Friday, March 27, 2009


Not long into the Credit Crunch and as recession beckoned, UK Prime Minister, Gordon Brown, announced an end to the "Age of Irresponsibility". This became his global statesman theme, his G20 and his Davos theme. Brown’s speech at the Davos World Forum was superb and head and shoulders above other leading politicians, and that included his technical as well as his policy grasp of the origins and necessary solutions for both the Credit Crunch and global recession. Of all political leaders, Brown found the best Churchillian-style phrases to both express the public mood and show that he can command the bigger picture. But, responsibility has to extend to politicians, and politics being politics and politicians being what they are, any big ideas, right or wrong are sniped at, argued against, and horse-traded. G20 in Washington produced a strong agenda. G20 in London should show progress in building on that and should by evidencing global agreements help enormously to restore confidence in the prospects of recovery and thereby hasten that recovery. Economies can operate relatively freely of government intervention and control when employment is low and growth is positive. With record rising unemployment and negative growth all responsibility to steer the economy falls entirely to government. But to be effective politically, financially, technocratically it needs authority and confidence. Essential to confidence is belief in the expertise of government to “do the right thing”, “to do whatever it takes” and to make a reality of “Yes, we can”! But, who is there who can validate the expertise of government when bankers, economists, regulators, accountants are all variously discredited. Not the journalists or the internet bloggers constantly seeking after sensation and scandal. Government politicians today have no-one to turn to validate their polices except other governments. Only the clearest evidence of the world’s leading governments, the G20 governments, who are in charge of 80% of the world economy, agreeing to a common set of principles, policies and priority actions, can restore confidence, provide something for everyone to place their trust in to face down the crisis.Given the seriousness of the global crisis (truly global) it is dangerously wrong therefore, not just pathetic or malapropos, of opposition parties in the UK (and USA and elsewhere) to use this crisis for domestic political point-scoring to damage the credibility of government or to put the outcome of the next election before the question of solving the global crisis. Martin Wolf in the FT made a very valuable point, which is that we need to do more than enough. The risk of doing too little is too important to economise on; the chances of doing just enough, not too much, not too little, are too remote. Jamie Dimon, CEO of JP Morgan Chase, has very valuably said, the time for new ideas is over. We have the means and the tools, maybe not the most perfect, but definitely good enough to do the job and that is all we should focus on. We can undo some of it later or worry about analysis of all the blame-game, fault-finding, engine-repair and fine-tuning later. Therefore, when the Prime Minister Mirek Topolanek of the Czech Republic, half-way through his 6 month presidency of the European Union, lost a vote of no-confidence on Thursday, and resigned, and then attacked US policy of spending trillions of dollars (and by implication UK policy seeking a $2 trillion fiscal boost to world GDP) as “the road to hell” (implying one paved with ‘good intentions’) that all EU government must avoid, he was damaging all governments. President Obama will visit Prague next week after the G20 Summit in London. White House spokesman said, "I think the Czech people and the American people can stand assured that the President of the United States of America is going to do all and everything in his power to get our economy moving again and to restore confidence in that economy."
At the G20, the USA and the UK want to push for concerted fiscal deficit spending along Keynesian economic theory lines of 8% ratio to GDP. Europeans leaders want to the USA to emphasise more measures to tighten regulatory oversight over the global financial system. The UK wants to do both. The US has some traditional concern about agreeing to international or non-US laws on anything except some basic UN rights and accountancy standards. Why there is resistence to regulatory rules and laws that it was in process of acceding to anyway i.e. Basel II, is unclear? The USA is focusing on economic stimulus, with a $US787billion spending plan, as well as the $US1trillion it plans to pump into the financial system to revive lending. Some other countries are traditionally resistent to giving up Monetarism and embracing Keynesianism, so it appears. In reality, the problem for Euro Area economies is that government do have political control of money market interventions.
Mr Topolanek said, "All of these steps, these combinations and permanency is the road to hell. The biggest success of the (EU) is the refusal to go this way. Americans will need liquidity to finance all their measures and they will balance this with the sale of their bonds but this will undermine the liquidity of the global financial market." His views are eminently disputable. Martin Schulz, leader of the Socialists in the European parliament said his comments were "not the level on which the EU ought to be operating with the US"… "You (Topolanek) have not understood what the task of the EU Presidency is." EU Commission President, Jose Manuel Barroso, said it is "not helpful ... to try to suggest that Americans and Europeans are coming with very different approaches to the crisis". Within the EU 8% budget deficits is a break with the Maastricht Agreement criteria. Several leaders, notable Germany’s Angela Merkel, are saying they will not be dictated to as to how much money to borrow and spend. Ireland may however have to embrace a 10% fiscal deficit. The ECB could do more but it is also constitutionally constrained. The structure and framework of the Euro single currency is under great strain alongside the problems for the Lisbon Treaty, the Lamafussey Framework and the Single Market in financial services. Governments are also stressed by their governance of big banks, most notably the Benelux countries re. Fortis and ABN AMRO and Ireland and its four biggest banks. Spain, Greece, Italy and all others have comparable problems. The equivalent in the USA would be if all states had to bale out their banks and negotiate for this with the regional Federal Reserves and liaise with all other states affected. I don't think the rest of the world entirely appreciates how big the US economy is, albeit Europe is just as big but in many economic power aspects much less so. Here are two views of this:- The technical issues, policy agreements and political problems, are all so complex that on these matters, and beyond them the global dimensions of the crisis, we need governments to collectively retain their credibility to work together in unison. Only agreement between governments across the world is left to validate the measures needed to get the banks working properly and for fiscal boosts to gain economy recovery soon. The best resolve therefore is simply to take the lead from whichever country appears to be managing most successfully, and it is probably the UK. And, therefore, Gordon Brown, might for perfectly commonsensical and practical reasons expect that how he has defined the problems and the solutions, working closely with the USA, should be the template for all, the common agenda. The continental Europeans cannot continue to eke political capital out of the idea that this is essentially an American or Anglo-American problem and that they, the Europeans, can diverge onto another way forward, a European way. In the globalised world all have hitherto bought into there is no American or European way, only a global one-way forward, one-way off the blocked freeway, or from Recession, next stop Depression.
The global version right now is Gordon Brown and what will survive and hopefully prosper of the moral and ethical dimensions of the G20 Agenda. Gordon Brown this week touched down in three continents. On Wednesday he faced down American scepticism over his (and that of the G20) proposals for tighter regulation of the banks, telling a Wall Street audience the financial sector had to rediscover moral principles. There was meanwhile dissenting voices in Europe from Germany and the Czech Republic about long term consequences of sharply higher government spending. It is not just that some Euro Area political leaders are doubting their political capacity to sell state imprudence as a response to the imprudence of bankers, they have another problem in that they do not have direct control over money market interventions. Issuing government bills is in the exclusive control of the quasi-politically-independent European Central Bank (ECB). Yet it is only at the treasury bill end of money markets where the US and UK have been able to leverage trillions. The Euro Area governments lost that direct off-balance-sheet financial firepower when they joined the single currency. When Mervyn King Governor of the Bank of England (BoE) said publicly that we have to be cautious about how far to go in fiscal deficit-spending, he was only referring to the Government's on-balance-sheet budget. Off-budget he (with the Debt Management Office of HM Treasury) has grown the financial balances of the BoE to $4 trillions, which is more than the ECB and even slightly more right now that the US Federal Reserve!
(Note: Moral rectitude in government finance is fine for politicians, but arguably too much of it was what allowed the private sector households, corporations and banks to grow their borrowing to over three times that of the government in only 10 years! Moral rectitude if taken to fundamentally at face value, to woodenly, is also a mask behind which there is 'can of worms'. For example, one unreported irony of moral rectitude in finance is that Bernie Madoff since his time as Chairman of Nasdaq, before he was found out to be among the most unethical practitioners of all, presided over a host of new ethical reforms to do with protecting against conflicts of interest, series 7 investment advice examinations, other such regulatory certifications and the independence of analysts and probably aspects of Sarbanes-Oxley. He was the epitome of rectitude and moral authority. He was the moral paragon deferred to when rapping miscreants and exam failures over the knuckles. "Bernie wouldn't approve of that" etc.)
Macro-economics is about seeing the world in three dimensions, not two. In two dimensions, hypocrisy and paradox are inevitable, even natural, or let's just say the aliens we all know. And, indeed, moving on to the G20 idea of a global executive on the flight-deck of the world, how these grand meetings are stageed can appear like some inter-planetary science fiction government. Do people believe in fine words and a good show, or will they now jaded and dispairing only believe in practical proven results. Will the public have the patience to wait and see? For that they need to feel confidence in governments. If national political leaders squabble in public that confidence is blown. Let's expect that the London G20 (at London's Ex-cel Centre, which looks like a large airport style sea-terminal) is less stage-designed and has more of that moral and ethical down-to-earth goodness that should persuade all participants that their collective credibility is on the line if they do not all "do whatever it takes" (DWIT) to get out of the global recession sooner than later. DWIT is the political phrase of choice by the whole of the UK (economic peace?) Cabinet and has become the phrase too of the Obama administration, the businesslike end of the 'end of the age of irresponsibility' dogtag that should be inscribed in latin somewhere. Maybe we could have medals issues for good service in this cause inscribed on the back of the ones we usually wear. The more genuine article is undoubtedly the UK Prime Minister saying clearly “We have to clean up the banking system,” ...“We must give people confidence that the principles that guide their daily lives are those that also guide the markets. I know people are angry at what they see in banking bonuses.” In the US after the S&L crisis, Enron and Worldcom scandals, and the collapse of LTCM, Sarbanes-Oxley is a powerful attempt to do that - could SarBox now go global? How can such moral principles be translated into regulations, standards, financial practise laws? In all respects Basel II covers the same ground in finance but goes much further, perhaps too far only insofar as there is so much to learn and so much also to innovate to comply fully. SarBox possibly delayed the US banks from embracing Basel II by 1-2 years.
Mr Brown delivered his uncompromising viewsin the grand ballroom of New York’s five-star Plaza Hotel. As any investment banker knows this hotel is the eponymous meeting place for corporate finance deal-making. The London equivalent might be the Savoy grill-room or the Cafe Royal. Last time I was at the Plaze it was for a conference of the biggest NY hedge funds. Attendees at Gordon Brown's speech included the presidents of Citibank, Nasdaq and Goldman Sachs. The PM warned them they could not operate in a moral vacuum ruled by “avarice”. In some ways his speech, while echoed too in the view of President Obama, also had a comparable version a week earlier in the speech by Jamie Dimon, the JP Morgan Chase CEO (see 11 March blog below).
Gordon Brown said, “The principles and values we apply in our everyday lives, you have got to ask did we apply them to the running of our financial institutions?” said Mr Brown. There is a sense that the global economy was outside these standards that we applied in our everyday lives.” It might be arguable that the whole of banking finance is being tarred and with the same brush that of structured product proprietary trading desk types. But, of course, we all know that the Gordon Gekko greed is good types became very over-dominating in banking generally - the worst sorts were attracted to and corrupted by the diea of making easy money, lots of it, fast. The culture defined the 80s, 90s and noughties, but was also defined by it, by the cult of entrpreneurial individualism that for too many card-sharps in business and politics seemed to be the only worthwhile and purest essence of capitalism and then too of neo-conservatism in politics that for now have been binned. Gordon Brown is a bruiser of a politican according to some, and a brilliant genius according to others, and ego-driven and moralistic, and in truth something of all of these, and yet also a finely-honed politician with all the understanding about timing and horse-trading that requires. He knows this is the time to head for the high ground and step severely on modern banking culture to get there. His perception is that banks were operating in a value-free hinterland, failing to adhere to basic principles of honesty and hard work, and had damaged the entire system, “Markets depend on morals in the end. A world without standards is going to be a world without stability.”
Mr Brown used the NY leg of a 5-day diplomatic tour ahead of next week’s G20 summit in London to confront American pressure for protectionist measures and scepticism about supranational financial regulation, which is the most European part of the G20 agenda. It was expected that the USA under President Obama would shift in this direction. But, clearly, there are problems for him to do so in the Senate and somewhat in Congress. If the US attitude remains reluctant to overtly abandon any protectionism or to embrace globally-overseen regulations, what is left is US insistence on all countries applying domestic fiscal measures to boost their domestic spending and consumer demand, which for many means giving up their trade surpluses and for the poorest going cap in hand to the IMF? World trade is in any case re-orientating so fast and unreliably that protectionism is a total non-issue in the short term when no-one knows how their external trading account is working out.
The PM signalled hopes that the London summit would impose a “name and shame” system to police governments that put up barriers to trade. “We will agree at the G20 to monitor any protectionism ... and report it.” This idea is easily attacked in terms of how are barriers to trade to be defined, narrowly or very broadly, and either way both US and EU could be named and shamed too? Policy makers despite the GATT and Doha and other global trade agreement negotiations operate on the basis of a narrow definition of trade barriers to do with quotas, import and export duties, government contracts, and producer subsidies. But, looking at the whole matter broadly, globally, macro-economically, then trade and protection issues can look very different. It would be a nice hope that new thinking will emerge, but the rush to decisions may not allow for that. The extreme world trade balances increasingly had to be financed by 'net acquisition of financial assets' in the trade deficit countries to be sold to the trade surplus countries. To calm fears that America would have to cede control of Wall Street under a new international regime, Mr Brown dismissed as “ridiculous” the idea the G20 would seek to impose a single global financial regulator (the IMF is planned to sit in the centre of a global network of regulatory authorities). The US doesn't want an equivalent of the International Court in the Hague for financial regulation i.e. the USA won't acknowledge a regulatory legal authority above that of its own national regulators, hence one reason why it preferred the IMF to BIS or other bodies to lead in this area. The IMF may not therefore be able to declare Basel II (or something akin to a Basel III) as a worldwide legal standard like we already have worldwide accounting standards? Why global standards for accounting but not with the same legal force for banking risk management regulations is potentially an anomaly here? Also, it probably means the global regulatory oversight of IMF becomes more of a forum of regulators but the BIS is that already, except it has more limited membership compared to the IMF. So, could the IMF membership be persuaded to sign on to Basel II as a condition of access to the IMF funding support?
One problem with Basel II is that the jury of public opinion is still out on whether it contributed to the problem or is the solution to the problem. The general assumption has been that Basel II was already in place and should have prevented the crisis, either that or its prudential capital rules meant that banks have been forced to deleverage just when the world needs them to keep their lending up? The truth is that Basel II was not even half implemented, and the half not properly implemented at all was precisely those parts that would have mitigated the crisis, liqudity risk, economic capitla model stress-testing, integrating all risks to forecast economic capital requirements etc. stuff that the vast majority of bankers don't understand, don't have the tools for, and couldn't be bothered unless there are bonuses in it for them.
It was partly to get banks to embrace Basel II that the mantra they were all told was "do this well, and you can save on your capital requirement and therefore do lots more business" (i.e. more bonus). The opposite was true. But, this shows the problem of how to incentivise banks to be more prudential and ethical and so on. The answer is, of course, there is no incentive (or not much of one unless as a bank you believe it serves to win customer loyalty) and therefore it is stick not carrot time! 'Name and shame' is not a big stick unless it means next stop nationalisation or loss of some banking licenses, or being broken up, or ordered to stop certain lines of business. The Credit Crunch Crisis has shown governments rediscovering that they have all these powers. Systemically important banks and their shareholdersnow know that their ultimate owners are national governments, whether they are wholly, partly, or not at all govern-owned in % share-holding terms. Brown stressed the “remarkable consensus” developing about the regulation of hedge funds and other shadow banks. This sounds clearly as if transparency reporting laws will be passed. The SEC under its new Director will try again to get laws passed that the Supreme Court last time rejected. New laws will probably be coordinated internationally all at the same time so that hedge funds cannot jump from one jurisdiction to another - and that means also coming down firmly on tax havens?
Brown cautioned against trying to reform America’s regulatory system in isolation, stressing the extent to which the US subprime crisis had infected European banks. It is also codespeak for the problem of Citigroup, which has most of its assets outside USA, much of them in Europe, and which seems most likely to be nationalised in the USA if only the complexity can be sorted out. And in a separate but potentially related development the prime minister revealed that Britain was in talks with Germany to agree a system for managing the withdrawal of banks, including the state-owned Royal Bank of Scotland, to their home markets. This sounds like the Single Market for Financial services going into reverse, which would be contrary to EU law and ethos! It is therefore surely about making it easier to nationalise banks when they are active in many jurisdictions - including US banks e.g. Citigroup - but also RBS giving up its AAB interests and non-core businesses outside of UK and USA. Gordon Brown called for a series of such bilateral agreements to try to prevent the exodus of banks from overseas markets exacerbating the global financial crisis.
For the FT's moving-talking graphic on the Geithner PPIP Plan see:

Friday, March 20, 2009


It is not always wrong to think positively in the midst of turmoil. I have tasked my bank's analysts to come up with the 'now is time again for going long' option (and very long blogwise)and stop thinking short-selling but contrarian-wise, contra-intuitively, how we can go forward here-on-in. The 'bullet-point, psychometric, feelgood-feelbetter, we-can-make-it-happen. "yes, we can" gurus, you just gotta really want something bad enough to make it big, animal-spirits back in the front-line, can-do Yankee culture, business strategy cheerleaders, home-team, self-help psychologists' et al, cannot be all wrong. Forget saving money; let's make money, go out there, and do the deals that truly believe in the Anglo-American capitalist model, that's what I tell the money folks. It's The Great Game all over again. Readers of my columns expect mixed metaphors and slightly mad euphenisms. This one could be Central Asia's 'Great Game' where a few great heroes held off the Russian Bear at the North West Frontier in the mid-19th century that unfortunately has now lasted into the early 21st century, or the great game of making par for the course deals with businesses struggling with their golf handicaps, or spread-betting on cricket scores in Caribbean tax-havens, maybe rugby is the great game, blind-siding a ruckus to cross the line (Six Nations Championship decided Saturday by Ireland), or Spanish bullfighting, or maybe all of these, 'great games' when thinking about the team-plays needed to make vast fortunes now in Asset Backed Securities, even today, yes, especially today. Issuance in the UK has never been greater, but so far it's all being packaged for, to be 'bought in' like repo-swaps, by HM Treasury and the Bank of England. And, so far, the amounts are more than the total of UK banks 'funding gap' (at $1 trillion out of $7 trillion bank assets, or 3 times China's true GDP, or one third more than the 'funding gap' of all emerging market countries' banks put together - data source:BIS). Euro Area banks likewise are active bundling & packaging their loan-books for ECB and other central banks and finance ministries. 'Funding' is not the only gap. European banks in total have a $2 trillions 'US dollar' funding gap, but that's only one third of their customer loans to deposits funding gap and what's left of the Pfandbriefe market. 'Funding gap' between customer deposits and loans is met by borrowing 'wholesale finance' (from banks and non-banks) in the form of 3 month, 1, 3, 5, 10, 30, even 50 year covered (bank) bonds and securitised ABS loans, which are amortizing and constantly topped up i.e. rolling credit-assets (my term). But, over in the USA, where are US banks getting their new roll-over financing for their funding gaps, not so far as we can see yet from bond issuances, securitizations or covered bonds? I asked one of my analysts for a roadmap late last year (see next slide), but when I found it impenetrable I just had to let the guy go. This is no longer a spreadsheet world I told him and he forfeited his stock options. We are not bonus-friendly right now. Upside-potential revenue-earners we keep; problem-fakirs who want to short everything that moves this year like last year we don't. I told him and his team I'm much more interested in how we leverage ISDA's new global standard for credit default swap processing, the latest move by Group of 30 and others to address issues that arose after the collapse of Lehman Brothers five months back, and how we can profit from efforts with the World Bank and IMF to plug the $275bn funding gap shortfall in emerging markets banks! My ex-analyst at least provided a foretaste of the Geithner Stress-test to figure out NPV of all US banks going forward if we place all toxic assets into a big bad bank.I am still at a loss to see how the US banks are financing their funding gaps. Published data is in very short supply, zero it seems. Maybe what they get from the Fed's TALF, FDIC guarantees, and Fed Liquidity Window is enough? If so, it must be eventually become $5-7 trillions enough, out of a total funding gap someways north of that? Precise data is hard to find. It's easier to uncover banks funding gaps in Europe. My guys could go through the waste baskets of the major banks published accounts or check the Fed's and FDIC backyards. For now, let's just ask the question. Gillian Tett in the FT (see comment at end below)tells us that private sector wholesale funding has dried up. At a Dublin conference I missed the hedge fund experts surmise that Hedge investment capital has shrunk since 2006 from over $2.5tn to close to $1tn! My data says the total is still up in the $2tn region? She also says the banks have stopped their proprietary trading (prop desks) except, in Europe, Goldman Sachs. She also says market-making has retreated, especially in credit markets. So liquidity has crunched, and the question is where is the wall of carpet-bagger money building in 'distressed funds' (the slightly politer term for 'vulture funds') circling and waiting to pounce on fire-sale price deals. Recession is always the time for the cash-rich to get spectacularly richer by buying productive assets, property and securities in anticipation of massive gains when recovery begins. Vulture Funds are building fire-power in the USA, why not in Europe too? Maybe it is all about who gets the Japanese, other Asian and ME sovereign funds on board ($ funds from export-surplus countries)? Ok, so either we invest in vulture funds or we finance banks funding gaps, or we pick up discounted banking-loans assets in securitised bonds at prices where further defaults do no harm, or pick up prime property and land, or maybe all of these. The question is price, timing and getting at the carcasses before the other vultures arrive. Meanwhile, stateside, the US banks are perhaps just treading water, holding hover, suckling at the breast of the Federal Reserve's short term liquidity window? I put this question to my auto-loans liquidity specialist and foreign trips special assistant, Ms Rita Chevrolet, to consider double-entry book-keeping issues of liquidity preferences in banks balance sheet treatments under GAAP, FASB, IAS and IFRS 7. Certainly, she concluded, if US banks are funding desperately in the shortest term depo money market, we can't rely on them to invest richly in my vulture funds! Almost all new new ABS and CB issuance in the USA died off when Lehman crashed and burned. How are the US banks funding their 'funding gaps' without it and others like it, I asked? Should, I and my other fundsters try to out-compete the Fed's deals and get 9%- 12% returns that way? The answer share gave me was that, on the one hand, they (the big banks) are still making money in underlying net interest from traditional banking and, in the other hand, big banks, especially Citibank (Citigroup), JPMC and BoA and Wells Fargo (maybe?) have received a lot of support to buy other big banks, Bear, Wachovia, WaMu and Merrill-Lynch. But, she says, the US banks aren't issuing covered bonds either, or weren't in first half of 2008. U.S. financial institutions sold more than $100 billion of government-backed notes in dollars, euros and British pounds in October to December and now another $300bn back to the Fed, maybe for QE cheques? It helped the banks that FDIC guaranteed their bonds to help them cope with over $770bn of losses and writedowns (including FM&FM). U.S. banks may be doing road-shows in Asia and among sovereign funds. Sales of FDIC-backed notes maturing in more than a year may reach $450bn by the end of June 2009, according to Bloomberg. But whatever's going on, she said, it's hard to get hard data? Whereas the European banks went on issuing ABS in 2008 and a lot of covered bonds to finance their 'funding gaps between customer loans and deposits, gaps that are considerable! And yet the problems of financing the gaps are what makes the credit crunch so-called, that and the ABS and CDO write-downs.
I suspect that the Euro Area is not quite so much down in recession terms as the most recent GDP data suggested (subject to significant revisions yet to come). So, I've just returned from discussing all this with my American colleagues, and giving them a few gold-plated steers, at the Silicon Valley of structured finance on St.Patrick's Day, at IMN Clover's Distressed Points Summit: Credit Crunch Investments for Cash-rich held at 'Dan a Point', Uppermill, Seeder Valley, CA, this week, and in the sky wasn’t the only sunshine. All bared their optimism through grated teeth about the dizzying perspective on Distressed Opportunity Assets in 2009 to 2012. I presented the present situation of the UK banking sector and the value of the Government's capitalisation infusions.I spoke about the UK banks and our branch there in that context. The above graph soared to new heights in the second half of 2008 but the £300bn was almost all for the Bank of England APS, added to which there has been over £600bn in only the last few weeks. We hope to get the management contracts for the pricing and maintenance for suchlike. Interestingly, the optimism shared here echoed what I felt recently at the What's Over the Edge AI fundsters hooley in Philly, PA. My audience at both events comprised the big pension and municipal fund credit-risk p/f, debt-capital managers, and their entertaining clients. The highlights include my thoughts on RMBS described below. I concluded each time by saying, in sum, we are staring into a big dark hole with a big light at the bottom about to switch on and flood out bathing us all in golden sunshine, however artificial of course, of a 'once in several lifetimes' opportunities buying into RMBS in 2009, given the right haircut. As we all know Mark-to-Market causes illiquidity by telling everyone just how one-way the credit market is, except at the shortest end dominated by the central bank liquidity windows and now in recent months the central banks have also taken over 3month, 1 year and MT maturity term markets - it's a race to profit between Government doing ABS asset-swaps and private cash investors trying to get back in on their terms(I advise both). We need a new Big bang Theory, the Standard Theory lacks a mathematically convincing two-way theory of gravity. Time to get back to basics and reconsider what we've been taking for granted. Corporate debt is too volatile for going long or 'long' strategies, alongside CDOs and CLOs; best to surf round turning points on v.short-term 2% = 50xleverages. Bit early for Commercial MBS except for secret fire-sale deals. Government isn’t helping the credit-marketeers with mortgage cram-downs and slam-dunk liquidity window giant swaps enjoying 30% haircuts on A+ paper already at 70-80
Governments' unlimited fiat-money has changed the “rules of the game.” But so far, still a richly-rewarding, one-way buyers' market if you've no qualms depriving taxpayers of big MT gains, and don't feel moral queasiness of adding yet more mega-bonuses to your 2008 Christmas came every day and twice on Sundays shorting profits. My friends Soros, Nebachudnezzer, Ozymandius and Buffett have such moral thoughts
This I will share with King Midas (Mervyn) and tell him this is all about who is allowed to be the carpet-baggers of the credit crunch global recession (first recession where aggregate of world GDP could become negative?) - the shadow-banks & friends who profited on way down, now have far more gain on way up - it is them or the public sector who makes biggest returns (at least the latter is on everyone's behalf and that risked to bail out economy & the finance markets?)I wonder if European banks are lending to the US banks in place of paying up their dollar gap, the euro-dollar system at work? My advice to clients such as Don Di Bias (Advantus), Larry Poker (Paulson), Mikey Picko'raro (NPM), Mick 'to model' Clark (Meridian), Johnny d'Pluto (Declaration M&R), Michel Levitt (Stone Tower), Johnny 'pibroch' Morrison (Asymtotix) and his namesake at Macquarie, Phill "fill ‘em while they're hot” Baruch (Trust Co.West) are that we face immediate opportunities in selected RMBS (picked using my REvolutionary Super-Computer UE harness, caveat “get 'em cheap” and investor firms with cash can indeed.I can factor in any structure and any type of market participant. The market is ripening like Spring, with 30-40% returns on RMBS trading at postage stamp rates $0.40c. Time is now, '09 = Big Opportunity REturns in Short- to less-short term. DIStressed CREDIT over 5-6 year strategy = '08-09: Stressed housing market, '09-11: Stressed Consumer Credit, '10-13: Commercial Real Estate only if you think CRE lags economic weakness (I don't). Housing correction is 2.5 years into its peak to peak 7 year cycle. Forecasts to my investors on frequency & severity of loss, amortised run-off and cash-flow balloons sell like hot-cakes. Corporate defaults just starting look tremendous volatility for inter-day trades. Buying into RMBS with short, predictable cash flows is effective for quarterly plays, better per year than 7+ years for corporate debt coupons after knocking off the insurance. (This viewpoint on corporate debt was shared by many fellow carpetbaggers – too much volatility for self-respecting investors and too early to know where best opportunities are firmest.)Fundamentals are always a challenge, to market outsiders, finding a willing seller at these prices can only be among the over-leveraged AI merchants and disintegrated banks like Fortis and ABN AMRO, but how many more of those can we find, gold-dust, if you can trust the accounting. Asset holders subject to mark-to-market fair-value need to protect their p/l, especially banks with dominant government shareholders who want profitable exits sooner than later and aren't too anxious to wait for the bigger pay-offs, so they're swap-repo-selling small juicy portions of their bond-packaged loan portfolios at 40c/$1, down from the 60c or 70c where currently marked. To go further would require the banks (selling privately, directly, or via SIV or Warehouse intermediaries) to re-mark all remaining loan assets on the books, and risk analysts' views feeding through to the ratings agencies! This would wreak havoc on most banks’ capital ratios far more than narrow the banks 'funding gaps', causing bank regulators to step in and shut down banks for 'capital insolvency' where the 40c sale revenue equates to 40+% 'funding gaps'. No signs of improvement in the illiquid MT & 3m credit and money market – there’s not much activity right now because of the mark-to-market effects on sell-siders, only suits those of us with deepest pockets and more of them than a busy snooker club. The US banks have raised more than they've written down in 2008, half of it from government. They lost 75% of their capital reserves ($1tn) and have replaced 80% of that so they are well provisioned for some more big haircuts yet to come onstream? But, when will liquidity start to flow? Maybe when the Carpetbag Clubbers get into buying distressed ABS at sufficiently deep discounts to leverage against at negative cost? There is liquidity flowing, but right now only from government to banks. And the governments are imposing 25-30% haircut and levering big fees so it ain't cheap money, but it is money, the best kind in exchange for the worst kind of currently semi-liquid assets. Governments are taking the banks' impaired assets on am equivalent to a swap-repo basis and thereby removing the M2M market risk from banks' balance sheets, while also ensuring governments get their preference share coupons and other dividends paid plus better prospects for bank shares rebounding. The banks need the money to fund their funding gaps and that locks out the private sector from what was a lucrative business. Great time though for the insurers to buy very long term paper at good discount and high LIBOR Plus rates.
Right now, there's roughly $1.4tn RMBS currently on offer in the US, even after the Fed's $300bn slam dunk. And there'll be forced sale situations from secondary market structured product funds through '09. The Fed's purchase of FM&FM assets at Agency and sub-prime spreads is like a cheap share buy-back. Has the Fed or the Bank of England or the ECB got the analytics such as I have for valuing all forms of structured product? Carpetbagger Club members agree with me. They say stuff like, "dose depress-price RMBS don' mean dem assets is distressed f'sho', onny priced as distress' wuz like loan portfolios is priced as non-performing when deez 'ere default rates is bein' sticky between 1.5% (normal 45% recovery rates) an' 3.5% (30% recoveries)". I tell them, "that's certainly most interesting and insightful". That's the Veronica of the deal. I next show the Espada (Estoque) saying, "but lookee here this requires asset modelling at loan level, then integrating at property-level, plus macro-analysis using my super-computer right here (my Traje de luces). See, IRRBB securitized bond driver is price at sale, cash-yields, & recoveries less cost-haircuts at defaults + mitigants for smoothing like the 30% of borrower income idea and other stuff like mortgagee re-contracting and new IR settings, and principal 'aromatization' (amortization with a play-nice smell)". That Puntilla gets their attention. Then I finish with my "tercio del momento supremo".
At current price levels, 17-25% IRR is realistic and RMBS offers a good “margin of safety.” The primary risk lies in government cram-downs of sub-prime mortgages, where 60% of sub-prime loans are currently performing to 10-12% heading for 25% (representing in turn about 25% of US RMBS, but the discerning buyer can get half that first-loss protected and still come good with double-digit returns. fact is, as i tell everyone I know, it's time they caught up with the latest most modern financial products. Some fools say,“Just because it’s cheap doesn’t mean that it’s cheap, or that it won’t get cheaper.” Government’s actions introduce opportunity constraints for private buyers in the distressed credit market esp. in RMBS. Why would RMBS holders sell at 40 when they can wait for a government bailout and get 75? Well only 80% of holders can do that. They are the systemically important big banks. That leaves $2.8tn of paper out there to play for, plus what's left behind in the banks vaults, and another $1.5tn maybe available in Europe and Asia for say that looks good when you've got US dollars to buy with and want to book a US mega-profit when the dollar falls later this year and next. £ Sterling holders would be happy to sell just now for $ dollars at 40-50c.There is life in these assets! This spawned some Bohemian Grove style chats about the lack of “rule of law” in the credit markets. Most managers feel the government’s spurts of activity is unsettling. But, I just calm the anxiety by putting some numbers on outcomes for a Performing ABS Loan Portfolio whereby baseline ROI reaches 17% (or higher closer to 40s): Default rate of 10% per year; Prepayment 5% per year; Recovery Rate 50% less hc; and hey presto the AAA is back up trading at par! The greediest clients like the 17% but but hop market price will strike at 40c/$, not 50c-60c range. When stock markets crashed it was also because institutional investors sold stock and held cash (& near-cash) and some/many are cash-rich with once in lifetime opportunity to buy in at the bottom of bottoms. It was not just my short-selling friends who did the damage, though plenty of that too, but as we say where would we be if the institutions wouldn't agree to our renting their stock and sending it back trashed - just like rock bands in their hotel rooms - lot of fun for money. Short-sellers are the new rock & roll! Funds with the best actuaries have the best forecasting economists and many are public pension sector funds, though they can't work out that stock lending is foolish in turbulent markets? So what we see is rich 'jump in deep end' stuff. But, within the complex world of distressed investments, lies a labyrinth of contractual issues. With good advice, public pension funds & institutional investors can be led through the complicated legal web of the distressed arena. My firm's expertise is the practicalities of the marketplace- legal/ contractual expertise and specialized added-value-pricing trading-to-banking-book requirements. Using our analysis I evidenced the case of US big 6 banks and the different capital reserve schedules that occur whether banks discount their ABS by 25% or 50% more, and why the lower rate is obviously so much safer for them. Hence, I was saying forget about 40c on the $, take 50c-60c and wait for return to 85c. If US banks' distressed assets are therefore less appealing, I counseled the attractions (upside currency risk) of dramatic rises in distressed opportunities in Europe and Asia due to increased default rates resulting from an inability for companies to service debts. Although conditions vary between regions, both Europe and Asia are feeling the effects of the credit crunch turmoil. We have specialists who analyze why funds should consider investing outside the USA:- the driving forces behind the surge of European and Asian distressed investing - most appealing sectors and cycles to public pension funds - case studies of public pension fund investing in European and/or Asian distressed markets and of municipal bond issuers trying to trace their bondholders to buy the stock back at half price! Our Outlook for 2009: Will others follow our lead, and with how much $ and who? We quite happily will advise the public sector buyers too. Dramatic rises expected in distressed opportunities in Europe and Asia due to increased default rates (inability of companies to service debts - already S&P500 EBIDTA = only 100% of interest payments! this is not good news. I want good news. This is the time for future-perfect not past-imperfect thinking. This I fleshed out on the blackboard - good old traditional technology. Conditions lag-vary between Europe and Asia in feeling effects of credit crunch turmoil(tsunami arrival rates meeting 'surge' of 'surfers', also known as, carpetbagger investment funds). Specialists will analyze why public funds should consider investing outside United States (especially just when US $ is riding v.high +30% to £ where half of Europe's ABS resides):
• driving forces behind surge of European & Asian distressed investing
• most appealing sectors & cycles? - how to identify them?
• Case study work - public fund investing in European & Asian distressed markets
• Outlook for 2009 - how much and how many others will follow?
Which sectors afford the best prospect to leverage returns.
Analyze where next opportunities appear - look at the distressed markets - most popular sectors for distressed investments - Opportunities this quarter, this year - driving forces behind funds' decision to use Our Opportunity Funds? - positioning these assets into present strategy? - super-calc of risk/rewards of investing in OOFs? When share prices of bank stocks are the price of postage stamps (see example of the recent Bond 'forever stamps' I've invested in that will soon be showing 8% returns, and no stamp-duty or capital-gains tax?) to allocate assets to distressed investments is a matter of 1. timing; early/ middle/ later in distressed cycles? - 2. valuation - 3. performance measurement - 4. defaults & their corresponding distress-cycles - 5. relative risk - 6. upside potential - 7. plan to leverage value into the future. I surprise folks with my Stamp Bond returns compared to bank stocks. I tell clients what it is attracting them to invest early/middle/later in distressed cycles and how they plan to leverage value into the future and then hand them my T&Cs (business cards are for wimps). When Buying value under par (adage "the day you buy is the day you sell": present valuation NPV & performance measurement - Limited supply & high demand of distressed debt & equities - Future outlook: review of defaults & desire to get to the party before it’s over - Beyond timing: commitments from hedge funds & private equity firms to invest in opportunities that meet targeted benchmarks. To optimize distressed cycle & provide practical aspects of integrating distressed opportunities into the institutional portfolio: - Successfully identifying assets showing distress & maximizing on opportunities - How distressed debt investors can profit from subprime mortgage meltdown - Distressed debt development & investment opportunities in key markets - Understanding deal structures & implementing creative strategies.
Capital for leverage buyout transactions from institutional investors & pension funds (+ lease-finance style from banks) who pulled money out of the stock market in search of higher returns, some are sitting on record amounts of capital and will seek opportunities designed to meet higher opportunity OOF benchmarks - to target distress-funds for desirable takeovers. For these we provide: - Trend line: Investment cycle review - Baseline for returns-looking out onto the investment horizon - How is distressed market expanding or contracting? I gave the example of my very own private bank, Banque Rupp et cie and how 2008 impacted our funding liquidity. I explained how typical we are of the sector and on the basis of our trillion (multi-currency) balance sheet, using our own IFRS enhanced accounting standard how one third of our balance is annually refreshable after the capital has been wiped out 150%, even though we remain profitable if not for our ABS writedown that we only take on balance sheet to satisfy the investors in it how much we care albeit the tax authority has a few questions about how macro-prudentially and micro-prudently we record our P/L loss. I had to present recently to a panel of our institutional investors about our various responses to the new liquidity-distressed market conditions and why we now consider our off-balance sheet vehicles to be vulture fund opportunity for private banking HNW clients. Public and private sector pension funds are also raising capital to take advantage of current opportunities from supply/demand imbalance in market for mortgage-related and other assets like ours: - we statistically report in weekly detail on residential & commercial mortgage-backed securities and the underlying that supports our various MBS collateralized debt obligations, collaterized loan obligations (CLOs), single-name & index credit default swaps on CDOs, and how these compare to our whole-loan risk-buckets, soon to be in new CDO repo-packages and investment funding repo packs too (prospectuses mailed-out subject to your last 3 years margin call history & NSIMA series 7 SEC certifications - no prime brokers or ex- Lehmans, AAB, Fortis, UBS, Citi, RBS-GC or other ex-structured product prop-desk execs need apply). Golf footnote: in the afternoons of our conferences after the hectic breakfast sessions attendees are invited to play in IMN's Golf Invitational at Monarch Beach Golf Links' pristine location, along with abundant amenities that offer guests an enjoyable experience, truly unforgettable. The course has been host to nationally televised events with top golfers of all three capital markets with money leaders from the PGA, Senior PGA and LGPA tours with coaching tips from Arnold Palmer, Jack Nicklaus, Tom Watson, Fred Couples, Tom Kite, Julie Inkster and Dottie Pepper who have all spiritly competed on this picturesque course, where our Tees & Cees were finalised on leveraging the subprime situation, turning handicaps into par, losses into profits, water into wine!

Friday, March 13, 2009

Financial Services Authority: bird's eye view

We expect the FSA to be like a hawk, an owl, an eagle, a warning look-out, noting smallest signs of foolish risk-taking, a regulator bird of prey... if the FSA is bird-like, it's not a 'raptor' as per 'bird of prey', more a vulture, a Turkey Vulture Shaver probably? Raptors kill their prey. Vultures, also crows and ravens, eat carrion, Nature's and our road-kills. In the 1980's Charles Sibley, using DNA-DNA hybridization to check genetic taxonomy of avian species, found vultures especially perplexing. Tweny years on, no academic consensus has been reached. So it is with the FSA (set up in 1997 to amalgamate financial regulators, much as the G20 agenda hopes to do by creating a global IMF umbrella inter-linking bank regulators worldwide). The FSA started out well, but had so much to do, and then along came Basel II. It is by far Europe's biggest regulator. Half of Europe's financial assets are variously managed or operated in London and the UK. The FSA is smaller than the USA's SEC, but has twice the scale of work,. The SEC (set up in 1934 after the '29 crash) receives half a million statements from over 100,000 firms but actually supervises 16,000 securities firms and can only scrutinise about one in seven annually. The USA's FDIC and the regional Federal Reserves cover banks and other firms taking deposits and selling loans etc. The FSA has relatively more to do but much less resources. Its budget is charged to the firms it supervises. It covers all financial sectors and 28,000 firms. It approves over 170,000 persons. It regulates, monitors, supervises, licenses insurers, investment funds, brokers and banks (about 400 UK licensed banks and building societies including foreign-owned). The flow of new regulations, especially CRD (Basel II and Solvency II), and their complexity is enormous, on top of a great number of other laws and procedures, plus national and international coordination - hard for anyone at the top to fully comprehend. It is unimaginable how the jobs of the FSA or the SEC or other such large agencies today could be done, publications alone, without the internet. Compared to ministries of state, the FSA is a minnow, yet it has jobs to do as important, broader and deeper, and a lot more difficult technically. The sums involved in bailing out the banking system are such that now everyone can see just how serious all this is. This graphic shows only a fraction of the UK response. The FSA has a budget of about £350m and employs 2,700 spends two third of its budget on staff costs. The SEC has 900 more personel and twice the budget of the FSA, only half the number of firms to closely regulate, most on a rolling 3 year basis, and even it should be doing much more. The FSA staff and budget is slightly more than the Bank of England, but the FSA probably does several times more work, or it should be doing that much more if it was properly resourced. The FSA's work is as varied and complex or more so than any of our largest banking groups. It acts in theory like a non-executive oversight, to challenge executives like a massive audit committee. The UK has sought to have regulation cheap, not slightly cheap but at least 4 times too cheap (my guess)! Some people imagine regulation is like health-checks. Get the patient in, stick monitors on, go through some tests and scans, process the data, and then ask some searching questions like do you smoke, drink, suffer anxieties, take medications, but exercise enough? Then, if complaints persist, we expect the FSA to write a prescription? Unfortunately, there is a large element of that being how the FSA itself thinks, it is here to help the clients get well, to work with them, privately, collaboratively, non-threatening except in most exceptional circumstances, an emergency. Now its plague and the FSA hasn't got the manpower or the equipment for the job. It has to rely on risk teams in the banks and that's a curate's egg too. There are massive health-check manuals, but regulation is based on expecting the banks and others to read and comprehend it all and mostly self-medicate. In a mature stable world when all the new reulations are one day well imbedded and second nature for bankers, insurers and so on that might be possible, but it is very far from possible today. The FSA is certainly negligent and partly culpable for the credit crunch, but not nearly so much as he regulated firm themselves. And government with the FSA has some self-assessment to do as to whether the FSA has been at all adequately resourced? It has not been light-touch regulation though. That's a myth. The regulations are heavy-duty, comprehensive and even brilliantly conceived, elegant, legalistic, comprehensive, but presuming on a level of intelligence, priority-setting nd resource commitment by banks and others that is simply not happening more than half as much as should be. Where the FSA has fallen down is in the expertise of people and systems at both the FSA as well as the banks. The mass of guidance reports, firm rules, reporting requirements, processes advised, and scrutiny is enormous. The flow of publications exceeds that of any other of Europe's regulators. But, the FSA should have warned of the risks of being under-resourced! Risk experts are in very short-supply, high quality experts as rare as sea-eagles, and the FSA has a constant problem of staff being poached. Audit firms cannot take on the burden, not yet. They are not tasked to cover risk - while they have expertise not enough of that either. Will the full scale be fully addressed now, probably not! There will be 10% increase in FSA professionals to be trained up, when several times this are needed.
Hector Sants today, yet again, defended the FSA while at the same time accepting some blame. but not enough ruthless self-assessment. Echoing his boss, Lord Turner, Hector Sants blamed the credit crunch on world trade and payments imbalances and politically-driven credit-boom culture. (This is noteworthy: These causes are new, gaining recognition in the last few months - from economists and models that predicted the crisis - the Levy Institute models of my economist friends Wynne Godley, Alex Izurieta, Francis Cripps, Gennaro Zezza, Marc Lavoie and others now lauded as seers in the WSJ, FT, UN, Goldman Sachs, Cambridge Judge Institute and elsewhere by Paul Krugman, Martin Wolf and others.)
Sants said today (echoing his Chairman's view Lord Turner): "...the main drivers of the crisis as follows. ...a set of macroeconomic and macro-prudential issues... global imbalances caused by the response of the Asian countries to the last crisis... period of historically very low interest rates and in general globally, particularly in the US, a drive by the wider authorities – governments, finance ministries and central bankers - to encourage a significant credit boom particularly for the benefit of consumers who wished to purchase housing. In addition ...a set of cultural drivers ...that credit was good for votes and would be possible for the authorities to avoid a boom/bust culture." This is well and good, but problems persist in that we don't have models that fully link the macroeconomic to the financial sector in enough detail to guide the micro-prudential or even to assess the impact of government bail-out measures. Clues will come out in the wash only when we see how the top US and European banks complete the scenario stress-tests they have been tasked with - something Basel II regulations have insisted upon for years but too few people in the world have known how to accomplish. The big question is can banks be saved from making the recession worse by withdrawing credit and will better regulation play a role in this now? Then in a mea culpa, not unlike David Cameron's today apologising for the Conservative Party's failure to warn about the credit-boom economy (as a challenge to Gordon Brown to do the same), Sants went on to say, "These wider social and economic drivers were ...facilitated by ...weaknesses in the regulatory framework, respect of the rules, particularly in the way the prudential and accounting regime works in a procyclical way, but also ...fragmentation of the regulatory architecture both in many national locations and globally." This is the FSF, IMF and G20 agenda view.
In taking this to the FSA's role, sants said, " the UK... the principal gap in the regulatory architecture was in ...‘macro-prudential’, with the local supervisors of the FSA primarily focusing on individual companies and the central bank on interest rates. There was also, here in the UK, an inadequate depositor protection regime and bank resolution mechanism." No reference to Bank of England's role in Systemic Risk monitoring and its warnings in stability review reqports!
Sants said, "Other countries... had their regulatory architecture ...massive fragmentation, such as in the US which led to a lack of oversight ... of which AIG is the best example... lack of oversight of ‘bank-like institutions’, otherwise known as 'shadow banks'. So... economic... social and cultural... regulatory... market participant drivers ...failure of market discipline: markets did not self-correct... underpinned by ...investors and ... those who sell products not to ...'buy things you don't understand'... facilitated by credit rating agencies. Investors and banks ...too willing to accept their analysis as relevant to a whole set of risks ...not actually addressed by the research of the agencies... structural failures ...magnified by ...governance failures and poor business judgements by the financial institutions themselves."
The above provides blanket criticism but also get-out sub-clauses; blame fully-risk-dispersed!
Sants, "The key question then is where do we go from here and ...minimise ...this sequence of events ...happening again recognising... a belief we can fully abolish cycles' is an illusory goal? seeking to learn lessons very careful that we are not sowing the seeds for the next crisis. ...FSA's view ...will be laid out in our Discussion Paper ...18 March... responses that the authorities in aggregate can make... the FSA has already embarked on a programme of change ...greater supervisory resource of a higher quality... 280 extra specialist and supervisory staff ...30% increase in our supervisory capacity... new Training & Competence scheme ... right mix between professional regulators and market practitioners. ...working in partnership with the Bank of England and the Treasury is as a supervisor that we should be primarily judged ...under two headings: 'our philosophy' and our ‘operating model’... FSA characterised its approach as evidence-based, risk-based and principles-based. We remain, and must remain, evidence- and risk-based but the phrase 'principles-based' has...been misunderstood... principles alone is illusory ...policy-making framework does not allow it. ...limitations of a pure principles-based regime ...does not work with individuals who have no principles. What principles-based regulation does mean moving away from prescriptive rules to a higher level articulation ...emphasise that what really matters is not that any particular box has been ticked but rather that when making decisions, executives know they will be judged on the consequences - the results of those actions... FSA, when it supervises, needs to supervise to a philosophy that says 'It will judge firms on the outcomes and consequences of their actions not on the compliance with any given individual rule'... 'outcomes-focused regulation'. ... philosophy was that supervision was focused on ensuring that the appropriate systems and controls were in place and relied on management to make the right judgements. Regulatory interventions would thus only occur to force changes in systems and controls or to sanction transgressions based on observable facts. It was not seen as a function of the regulator to question the overall business strategy ...possibility of risk crystallising in the future." This is saying FSA was not responsible for criticising and stopping or changing the Northern Rock business model or similar models of excessive liquidity concentration risk. A look back to see that defaults could rise 3-400% higher than currently experienced in 2007. Funding risks were also not that hard to look back historically to see they could also suddenly spike sixfold.
Sants on the future: "...we will seek to make judgements on ...senior management and take actions risks to our statutory objectives ...moving from regulation based only on observable facts to regulation based on judgements about the future. This will of course carry significant risk and our judgements will necessarily not always be correct with hindsight. Furthermore, too aggressive intervention will stifle innovation and arguably reduce risk to a level that inhibits economic prosperity. ... what society as a whole expects regulators to be doing... what they thought we were doing. This more 'intrusive' and 'direct' ...'the intensive Supervisory Model'. ...'our credible deterrence philosophy' ...use all our powers including criminal prosecutions to deliver our mandate ...not ducking that responsibility. This week the first of our insider dealing criminal prosecutions has come to trial ...more in the pipeline." In the USA, the FBI already has over 200 such prosecutions in their pipeline.
Sants: "There is a view that people are not frightened of the FSA. I can assure you that this is a view I am determined to correct. People should be very frightened of the FSA... focuses on delivering credible deterrence in respect of its Financial Services & Markets Act (FSMA) mandate... on market-related offences ...not seek to be the responsible agency for prosecuting financial fraud in its ‘conventional’ or wider sense. ...responsibility is shared elsewhere and ...was not taken seriously enough but we are clear about our responsibilities and are delivering on them. To split enforcement powers from supervision would in my view make both tasks immeasurably more difficult... A comprehensive understanding of risk requires both prudential and conduct oversight responsibilities. The idea that 'twin peaks' regulation would have helped mitigate the current crisis is, in my view, not supported by events at all. Events such as the failure of AIG clearly demonstrate the value of integrated risk assessment delivered through a single supervisory authority. As the FSA ...was an operational and managerial failure in our supervisory area which was responsible for large UK institutions but the response to that should be to address the operational failure not to change the operating philosophy and structure. The problem was not structural, it was cultural. Much has been made recently of the importance of understanding business models. The twin peaks approach creates structural barriers to a full risk assessment of an institution and would sow the seeds of the next crisis. My second point, however, is to emphasise that effective risk assessment of a firm requires industry knowledge and ...not done in the past, but will be done in the future...involve both central banks and supervisors. The process should be 'top down and bottom up'. It needs to be a balanced partnership. My third point ...greater emphasis on outcomes testing relative to & controls. In the past ...focus was ...adequate management information and controls ...relying on management to address the issues. ...we will switch resources to outcomes testing...e.g. 'mystery shopping' and 'branch visits' rather than detailed reviews of high-level management information. This switch to outcomes testing is also central to the delivery of 'credible deterrence'." This revives ARROW reviews approach, which did frighten the horses, while detailed assessments did not because the ultimate penalty was taking away a bank's banking license and no bank believed in that threat! Now the climate permits FSA to recommend change of management, penalties and reputational criticism in public, "name and shame". This will be backed by the Treasury Committee report.
Sants: "..this switch causes risks... due to finite resources, we cannot test all outcomes and failure will be missed... ‘with hindsight’ criticism....better if the systems limitations were recognised, upfront, by all. ...changes are required but ...not realistic that we could deliver to perfection. ... fourth and critical of supervision has to be done in partnership with responsible firms, shareholders and auditors. The supervisors cannot operate alone. All ...must ensure ...strategies and behaviours ...greater engagement by all particular by shareholders and the non-executive community... central to this ...non-executives responsibilities... need to commit more time and raise their technical skills to exercise rigorous oversight. ...more support and indeed compensation for these individuals... more willing to challenge executives. ... more like full-time 'Independent Directors'. Sir David Walker’s report ...addressing these issues in more detail ...we cannot ignore that the principal responsibility for managing firms responsibly lies with the management themselves. ...ultimate responsibility for what has happened rests with firms’ senior management. ...specific decisions and strategies can be seen to be at the root of those firms' demise. ...improve the quality of management decision making to minimise failure. Yes, regulators can intervene more decisively, could have greater technical skills ...through changes to our authorisation process judge competence as well as probity. ...issue is behavioural. Markets have shown not to be rational; excesses have not been corrected by market discipline. ...managers... must acknowledge and fight against the ‘herd mentality’; ‘the collective wisdom’. ...'Do not take risks you do not understand.' 'Ensure the focus is on the long run franchise and profitability of the institution not the short term. 'Ensure a healthy and ethical culture in your organisation!' 'Recognise the future is not predictable and ensure at all times you understand the circumstances under which your firm will fail and that you are happy with the degree of risk mitigation you have.' 'Ensure a healthy and thoughtful culture of challenge from the independent directors.' These rules ...regularly ignored.... financial markets are not rational but ...a behavioural system built around personal aspirations is critical ...changing this time round... this crisis the reaction of society ...a contributor to the severity of events. ...a negative feedback loop... between wider society and the financial sector has been a unique characteristic of this crisis. ...require further consideration by us all... FSA has been seared by recent events but it is tougher and better as a result. The FSA has grown up." The idea of principle-based stated as late as Dec.08: "Detailed rules clearly have limitations. They have not always delivered the outcomes they were supposed to achieve. Detailed rules cannot cover all circumstances and eventualities - we cannot hope to devise a set of detailed rules to cover all types of business and all types of firm; and we cannot expect detailed rules to be responsive to market innovations and structural changes. Detailed rules tend to address processes, not outcomes - this can encourage a narrow approach to compliance, and can inhibit innovation and competition. And regulators need to avoid tackling problems by writing yet more detailed rules to address yesterday's problems - shutting the stable door after the horse has bolted."
There is sophistry here. It is based on the FSA's limited resources. The banks in practise could only adequately implement the regulations when they had detailed guidance. Primnciples, though just as mandatory, they found hard to implement, hard to do anything when innovation and some creative judgement was required. What the shift to principled-based supervision really reflected was not just being under-resourced and having insufficient expertise, but also a view that Pillar I, the quantitative accounting of current financial risk positions was completed and banks had to next move on to Pillar II, which everyone said was really about qualitative assessments and supervisor challenge. This was a general mistake, mistaking the principle-based definitions of Pillar II for qualitative and failing to see the massive amount of quantitiative modeling in economic capital models and how to integrate liquidity and all other risks. This is only being discovered now with scenario stress-tests in the wake of the credit crunch being placed centre-stage in risk management.
Principle-based supervision sought to shift the burden onto the banks and for some reasons, like 'innovation' and 'competition' imagine this is better? Basel II regulation is principle-based where it becomes too complicated to explain everything in precise etail. Bankers should understand, and also that the requirements have the force of law, therefore must be implemented thoroughly. In the UK it seemed that the legal force of Basel II was under-estimated. Verena Ross in a Dec 08 speech explained the new FSA policy in terms also of the need to convince Europe to follow the UK lead saying,"Finally we are also conscious that regulation and legislation that is coming from Europe is not always yet written in a fully principles-based way and ...we need to take a more prescriptive approach than we would probably have decided ...working actively in Europe to ensure that the Commission and other member states move increasingly towards more principles as well... worth at this point just dealing with some of the myths ...FSA's regulatory approach...being described as "light-touch" or "soft-touch". We are emphatically saying that it is not... It is purely about how we best achieve that regulatory standard ...we continue to regulate the areas the most effective and efficient way ...We strongly believe that the more flexible approach the right way forward ...we have limited regulatory resources ...we need to allocate ...where the greatest risks are... risk-based and proportionate, certainly not "light-touch". ...recent events surrounding the credit crunch, more properly called liquidity crunch ...reinforces, rather than contradicts the need to focus on the outcomes ...than just on the compliance of the action with a set of detailed rules. We are not operating a zero failure regime. We recognise that a successful financial market place requires innovation and competition and... there will occasionally be failures. But ...a more principles-based regime provides the best chance of achieving the requisite balance between benefits and risks ... such as conflicts of interest management or stress-testing, ...very difficult to ever have very prescriptive rules in those areas... businesses and their circumstances ... difference needs ...a flexible approach ...of either managing conflicts or conducting proper stress-testing." Note where this ends up! All roads in regulation and bank bailouts now lead to stress-testing, to Pillar II of the three Pillar Basel II. Banks and others failed to understand that it is not the accounting in PIllar I that is the essential detail, but the economic capital modeling in Pillar II that holds up and makes sense of the risk regulations. Just like liquidity risk was bottom of most banks' risk agenda until he credit crunch crunched them, so too was stress-testing the treated as least important of all concerns among the banks about getting their numbers right and systems in for Basel II compliance.
Not many can says events have validated their models and predictions. But I and my colleagues can rightly claim that. Getting unwelcome messages through at various banks was almost always a political and bureaucratic thicket.