds are in money market funds and another third is committed to short-selling. The final third may be pledged as collateral or in various vulture fund plays. A big percentage must be in macro-strategies. Who knows? The leverage (excluding derivative market leverage) of hedge funds could be anywhere in the $10-20 trillion range, which could therefore represent anywhere from 8% to 16% of world financial assets ($118tn at end 2006) or more likely 10-30% of world financial assets today. We don't know. But this rough estimate alone suggests that 'shadow banking' is enormous. When we consider leverage via derivatives the scale becomes hard to compute. The FSA, following the SEC's similar stance, said on Thursday it plans to make (short-selling) investors disclose holdings of more than 3% in companies through CFDs (contracts for difference). This would seems absurd even if the reporting must cover positions held to that threshold or above at any moment in time however brief, except when we appreciate the scale on which hedge funds can operate. The rationale is unclear, however, since prices can be moved very effectively by the frequency of the net direction of buy/sell signals more than by the volumes involved. Price movements do not correlate with volume. That is stock market 1.01 (US expression).
The FSA said a final draft of long overdue rules on CFDs (said to be one third of trading in UK equities) - under which one party agrees to pay another the difference between the current and future price of a share - will be published in February 2009 and come into force by September 1 2009. Do we hear stable doors closing? This delay reflects the fact that the FSA does not regulate by simple fiat, or very rarely and reluctantly. It is really still part of a self-regulation culture like a membership club that relies on consulting with the industry first, seeking the agreement of the members who, after all, pay the FSA's fees, like membership subscriptions even if they have no choice and no power to determine those fees. Lord Turner has said that the FSA will from now on stop regulating on the cheap. But, until and unless government pays for its own agency, it would seem unlikely that the membership club regulatory culture will change. "Our goal is to provide an effective and proportionate disclosure regime that works for all involved, and sustains market confidence and efficiency," said FSA Director of Markets Alexander Justham. Clearing services publish stock lending and we can see the effect on bank shares.
Reuters explains that “CFD holders, who effectively have the benefits and risks of a stock without owning it, are currently not obliged to make their positions public, allowing some hedge funds to use them to anonymously build sizable stakes in companies they wish to influence.” This also sounds insouciant, when we know that the “benefits and risks” referred to are the inverse of long term investors' interests, especially with respect to bank stocks that have a systemic importance in banks' capital and why naked short-selling of bank stocks was temporarily banned! The ABI Director of Investment Affairs Peter Montagnon (Association of British Insurers, the UK's biggest institutional investors), referring to the FSA's proposed new rules on CFDs, said “the measure would improve transparency...This is a welcome step forward. Companies should know who has built up a stake and investors too should be aware of what would otherwise be happening behind their backs." If they are lending out their shares to CFD speculators, how is this happening behind their backs? The UK's Association of Investment Companies, the investment trust industry, also welcomed the move, saying, "These disclosures should let shareholders understand who might try and exert influence over the affairs of companies they own and then allow them to act accordingly to protect their own long-term interests." Again, why do they not take action themselves on stock lending? It is not that hard to know what is going on already.
Hedge Funds are said to devote 30% of funds to short-selling (renting borrowed shares to sell into the market then buying them back cheaper later to return the lender). The markets and shares that are the targets of short-selling are those expected to fall, or already falling and expected to fall more or known to be vulnerable to being dragged down by short-sellers. They are will be 'shorted.' This is not hard to know by traders with access to derivatives markets who can detect overnight 'puts' that will trigger price falls in the cash market as soon as stock exchanges open next trading day. For prime brokerages and their hedge fund clients this is not rocket science.
Intra-day short-sellers using borrowed stock will seek to sell at times and in exchanges for maximum negative impact, say on opening to mid-morning and then buy them back at mid-day before the afternoon mini- “dead cat” bounce – or at whatever time fits with the period over which the shares are borrowed. For maximum impact short-sellers try to signal as loudly as they can to the whole market. detecting these signals is easy for market insiders and leaks out to all others. How this is done is exactly the opposite way to how big buyers or sellers normally seek to minimise market impact by disguising signals when trying to buy cheap or sell dear. Maximum market impact is obtained not by size and direction (a big sell-order) but by the frequency of sell orders in the cash market i.e. a lot of smaller sell-orders. I know this from my own models and from work done by and for stock exchanges in the past.
When stock markets in US and Europe fell by over 40% in the year to date, what profit gains were possible for short sellers sector by sector for June and July? How when falling sectors devastate the portfolios of most investors can this multiply the wealth of those who use CFDs and inverse ETFs (Exchange Traded Funds). Again this is not hard to know. below is a list of short-selling CFD gains that were possible in the US this year. Hedge Funds may wish to check whether they performed this well. Between June 5 and July 15 the technology sector share falls delivered 30.9% gains to short-sellers, and the real estate sector 46.1%. Between June 5 and July 11 in the semiconductor sector the gain was 37,2%. May 15 to July 15 the consumer services sector delivered 37.7% and the financial sector a whopping 106.7%.
What about September and October, great days for shorting? 49.6% gain in 14 days in semiconductor (October 1 – 15), 61.0% in technology (September 25 - October 10), 89.13% in real estate (September 26 - October 15), 89.6% in consumer services (September 26 - October 15), and 89.9% gain in financial stocks (October 1 - October 9)! If Hedge funds deliver loss performances given these gains, offering gains to concerted equity plays of 300-500% in 4 months, then that does suggest that they really do need some risk regulatory oversight or cash-flow forensic audits. The other side of this coin of course is what has happened to mutual funds, insurance and pension funds who funds have lost massive value? This is surely a massive shift of several $trillions, a Mount Everest of Funds, from funds that serve the general public interest to hedge funds serving the super-rich. That would be one view. Of course, mutual funds, insurance and pension funds may be complicit with hedge funds (some of biggest of which are owned by banks) insofar as possibly up to 10% of the funds of the former may be vested in the latter? US Mutual funds 5 years ago used to be ten times the size of hedge funds. They may now be less than three times or even only twice the size of hedge funds! Banks as we know are desperate to bank profits and restore their capital reserves. They also have hedge funds who may be aggressively doing their bit to book profits by short-selling, which can be ironic when the banks have for short period been protected from naked short-selling. But also the banks' corporate clients would be somewhat aggrieved to learn when the FSA's disclosure rule results in publishable data to learn that hedge funds owned by banks were dumping their stock. It may also be a dysfunctional fact of life that banks happily extend credit facilities to hedge funds that are shorting bank shares and the credit-worthiness of the banks' corporate finance clients. Short selling is an easy choice when bank managements lost credibility in how they cope with the changed macro-economic situation. It does not help when banks and their underwriters, not just hedge funds, are short selling each others' stocks to make money as their own share prices fall. Banks short-selling each other cannot be conducive to restoring interbank credit markets. As one US newsletter defines seeking to mitigate the rapidity with which markets can collapse in our dog eat dog world is merely “protecting assets like a junk-yard dog!”

Thursday, October 23, 2008


The banking crisis appears remarkable for so much depending on just one asset class? If you are puzzled as to why US legislators and EU politicians are especially angry about the central role of the ratings agencies (Standard & Poor's, Moody's Investors Service and Fitch Group) in the financial crisis, read on. Ratings agencies are arguably more vital to the financial system than even accountants! Why? Because the ratings agencies value banking assets more succinctly or persuasively than accountancy firms. As a theological reminder, it is important to bear in mind that risk grade ratings (using Letters A,B,C,D with + or – and numbers 1.2.3 etc.) are essentially the aggregate of re-payment default and final loss after recoveries. The potential to default and loss given at default are estimated historically over a full economic or credit cycle pertaining to many thousands of examples of asset classes, obligors, counterparties, and very large pools of millions of retail loans, credit cards, mortgages etc. A credit risk grade expresses the known likely % within large populations of borrowers that some will default on loan repayment. Risk grades can also reflect market risks of tradable financial instruments if they are suitably long-established with a reliable history of price volatility. It is on the basis of the risk grades that financial assets have value and prices (or spreads). These risk estimates have to adjust however depending upon the maturity of a loan. That is to say if a loan (asset) has a maturity of months or a few years only, say 1-3 years, then if repayment of principal and interest can be forecast to occur in a downturn or other predictable shock period, or cycle turning point, then the average default rate over a whole cycle is not the true representative risk-price. This is the problem especially with SME loans, credit card and car loan debts which are short term, while mortgage debts are much longer term and are likely to experience one or two economic cycles. Corporate loans are also rated according to the company's type and size since a large % of small firms (about 10% close or fail each year) and firms that are heavily borrowed, such as property developers, do not generally survive well over economic cycles, similarly for certain classes of household borrowings such as overdrafts and general consumer credit.
The credit crunch story of ratings begins with Moody's and Fitch the first bond ratings agencies, both formed in 1913. S&P followed in 1941. Only Moody's is publicly quoted (as of 2000). Its revenues grew fast, as did the other two global raters, reporting the highest profit margins of any company in the S&P 500 index for five years running; shares up 500% in 4 years, earnings up 900 % in 7 years, with nearly half of its revenue coming from its collateralized debt obligations (CDO) ratings service, until in the past year it lost over 60% share value to a P/E of 5 ($2bn income, $1bn profit, $5bn mkt.cap.) Two years ago, by the winter of 2006 it was clear something was going wrong with the risk ratings of CDOs most of the contents of which (about 90-95%) were originally rated triple-A by the three ratings agencies. This was hardly unexpected, however, as US real estate began falling in certain areas in 2005 and in the US there is always a risk of mortgagees abandoning their properties when the remaining equity is below the remaining debt; the only recourse of the lenders is to the value of the property, not the borrower, unlike in Europe. In areas between San Francisco and Los Angeles a large % of new house buyers have negative equity today of approx. 66% compared to the outstanding loans! Before the end of 2006, about 750 CDO bonds had been downgraded in the previous 2 years. They fell in value by about $25bn (or 2% of the total mortgage backed CDOs) because of falls in repayment rates by sub-prime U.S. mortgage holders, according to Lehman Brothers Holdings who claimed to maintain the most thorough analysis. CDOs (a broad term for unregulated fixed income asset-backed securities, mainly bonds supported by mortgages or credit card debt) were designed to sell chunks of banks assets to free up capital for faster lending growth (fueling 'credit boom' economies). CDOs could average 5-8% yields and given their high credit-rating appeared to be very good value to investors; Cdos were easy to sell. The first CDOs were packaged by Drexel Burnham Lambert in '87. In those days (since '78) the term 'sub-prime' meant high credit-worthy borrowers just below the highest grade. In late 1992 the term suddenly changed meaning. It now meant low credit-worthy borrowers? In 1992 at the end of the outgoing George H. W. Bush administration regulation had changed allowing financial brokers, not just commercial banks to offer mortgages. It was then when financial engineers at JP Morgan figured out how large amounts of sub-prime mortgages could be included in investment-grade CDOs. The sub-prime mortgage market grew dramatically at an annual rate of 25% between 1994 and 2005, a tenfold increase in a decade. By early 2007 CDOs were worth over $2tn (almost as much as all banks' own capital), of which a quarter was sub-prime mortgages. At first this was considered a good thing. Sub-prime mortgages were an important social policy, growing the property-owning democracy and appropriately underwritten by federal government agencies Fannie Mae and Freddie Mac. In 1994, less than 5% of mortgages in the US were sub-prime. Home ownership increased 1.94% annually during the Clinton administrations, reaching 67.7% by 2000. Today, of about $11.6tn in outstanding mortgages, one-quarter are sub-prime and Alt-A loans. In the '80s S&L crisis, by comparison only about one tenth as much at today's prices was sub-prime and yet even at that level was partly blamed for the '90-'91 recession! A major problem for investors in CDO securities was the absence of a liquid secondary trading market with price transparency. Investors or their brokers had no screen service they could look up to check daily prices. Consequently, investors (unless they were market insiders) did not know when values dropped as defaults increased. There was no easy way then or since for investors to find out what their CDOs are worth in the market, which is not an uncommon problem for many bank bonds, but became alarming for a market that grew to become huge in scale. Though, from a regulator's viewpoint, however, CDOs represented only about 2% of the total of world financial assets (totaling $118tn by end of 2005). Even today, the delinquency in the underlying US mortgages is estimated at about 3.5%, but 3-4 times this in sub-prime mortgages (say 13% of $700bn) and rising. Indicators did emerge of the market value of the bonds, but mainly the valuations (ABX index etc.) are based on risk gradings. CDOs are variable in their contract details and not easy to compare. To date write-offs have totaled about $505bn, or 4.3% of the total mortgage market.
The difficult-to-chart slide in CDO values exposed the little understood role played by rating companies in assessing risk and acting as the only de facto regulators in a market that lacked official watchdogs. Again, from a regulator's perspective the market was considered to be a professional interbank and institutional investor market. Most of the world's CDOs are owned by banks and insurance companies, and the people who regulate those firms rely on the ratings to provide a sound basis for valuations of CDOs. But, the market changed once regulations were relaxed to allow Alternative Investments to be included in retail investment funds, pension and insurance funds. Rating agencies facilitated this greatly by maintaining high risk grades for new issues, surprisingly so when signs of possible recession were on the horizon and obvious at least to economists. The ratings agencies did more than value CDOs by giving them letter grades; they helped banks and other financial firms create CDOs (e.g. wrapping together 100 or more bonds and other securities, including debt investments backed by home loans) and then slice and dice them into tranches, each with a separate grade. The raters told CDO originators how to get most profit by maximizing the tranches with the highest ratings so that typically 80%-95% will be AAA and the rest AA or A.
All pretence that financial engineering could dispel expected risks was lost on August 16 2007 when, after an internal revision of its ratings practices, Moody announced new corrected ratings models. These ignited the credit crunch like a dirty bomb devastating $trillions of assets and derivatives and in turn most the world's biggest banks, and as yet untold numbers of investment funds worldwide! If a company's bond is given a triple-A rating, it means Moody (or its nearest competitors ,S&P and Fitch) believes unsecured loans to the company (its bonds etc.) are as safe as Government debt, an extremely high probability of lenders being repaid the principal plus interest, bonds that could become collateral for at least 80% of face value. A great deal more in loans and funding was teetering on the values of CDOs. The lower the rating - from Triple A to Double A to Single A - and on down to Baa, below which the bond or loan is rated junk, certainly not investment grade i.e. high-risk! rapidly $100s of billions of CDOs dropped 4 to 17 notches, from highest grade to lowest grade and over a year were discounted by 60% to 80% to over 90%!
It has been essential for nearly a century that all bonds by publicly quoted issuers receive a credit rating. Ratings services are paid for by issuers, and only in some cases by investors, through fees or subscriptions. As debt markets grew, investors sought two ratings, Moody's and Standard & Poor's, a duopoly and sometimes as a third check, Fitch, which with Moody's and S&P, is internationally recognised by all regulators. Basel II, for example, requires 3 independent ratings from which banks may take only the middle or lowest value for risk assessment if the ratings differ. Until 3 ratings were required and not merely 2, Banks could avoid Moody's, which was known for giving lower ratings than its competitors until recent years when some of their strict internal rules were abandoned.
Rating a corporate bond, involves rating a company, and companies have assets, business models, balance sheets, management qualities, shares if public, and, most importantly, credit history. A rating is based on a quantitative model plus qualitative human judgment, just as banks do internally. Increasingly banks have become almost wholly dependent on external ratings and their internal analytics have therefore suffered. Rating a structured-finance instrument like a CDO is different if it is an asset-backed security vested in a 'failsafe' or 'bankruptcy remote' Structured Investment Vehicle (SIV) or Special Purpose Entity (SPE), which more often than not is a registered company in an off-shore tax-haven managed by lawyers and/or an accountant. Rather than having an established corporation or bank as direct issuer, the securitized (structured) bonds are backed by pools of debts (either mortgages, or auto loans, or credit card loans or other loan types, not a mix of these (usually from a single national jurisdiction) but can be from more than one bank or mortgage broker , building society etc.) These are collected, packaged into tranches, rated per tranche, and sold on by banks' arms-length SIV/SPEs or others (while the banks or agencies that originated the assets continue to manage them for a fee and who may contribute commercial paper and/or insurance against defaults above certain % levels in the issued bonds). Higher ratings were believed to be ensured (justified) by various credit enhancements including over-collateralization (pledging collateral in excess of the debt issued), credit default insurance, and equity tranche investors willing to bear the first 5% losses and mezzanine investors the next 5%. The high ratings achieved allowed banks to sell on mortgage assets paying them 8% or higher in the form of bonds that paid the senior tranche (80-95% of the total) only say 5-6%. The banks called the difference 'the spread' and booked it as profit. Such a wide spread should have indicated to experienced secondary market traders that the bonds were much riskier than they appeared. Banks could use the spread to cover the insurance and CP cost of securing higher grades, but also borrowed to do so thereby keeping the spread as profitable additions to own capital i.e. they replaced the funds loaned (enabling accelerated loan growth), sold of much or most of the risk, and still generated a profit equivalent to what they would have earned had the loans remained on their balance sheets – or so they thought that is, until Moody's discovered a bug error in its rating model software!
After August 16 2007 when Moody's announced new improved ratings models, rating agencies lowered the credit ratings on $1.9tn in mortgage backed securities by July 2008. The downgrades may have averaged about 50% of the face value a year earlier, but that became academic when Merril-Lynch sold $30bn of CDOs for 22 cents on the dollar, which now looks actually a good deal?! About 6m sub-prime mortgages were securitized in the US (of over 7.5 million first-lien sub-prime mortgages outstanding) and one quarter of these resulted in possible foreclosures by 2008! Big banks and other financial firms around the world reported losses of approx. $435bn by mid-July 2008 and $505bn by end of September, equal to about one fifth of all banks' capital reserves. Approx. 16% of sub-prime loans with adjustable rate mortgages (ARM) were 90-days delinquent or in foreclosure proceedings as of October 2007, roughly triple the rate of 2005. By January 2008, the delinquency rate had risen to 21%and by May 2008 it was 25%.
The U.S. mortgage market is just under $12tn with approx. 9.2% of loans delinquent or in foreclosure by August 2008. Sub-prime ARMs are 6.8% of the loans outstanding in the US, but 43% of foreclosures in 2007 when 1.3m properties were subject to foreclosure filings (up 79% compared to 2006).
HSBC was the first bank to announce a large write-off in mortgage backed assets of $10.5bn in January 2007. Such announcements by other banks followed in a steady stream ever since.
As we all now know the knock-on multiplier effect of these risk down-grades, write-offs, interbank credit crisis etc. is enormous. The question is how different would this have been if the risk gradings had been realistic from the start? The market would not have grown so fast. The credit boom economies would have been curtailed to slower growth. Property values would not have ballooned so much and the recession therefore less severe. Why were the ratings wrong? Most structured bonds are collections of mortgage or credit card loans originally packaged by banks and evaluated and underwritten by other banks based on rating agencies risk grades. Credit card securitizations are many times riskier assets (higher default risk) than mortgages because credit card debt is unsecured, yet as much credit card debt has been securitized and sold off banks balance sheets just as sub-prime mortgages have been (both just over $900bn in the US, but credit card bonds have a much shorter maturity, typically 4-5 months!). The insurance cover of now $54tn in CDS also poses tens of $billions in losses. $16 trillions or so have been written off world stock market equity capitalisations! Much of this would have happened anyway whenever recessions hit. But, could a much more manageable situation have arisen if $ trillions had not been over-rated? The measure of manageable has to be within the Basel capital reserve ratios of the banks at 8% of net risk-weighted assets.The actual impact looks like being 2-3 times this! (For more on this see the attached comment.)

Tuesday, October 21, 2008

B2 or not B2? - another long essay!

Adair Turner, Chairman of the FSA (UK's financial regulator) suggests wiping the slate clean and redesigning bank regulation anew in the light of the lessons learned from the present crisis. Cleaning the Augean Stables sounds good to the public and politicians, but it is a Herculean task, in fact impossible and undesirable. It needs restating that global banking was already implementing comprehensive safeguards, Basel II (B2) and the almost identical Solvency II (for insurance firms), which in the EU have the force of law and are now reflected in new IFRS accounting standards. But of B2's three 'pillars' only Pillar I is close to complete implementation (covering credit and market risks for the calculation of minimum regulatory Tier 1 capital). And like generations of any service or product, first generation implementations are not yet as accurate or efficient as the law fully requires. It is on the basis of Pillar II that regulators now demand capital adequacy ratios of 10-12%, that is half as much again as the minimum regulatory capital.
Reasons why Basel II cannot be abandoned, apart from its good sense and the years and many $billions spent on its implementation, include the instant impossibility of extending banking and insurance regulation to 'near-banks' such as hedge funds, and the immense legal risk if the credibility of B2 is junked. How these regulations are improved upon will be driven as much by the hundreds of cases before the law courts as by what regulators decide. We know that banks and non-bank financial institutions over-leveraged and to a great extent because of flaws in ratings agencies credit risk models. One common illegality, however, by banks was to adopt the highest risk grades for securitised assets when the law states that at least 3 grades must be obtained from competing ratings agencies and where they differ the average or middle rating should be adopted. It was in any case absurd that retail banking assets could be repackaged so as to obtain much higher credit risk ratings than when they remained on banks' books secured by capital reserves (replaced by in CDS insurance and standby CP). There was complicity in this by the ratings agencies (see next essay) who, like Moody's, place the blame on bugs in their rating models! Whatever could not be analytically regulated by the financial regulators was in practise regulated (valued) by the ratings agencies, but on a commercial basis, which inevitably invites conflict of interest (reputational risk) for which the ratings agencies are paying in fallen share values (after August 2007) and likely to remain depressed for years by future legal risks!
Banks like hedge funds went ‘long’ on loans and short-term borrowings, often far in excess of what could prudentially be supported by collateral, equity and deposits. Over-leveraging was an implicit, not explicit, part of Basel II’s risk assessments. It could be captured only by calculating how much unsecured assets and liabilities overhung the bank that would require reserve capital if still persisting at the time of end of the accounting and reporting period. The problem with what regulators can see is they only see annual or six monthly data measured at a specific cut-off date, not dynamically over the reporting periods. It is up to the intelligence and principled discretion of a bank to calculate and show internally (if not externally on request) how far assets and liabilities can move within accounting period to be out of touch with capital reserves. This is only captured in a bank's business model expressed as credit limits. The rule of thumb is that if unsupported risk occurs this means risk mitigators (including capital-raising) are in short supply (or prohibitively expensive). But, banks, like hedge funds, do permit short term excesses. This risk sensitivity is the last building block of Basel II - a real-time reporting system to the bank's board whereby excess leverage might be reported for all of a bank’s economic capital model and then adjusted top-down. UBS, Merril Lynch, Citigroup, Bear Stearns, Fortis and Lehman Brothers and others all found structured finance departments did not report bad news until they have exhausted all alternatives to doing so (long common practise in dealing rooms and a reason why Basel I and Basel II were conceived)! This is a treasury risk oversight function, to manage risk-assessed cash-flows. Cash-flow risks in real-time are within Basel II’s scope as periodic default risk and liquidity risk (an aspect of Pillar II still 'under development'!) with as an indicator to the market of a bank in trouble when it's seen borrowing short term at high rates)! When regulators start to look hard at the limitations of Basel II in the context of the present crisis this is a big concern, to ensure transparency and honesty inside banking groups (operational risk) as well as externally (credit and market risk). Internal audits and external auditors have this responsibility too, but periodic formal audits can be gamed, especially when most banks' general ledgers are too old, too limited, to capture all of the latest exposure types. It is no lie when Bradford & Bingley, Fortis, UBS or Lehman Brothers board executives statde they could no see the full picture from their accounts! In wholesale market trading, in the dealing rooms, it is a long established practise by traders to hide losses and work them out over time. This was no longer possible given the scale of sub-prime mortgage backed assets generally and their derivatives after Moody's issued multi-notch downgrades following introduction of a new bug-fixed model after 16 August 2007. But, there is no doubt too that exposures were cack-handedly hidden from many senior managements for many months by use of various fair value subtleties, and therefore there is strength behind the argument that fair value accounting rules should not be relaxed. The only fair value solution is to report mark-to-market values alongside fair value model estimates with explanations for the difference. Right now, however, the first priority is to save the banks and then dictate new detailed solutions. Today, thanks to confidence-boosting efforts by Governments and central banks overnight LIBOR has fallen to 1.5%, but 3-month money is falling more slowly to just above 4%. The Irish Government's guarantee of its banks' interbank borrowing (until 2012) has had a more marked effect in bringing down the perceived longer term risk of loans to banks, with the unexpected consequence that the riskiness of Government debt has risen by the same amount that bank debt's riskiness has fallen! This, rather than actual taxpayers' money invested in banks' equity may be the biggest long term impact of SARP on government budgets?
B2's Pillar I aims to achieve a ratio of 8% capital reserve to risk weighted net assets (loans). This is usually quite enough to survive a recession when loan defaults triple and quadruple and go even much higher. B2's Pillar II is designed to look at how all major risks coincide in severe shocks, or systemic crises, or recession (over the economic cycle) and the B2 P2 calculations therefore form the basis for reserve capital buffers (alongside financial stability analysis by central banks) that currently require another 4% or more of reserve capital generally (enforced by regulators and central banks). UK banks are being advised currently to aim for a total capital reserve (including equity capitalization) of 11.5%. Every % increase in reserve reduces by eight to twelve times the amount of net loans exposure a bank can allow itself and double that in gross exposure. One $billion in capital reserve typically supports $25 billions in business deals, in gross assets. These prudential ratios, expressed as rules, equations and principles, did not however explicitly discuss what happens if a bank’s share price collapses by $10-90 billions as we have seen across a range of banks, nor over what period of time the banks can be allowed to replenish their reserves! It is to buy this time that governments have stepped in with their SARP bailouts. The longer run regulatory implications of that are also implicit, but should perhaps now be spelled out in more precise detail. B2 was designed to minimise the need for central banks' lifeboats and to delegate much of regulators' risk audits to risk units internal to the banks to be staffed by risk experts outside of banks' regular promotion stakes who have no responsibility for profit & loss, only responsibility to uphold the law, as is true too for compliance officers.
Compliance with Basel II is essential to banking licenses in any EU state, and practically also to a bank’s internal and external cost of funding, and thereby to its credit risk grading with AA- or at worst A as the minimum required to borrow unsecured funds on the interbank market, but depending on the period (maturity) of the loan. For some two years before the credit crunch many banks in all OECD countries were on the AA- threshold, but this was considered a line below which they were unlikely to fall except in exceptional circumstances. That interbank liquidity could totally dry up in a systemic crisis was not expected in OECD countries; that was something that only happened in emerging markets during currency crises. Like any public quoted firms, big banks are very attuned to their quarterly and annual accounts reporting. Without being derogatory to all, the plain truth is that all firms are attuned to gaming the end of accounting period results and less attuned to monitoring how volatile the balances can be between reporting deadlines. Yet, this is at the heart of what banks did wrong? They “bet the bank” by using too much temporary leverage, sweating assets and liabilities to the maximum, meaning the bank could go bust if big bets suddenly behaved far out of line with value at risk models. This is conventionally called “concentration risk”, but actually means more than that. High leverage must be safe all the time because even if they are safe long term, they may not weather a short-term shock. Ensuring safety means resorting to insurance cover, derivatives etc. and that means higher counter-party and double-default risks. But, these are only expected to be a problem in a systemic collapse. One safeguard banks hid behind was that if they were only doing what everyone else is doing, then if a systemic risk occurs it is not their fault; it is everyone’s fault. This is the classic criminal’s defence: I was only following orders; I was only doing what everyone knows everyone else is doing! Institutions should have learned from the 1998 experience of Long-Term Capital Management (LTCM) hedge fund and many other such examples from the quite recent past. That said, most bankers seemed to assume that these lessons are always learned and appropriate safeguards must, somehow or other, have been implemented in a banks’ risk systems or regulators’ rules. On the face of it there was a misconstruing of what ‘own capital’ reserves are and confusing this with deposits. While banks, with stable deposits bases, leveraged between 10:1 and 12:1, very high when aggregate risk-adjusted collateral was usually only 50%. Lehmans and Bear Stearns (typically for investment banks and hedge funds) had leverage ratios of more than 30:1—and that was only balance sheet assets. Their actual leverage including off balance sheet risks was much higher. In other words, these banks had evolved into highly leveraged hedge funds, and experienced a fate similar to LTCM ten years earlier – lessons were not learned.
Commercial banks and investment banks failed to effectively diversify risks, placing too many eggs in a few highly correlated baskets (such as residential and commercial real estate). The only defence here is that real estate is a ubiquitous collateral, appearing everywhere hard-wired like risk grade ratings directly and indirectly hidden in banks' balance sheets. Consequently, banks had great difficulty across all their business lines and asset classes of knowing what their exposure to property in total actually was. It therefore, does little good to say banks simply believed residential property would always rise in value when this was the universal collateral of the whole economy. Ultimately, banks did not examine the diversity of asset classes in all collateral, but instead focused on published risk gradings. Here again these were misunderstood. Risk grades are through-the-cycle values observed over large populations of borrowers by type. They are not generally adjusted for short term changes in economic circumstances. That was left to the lenders to do and they neglected this just as they generally neglected economic forecasting.
General problems are difficult to quantify when evaluating risks; banks for example do not assess the risks they themselves pose to their counter-parties, clients and customers, or to the economy as a whole, notwithstanding that central banks do and issued many warnings over the years, warnings that again the banks mostly ignored. From a borrower’s point of view the bank is the most insecure creditor because the bank can deem a loan contract at any time without notice. Similarly, banks borrowings from each other including collateral and call-margins they pledge in return are always at risk of being deemed or liquidated at any time with little or no notice! A huge amount of risk was assumed as being mitigated by the regularity and dependability of interbank liquidity. Regulators and banks were still grappling with how to transform the principles of managing liquidity risk into detailed analyses when the credit crunch crisis erupted. They forgot that even if assets have low risk correlations, those risks may turn high very suddenly at the wrong time. But, this was deemed under the regulations as a 1 in 25 year event. What urgency is applied to a 1 in 25 risk is precisely where moral hazard resides. It is said that bankers treated the prospect of house prices falling sharply as impossible or sub-prime borrowers as being unlikely to default. Neither claim is true. The banks merely preferred to assume that such problems are more likely to be over the horizon than precisely this year or next. Sub-prime borrowers are not more risky that the regular allowance for such risk; they become extremely risky only when there is a recession and sudden high unemployment. Governments had paid lip service to the idea that boom and bust could be massaged out of modern economies, and they also encouraged mortgages for the poor as a social good, (saving governments the cost of spending on social housing).
Some commentators say that banks failed to understand that liquidity can be illusory. This is true. Liquidity cannot be measured by primary markets, only in secondary markets. There were many buyers for mortgage-backed bonds when first issued but that does not prove the market is liquid. This is only proved when the bonds are successfully resold without buyers worrying that if they’re so good (triple-A) why are they being sold on? Investors in senior (protected) tranches of mortgage backed bonds were buying the rating not the underlying. Triple-A rated bonds were deemed to be as good as government bonds and could be easily pledged as collateral for 80-% or more of their face value. The situation became critical when banks also sold the high risk equity (basement) tranches and the bonds became effectively divorced, except by management contract, from the underlying assets. Buyers were trusting and naïve and the banks were cynical and foolish.
Investment banks and active managers (including hedge funds) cannot protect investors from bear markets, but this is what investors demanded and the basis upon which many $billions are being demanded in reparations in the law courts!

Sunday, October 19, 2008


Politically, one of the single biggest issues arising from the financial crisis is capping investment bankers' bonuses and CEO-pay on the grounds that the bonus culture is said to have led to irresponsibile risk-taking. It is proving not at all an easy or simple matter to resolve, notwithstanding that it is a vital condition that politicians and taxpayers demand be attached to bailouts, to TARP and SARP. Bonus culture has been declared dead several times in recent weeks. At the UK Labour Party conference on 22 September, Alistair Darling, The Chancellor (Finance Minister), promised a crackdown on City bonuses, tougher financial regulation and the early publication of banking legislation, telling the Labour conference: “The financial system will never be the same again.” Less than a month later, yesterday the newspapers were aghast with shock that massive bonus payments are going ahead anyway. The survival of bonuses appears to be more than just a matter of irresponsible greed. The Chairman of the UK Regulator, FSA, said today that it is outside the FSA's mandate to curb bonuses, that is matter only for progressive taxation. The FSA can insist that banks must only ensure that they comply with capital adequacy ratios first before making payouts. Why are multi-million bonuses so vital to banking? To understand the answer further it may help to consider vitalism*, a centuries old doctrine (like soul-force). This posits that the functions of a living organism are due to the processes of life not being explained by the laws of physics and chemistry alone, but somehow self-determining. Some form of Vitalism may explain the $70bn Wall Street pay, mostly bonuses that will be paid and that has inexplicably survived this year’s performance disasters (front page The Guardian 18 Oct). In the City of London the sum is $28bn (front page The Independent 18 Oct). When Morgan Stanley fell to under $11bn equity value, it could have been purchased on behalf of all employees by the firm’s wage & bonus pot. There was $6bn bonus & wages pot, mostly bonuses, at Lehmans when it went bust. Government ministers, legislators and new media have all called the “end of the bonus culture”. “end of the era of irresponsibility”, and “no more rewards for failure!” Regulators like the FSA said at first they would write new rules for capping bonuses as a risk mitigation measure, bonus culture having been blamed for much of the crisis. The result of this is more in line with polite guidance and a reiteration of broad principles. Within days this was followed by a warning that principles-based regulation is over and rules will be strictly prescribed and fully enforced. Question marks were also raised over whether to wipe the regulation slate clean and start again, thereby placing the future of Basel II in doubt (more on this next essay). But Basel II is law and no-one can show that it is to blame when it was only half-way to being fully implemented by banks? One additional idea is a new set of rules about bonuses (maybe as part of Operational Risk)? Now, days later, we learn that ending the bonus culture hard because it is competitively necessary; any centre that curtails bonuses may lose out to other financial centres?
Shareholder action (such as at UBS and similar elsewhere) has in recent years challenged the bonus pay models. Banks defended their bonus algorithms by saying performance should be measured absolutely (competitively) and relative to peer groups, with a modest % related to share price performance i.e. shareholder value is only part of a bigger picture? This means less that bonuses would fall as performance falls (year on year) and more that bonuses correlate to net performance above the average performance of peers, and, say half, be measured over a few years. Much of the bonus pay is therefore related to performance over several years as well as to whether the stock fell more or less than some other, or all other, bank stocks? Performance is not to be measured absolutely but relatively, subject to what is competitively necessary to keep the rainmakers based on what other firms are willing to pay. This then make bonuses a market rate, not a fundamental value calculation. In any case are there are other maybe more compelling reasons for the sub-prime crisis? Legislators, shareholders and the general public are asking why this is? Why there is such life in the bonus culture that bankers will be paid the same this year as last year and were paid last year the same as the year before? Up until a few years back, if banks’ profit and share price performances were down so too were the bonus payouts. Senator Barbara Boxer of California kindly emailed me last night to say that Congressional Democrats who opposed TARP did so to stop it subsidizing CEO pay on top of stunned outrage at being asked to sign a blank cheque (check) after the Administration had been telling them “the fundamentals of our economy were strong just two weeks before”. She says, “They had failed to use the powers Congress gave them to stop bad mortgages. Where was the oversight in their proposal? Where was taxpayer equity? Where was the control over CEO pay?” The legislators put these questions into the negotiations with Hank Paulson. “The answer back from Mr. Paulson on a phone call with dozens of Senators was: No restrictions on this bailout.” It should be no great surprise therefore that Congress caused a week’s delay and got its political conditions attached to TARP. Since then TARP has been on a back-burner and may have died now that over a third of the money has been taken to buy preference shares instead of buying toxic assets directly. As I wrote at the time (in various earlier essays) no banks are going to suicide themselves by applying to TARP if it means they advertise that they are so desperate they would sacrifice bonuses (and thereby still risk credit rating downgrades) just to save the bank in this way; any other way is better. One obvious reason for this is that if bonuses are curtailed in banks, bankers will leave to join fund managers and hedge funds or leave the country for wherever they are better rewarded. Some answers to the question of vitalism in bonus culture is that many bonuses became non-discretionary contracts (salary plus minimum bonus). Bonuses were also backing up from previous years and are particular to each line of business and subsidiaries with only some of the pot subject to the performance of the group’s stock. Large Banking groups in this regard are like franchises and partnerships. But, shareholders don’t see it that way. In a world of high leverage shareholders interests get shunned, no less than they’ve been shunned in government bail-out packages. Anyway maybe shareholders, some of them, should be penalized for lending, renting and pledging (as collateral) banks’ shares to short-sellers (prime brokers, hedge funds etc.) Nevertheless, it appears a fair question; should bonus funds have been raided to top up banks’ capital reserves? Instead, they were been treated contractually with the same inviolate sanctity that applies with the force of law to corporate pension funds (to many, if not to all of them?). Truth is that many banks found themselves this fall as having potential net liabilities far in excess of equity and other capital reserves. If there was vitalism in the bonus pool, there seemed absolutely none in interbank liquidity and suddenly very little in mortgage assets or most big banks’ share values. In the teeth of such disaster that last thing a bank can afford, which is a professional service, is a bunch of de-motivated people handling its finances and maybe losing clients and engaging in loss-making or illegal deals. It is an immense Operational Risk to disincentivise employees. In the trading rooms of big banks a single dealer has the same economics about him or her as an average main street branch. When you have senior managers with personal sign-off over $100s of millions, or even $billions, you do not tell them they’re only going to get paid the equivalent of what they see as one day’s win or lose!
Ironically, the more banks talked the talk of shareholder value the more they walked the walk of star-player bonus culture. It would not be wrong to equate this change with the wider zeitgeist of similar and even more extreme financial culture change in Hollywood, Sport, Television and media generally. Old-fashioned ethics and moral values went when most of the generation in its 50s were forced into early retirement in the ‘90s leaving the way open for a dramatic change in culture across several major industries. Bank customers were the first to notice the technocratic changes, the automation of risk. Only rich customers and big ticket deals got the personal manager-level treatment. From the bank’s point of view bonuses topped up the wage bill until the total was half or more of net revenues. Shareholders were increasingly concerned, but this concern may have translated into banks taking even bigger risks to continue generating double digit revenue growth to keep the shareholders happy and not press harder and successfully to change the bonus regime. It was not for nothing that banks paid 40% of all share dividends when they were only 20% of stock markets' value. Shareholders needed to recognise the risks implicit in that margin when banks were growing their share of GDP at twice the rate of all other sectors. When Nomura bought bankrupt Lehmans London, pay and bonuses they promised to keep 2,500 staff was $400,000 on average per person! Unlike Lehmans New York (bought by Barclays) there was no pay and bonus pool left behind since $4 billions had been transferred to NYC hours before the firm went into chapter 11. I struggle to believe either that all those people are so vital and impossible to replace or that without them the business would become so hard to financially account for and manage? Maybe the truth is that, despite the amount of computerization and front, middle and back office accounting systems, and risk accounting of relationship banking, the true infrastructure of an investment bank is far more its people than its systems or its brand?
Melvyn Bragg (BBC radio) tells me in an email that vitalistic ideas from Aristotle to DNA have all that time been a tough call to refute. There are no books written about vitalism, only about bits of it, e.g. 18th century schools at Paris and Montpellier, but not about the whole thing. To track vitalism through the centuries is nowadays regarded as old-fashioned. Who among the regulators is going track it through modern banks' bonus cultures? Vitalism, like bonuses and commission fees, is now outside of time, rather like stem cell research, it can’t be discussed without bringing in religious ideology and politics (for which read trust in markets and ratings agency ethics). It is noteworthy that while retail bankers who have had to resign or been sacked have sometimes walked without getting a severance pot of gold, investment bankers tend to insist on severance pay!

*Note: An Italian Dr. Ure experimented with resuscitating the hanged murderer Clydesdale in 1803 using electric shocks to try a prove this was the vital spark of life, and inspired Mary Shelley's Frankenstein (1818) in which the revived monster has a fine intelect but is soulless. Hollywood’s 20th century versions didn’t even allow the monster intelligence except of the most brutish kind. Today, is this not unlike the public’s idea of investment banking and its bonus culture. They do not want this revived. But neither is it yet dead.Where vitalism explicitly invokes a vital principle, that element is often referred to as the "vital spark," "energy" or "élan vital," which some equate with the "soul." I’m reminded here of a recent visit to Holy Loch in the Firth of Clyde and seeing where the puffer boat Vital Spark is now moored from the popular Para Handy films of 1959-60, written by Neil Munro (d.1930) who also wrote the history of the first two centuries of the Royal Bank of Scotland whose history as an independent bank now appears to be ending in calumny. Holy Loch is also where the most important US nuclear deterrent, the North Atlantic Polaris and Trident fleet was based for 30 years during the Cold War, which with the British Polaris fleet next door had enough power to blow up half the world. The sub-prime crisis is said to be capable of blowing up half of the world’s capitalism. Analysis of what went wrong is as complicated for political-economy as Vitalism’s long history in medical philosophy: most traditional healing practices posited that disease is the result of some imbalance in the vital energies that distinguish organic from inorganic matter, or flows from stocks and income from assets. In the Western tradition founded by Hippocrates, vital forces were associated with the four temperaments and humours; Eastern traditions posited similar forces such as qi and prana.