Should regulation be dumb?  In one sense yes, in others, no.  It really depends on how well the regulators understand the risks involved, and how much they can encourage professionalism among profit center heads and risk managers.  As those two increase, regulation can be smart.  “Follow these detailed rules to calculate the capital you need to be solvent 99% of the time.”

But when either of those two aren’t true, dumb regulation may be in order:

• Strict leverage limits, reflecting the worst outcome from underwriting poor quality loans.
• Disallowing risky types of lending, regardless of capital level.
• Disallowing liabilities that can run easily.
• Disallowing products that commonly deceive buyers.
• Disallowing certain types of contracts that fuddle accounting.
• Those regulated may not choose their regulator.  The highest regulator assigns a regulator to you.  The highest regulator must evaluate the jobs that lower regulators are doing, and eliminate/lessen regulators that do not use the powers they have been granted, and get co-opted by those that they regulate.

If everyone were smart, things could be different.  Deceiving people would not take place, and managements would not take undue risks.  Limits could be looser, and products would be designed for discriminating buyers.

But, face it, we are dumber than we think, myself included.  Consumer choice is a good thing, though it implies that some will be deceived, no matter where one places the line of demarcation.  Along with that, some bank will not fit the rules and go insolvent, though it previously passed the solvency tests.

Dumb Regulation: Insurance in the US

My poster child for relatively good dumb regulation is the insurance industry in the US.  The industry is far less free-wheeling than the banking industry, and under most circumstances, the solvency margins are set high enough to have few insolvencies.  There is room for improvement, though:

• Make risk based capital charges countercyclical.  Perhaps tinkering with the Asset Valuation Reserve would do that.
• Have some sort of rigorous testing for capital relief from reinsurance treaties.
• Ban surplus notes in related party transactions.
• Ban all forms of capital stacking, especially where the transactions go both ways.  I.e., subsidiaries can’t own securities of any companies in their corporate family.  All subsidiaries must be owned by the holding company.
• More rigorous testing for deferred tax assets.
• Assets as risky as equities, including limited partnerships, should be a deduction from capital.
• Securitized bonds that are not “last loss” should have higher RBC charges than comparable rated corporates, because loss severities are potentially higher, and assets that are originated to securitize are always lower quality than those held on balance sheet.
• A standardized summary of cash flow testing results should be revealed.

As for the banks, they need to do that and more:

• Insurance companies list all of their assets.  Banks should as well.
• Intangible assets should be written to zero for regulatory capital purposes.
• Risk-based capital standards need to be tightened to at least the level of insurance companies, if not tighter.
• Some sorts of lending to consumers should be banned.  I am talking about complex agreements, that individuals with IQs less than 120 can’t understand.  Insurance policies have to be Flesch-tested.  Bank lending agreements should be the same.  If some argue that the poor need access to credit, I will say this: the poor need to get off of credit.  Credit is for the upper-middle-class and rich.  Poor people should not go into debt.
• Standardized summaries of terms and fees must be created for consumer lending, with large, friendly letters, and simple language that all can read.

What I am saying is that accounting has to be more conservative, and that regulators have to require larger amounts of capital to support their business, particularly at the banks.  Financial products must be made simpler for consumers to understand.  More transparency is needed everywhere, and if the financial companies complain, tell them that they will all be in the same goldfish bowl, so no one will gain an unfair advantage.

Preventing Too Big to Fail

As part of preventing too big to fail, the Risk based capital [RBC] percentage should rise with the amount of risk-based capital.  Say, when RBC gets over $10 billion, the percentage of capital needed for RBC grades up to 50% higher than the level needed at $10 billion by the time RBC gets up to $50 billion.

Here is my example of how it would work:

I have assumed that firms undertake their highest ROE projects first, and do progressively lower ROE projects later.  Now, by raising capital requirements on bigger firms, a common response is, “Well, then they will just take on riskier loans to compensate.”  Sorry, but that dog don’t hunt.  If they take on riskier loans, their RBC goes up even more rapidly, because loan quality is reflected (or, should be reflected) in RBC formulas prior to adjustment for bank size.

More Dumb Regulation

Dumb regulation bars certain lending practices, and raises capital levels higher than is needed over the long run.  So be it.  Smart regulation is far more flexible, and trusting that companies and consumers know what they are doing.  Unfortunately, when financial firms fail, there are often larger repercussions.  It is better to limit regulated financial companies to businesses where the risks are well-understood.  Let the less understood risks be borne by those outside the safety net, and bar those inside the safety net from holding any assets in those companies.

That brings me to the Volcker Rule, which is a good example of dumb regulation.  My preferred way would be to do something similar through adjusting the risk-based capital formulas — Equity-like risks should be funded through a 100% allocation of equity. Few banks would take on that level of speculation at that level of capital used.

If you need proof, look at the life insurance industry. Companies used to hold a lot more equities prior to the tightening of RBC rules. Now they hold little, except at a few mutual companies that are flush with capital.

That also has preserved the insurance business in this crisis, leaving aside mortgage and financial risks, where the state regulators still have no idea what they are doing — that a proper reserve level would leave most of the companies insolvent today, but had it been implemented ten years ago, would have preserved the companies, but eliminated much of their profits.

At the Treasury meeting with bloggers in November 2009, I commented that the insurers were better regulated for solvency than the banks.  One of the reasons for that is that they do harder stress tests, and they look longer-term. Life and P&C insurers survive the process because of better RBC standards, and “scaredy cat” state regulators. What a great system, which prior to the crisis, was criticized as behind the times.  (I suspect that if we ever get a national regulator of insurance, there will be a big boom and bust, much as in banking at present. It is easier to corrupt one regulator than fifty.)  The more state involvement in bank regulation, the dumber (better) bank regulation will be.

What to Do

So, if one is trying to regulate banks for solvency, there are seven things to do:

• Set risk-based capital formulas so that few institutions fail.
• Make it even less likely that larger institutions fail.
• Limit the ability of financial institutions to invest in other financial institutions.
• Regulators must benchmark the underwriting culture, and raise red flags when underwriting is poor.
• Insure that equity is truly equity.
• Institute a code of ethics for risk managers.
• Make sure that balance sheets fairly reflect derivatives.

It is almost always initially profitable to borrow short and lend long.  That said, it is a noisy trade.  Who can be sure that short rates will remain below the rates at which one invested long?  Another component of a good risk-based capital formula is that there is no investing in assets that are longer than the liabilities that fund the financial institution.  (For wonks only: regulated financial institutions should be matching assets versus liabilities as their most aggressive posture.  Unregulated financials can do what they want.  And no investing in unregulated financials by regulated financials.)

One of the great subsidies banks get is the cheap source of funds through deposits.  It is only cheap because depositors know the FDIC is there.  The FDIC should raise its fees to absorb that subsidy back to the taxpayer.  Keep raising it until you see banks begin to shift to repo and other short-term sources of funding.

As a clever old boss of mine once said, “A banks liabilities are its assets, and its assets are its liabilities.”  The idea is this — banks that focus on their deposit franchises have something of real value — that is hard to replicate.  But any bank can invest their funds aggressively, which will lead to defaults with higher frequency.  It is true of insurers as well, most financials die from bad investing policies, and short-term liabilities that require complacent funding markets.

That’s why there has to be a focus on liabilities in regulating solvency.  Financial institutions, even simple ones, are opaque.  Most die from the deadly combo of illiquid assets and liquid liabilities.  Those that have funded the bank in the short run refuse to roll over the loans at any price.  Assets can’t be liquidated to meet the call on cash, and insolvency ensues.  Those that have read me for a long time know that I don’t buy the malarkey that some managements will trot out, “We’re not insolvent; we merely have a liquidity crisis.”  Hogwash.  You took too much risk, because the first priority of risk control is liquidity management.  Assets are only worth what you can sell them for, or, what cash flows they can generate.  If assets can’t generate cash flows or sale proceeds adequate to service liabilities, then you are insolvent, not merely illiquid.

Cash flow testing for banks should focus on the ability of the bank to finance itself without recourse to selling assets.  To the extent that selling assets is allowed in modeling, they must be Treasury quality assets.

The essence of a good risk-based capital formula is that it forces intelligent diversification, and forces adequate liquidity.  No assets should be bought that the liability structure of the bank cannot hold until maturity.  There should be no concentration of assets by class, subclass, or credit, that would be adequate to lead to failure.

My view is that a proper risk-based capital regime would start with asset subclasses, and double the capital held on the largest subclass, and 1.5X the capital on the second largest subclass.  After that, within each subclass, the top 10 credits get twice the level of capital, the next 10 1.5x the level of capital.  Having managed assets in a framework like this, I can tell you that it creates diversification.

Beyond that, no modeling of asset correlations would be brought into the modeling because risky asset correlations go to one in a crisis. Any advantage derived from diversification should be accepted as earned, and not capitalized as planned for.

Securitization deserves special treatment: risk based capital should higher for securitized assets versus unsecuritized assets in a given ratings class, because of potentially higher loss severities, and assets that are originated to securitize are always lower quality than those held on balance sheet.  Capital charges should be raised until banks don’t want to securitize as a matter of common practice.

Eliminating Contagion

In order to avoid systemic risk and contagion, banks should not lend to or own other financial firms.  That would end contagion.  At least that should be limited to a percentage of assets, or through the RBC formula. Think of it this way, financials owning financials is a form of capital stacking across the country as a whole.  In a stress situation it raises the odds of a deep crisis.  Setting a limit on the ability of financials to own the assets of financials is the single most important step to avoid contagion.  I would set the limit at 5% for equity, and 20% for debt.

Regulating Underwriting

Most of the real risks came from badly underwritten home mortgage debt, whether conventional, Alt-A and Jumbo, or subprime.  Underwriting standards slipped everywhere.  Commercial mortgage lending hasn’t yet left its marks — there is a lot of hope that banks can extend maturing loans rather than foreclose and take losses.

For much but not all of this crisis, it was not a failure of laws but a failure of regulators to do their jobs faithfully.  Regulators should have looked at indicators of loan quality, and raised red flags when they saw standards deteriorating.  Where I worked, 2003-2007, we saw the deterioration, and were amazed that the regulators had been neutered.

Let Equity Be Equity

Beyond that, there was a dearth of true equity, and a surfeit of preferred stock, junior debt, trust preferreds, and particularly, goodwill.  Equity has to reflect assets that are high quality and that are not needed to support short-term obligations from the cash flow tests.

Code of Ethics for Risk Managers

One reason the banking industry is worse off than insurance, is that they don’t have many actuaries.  Actuaries have a code of ethics.  They tend to be “straight arrows” telling it like it is.  Bank risk managers need the same thing, together with the rigorous education that actuaries receive.  Accept no substitutes: CFAs and CERAs are no match for FSAs.

Reflect Derivatives Properly

Derivatives must come onto the balance sheet for regulatory purposes, revealing leverage increases/decreases, counterparty risk, overall sensitivity to the factors underlying the contracts.  Any instrument that can cause cash to flow at the regulated entity should be on the regulatory balance sheet.

Other Issues

I would not create a prospective guarantee fund. The insurance industry has a retrospective fund that has worked fairly well.   Do you really know what it would take to create a macro-FDIC, big enough to deal with a large systemic risk crisis like this one?  (The FDIC, much as it is pointed out be an example, is woefully small compared to the losses it faces, and it is not even taking on the large banks.)  It would cost a ton to implement, and I think that large financial services firms would dig in their heels to fight that.  Also, there would be moral hazard implications — insured behavior is almost always more risky than uninsured behavior.

Though it is not bank reform, we need to end the Greenspan/Bernanke Put.  The Fed encouraged risk-taking by the banks by not allowing recessions to damage them.  They tightened too late, and loosened too early, and that pushed us into a liquidity trap. Monetary policy that is too loose creates perverse incentives for the solvency of financial institutions in the long run.

Bonuses to executives skew incentives.  Bonusing a financial executive on current earnings creates perverse incentives.  It is a form of asset/liability mismanagement, because cash flows in the short run, while the value of the institution is a long-run issue. Far better to incent using long dated restricted common stock.  The only trouble is, it doesn’t incent as well as cash.  Tough, sorry, but that is a loss that must be accepted for the good of the system as a whole.

Summary

Dumb regulation is good regulation.  Regulators should be risk-averse, and take actions that limit ROEs for banks in order to promote solvency, and reduce the likelihood of liquidity crises.  The remedies that I have proposed here will do just that.  May we use them to regulate our financial sector better, for the good of all in our nation.

I will have a more comprehensive post tomorrow on my thoughts on bank regulation, but I will offer a few thoughts here.  One thing I found interesting at the conference was what did not get much play in terms of what helped to create the crisis.

It was fascinating that no one talked about why the US bailed out holding companies, rather than letting them fail, and merely backing up the operating subsidiaries. This is significant.  The moment you put money into a holding company, it goes everywhere.  Regulators should only care about operating subsidiaries, and let the holding companies fail; let the costs be borne by the stockholders and bondholders of the failed company, but protect the regulated entities.

Also, few fingered the Fed’s monetary policy, where Greenspan and Bernanke created a culture of lenders who knew that the Fed would ride to their rescue when thing got modestly tough.  Unlike William McChesney Martin, who joked that the Fed’s job is “to take away the punch bowl just as the party gets going,” Greenspan and Bernanke were slow to remove the punch bowl, and quick to bring it back, creating lenders who would rely on the Fed to allow them to take too much risk.

Another miss was not blaming the failure of neoclassical economics to explain, much less predict the problems that we experienced.  Why invite any neoclassical economists at all to the conference?  The few economists that were ahead of the asset bubbles were ignoring neoclassical economics.  Neoclassical economics is a failed discipline that needs to be replaced by something that realizes that applying math to economics does not yield significant increases in understanding.  The Austrians, those who follow Minsky, and the non-linear dynamic school understand what is going on better, because they treat economics the same way we understand ecology.  And, no, applying math to ecology doesn’t help that much.

Preventing Too Big to Fail

There are three main ideas as I see it, in preventing “Too Big to Fail.”  The first is changing risk-based capital [RBC] policy to raise capital requirements on larger institutions.  Use RBC to discourage banks from getting too large.

The second idea, which also wasn’t talked about much at the conference, was to limit regulated entities from owning or lending to other financial institutions.  Do you want to limit contagion?  Well, if you do, you must limit the amount that regulated banks own of/lend to other financials.  That even applies to subsidiaries with the same ownership group.  Keep it clean.  If you are going to have financial holding companies let them own all subsidiaries directly to avoid capital stacking.  Ban cross-guarantees among subsidiaries.

The third idea, which I have touched on is that regulators should ignore holding companies and never, never, NEVER bail them out.  Bailouts should only come to regulated entities, and only after the resources of the holding companies have been drained to zero.

On Detecting Fraud

I appreciate what was said on detecting fraud by one presenter: check for adverse selection, honest businessmen won’t do business that way.  Also, it never make sense for a secured lender to accept inflated appraisals.  In short, the originate to securitize model allows originators to make substandard loans that they will not hold onto.

This is why I say look for gain-on-sale accounting. There is something perverse about making money simply because a sale is made.  Under the GAAP principle of release from risk, which I believe is misapplied, financial entities should recognize profits more slowly than is the current practice.

When I was a buy-side analyst, I would analyze a company’s management culture for short-termism. Any management team that seemed too aggressive would get negative marks in my book and I would avoid them, or short them.

Remember you can never get pricing, volume and quality at the same time in lending. Companies that go for volume, or sacrifice quality are begging for trouble.  Financial companies are in a mature industry, so beware companies that grow fast.  Also beware of long dated accruals.  Accrual quality declines with length of time until payment and likelihood of payment.

Those that want to have regulators war-game future problems and predict black swans have their work cut out for them, even considering what I have said already.  But most of their attention should be fixed on the areas of the market where the greatest increase in lending is occurring.  Where debt is increasing the most is usually the area where there will be the most financing problems in the future.

One more note for regulators: look at the high short interest.  The shorts are doing you a favor.  They spend a lot of time analyzing who they think is cheating the system, and then they put their money on the line.  I would tell regulators to use the shorts as a guide.  Don’t automatically trust that there is something wrong, but use it as a guide to now begin your own due diligence into the solvency of the financial institution in question.

More Tomorrow — until then.

Carl Felsenfeld: Do we know what the problem is?  What are we trying to solve?  Antitrust does not deal with Citigroup/Travelers, it should deal with Bank of America/Fleet, Wells Fargo/Norwest.  But it didn’t deal with those bank acquisitions.  The regulators were out to lunch.

Jesse Markham: Antitrust can only do so much. It also does not do so well where size is due to organic growth.  (DM: like Google or Microsoft.)

Zephyr Teachout: Antitrust should be based on size.  The DOJ is less subject to regulatory capture, and more inclined to prosecute.

Paul Kaplan: These ideas are against current trends in antitrust.  Perhaps a more rigorous application of the Sherman Act would be more effective.  Organic growth to a large size is still a problem, but how do you avoid punishing success?

(DM: just met Colin Barr of Fortune.  Nice to put a face to the name after all these years.)

Discussant: Canada disallowed securitization for the most part, and stopped more mergers with their banks.

False Assumptions

William Black — Control Fraud & Systematically Dangerous Institutions -Accounting values can be fudged.  RBC as well.  Difficult to detect Control Fraud.  Originating bad loans allows a bank to grow rapidly.  Need forensic accountants.

(DM: look for fast growth — quality, quantity, price. Look for new products.)

Lawrence Baxter — When Big Becomes a Problem.  – Worked ten years at a major bank that went through  a ton of mergers.  The self-regulations with each bank having its own risk model doesn’t work.  The regulators don’t understand them, and spend time learning what is going on.

(DM: fascinating that no one has talked about why the US bailed out holding companies, rather than letting them fail, and merely backing up the operating subsidiaries.  Also, few have fingered the Fed’s monetary policy.)

Shawn Bayern — False Assumptions in Law and Economics — Innovation in the banking is not always a positive.  Bonuses to executives skew incentives.  (DM: it is a form of asset/liability management.)

Russell Pearce — discussant — Business is self-interested, and short-term greedy.  Profit-making is maximized, not even long-term greedy (DM: maximizing the net present value of profits).  (DM: incent using long dated restricted common stock — trouble is, it doesn’t incent as well as cash.)

Mark Gimein — discussant — 3 questions a) What of a big rogue banker?  The market is good at absorbing single failures.  (DM: but not multiple failures.)  b) who should do the regulation?  Tough to get bright men who are tough who won’t go to work for the banks, or buy into the banks logic. c) Control Fraud is hard to prevent; human nature is that way.  No systematic approach to dealing with fraud.

Detecting Fraud — check for adverse selection, honest businessmen won’t do business that way.  Also, it never make sense for a secured lender to accept inflated appraisals.

(DM: Look for gain-on-sale accounting.  Analyze management culture for short-termism.  Remember you can never get pricing, volume and quality at the same time.  Financial companies are in a mature industry, so beware sompanies that grow fast.  Be aware of long dated accruals.)

Discussant — are we worse off today than in the robber baron era? Not necessarily.

Holmes bad man theory — the law exists to constrain bad men.

I gave a 3-minute rant on how insurers are better regulated than banks.  I’ll write more about that tonight in a piece that articulates my views on banking reform.

Simon Johnson’s lunch talk was pretty standard: there is no social benefit to banks being larger than $100 billion in assets.  Major banks are too politically powerful, but they should be fought the same way Teddy Roosevelt did with JP Morgan and trustbusting.  Simon thinks that political opinion is shifting on this issue.  He calls for a size cap based off of a 4% percent of GDP for commercial bank assets, and 2% for investment banks.  This would only affect 6 banks, and would put the banking system sizewise where it was in 1990.

A frequent comment is that Canadian banking is concentrated, and they haven’t been hurt.  But other nations have concentrated banking and have gotten into trouble, notably Switzerland and the UK.

One commenter noted that reliance on wholesale funding drove much more of the panic than deposit funding.

Now the third panel starts:

Rob Johnson spoke about creating a credible resolution authority.  He asked why we can’t send Large Complex Financial Institutions [LFCI] through Chapter 11?  Derivatives must be simplified and brought into clarity.  Contagion, complexity, etc.  No real solution offered.

Jane D’Arista — Financials cannot insure other financials.  Leverage must be scaled back.  Various types of short term funding must be scaled back.  Margin standards must be extended to all financial instruments.

Richard Neiman — Banks are risk-takers, that provide a social service, thus taxpayer guarantees via the FDIC.  Volcker rule may not have prevented the last crisis, but it might prevent the next.  Need a group to try to be proactive on future risks — war-gaming.  Attempt to predict black swans.

(DM: most of this can be done by following increases in leverage.)

Arthur Wilmart: no magic bullet.  Fed overstimulated housing market after dot-com crash.  Reduce implied subsidy to banks.  How to internalize the costs?  Three problems on deposit limits: failing banks, intra-state acquisitions and thrifts aren’t counted.  Narrow banking would contain the subsidy.  Systemic risk insurance fund — at least $300 billion, pre-funded.  FDIC would manage it — most competent of the regulators.

Frank Pasquale — Talks about information asymmetries, need more disclosure.  Financial privacy — banks that are big would have to reveal a lot more.  Records of everything would have to be kept for a long time 10-15 years.

A discussant: choosing the lax regulator (DM solution: government assigns the regulator)

DM: banks should not lend to or own other financial firms.  That would end contagion.  At least that should be limited to a percentage of assets, or through the RBC formula.

One panelist suggests that all financial instruments be traded on exchanges.  (Ridiculous, because only common instruments can can trade on exchanges.  Unique things don’t trade on exchanges.  That’s why IBM equity trades on an exchange, but most IBM bonds don’t.)

Discussant: banks cannot self regulate, not even as a group.

Cheapest source of funds are FDIC-backed deposits.  That’s the big subsidy.  (DM: Charge a much larger FDIC fee.)

Discussant: won’t narrow banking create more risk outside the banks?  Where things are less regulated?  Those losing money outside of the banks would end up taking a haircut.

Discussant: GS or MS failing would still shake the system.

Discussant: a new insurance fund would be difficult to make work.  Also,a new regulator might not be better than existing regulators

Discussant: Regulating money market funds as banks.  (DM:  money market funds lost so little, and banks lost so much… why is this an issue.)

Okay, here is tonight’s rule:

The assumption of normality for asset price changes is wrong in virtually every financial market setting.  The proper distributions are fatter tailed and more negatively skewed.

Normality allows researchers to publish, regardless of the truth.

Normality allows risk managers and regulators to pretend that adequate reserves are held against disaster.  It also allows businessmen to achieve acceptable ROEs, while accepting a probability of ruin far in excess of what is prudent.

The normal distribution is a wonderful creation, because it is so simple.  All we need to know is the mean and the variance, which are very simple to calculate.  And… it seems close to fitting a large number of phenomena in nature where the behavior of one party does not affect the behavior of others.

But in economics and finance, the assumption of normality is perpetually violated.  I would guess that it is wrong more often than it is right.  Academics continue to drag out studies assuming normality because it allows them to publish.  academics get statistically significant results more often than they should, because they pursue specification searches, and get to results that they can publish via data mining (and ARIMA error terms — unless there is an a priori reason them, they facilitate specification searches).

And, lest I be accused of being merely biased against academics, this biases me against many businessmen as well.  Many bankers looked at their loss distributions over the prior 25 years in 2007, and assumed that risks were minuscule.  Yes, there were bad periods, but the Fed always rode to the rescue, and losses were low, aside from a few egregious offenders.

Bankers concluded that they could do no wrong, and underwriting suffered.  Rather than looking at more objective measures of risk, bank managements looked at the need to hit their earnings estimates.  Losses had not been large in the past, so the future should be equally good.

When I was a risk manager, I would look at the level of surplus, and would compare it to expected normalized annual losses — if I didn’t have at least 15x normalized annual losses, then I knew I could not survive a reasonably normal spike in defaults at the bottom of the credit cycle, though an assumption of normality, where losses don’t come in bunches, would have allowed me to lever up more.

And I have known my share of management teams that pushed at the risk manager, telling him he was too conservative.  The company couldn’t earn an adequate return on capital at such low levels of leverage.  Equity analysts expected constant growth out of financial stocks, which sadly are cyclical stocks — it is a mature industry, and mature industries are cyclical by nature.  So they added more leverage, and things worked well for a while, until things blew up.

So long as consumers felt that they could add more debt, the bet could go on, with occasional minor interruptions while the Fed mopped up the damage.  But that stopped when the Fed could not drop rates below zero.  Still, the Fed found new ways to subsidize the debts of privileged parties, by buying up their long term debts and holding them.

Look, if you want to regulate properly, you can’t rely on normality.  It does not work in finance and economics.  When looking at loss statistics, don’t look at the mean or the variance.  Instead look at the maximum 3-year loss, and gross it up by 20%.  The surplus of a company should be able to absorb the maximum amount of losses from 3 years, and then some.  I use this as an example rule; tailor it to your needs as you see best.  I used 3 years because the bust phase of when the credit cycle is rarely severe for more than 3 years in a row.

If you want to manage risk internally properly you should think similarly — look at the outliers, and ask whether you can survive something worse than that.  Here’s a personal example: if someone had come to me two months ago and asked me how likely it would be that my area near Baltimore could get 60+ inches of snow in a one week time span, I would have said, “That’s not impossible, but that is way beyond the prior record, which I think is around 30+ inches.  Very unlikely.”  Well, it happened, and five weeks of warmer weather later, my backyard is still half covered by snow.

Markets, like the weather, are far more variable than we would like to admit, and attempts to tame them often lead to suppressed volatility for a time, but with explosions of volatility later, as economic actors begin to presume upon the low volatility as their birthright, and begin to speculate more aggressively, building up progressively more leverage as they go.

So when analyzing risk look at the worst possible outcomes, and build a plan that can handle that.  Size your leverage to reflect that; in a really risky business, you might have no leverage, and extra bits of slack capital in high-quality short-term debt claims.

Finally, remember my analogy of bicycle versus table stability.  A bicycle has to keep on moving to stay upright. A table does not have to move to stay upright, and only a severe event will upend a large table.

I developed this analogy back when I was a corporate bond manager, because there were some companies that would only stay afloat if they kept moving, i.e., if operating cash flow continued at its projected pace. That is bicycle stability; they have to keep pedaling. There were other companies that could survive a setback in earnings, and even lose money for a time, and the debt would still be good. That is table stability.

This is why stress-testing beats value-at-risk in a crisis, and why the insurers came through the crisis so much better than the banks.  When liquidity disappears, strategies that require continued liquidity can cause their companies to disappear.

Better safe than sorry.  Banks should run their businesses using stress tests that will cause them to have lower ROEs because of the additional capital needed to assure solvency.  The regulations have been too loose for too long.

Before I start tonight, a reminder, those that want to follow me on Twitter can do so here.  I will be sharing posts and ideas that I find insightful, that I might or might not share on the blog.  I’m still working with it.  Thanks to all of those that tweeted and retweeted, and those that are following me now.

One more note, I disagree with Volcker and Sarkozy regarding supporting Greece, versus the Euro.  If Greece defaulted, Greece would lose the low cost funding of the Euro.  The Eurozone would lose a country, but the Euro would retain its strength, and marginal nations prone to cheating would come into line.  Tough love is the best policy; don’t bail others out if you care about the union as a whole.

On to tonight’s rule: Unless there is a natural purchaser of an exposure that one is trying to hedge, someone must speculate to a degree to allow you to hedge.  If the speculator is undercapitalized, risks to the financial system rise.

This rule is pretty simple.  There are few places in the financial markets where there are naturally offsetting exposures that have not been remedied by an institution created for that very purpose, such as a bank.  In most cases with derivatives, the one that wants to reduce exposure relies on a speculator.  There are rare cases where the risk of one is the benefit of another, but situations like that tend to create new firms to internalize the trade.

The trouble occurs when the speculator can’t make good on his obligations.  As with many speculators, he overcommits.  He is short of funds because many trades are going against him at the same time.  It is in these cases that those who hedge learn to evaluate counterparties for their riskiness.

That is why it is worth knowing who is at the end of the chain in this financial game of crack-the-whip.  The status of the ultimate speculators, and whether they can make good on promises or not is a huge thing.  After all, subprime mortgages were downplayed by many as the crisis was rising, but they were at the end of the financial game of crack-the-whip.  They were one of the main classes of marginal borrowers.

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Taking this a different way, this argues against the academics that look for complete markets in the sense of Arrow-Debreu.  There are trades that no one wants to take at any price that a seller could live with.  There are securities that can be created that no one wants to buy, at prices that are unprofitable to the securitizer.    Complexity is a minus.  We can create securities that are the financial equivalent of toxic waste, but no one should pay much for them.  It is the price of creating safe securities.

No surprise: people pay a lot more for certainty, even if it is seeming certainty.  We see it in corporate bond spreads.  High quality borrowers borrow cheaply.  Low quality borrowers pay up. So what else is new?

What is new is the low-ish spreads for going down in quality.  This one could go either way; spreads are wide against history, but might be narrow against current difficulties.  The rebound has been rather sharp.

Note: this is reposted because of a system glitch.

Dear readers, I am now on Twitter — AlephBlog is my moniker if you want to follow me.

I have been somewhat reluctant to do this, but tonight’s post stems from a file on nonlinear dynamics on my computer that I developed between 1999 and 2003 for the most part.  Not so humbly, I called it “The Rules.”   This is the first in a series of what will likely be long set of irregular posts about what I call “The Rules.”  Please understand that I don’t want to make grandiose claims here.  After all, as I once said to Cramer (yes, that one): “The rules work 70% of the time, the rules don’t work 25% of the time, and the opposite of the rules works 5% of the time.”

My best recent example of the rules not working was when the formulas of the quants were blowing up in August 2007.  There were too many quants following the same strategy, and they had overbid the stocks that their models loved, and oversold the ones that they hated.  For a while, the quant models were poison.  Every investment strategy has a limited carrying capacity, and those that exceed the strategy’s capacity are prone for a comeuppance.

Here is today’s rule: There is no net hedging in the market.  At the end of the day, the world is 100% net long with itself.  Every asset is owned by someone, regardless of the synthetic exposures that are overlaid on the system.

There are many people, particularly dumb politicians, who think that derivatives are magic.  To them, derivatives create something out of nothing, and that something is strong enough to smash innocent companies/governments that have been behaving themselves, but have somehow found themselves caught in the crossfire.

First, if a company or government has a strong balance sheet, and has a lot of cash or borrowing power, there is nothing that speculators can do to harm you.  You have the upper hand.  But, if you have a weak balance sheet, I am sorry, you are subject to the whims of the market, including those that like to prey on weak entities.  Even without derivatives, that is a tough place to be.

With derivatives, for every winner, there is a loser.  It is a zero-sum game.  Yes, as crises arise there are always those that look for a way to make money off of the crisis.  And there are some parties willing to risk that the crisis will not be so bad, at a price.  Derivatives don’t exist in a vacuum.  Same thing for shorting — there is a party that wins, and a party that loses.  So long as a hard locate is enforced, it is only a side bet that does not affect the company whose securities are being played with.

When there are troubles, it is because a company or government has overstretched its limits.  You can’t cheat an honest man (or country).  You can take advantage of countries and companies that have overreached on their balance sheets and cash flow statements.

Cash on the Sidelines, Market is Oversold/Overbought, Money is Moving into or out of…

Every bit of cash on the sidelines is matched by a short term debt obligation somewhere.  Now, that’s not totally neutral, as we learned in the money markets crises in the summers of 2007 and 2008.  If the money markets get too large relative to the economy on the whole, that means there is possibly an asset/liability mismatch in the economy, where too many are financing long assets short.  It costs more in the short run to finance long-life assets with long debt or equity, but in the short run you make a lot more if you finance short… do you take the risk or not?

GE Capital nearly bought the farm in early 2009 from doing that.  CIT did die.  Mexico in 1994.  When you can’t roll over your short term debts, it gets really ugly, and fast.  Think of the way we messed up housing finance in the mid-2000s; one of the chief signs that we were in a bubble was that so much of it was being financed on floating rates, or contingent floating rates with short refinance dates.  Initially, that gave people a lot more buying power, at a price of higher unaffordable rates later.  “The phrase, “You can always refinance,” is a lie.  There is never a guarantee that financing will be available on terms that you will like.

This is also a good reason to go for debt that fully amortizes (i.e., when you get to the end of the loan, the payments haven’t risen, and the loan pays off in full).  I’ve never been crazy about the way commercial mortgage loans don’t fully amortize.  I know why it happened this way.  A) in the late ’80s and early ’90s, insurance companies were issuing GICs by the truckload, and needed higher yielding debt with a 5-year maturity.  Voila, 5-year mortgage loans with a balloon payment.  For the real estate developers, the loans were cheaper, but they had to trust that they could refinance — an assumption sorely tested in the early ’90s.  After the death of many S&Ls, a few insurers and developers, and the embarrassment of a more, borrowers and lenders became a little more circumspect.

But the loss of the S&Ls left a void in the market.  The Resolution Trust Company created some of the first Commercial Mortgage Backed Securities [CMBS], that Wall Street then imitated, filling in the void left by the S&Ls.  But to make the securitizations more bond-like, for easy sale the loans were 10-year maturities with a balloon payment at the end.  That way the deals would closer at the end of ten years.  Maybe some of the junk-grade certificates would be stuck at the end with a some ugly loans to work out, but surely the investment grade certificates would all pay off on time.

And that is a big assumption that we are going to be testing for the next five years.  Will developers be able to refinance or not?

This has gotten long, and have more to say, but I’m going to a wedding of a friend, and must cut this off.  Let me close by saying there is a corollary to the rule above, and it is this:

Long-dated assets should be financed by non-putable long-dated liabilities or equity.  Don’t cheat and finance shorter than the life of the assets involved.  There is never an assurance that you will be able to get financing on terms that you will like later.

1) After reading a piece on Falkenblog yesterday, I decided to add up all of the profits from Fannie and Freddie over the last 20 years.  Ready for how much they made?  Ta-da!  They lost $114 billion.

When writing at RealMoney, I was always skeptical of the GSEs, and felt that they were too lightly reserved, because eventually they would run into a situation where real estate prices would fall.

2) Bruce Krasting comments on the solvency of the FHA.  I comment:

“I’ve argued that FHA would go negative for some time. Even the FDIC is engaged in a bit of chicanery by fronting future premiums forward to avoid borrowing from the Treasury.

We may avoid a banking crisis — at the cost of a sovereign crisis.”

3) I probably have a longer post coming on the paradox of thrift, that bogus concept that Keynes put forth.  But Paul Kedrosky crystallized it for me when he posted this.  And so I wrote:

The problem with the “paradox of thrift” is that it assumes there is only one way to save. Same for the “paradox of toil.” It assumes that all work is interchangeable and uniform.

The aggregation of all saving and all labor is necessary to make these models work mathematically, but isn’t valid in real life.

Yes, if everyone tries to do the same thing, stupid things happen, like bubbles from overinvesting. If there only a fixed possible number of tasks, and people work longer hours, it takes fewer people to do them.

But there are many opportunities, including ones that we don’t presently know about. Businesses that no one could imagine before the crisis can spring out of hard times.

This paper oversimplifies the economy. If the economy were that simple, he would be right. But the economy is not that simple.

4) I don’t know if the Volcker Rule will be eliminated or not, but I do know that the same ends could be achieved through changes in the risk-based capital formulas.  What I wrote:

The same ends of the Volcker Rule can be accomplished through adjusting the risk-based capital formulas — Equity-like risks should be funded through a 100% allocation of equity. Few banks would take on that level of speculation at that level of capital used.

If you need proof, look at the life insurance industry. Companies used to hold a lot more equities prior to the tightening of RBC rules. Now they hold little, except at a few mutual companies that are flush with capital.

For another off-the-wall idea: ban interstate banking, and let the states rule all depositary institutions. Results: No more too big to fail, and you get back “scaredy cat” regulators who don’t let banks deal in anything they don’t understand, which isn’t much.

That also has preserved the insurance business in this crisis, leaving aside mortgage and financial risks, where the state regulators still have no idea what they are doing — that a proper reserve level would leave most of the companies insolvent today, but had it been implemented ten years ago, would have preserved the companies, but eliminated much of their profits.

But Life and P&C insurers survive the process because of RBC, and “scaredy cat” state regulators. What a great system, which prior to the crisis, was criticized as behind the times.

PS — if we ever get a national regulator of insurance, there will be a big boom and bust, much as in banking at present. It is easier to corrupt one regulator than fifty.

5) Is the stock market overvalued?  Probably, but consider this article here.  I wrote:

truth, P/Es are best related to corporate yields, not deposit rates or government bonds. And, you have to flip them to be E/Ps. Current E/P on the S&P 500 is 5.4%. A dividend yield of 2.05% is 38% which is close to the long run average.

The longest corporate series that I have is the Moody’s Baa series — because of the growth inherent in stocks, for bonds to be the better deal versus stocks, Baa bonds need a 3.9% premium over the earnings yield, or a yield of 9.3% in the present environment.

So, I’ll take it back, because the present Baa yield 6.45% augurs in favor of stocks versus bonds. Not crazy about bonds in this environment — few categories offer good risk-adjusted yields. Now, maybe both are overvalued vs. commodities, but that one I don’t know.

6) Perhaps the phrase “Greek Banking System” will be a cuss word someday.  Fitch recently gave them a downgrade, and I wrote:

Rating agencies exist to be scapegoats. When they are proactive (yes there have been eras where they have been proactive) the bond buyers scream — “Ratings are supposed to be good over a full market cycle!” When they are reactive, which is most of the time, they get accused of being coincident indicators.

They can’t win, which is why institutional investors ignore the ratings, aside from the capital charges that they force, and instead, read what the rating agency analysts write. The true opinion is in the writing, not the rating.

7)  Barry comments on how Goldman Sachs bags clients.  Truth, almost all investment banks bag clients, selling complex products that they understand better than their clients do.  My comment:

I always advise retail investors not to buy structured notes — Wall Street offers an above-average yield, and has the buyer sell short some expensive option. You lose more in capital losses than you gain in interest on average.

This isn’t any different. It just that bigger players that should have known better are getting hosed.

There is no better defense than “buyer beware,” and “Don’t buy what someone else wants to sell you. Buy what you want to buy.”

Unless we want radical revisions to contract law, you are your own best defender.

8 ) One story with more sizzle than substance is put-backs, at least as far as it affects homeowners.  It was featured by Barron’s and picked up in a piece by Barry.  Investors that purchase a mortgage or any o=ther sort of loan have a limited window of time to give the mortgage back to those that they bought it from for full value.  My comment:

This seems to be useful for investors, but not for homeowners. Reps and Warranties claims can be enforced by investors that bought loans through securitizations. It does not help homeowners.

9) Jeff Matthews wrote a piece that was a little critical of splitting the “B” shares and Buffett’s logic on the Burlington Northern acquisition.  My comment:

I don’t always agree with Warren Buffett, but I do agree here. Index investors are passive investors. Individually, they are dumb. As a group they are smart, because they lower their investment costs.

Warren is also correct on Burlington Northern — it should be like his utilities, and throw off a growing inflation-protected return over time, allowing him to earn a spread over his cost of funds (negative) that his insurance enterprises generate.

He is still a bright man after all these years.

PS — I am a Calvinist Christian; the question asked regarding Jesus is not relevant to the short-term running of Berky, but is relevant to an Christian investor who cares about the ethics of the organization. Also, it is relevant to the long-term well-being of Mr. Buffett. The rest of us will have to face the results of that question one day as well.

10) The Developments blog at the WSJ hides in the shadow of better known blogs, but often puts up some really good pieces.  They recently did a piece on whether it is better to buy a home now or wait a while.  My comment:

I’ve said this before in different ways, but I will say it once more, “Governments are smaller than markets; markets are smaller than cultures.”  The reasoning is simple:

• Governments can only control a fraction of what an economy or culture does.  Governments that are overbearing on an economy or culture may gain greater proportional control, but the size of the pie will shrink.  More of the economy or culture goes into hiding, away from the prying eyes of the government.
• Markets only express a fraction of what mankind does.  They cover the tradeable aspects of what we do, but typically do not give us our deeper goals or desires for ourselves, and the culture as a whole.

When I look at the biggest economic problems facing the world today, many of them stem from deeper cultural problems.  Let’s start with the current poster child, or, canary in the coal mine, Greece.

Greece got into the Eurozone via subterfuge; they lied about the true status of their indebtedness, and Wall Street (with its counterparts in European investment banking) helped them do it.  So did a number of the other nations in the Eurozone that are presently under stress.

Now, the core members of the Eurozone wanted the Euro to grow as a currency — they were committed to an ever-wider and -deeper union.  The dream of a united Europe made them willfully blind to the low probability that the nations which were fiscal basket cases had genuinely changed.  The core should have been skeptical, and now they are paying the price, though not paying any money, yet.

The core nations that could pay or guarantee to help Greece are playing a tight game.  They act as an internal European IMF, insisting on reductions in the Greek budget deficit.  Greece does its part by saying it hasn’t asked for aid, which is unlikely.  At the same time, reductions in the Greek budget deficit bring the competing political factions inside Greece out in force.  Protests!  Strikes!  There are few arguing for what is best for Greece overall, and many arguing for a larger piece of what is a shrinking pie.  In a situation like this, it might be better for outsiders to let Greece fail,but they won’t do that.  Why?

The banks in the core nations can’t afford a default by Greece if by contagion it leads to defaults in Portugal, Spain, Italy, and Ireland.  A failure of the banking system does not conduce well to maintaining power for elites.

I have already talked about the perverse incentives for the core European nations to do anything to support Greece.  If Europe was rational, they would abandon the experiment now, or press for a Federal Europe akin to the US.  I don’t see either happening — I just see slow suffering for now, and futile playing for time.

Dubai is a place where anything can get done.  Anything indeed, but who pays the bills?  Dubai is a place of big ideas and little responsibility.    It is a moral flaw to bite off more than you can chew, particularly if you do so on behalf of others.

Many US States and Municipalities are in a world of hurt, because they compromised their long-term financial position to solve short-run budget crises.  That is the nature of the crises that we face today.

The same is true of the current US government — they fight for short term political advantage, rather than the long term good of the nation.  Who will favor the long-term and sacrifice for the greater good?

A simple summary statement here is “Greed is not good.”  Societies that are willing to sacrifice self interests have a much better probability of succeeding than societies that pursue self interest.

That’s all for now, I will pick this up in part II.

I know I have written about ideas like this before, but I cannot remember where.  Let me start with a story.  I was at a Society of Actuaries conference in 2001 when I bumped into an actuary who was well-known to most before a meeting.  She recognized me, and I asked her what she was seeing that was new.  She told me, “Liquidity Derivatives.”

I shook my head for a moment and said, “Wait a minute, you mean getting a counterparty to pay cash at a time when liquidity is scarce?”  She giggled and said “Yes.”  I continued, “But wait, who would offer to pay at a time when liquidity is scarce?  She said, “That’s the problem.”  The speaker started to talk, so our conversation ended.

That is why I am skeptical about crisis derivatives.  Felix has commented on this, and he is worth a read here.  Unlike many, I do not think that all events in life can be hedged or insured.  In major disaster situations, no one can marshal the resources to make up for the disaster.  No one can insure against property damage in a war.

Citi has its own index of financial stress.  Here it is over the last 13 years:

Surprisingly, Aleph Blog has its own proprietary index for the same thing.

The graphs go the opposite way, but the correlations are over 80% in absolute value terms, and I can tell you that my measure more directly covers what Citi is going for, because it is the difference between the yield on the two-year Treasury and an index of A2/P2 commercial paper.

So, do you want to be able to fund yourself in a crisis?  Do the following: buy two-year Treasuries, and sell short A2/P2 commercial paper.  Most of the time this is a costly trade, if you can get it done at all.  But access to financing during a crisis is valuable, and should require compensation in advance to obtain it.

As for the Citi product, they should ask the question, “who would be willing to part with liquidity during a liquidity crisis?” and ask the question “Are they unquestionably solvent?”  Insurance is no good if the insurer is insolvent.  If Citi is the counterparty, I for one would not be comfortable.

Let me summarize.  Liquidity derivatives are not a reasonable product.  You never want to be asking for something when it is in scarce supply, because the odds are it will be very difficult to deliver.