Banks – Page 25 – The Aleph Blog

The Rules, Part XV

Posted on 19 May 201020 June 2017 by David Merkel

What if securitization allows the economy to expand more rapidly than it would at a price of volatility, when intermediaries would prove useful?

Sometimes securitization and tranching creates securities for which there is no native home.

As the life insurance industry shrinks, it will be hard to find buyers for subordinated structured product.

Securitization is an interesting phenomenon.? Take a group of simple securities, like commercial or residential mortgages, and carve the cashflows up in ways that will appeal to groups of investors.? Do investors want ultrasafe investments?? Easy, carve off a portion of the investments representing the largest loss imaginable by most investors.? The remainder should be rated AAA (Aaa if you speak Moody’s).? Then find risk taking parties to buy the portion that could suffer loss, at ever higher yields for those that are willing to take realized losses earlier.

What’s that, you say?? What if you can’t find buyers willing to buy the risky parts of the deal at prices that will make the securitization work?? Easy, he will take the loans and sell them as a block to a bank that will want them on its balance sheet.

That said, securitized assets are typically most liquid near the issuance of the deal, with the short, simple and AAA portions of the deal retaining their liquidity best.? Suppose you hold a security that is not AAA, or complex, or long duration, and you want to sell it.? Well, guess what?? Now you have to engage in an education campaign to get some bond manager to buy it, or, take a significant haircut on the price in order to move the bond.

It helps to have a strong balance sheet.? If the credit is good, even if obscure, a strong balance sheet can buy off the beaten path bonds, and hold them to maturity if need be.? And yet, there is hidden optionality to having a strong balance sheet — you can buy and hold quality obscure bonds, but if thing go really well, you can sell the bonds to anxious bidders scrambling for yield, while you hold more higher quality bonds during a yield mania.

Endowments, defined benefit pension plans, and life insurance companies have those strong balance sheets.? They do not have to worry that money will run away from them.? The promises that these entities make are long duration in nature.? They have the ability to invest for the long-run, and ignore short-term market fluctuations, even more than Buffett does, if they are so inclined.

If there was a decrease in the buying power of institutions with long liability structures, we would see less long term investing in fixed income and equity investments.? Investments requiring a lockup, like private equity and hedge funds, would shrink, and offer higher prospective yields to get deals done.

-==–==-=-=-=-=–=-=-=-==-=-=–=

But what of my first point?? There are securitization trusts, and there are financial companies.? During a boom phase, the securitization trusts can finance assets cheaply.?? During a bust phase, the securitization trusts have a lot of complicated rules for how to deal with problem assets.? Financial companies, if they have adequate capital, are capable of more flexible and tailored arrangements with troubled creditors.? Having a real balance sheet with slack capital has value during a financial crisis.? Securitization trusts follow rules, and have no slack capital.? Losses are delivered to the juniormost security.

=-=-=-=-=-=-=-=-=-=-=-==-=-=-=-=-=-

Sometime around 2004, a light went on in the life insurance industry regarding non-AAA securitized investments.? In 2005, with a few exceptions, the life insurance industry stopped buying them.? AIG was a major exception.? The consensus was that the extra interest spread was not worth it.? Fortunately for the investment banks there were a lot of hedge funds willing to take such risks.

There should be some sort of early warning system that clangs when the life insurance industry stops buying, and those that buy in their absence have weaker balance sheets.? When risky assets are held by those with weak balance sheets, it is a recipe for disaster.

-=-=-=-=-=-=-=-=-=-=-=-=-===-=-=-=-=-

During the boom phase, securitization trusts provide capital, cheaper capital than can be funded through banks.? That allows the economy to grow faster for a time, but there is no free lunch.? Eventually economic growth will revert to mean, when securitizations show bad credit results, and the economy has to slow down to absorb losses.

In addition, when losses come, loss severities will tend to be higher than that for corporates.? Usually a tranche offering credit support will tend to lose all of its principal, or none.? (Leaving aside early amortization and the last tranche standing in the deal.)? For years, the rating agencies and investment banks argued that losses on securitized products were a lot lower than that for corporates, because incidence of loss was so low on ABS, CMBS and non-conforming RMBS.? But the low incidence was driven by how easy it was to find financing, as lending standards deteriorated.

Thus, securitization allowed more lending to be done.? First, originators weren’t retaining much of the risk, so they could be more aggressive.? Second, the originators didn’t have to put up as much capital as they would if they had to hold the loans on a balance sheet.? Third, there were a lot of buyers for higher-rated yieldy paper, and ABS, CMBS and non-conforming RMBS typically offered better yields, and seemingly lower losses (looking through the rear-view mirror).? What was not to like?

What was not to like was the increased leverage that it allowed the whole system to run at.? Debt levels increased, and made the system less flexible.?? Investors were fooled into thinking that assets were worth a lot more than they are worth today because of the temporary added buying power from applying additional debt financing to the assets.

=–=-=-=-=-=-==–=-=–==-=-==–==-==-=-=

Securitization has been a mixed blessing to investors.? It is brilliant during the boom phase, and exacerbates trouble during the bust phase.? And so it is.? As you evaluate financial companies, have a bias against clipping yield.

Regulators, as you evaluate risk-based capital charges, do it in such a way that securitized products get penalized versus equivalently-rated corporates.? Just add enough RBC such that it takes away any yield advantage versus holding it on balance sheet, or versus the excess yield on equivalently rated average corporates.? It’s not a hard calculation to run.

=-=–==-=-

Off-topic end to this post.? I added Petrobras to my portfolio today.? Bought a little Ensco as well.? I haven’t been posting as much lately since I was busy with two things: studying for my Series 86 exam, which I take tomorrow, and I gave a presentation on AIG to staff members on the Congressional Oversight Panel the oversees the TARP yesterday.? Good people; they seemed to appreciate what I wrote on AIG’s domestic operating subsidiaries last year.

Full disclosure: Long PBR ESV

The Rules, Part XIII, subpart C

Posted on 4 May 201020 June 2017 by David Merkel

The need for income naturally biases a portfolio long.? It is difficult to earn income without beneficial ownership of an asset ? positive carry trades will almost always be net long, absent major distress or dislocation in the markets.? Those who need income to survive must then hope for a bull market.? They cannot live well without one, absent an interest rate spike like the late 70s/early 80s.? But in order to benefit in that scenario, they had to stay short.

More with Less.? Almost all of us want to do more with less.? Save and invest less today, and make up for it by investing more aggressively.? We have been lured by the wrongheaded siren song that those who take more risk earn more on average.? Rather, it is true 1/3rd of the time, and in spectacular ways.? Manias are quite profitable for investors until they pop.

As I have said many times before, the lure of free money brings out the worst in people.? Few people are disposed to say, “On a current earnings yield basis, these investments yield little.? I should invest elsewhere,”? when the price momentum of the investment is high.

I will put it this way: in the intermediate-term, investing is about buying assets that will have good earnings three or so years out relative to the current price.? Whether one is looking at trend following, or buying industries that are currently depressed, that is still the goal.? What good investments will persist?? What seemingly bad investments will snap back?

That might sound odd and nonlinear, but that is how I think about investments.? Look for momentum, and analyze low momentum sectors for evidence of a possible turnaround.? Ignore the middle.

Less with More.? Doesn’t sound so appealing.? I agree.? As a bond manager, I avoided complexity where it was not rewarded.? I was more than willing to read complex prospectuses, but only when conditions offered value.? Away from that, I aimed at simple situations that my team could adequately analyze with little time spent.

That is one reason why I am not sympathetic to those who lost money on CDOs.? We had two prior cycles of losses in CDOs — a small one in the late ’90s, and a moderate one around 2001-2003.? CDOs are inherently weak structures.? That is why they offer considerably more yield relative to similarly rated structured assets.

So, for those buying CDOs backed by real estate assets mid-decade in the 2000s, I say they deserved to lose money.? Not only were they relying on continued growth in real estate prices, but they were reaching for yield in a low yield environment.? Goldman and other investment banks may have facilitated that greed, but the institutional investors happily took down the extra yield.? No one held guns to their heads.? The only question that I would raise is whether they disclosed all material risk factors in their prospectuses.? (Not that most institutional investors read those — they call it “boilerplate.”)

Reaching for yield always has risks, but the penalties are most intense at the top of the cycle, when credit spreads are tight, and the Fed’s loosening cycle is nearing its end.? It is at that point that a good bond manager tosses as much risk as he can overboard without bringing yield so low that his client screams.

Perhaps the client can be educated to accept less yield for a time.? I suspect that is a losing battle most of the time, because budgets are fixed in the short-run, and many clients have long term goals that they are trying to achieve — actuarial funding targets, mortgage payments, college tuition, cost of living in retirement, endowment spending rule goals, implied cost of funds, etc.

That’s why capital preservation is hard to achieve, particularly for those that have fixed commitments that they have to meet.? It is impossible to serve two masters, even if the goals are preserving capital and meeting fixed commitments.? Toss in the idea of beating inflation, and you are pretty much tied in knots — it goes back to my “Forever Fund” problem.

This third subpart ends my comments on this rule.? You’ve no doubt heard the Wall Street maxim, “Bulls make money; Bears make money; Hogs get slaughtered.”? Yield greed is one of the clearest examples of hogs getting slaughtered.? So, when yield spreads are tight (they are tight relative to risk now, but could get tighter), and the Fed nears the end of its loosening cycle (absent a crisis, they are probably not moving until unemployment budges, more’s the pity), be wary for risk.? Preserve capital.

The peak of the cycle may not be for one to three years, or an unimaginable crisis could come next month.? Plan now for what you will do so that you don’t mindlessly react when the next bear market in credit starts.? It will be ugly, with sovereigns likely offering risk as well.? At this point, I wish I could give simple answers for here is what to do.? What I will do is focus on things that are very hard for people to do without, and things that offer inflation protection.? What I will avoid is credit risk.

The Rules, Part XIII, subpart B

Posted on 1 May 201020 June 2017 by David Merkel

To short bonds with success, you have to identify a tipping point.? The one shorting a bond borrows it and then sells it.? After that, he has to pay the interest on the bond, and maybe a little more, if the bond is hard to borrow, while he waits for the bond’s price to collapse.? If the capital losses to a holder of the bond are not greater than the interest paid, the short loses money.? (Yes, he makes some money off of interest on the proceeds from the sale, but let’s ignore that for now.) Bonds mostly have finite maturities; time can work against the short seller as the bond gets closer to maturity, because the bond will mature at par, and he will have to pay the par value.

The same applies to credit default swaps [CDS].? The party buying protection must pay for the protection. He looks for a disaster to happen, but as time elapses, and gets closer to the swap termination date, the odds of making money off of a failure declines.

Thus being short any sort of fixed income, whether through shorting or CDS involves paying money out regularly to support the position, with the possibility of incredible payoffs if default happens within the lifetime of the bond or CDS.

This mindset is the opposite of the way bond managers think.? A common way they view things is to maximize expected yield over the expected lifetime of their liabilities.? That is a simple way for bond managers at banks, insurance companies, pension funds and endowments to manage their bond assets.? It is not so easy for total return mutual fund managers, because they can’t tell with accuracy how patient/jumpy their mutual fundholders will be.? Typically, they pick an index of bonds, and mirror the most critical aspects of it — duration, convexity, credit quality, etc.? Retail investors don’t care about that but they look at the return series, and analyze whether the volatility is too great or too small for them, and if they have beaten many of their peers.

To a good bond manager, he aims to add risk when he is well compensated for it, and reduce risk when it is not well compensated.? That said, many bond managers have dumb clients.? They want more yield, because they think that yield is free.

I remember the Chief Actuary of a client insurance firm saying to me, “Why can’t you earn the returns of ARM Financial, General American, Jefferson Pilot, and Conseco?? (This was around early 1999.)? My response was: “You want to take absurd risks?? Not only do these firms take asset risks, they are taking more risks than any large firm that I can find.? They take asset risks everywhere.? Worse, their liability structures are weak, and their leverage is high.? A lot of their liabilities can run at will.”

It was not long before General American and ARM Financial failed.? Conseco took a few more years; the acquisition of Green Tree helped kill them.? Jefferson Pilot wasn’t as bad as the others, but they sold out to Lincoln National while they could.

It is foolish to be a yield hog.? Yet, many institutional investors were yield hogs prior to the crisis.? Someone had to buy the CCC junk bonds.? Someone had to sell protection in order to receive yield.? The investment banks could not manufacture gains for those shorting the mortgage market on their own.? There had to be yield hogs that wanted to receive yield in exchange for guaranteeing debts.? Given the low interest rate environment that they faced, many parties felt they needed to earn more.? AIG in particular offered protection on many bonds in order to suck in extra income so that earnings estimates might be achieved.? They were the ultimate yield hog, and like most hogs, they got slaughtered.

As for the one offering protection, he must be sure that there is no tipping point over the life of the swap.? Then the extra yield would be safe.

I have more to say on this, but let me summarize for now.? The need to earn income biases many bond investors to take too much risk.? Repeat after me: “Yield is not free.” It exists because of perceived risks; the great question is whether the perceived risks are underplayed, overplayed, or accurate.? The good bond manager looks at the risks versus the incremental yields, and spreads his investments among? a mix of good risks.

The Lack of Cultural Agreement Roars, the Eurozone Mews

Posted on 28 April 2010 by David Merkel

Economic systems are the result of cultures.? Where there is little cultural agreement, the economic system will be unstable, as will be governmental action.

No, this is not another “Rules” post.? But this is a post about the Eurozone and Japan today.? Japan faces trouble, but there is cultural agreement on what should be done, so there is no great crisis today, though the demographics may force issues eventually.

The Eurozone does not publicly recognize that there are large disagreements over what economic policy should be.? In the countries that are in economic trouble, there are many that push their governments to spend more on them, forcing the governments to borrow more.? This is particularly true of the unions.

My view of unions is that they slowly kill whomever they serve.? Industries with high unionization die eventually.? Countries that support unions die slowly as well.

Unions introduce inflexibility into the economic process which has a huge cost, eventually.? Greece is controlled by its unions.? They are willing to seek their own prosperity even if it leads to the destruction of the nation.? They don’t think the nation will be destroyed, but think that there are parties in power that hold back value from them, and they must be opposed, deluded fools that the unions are.

But there is a bigger problem for the Eurozone.? What do they do about Portugal, Ireland, Spain, and maybe Italy?? Yeah, the Eurozone could rescue Greece, but could it rescue Spain?? The answer is simple, NO.? But rescuing Greece discourages Spain from taking hard actions.

There is a lot of moral hazard involved in rescuing countries in the Eurozone.? Far better for nations to rescue banks that have lent to Greece, Portugal, Ireland, Spain, Italy, etc.? From what I have read, Europeans don’t exist.? Nations exist around a common culture and language.? Nations in Europe exist, and many act against the concept of a Eurozone.

Both positively and negatively, one can say that the Eurozone can’t make everyone into Germans.? The Germans exercised discipline that other nations would not.? Because of the size of Germany, and those allied with them in the Eurozone, the Euro is a hard currency, harder than many cultures/nations with lower labor productivity would like.

Why is the Euro weak?? Because the present crisis has relegated it to the status of an experiment.? Wondering over how Eurozone obligations will be repaid is an issue outside the Eurozone.? There are solutions, but they are painful — 1) let Greece become a state of Germany.? Not happening. 2) Let the Eurozone pour money into Greece; I’m sure they will reward you by adopting austerity measures, not. 3) Let Greece default, and then, let the Eurozone attempt to ameliorate it.? It will be difficult, and I doubt that debts to Greece will be settled at over 40% per Euro.

The major trouble is that banks in countries with relatively orthodox finances have lent to countries with liberal finances.? Well, who else could have done it, but the banks making the loans are in a fix because their health is subject to the creditworthiness of those that they lent to, which should be no surprise, but we forget.

Thus the big crisis in Europe is really over the soundness of the banking sector.? Rather than bailing out nations in trouble, far better to bailout your own banks that made bad loans, and let the profligate nations fail.? Remember, the Eurozone was not a promise to support profligate nations, but an effort for responsible nations to share a common currency.? If nations are not responsible, it is not the responsibility of the other Eurozone nations to subsidize them.

Do you want to save the Eurozone?? Save it by protecting your own banks, and letting profligate nations fail.? You will end up with a “hard” Eurozone of nations that are not profligate, and can live up to the demands of a strong currency.? The Eurozone exists without the UK.? It can exist without Greece, Portugal, Spain, Italy, and Ireland.

Subsidies don’t work, and that is what the loans to Greece are.? The Greeks will just suck them in, and continue their unruly fracas over who gets what.? Far better to let Greece fail, and scare marginal nations to clean up their acts.

-=-==–==-=-=-=-=–==-=-=-=-

I don’t write this because I want the US Dollar to prosper because of a failure of the Euro.? Hey, I want credible alternatives to the Dollar, because it is at best the best of a bunch of sorry currencies, and I am not ready to sign on to the cult of Gold.? I like gold as a currency, but am not crazy about it as an investment.

My view is that the Euro can exist even after the failure of nations that leave the Euro, and that Euro obligations could still be enforced on defaulting nations because of the large amount of commerce inside Europe.

My advice to European statesmen, including those that share my surname, is to focus on your national interests.? The Eurozone is too vague to matter to those who elect you.? Focus on protecting your banks, rather than those the banks have lent to, which would waste money.

In Defense of the Rating Agencies ? V (summary, and hopefully final)

Posted on 23 April 2010 by David Merkel

I write this because I was invited to be on CNBC on the topic, but I suggested that my opinion would not make for good television.? That said, I have taken my four prior posts on the topic, and assembled them into one comprehensive post.? I do not intend on posting on this again.? With that, here is my post:

The ratings agencies have come under a lot of flak recently for rating instruments that are new, where their models might not be do good, and for the conflicts of interest that they face.? Both criticisms sound good initially, and I have written about the second of them at RealMoney, but in truth both don?t hold much water, because there is no other way to do it.? Let those who criticize put forth real alternatives that show systematic thinking.? So far, I haven?t seen one.

Most of the current problems exist in exotic parts of the bond market; average retail investors don?t have much exposure to the problems there, but only less-experienced institutional investors.

Here are my five realities:

Somewhere in the financial system there has to be room for parties that offer opinions who don?t have to worry about being sued if their opinions are wrong.
Regulators need the ratings agencies, or they would need to create an internal ratings agency themselves, or something similar.? The NAIC SVO is an example of the latter, and proves why the regulators need the ratings agencies.? The NAIC SVO was never very good, and almost anyone that worked with them learned that very quickly.
New securities are always being created, and someone has to try to put them on a level playing field for creditworthiness purposes.
There is no way to get investors to pay full freight for the sum total of what the ratings agencies do.
Ratings can be short-term, or long-term, but not both.? The worst of all worlds is when the ratings agencies shift time horizons.

Ratings are Opinions

The fixed-income community has learned that the ratings agencies offer an opinion, and they might pay for some additional analysis through subscriptions, but if they were forced to pay the fees that issuers pay, they would balk; they have in-house analysts already.? The ratings agencies aren?t perfect, and good buy-side shops use them, but don?t rely on them.? Only rubes rely on ratings, and sophisticated investors did not trust the rating agencies on subprime.? My proof?? Look how little exposure the Life and P&C insurance industries had to subprime mortgages outside of AIG.? Teensy at best.

Please understand that institutions own most of the bonds out there.? We had a saying in a firm that I managed bonds in, ?Read the write-up, but ignore the rating.?? The credit analysts at the rating agencies often knew their stuff, giving considerable insight into the bonds, but may have been hemmed in by rules inside the rating agency regarding the rating. It?s like analysts at Value Line.? They can have a strong opinion on a company, but their view can only budge the largely quantitative analysis a little.

Let?s get one thing straight here.? The rating agencies will make mistakes.? They will likely make mistakes on a correlated basis, because they compete against one another, and buyers won?t pay enough to support the ratings.

So there are systematic differences and weaknesses in bond ratings, but the investors who own most of the bonds understand those foibles.? They know that ratings are just opinions, except to the extent that they affect investment policies (?We can?t invest in junk bonds.?) or capital levels for regulated clients.

On investment policies, whether prescribed by regulators or consultants, ratings were a shorthand that allow for simplicity in monitoring (see Surowiecki?s argument).? Now, sophisticated investors knew that AAA did not always mean AAA.? How did they know this?? Because the various AAA bonds traded at decidedly different interest rates.? The more dodgy the collateral, the higher the yield, even if it had a AAA rating.? My mistake: I, for one, bought some AAA securitized franchise loan paper that went into default long before the current crisis hit.? Many who bought post-2000 AAA securitized manufactured housing loan paper are experiencing the same.? Early in the 2000s, sophisticated investors got burned, and learned.? That is why few insurers have gotten burned badly in the current crisis.? Few insurers bought any subprime residential securitizations after 2004.? But, unsophisticated investors and regulators trust the ratings and buy.

Financial institutions and regulators have to be ?big boys.? If you were stupid enough to rely on the rating without further analysis, well, that was your fault.? If the ratings agencies can be sued for their opinions (out of a misguided notion of fiduciary interest), then they need to be paid a lot more so that they can fund the jury awards.? Their opinions are just that, opinions.? As I said before, smart institutional investors ignore the rating, and read the commentary.? The nuances of opinion come out there, and often tell smart investors to stay away, in spite of the rating.

How Can Regulators Model Credit Risk?

It started with this piece from FT Alphaville, which made the point that I have made, markets may not need the ratings, but regulators do.? (That said, small investors are often, but not always, better off with the summary advice that bond ratings give.)? The piece suggests that CDS spreads are better and more rapid indicators of change in credit quality than bond ratings.? Another opinion piece at the FT suggests that regulators should not use ratings from rating agencies, but does not suggest a replacement idea, aside from some weak market-based concepts.

Market based measures of creditworthiness are more rapid, no doubt.? Markets are faster than any qualitative analysis process.? But regulators need methods to control the amount of risk that regulated financial entities take.? They can do it in four ways:

Let the companies tell you how much risk they think they are taking.
Let market movements tell you how much risk they are taking.
Let the rating agencies tell you how much risk they are taking.
Create your own internal rating agency to determine how much risk they are taking.

The first option is ridiculous.? There is too much self-interest on the part of financial companies to under-report the amount of risk they are taking.? The fourth option underestimates what it costs to rate credit risk.? The NAIC SVO tried to be a rating agency, and failed because the job was too big for how it was funded.

Option two sounds plausible, but it is unstable, and subject to gaming.? Any risk-based capital system that uses short-term price, yield, or yield spread movements, will make the management of portfolios less stable.? As prices rise, capital requirements will fall, and perhaps companies will then buy more, exacerbating the rise.? As prices fall, capital requirements will rise, and perhaps companies will then sell more, exacerbating the fall.

Market-based systems are not fit for use by regulators, because ratings are supposed to be like fundamental investors, and think through the intermediate-term.? Ratings should not be like stock prices ? up-down-down-up.? A market based approach to ratings is akin to having momentum investors dictating regulatory policy.

Also, their models that I am most familiar with only apply to publicly-traded corporate credit.? Could they have prevented the difficulties in structured credit that are the main problem now?

What to do with New Classes of Securities?

Financial institutions will want to buy new securities, and someone has to rate them so that proper capital levels can be held (hopefully).? But what are rating agencies to do when presented with novel financial instruments that have no significant historical loss statistics?? Many of the likely buyers are regulated, and others have investment restrictions that depend on ratings, so aside from their own profits, there is a lot of pressure to rate the novel financial instrument.? A smart rating agency would punt, saying there is no way to estimate the risk, and that their reputation is more important than profits.? Instead, they do some qualitative comparisons to similar?but established financial instruments, and give a rating.

Due to competitive pressures, that rating is likely to be liberal, but during the bull phase of the credit markets, that will be hidden.? Because the error does not show up (often) so long as leverage is expanding, rating agencies are emboldened to continue the technique.? As it is, when liquidity declines and leverage follows, all manner of errors gets revealed.? Gaussian copula?? Using default rates for loans on balance sheet for those that are sold to third parties?? Ugh.

Some will say that rating agencies must say ?no? to Wall Street when asked to rate exotic types of debt instruments that lack historically relevant performance data.? That?s a noble thought, but were GICs [Guaranteed Investment Contracts] exotic back in 1989-1992?? No.? Did the rating agencies get it wrong?? Yes.? History would have said that GICs almost never default.? As I have stated before, a market must fail before it matures.? After failure, a market takes account of differences previously unnoticed, and begins to prospectively price for risk.

But think of something even more pervasive.? For almost 20 years there were almost no losses on non-GSE mortgage debt.? How would you rate the situation?? Before the losses became obvious the ratings were high.? Historical statistics vetted that out.? No wonder the levels of subordination were so small, and why AAA tranches from late vintages took losses.

When prosperity has been so great for so long, it should be no surprise that if there is a shift, many parties will be embarrassed.? In this case both raters and investors have had their heads handed to them.

Now there are alternatives.? The regulators can ban asset classes until they are seasoned.? That would be smart, but there will be complaints.? I experienced in one state the unwillingness of the regulators to update their permitted asset list, which had not been touched since 1955.? In 2000, I wrote the bill that modernized the investment code for life companies; perhaps my grandson (not born yet), will write the next one.

Regulators are slow, and they genuinely don?t understand investments.? The ratings agencies aren?t regulators, and they should not be put into that role, because they are profit-seeking companies. Don?t blame the rating agencies for the failure of the regulators, because they ceded their statutory role to the rating agencies.? But if the regulators ban asset classes, expect those regulated to complain, because they can?t earn the money that they want to, while other institutions take advantage of the market inefficiencies.

Compensation and Conflicts

Some say that rating agencies must be encouraged to make their money from investor subscriptions rather than fees from issuers, to ensure more impartial ratings.? If this were realistic, it would have happened already.? The rating agencies would like nothing more than to receive fees from only buyers, but that would not provide enough to take care of the rating agencies, and provide for a profit.? They don?t want the conflicts of interest either, but if it is conflicts of interest versus death, you know what they will choose.

Short vs. Long-Term Opinions

Ratings agency opinions are long-term by nature, rating over a full credit cycle.? During panics people complain that they should be more short-term.?? Hindsight is 20/20.? Given the multiple uses of credit ratings, having one time horizon is best, whether short- or long-term.? Given the whipsaw that I experienced in 2002 when the ratings agencies went from long- to short-term, I can tell you it did not add value, and that most bond manager that I knew wanted stability.

Non-solutions

Some say rating agencies no longer should have exclusive access to nonpublic information, to even out the playing field.? That sounds good, but the regulators want the rating agencies to have the nonpublic information.? They don?t want a level playing field.? As regulators, if they are ceding their territory to the rating agencies, then they want the rating agencies to be able to demand what they could demand.? Regulators by nature have access to nonpublic information.

Some ask for greater disclosure of default rates, but that is a non-issue.? They also look to punish rating agencies that make mistakes, by pulling their registration. ?Disclosing default rates is already done, and sophisticated investors know this.? Yanking the registration is killing a fly with a sledgehammer.? It would hurt the regulators more than anyone else.?The rating agencies are like the market.? The market as a whole gets it wrong every now and then.? Think of tech stocks in early 2000, or housing stocks in early 2006.? To insist on perfection of rating agencies is to say that there will be no rating agencies.? It takes two to make a market, and agencies will often be wrong.

Solutions

As for solutions, I would say the following are useful:

Competition. ?I?m in favor of a free-ish market here, allowing the regulators to choose those raters that are adequate for setting capital levels, and those that are not.? For other purposes, though, the more raters, the better.? I don?t think rating fees would drop, though.? Remember, ratings are needed for regulatory purposes.? Will Basel II, NAIC, and other regulators sign off on new credit raters?? I think that process will be slow.? Diversity of opinion is tough, unless a ratings agency is willing to be paid only by buyers, and that model is untested at best.
Compensate with residuals and bonuses (give the raters some skin in the game)

Deregulation (we can live without rating agencies, but regulators will have to do a lot more work)
Greater disclosure (sure, let them disclose their data and formulas (perhaps with a delay).
Have regulators bar unseasoned asset classes.

Summary

Let those who criticize the ratings agencies bring forth a new paradigm that the market can embrace, and live with in the long term.? Until then, the current system will persist, because there is no other realistic way to get business done.? There are conflicts of interest, but those are unavoidable in multiparty arrangements.? The intelligent investor has to be aware of them, and compensate for the inherent bias.

Unless buyers would be willing to pay for a new system, it is all wishful thinking.? Watch the behavior of the users of credit ratings.? If they are unwilling to pay up, the current system will persist, regardless of what naysayers might argue.

The Rules, Part XI

Posted on 20 April 201020 June 2017 by David Merkel

Could an investment bank go to junk status?

Some of my “rules” were phrased as questions.? I wrote that one prior to 2002, possibly musing about downgrades in the credit ratings of investment banks.? But today we know the answer: NO.

There are functions in the credit markets that only belong to strongly capitalized entities.? Anything involving a large degree of credit risk requires an exceptionally strong balance sheet.? Though my original question was about investment banks, think of mortgage and financial insurers.? Where are they today?

Looking at my list of financial/mortgage insurers from three years ago, this is what I find:

Ambac Financial Group [ABK] — Aaa/AAA to C/CC (default in all but name)
ACA Holdings — A to default
Assured Guaranty — Aa3/A+ to A3/A+
MBIA Inc — Aa2/AA to Ba3/BB-
MGIC — A1/A to Caa1/CCC
PMI — A1/A to Caa2/CCC+
Primus Guaranty — Baa1/BBB+ to B2/CCC
RAM Re — Aaa/AAA — Ba3/NR
Radian — A2/A to Caa1/CCC
Syncora — Aaa/AAA to default
Triad Guaranty — A- to default.

Let me make a modest suggestion: financial and mortgage insurance does not work in times of extreme financial stress.? Aside from Assured Guaranty every insurer offering coverage from financial/mortgage risks got smashed.? Aside from AGO, all are at junk credit levels.

What this says to me is that the method of regulating financial and mortgage insurers is wrong.? Financial risks are more severe than other risks, and a greater amount of capital must be held for solvency. When financial risks go bad, many risks go bad.

But wait, you say, at the greater level of capital, no one will buy the insurance.? That might be true in the short run, but in the long run pricing levels will adjust.? Insurance for mortgages will be bought, if the credit is secure.

Back to investment banks.? They must be fundamentally sound institutions, given the high degree of leverage employed.? Once they have a junk rating, fewer will do business with them, much like the financial insurers.

As a result my answer is no, no credit-sensitive institution can be junk-rated.? Even a low-investment-grade rating is a stretch. During the boom phase, any investment grade rating can work; in the bust phase only the best market practices maintain a credit rating. and few credit sensitive entities maintain an investment grade rating.

Book Review: 13 Bankers

Posted on 3 April 2010 by David Merkel

Simon Johnson and James Kwak write a popular blog, The Baseline Scenario.? They have written a? very credible book on the crisis, which I have .? It covers all of the bases in a methodical way, and there was little with which I could find fault, and it does so without conspiracy-mongering, or name-calling, while still finding fault with a great many parties.

The intro to the book begins with the 13 bankers meeting Pres. Obama at the White House in March 2009.? (Thus the name of the book.)? The Obama Administration treats the bankers with kid gloves, because they are afraid of a crash in the banking/economic system.? But like the old saw, where if you owe the bank $1000 and can’t pay, you have a problem; but if you owe the bank $10 billion, they have a problem — the US government concluded that they had to protect the banks in order to protect the system as a whole.

Now, part of this stems from a false belief system, thinking that we had to bail out the banks — we didn’t need to bail out the banks.? We could have resolved them through a new Resolution Trust Company.? Rather than bail out holding companies, we could have let holding companies fail, and protected the few operating subsidiaries that people and institutions rely upon.? But part of this stemmed from the influence that large banks exercised over the US Government.? So many in the government benefited from campaign contributions from banks.? Many had worked for the banks and had friends there; many wished to work there eventually.

The book takes us back to the beginning of the US, and all of the arguments over whether we needed a central bank or not.? This is one of the few places where I disagree with Johnson and Kwak.? I don’t think we need a central bank, though we do need to regulate credit in order to avoid banking panics.? They view Jefferson as right in viewing large banks as being a threat to government sovereignty, but naive that a central bank was not needed, while Hamilton was more practical, but would not see the risk of political corruption.

Think of the Greenspan era, which was central banking at its worst.? The least little squeak during a recession would make Greenspan open up the monetary spigots, and he would keep them on well beyond when stimulus was needed.? Because of demographics, his actions did not lead to price inflation, but asset inflation.? Thus the bubble that we face now.? Extra dollars did not chase goods; extra debt chased assets.

They take us through the international crises of the ’90s which largely did not affect the US, but would sound familiar to us today.? We don’t think of ourselves as having aristocrats in the US, but major CEOs seem to play that role well.

They catalogue the changes in policy that allowed for securitization, for swaps, for unregulated swaps, for increases in leverage, for decreases in regulatory oversight, and increasing influence over US policy by financial companies. Further, with the regulators outsourcing much of their responsibility for setting capital levels to the rating agencies, there was a further opportunity for failure, as the rating agencies rated novel securities for which they had no track record.

With sloppy regulators like the Office of Thrift Supervision, the stage was set for and a race to the bottom in lending standards.? In the short run, more lending promoted higher profits, but in the long run sealed the demise of many lenders.

The crisis hit, and the leverage that had been built up was unsustainable.? It rippled through many areas of the financial sector, hitting the firms that had cheated most the hardest.? Over two years, from February 2007 to March 2009, the first wave of the crisis shook the banks, and many failed.? Many smaller banks continue to fail, having no influence over the government.

Their solution to part of the crisis is modest, at least, more modest than I would pursue.? They suggest that the six largest banks be broken up.? Good, let’s do that.? They suggest consumer safeguards; yes, protect dumb people to some degree, but make them wear a scarlet letter “D.” (My thought, not theirs – you can’t have it both ways.? There should be stigma if you can’t protect yourself.)

It is a very good book and one that I would heartily recommend.

Quibbles:

You have to have average intelligence to read this book.? It is not a book that everyone can read.? Also, very few graphs.? No pictures.? That doesn’t affect me, but many other people have a hard time reading a book with little in graphics.

Who would benefit from this book:

Almost everyone would benefit.? It does a great job laying out the problems, and the solutions that they offer are eminently reasonable.? Again, you have to be willing to read a book where the words are big, the sentence structures are complex, and you already understand something about economics.

If you want to buy the book, you can buy it here: 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown.

Full disclosure: I received a free copy of their book at the Fordham Conference, as did all of the other attendees.? I never promise to review a book that I receive for free, and I never promise a favorable review. That said, when I receive free books, if I have a lot of them (normal), typically I do triage and pitch the ones that look like losers.? I do a similar filtering when book agents e-mail me to review books.? I really only have time for good ones.

If you enter Amazon through my site, and you buy anything, I get a small commission.? This is my main source of blog revenue.? I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip.? Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I usually do.

Most people buying at Amazon do not enter via a referring website.? Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.? Whether you buy at Amazon directly or enter via my site, your prices don’t change.

A Summary of What Bank Reform Should Be

Posted on 31 March 201031 March 2010 by David Merkel

I’ve thought about the issue for a while, and I want to summarize what the key areas for bank reform are, so that you all can know why legislation like the Dodd Bill won’t achieve much.? There are five key areas that have to be addressed to avoid “Too Big to Fail”:

Limit short-dated funding, and encourage liquid assets.? Place strict limits on banks regarding funding that is likely to run in a crisis.? Encourage asset-liability match across the whole yield curve.? For the cognoscenti, match partial durations.? For bank CEOs, hire some life actuaries to help you.? (We’re cheap — for what you get!? Plus, we have an ethics code superior to others in the financial sector.? Wait.? You don’t want that?!)
Limit the ability of operating banks/thrifts to lend to, invest in or enter into derivative transactions with other financial companies.? This is the critical provision to avoid contagion-type effects.? Most proposals ignore this.
Fix the accounting.? Go to a principles-based approach, and reveal the complexity embedded in securitization and derivatives.? Limit the amount of derivatives that can be written for purposes that do not reduce risk.
Raise the capital required as a percentage of assets, and make the capital required disproportionately rise with the assets.
Fix the risk-based capital [RBC] formula. The banks should copy the appointed actuary function of Life Insurance Companies. Then do industrywide experience studies on asset performance, so regulators will know how risky the assets really are, and then the regulators can feed the results into the risk-based capital formulas, and benchmark what banks lend well and badly by category, which would lead to much better overall risk control, and very frustrated bank managements, because capital would go up, and ROEs down.

Note that I have not mentioned Glass-Steagall.? My view is let banks do what they want with assets, but let the RBC formula limit risky asset categories.? Equitylike risks should be funded with equity.? What could be simpler?? Such a policy would have commercial banks out of equitylike businesses in a flash.

That is the heart of the matter.? But I want to expand on point 3.? Imagine a bank that has bought a Single-A slice of a trust-preferred collateralized debt obligation, 5% of the tranche.? Rather than placing the asset on the balance sheet at the amount paid, the following should happen:

The asset side of the balance sheet should have an asset equal to 5% of the assets of the CDO.
The liability side of the balance sheet should have two entries — one for 5% of the AAA and AA part of the deal, which are loans levering up the single-A interest, and one for 5% of the BBB and below part of the deal, which provide protection to the single-A tranche.

That is the real economics of the deal, though it is far messier than reporting one single-A bond.? As it happened with the not-so-hypothetical CDO that I describe, the liability for BBB and below is zero now, and the AAA and AA part of the deal have value equal to the loans.

As for swaps, they are an exchange of this for that.? Place this and that on the balance sheet.? Let RBC limit the exposures.

We can get really complex about preventing bank defaults, but the main trick is making sure short-term funding does not run.? A close second, is preventing investment in other financials, which destroys the possibility of contagion.

If we can do those two things, preventing too big to fail will be a breeze.? But who has the guts to do that?

Dumb Regulation is Good Regulation — How to Regulate the Banks

Posted on 16 March 2010 by David Merkel

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:

Equity [RBC]	Assets	E/A Ratio	Marginal E/A Ratio	Marginal Income	Income	ROE	Marginal ROE
10.00	100.00	10.00%	10.00%	2.00	2.00	20.00%	20.00%
26.25	200.00	13.13%	16.25%	1.90	3.90	14.86%	11.69%
42.50	300.00	14.17%	16.25%	1.80	5.70	13.41%	11.08%
58.75	400.00	14.69%	16.25%	1.70	7.40	12.60%	10.46%
75.00	500.00	15.00%	16.25%	1.60	9.00	12.00%	9.85%

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.

A Few Notes From the Fordham Conference

Posted on 13 March 2010 by David Merkel

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.