Even as we and other commentators have noted the underlying weakness of major bank balance sheets, which have been propped up by asset-price-flattering super low interest rates and regulatory forbearance, we still witness the unseemly spectacle of major banks keen to leverage up again. The current ruse is raising dividends to shareholders, a move the Fed seems likely to approve. Anat Admati reminded us in the Financial Times on Wednesday that we are about to repeat the mistakes of the crisis:
Paying dividends helps banks maintain excessive leverage. A typical bank funds over 95 per cent of its investments with debt and less than 5 per cent with equity. A small drop in asset values can lead to distress and possible insolvency. We have seen that furious “deleveraging” by any highly leveraged and interconnected bank can start a crisis…
The Basel III reforms agreed last year set minimum bank equity between 4.5 per cent and 7 per cent of “risk-weighted assets”, which are significantly smaller than total assets for most banks. Triple A-rated assets require little or no equity capital. The system of risk weights established by Basel II, which distorts banks’ investments towards favourably treated assets, was mostly maintained. Under Basel III, the ratio of equity to total assets can be as low as 3 per cent.
These equity requirements are dangerously low. Significantly increasing banks’ equity funding would provide many benefits to the economy, at little social cost.
Our Richard Smith has provided a series of posts analyzing the many shortcomings of Basel III (see here, here, here and here); below is his drive-by shooting:
Here are my main gripes:
Valuation: the capital ratios mean nothing if the assets are overvalued. Waldman is always going on about this. It ends up as quite a radical critique: capital ratios without valuation reform = cart before horse.
Accounting: there is still no harmonization of accounting practices on all the shadow banking apparatus: for instance, special purpose vehicles, derivative netting and repos. Actually, of course, when you come across things like Repo 105, or BoA’s quarter end balance sheet manipulations, there don’t seem to be any relevant reputable accounting practices at all; even if you think Lehman’s liquidity pool probably is an outlier, some of this stuff really, really needs fixing. And do we think that under Basel III there will be more accounting dodges that will cross the line from ‘asset sweating’ to ‘accounting manipulation’? Not Basel III’s fault, but I rather think we do expect exactly that.
Regulatory risk weightings are still a mess, with the ratings agencies still ensconced as the arbiters of credit quality.
Then of course there is shadow banking, which Basel III largely dances around. One particularly glaring example is the whole custody/client money/asset segregation/rehypothecation/title mess in London. There’s not a peep, burble or whisper here in the UK about the sort of legal reforms (somewhat in the manner of the US’s 1934 Securities Act, perhaps, plus a UK version of SIPC) that would sort this out. Recent Lehman-related rulings on Client Money actually mess the situation up even more. Of course, our obligingly vague 17th century line on “who owns what” works very capital-efficiently for Prime Brokerages. Which is a big part of why Mayfair now houses a $4Trillion shadow banking system. Push from Basel III would have helped get more of a grip.
I have nothing to say about enforcement; it’s been such a long time since I’ve seen any that I’ve forgotten what it is.
London Banker takes an equally dim view (“More on the lunacy of the Basel Accords”), and in particular, scotches the asset risk weightings:
I was looking at the preferred asset classes under the Basel Accords…and realised that every single asset class that is given less than a 100 percent credit risk weighting is now tainted by widespread default, scandals or bailouts.
The credit risk weightings mean that instead of reserving the standard 8 percent of capital in respect of a debt, the bank can cut that by the weighting applied to the asset class. Effectively, the reduction in credit risk weighting operates as a powerful subsidy to the borrowers and equally powerful incentive to over-leveraging the lenders.
But we don’t need to wait for Basel III to come into effect to provide cover for continued bank undercapitialization, which is tantamount to undue risktaking sure to be eventually eaten by taxpayers. We’ve pointed out that properly valuing second mortgage and commercial real estate exposures would put a serious dent in the reported equity of the four biggest banks. They have additional, yet to be determined liability as servicers and trustees of residential mortgage backed securities. The big European banks went into the crisis with even lower capital levels than their US peers and are widely considered to have done less to rebuild equity. And that is before factoring in their exposures to the evolving sovereign debt crisis.
Gillian Tett of the Financial Times today points to yet another time bomb which combined with the other factors listed above would wipe out the stated capital of major banks:
For one thing, this saga highlights something banks have long preferred to conceal: namely the wider level of under-collateralisation in the OTC derivatives market. Last year, Manmohan Singh, an economist at the International Monetary Fund, calculated, for example, that if market participants posted sufficient collateral to cover all OTC deals properly, they would need an extra $2,000bn (or about $100bn per big dealer). The TABB consultancy has reached similar conclusions*. And while banks dispute this data, these numbers are sobering; particularly since OTC business is now moving on to clearing houses – where collateral will be mandatory.
Those undercollateralized OTC derivatives are certain to consist largely, if not entirely, of credit default swaps, a product we have argued here and in ECONNED serves no legitimate social purpose and needs to be strangled over time (there are reasons that simply banning them and letting existing exposures run off would lead to dislocations). They are certain to continue to be undercapitalized at a clearinghouse, for adequate margining of CDS renders the product uneconomic. Thus moving them over to a clearinghouse is effectively another bailout, shifting risk from banks via creating another TBTF entity.
Einstein once said, “The definition of insanity is doing the same thing over and over again and expecting different results.” But the producers and top brass of the major financial firms found blowing up the global economy to be a hugely profitable exercise. 2009 bonuses were even richer than in 2007, and industry concentration increased, meaning their hold on power is even more secure than before. So for them, this conduct is completely predictable. I find it difficult to believe that regulators do not also see what is really at work, which means that one can only conclude that they are not insane but are either in denial or deeply corrupt.
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“… Singh…calculated, for example, that if market participants posted sufficient collateral to cover all OTC deals properly, they would need an extra $2,000bn (or about $100bn per big dealer).”
What does ‘cover all OTC deals properly’ actually mean? 100% collateralisation? 100%+ or so to cover market swings between postings? My recollection of a few years ago (i.e. about 2007) was that there were very few counterparties in the OTC derivatives markets that were able to trade uncollaterised. Based upon credit ratings a sliding scale of thresholds were determined above which collateral was posted. Can’t remember many credit officers giving carte blanche to running up exposures on the derivatives books – given the low volume of trading with the AAAs they set the thresholds high enough not to warrant collateral posting (that was the theory).
Anyways, assuming that every counterparty is AAA rated and was given $75m of derivative exposure (at the very top end of exposures granted) then Singh’s caluclations would assume that each ‘big dealer’ has over 1,300 active counterparties against which it has more than $75m of exposure. Am I missing something here?
I’ve discussed the margining problems with CDS at length. Because CDS will “jump to default” on a credit event, they are not adequately margined. CDS are not derivatives in any proper sense; they are not priced in reference to the price of an underlying actively traded instrument. Hence concepts like margining are badly misapplied to CDS.
Collateralized and adequately collateralized are very different beasts. From one of my numerous discussions on this topic:
As we have discussed on this blog, and recount in more detail in the book ECONNED, central clearing and/or putting them on exchanges are inadequate remedies. Only a small subset of CDS contracts trade often enough for to be suitable for exchange trading. As for central clearing, the logic is that this would provide for consistent and sufficiently large margin to be posted (think of it as a reserve against the ultimate possible insurance payment required on the contract). But unlike real derivatives, CDS are subject to massive price moves (”jump to default’) when a reference entity (the entity on which the CDS is written) defaults or goes into bankruptcy. That large price movement, means that the margin already posted will be insufficient, and there is no guarantee that the counterparty will be able to pony up the amount now due.
But perhaps more important, the idea that CDS have legitimate uses is questionable. They are used to hedge credit risk (sometimes) yet their pricing, per Bloomberg or any of the common commercial models, price CDS based on volatility, which is not based on any assessment of the underlying credit. So the idea that the pricing reflects default risk is spurious; indeed, CDS failed abysmally in predicting financial firm default risk during the crisis (Lehman was a particularly vivid illustration). But they serve to perpetuate the erosion of proper credit analysis (why bother if you can just lay off the risk?).
“But unlike real derivatives, CDS are subject to massive price moves (”jump to default’) when a reference entity (the entity on which the CDS is written) defaults or goes into bankruptcy. That large price movement, means that the margin already posted will be insufficient, and there is no guarantee that the counterparty will be able to pony up the amount now due.”
So you need to start analyzing/pricing in double defaults occurring same day/time? Taking this further, you’d also need to be applying this analysis to standard equity/fixed income/fx option contracts. They have similar trigger mechanisms (I don’t mean what actually triggers them: i.e. a default versus a price level) to CDS save the digital payout…unless they are, of course, digital options.
Wouldn’t a ‘big dealer’ when buying protection from a less than perfect creditworthy counterparty perhaps wrap up the CDS in credit linked notes thereby ‘fully’ collateralising their counterparty risk? Or perhaps buy protection, through a CDS, on that counterparty…
I’m with you on the legitimate uses of CDS and those cases where protection is required then reliance on the insurance market would be a better option. I just have trouble when people throw out big numbers that do not seem to have any resemblance to the now. I have to read the article that Ms. Tett wrote within its own geometry and based upon my existing knowledge of how collateralising derivative contracts works. As an influential financial writer she needs, perhaps, to be a little more sure about who she is quoting from and how she articulates those quotes to substantiate her argument. To write ‘cover all OTC deals properly’ is a cop out as she fails to inform the reader what ‘properly’ involves and thus leaves me relying on my own knowledge. This is not the first time I have felt this way about one of Ms. Tett’s columns. A previous column she wrote, again referring to a paper penned by Mr. Singh, left a lot to be desired about his understanding and interpretation of collateral (rehypothecation) practices and such misunderstanding was perpetuated further by her.
‘Financial sophistication’ is sometimes equated with high net worth. Or maybe better lots of money to spend (often other peoples money) Sovereigns, pension funds, muni funds all fell in this category and were easily duped by these opaque products… again from Econned
“”The beauty of the formula is that no matter what values were plugged in the value was always zero. The client was paying $4 million a month for three years for the privilege of having an utterly worthless contract.””
To the extent that CDSs have legitimate uses they are insurance.
They should be regulated like insurance. Like very dangerous insurance.
Large gamma.
Deeply corrupt.
I vote for “deeply corrupt.” The whole system is deeply corrupt. The fact that the previous administration can not only get away with war crimes and crimes against humanity, with the former president and vice president admitting it publicly without the present president rising to his constitutional oath to uphold the law of the land, shows that nothing is over the top now. Massive control fraud is small potatoes.
Kleptocracy is a system. It needs regulators who won’t regulate, a media that propagandizes and lies, an academy that justifies, and legislators who do what they are told. This deep into the crisis, denial is no longer plausible.
My understanding of this is weak to nonexistant, but I have one small question.
Would there be any way that the collateral could be ‘stipulated’ rather than ‘physically posted’. Just to draw a parallel to the MERS system??
The definition of insanity is allowing bankers to do the same thing over and over again knowing they’re going to achieve the same results.
Man, how the Chinese delegation must be laughing at us. I know one thing, if I was aid to Hu Jintao, I would have been whispering this in his ear the entire visit:
“Paramount Leader, remember, we administer powerful and well-capitalized banks; the Americans — have nothing.”
“We command the world’s largest oil and mining companies; the Americans — have nothing.”
“And do not forget, President Hu, we posses the most powerful tool ever wielded by a nation-state, a sovereign fiat currency, while those utter fools on the other side of the table, the leadership of the supposed richest and most powerful nation on OUR planet, believe they are bankrupt.”
“Above all, let us not fear their theoretical “trump card,” their nuclear arsenal. Any and all — well veiled — threats along these lines will be empty. The Americans are but dead stones on the go board. They know it, we know it. Now, let us smile humbly.”
I buy all of your arguments up to to the US having and not using its nukes.
We have used them before, it is clear the countries leadership has lost its moral compass and lastly, our military industrial complex would love to take on any part of the world that wants to question our imperialism.
I am beginning to seriously believe that the lunatics are running the asylum. A good measure will be the message coming from the presidents SOU speech. Most sane folk think our country is in deep doodoo but Obama and his corporatist buddies think the US has no structural problems….just needs some tweaking here and there.
I also believe that the banks are consciously extracting as much money from the system before it crashes to further cement the control of those that own the banks all over the world, a good chunk of the worlds politicians and their governments. As long as they can retain control over the media they can control the masses as history has shown. As soon as use of the internet becomes a serious threat it will be brought to corporate and government heel.
This is not fun to watch. While I want to believe that this is all salvageable, I am overwhelmed by the volume of folks who are now part of the problem to some degree or another…….and there are still none in jail for any of the shit that has gone down since (or before) 2008.
psychohistorian said: “I am beginning to seriously believe that the lunatics are running the asylum.”
Yes, it looks like the lunatics are running the asylum, and this is not fun to watch.
What we have are two slightly different versions of One Party Rule, which Gore Vidal correctly identified as the Party of Money. Since maintaining this Two-party illusion is essential for the Party of Money to keep running its scam, this is why I would like to see the Democratic faction totally collapse. Let us take down the curtains, destroy the illusion, and force the fascists to show their true face.
Because this might be the only way to shock the American people into finally waking up.
“The illusion of freedom (in America) will continue as long as it’s profitable to continue the illusion. At the point where the illusion becomes too expensive to maintain, they will just take down the scenery, they will pull back the curtains, they will move the tables and chairs out of the way and you will see the brick wall at the back of the theater.” – Frank Zappa
Exceptional comment and thread. Thanks for the prescient Zappa quote, one for the file.
I have a feeling we don’t have long before the velvet glove comes off the fascist fist. This is clear from the post topic. While its substance is otherwise incomprehensible to me, it clearly reveals the precarious nature of the Rube Goldman hypercomplexity of a parasitic industry that contributes little tangible value to society and has no concern for the health of its ecosystem or its victim host, both now deathly ill.
If the US uses its nukes, Russia is still set up to automatically destroy Washington, DC, the nuclear “bunker” in Colorado, and most of the US military installations.
I hope it doesn’t happen, but it sure wouldn’t cause the US to “win” anything.
Max, the Chinese have their own credit bubble. In fact, from what I have read over the years, their accounting is even more phony than ours. The idea that 3% capital is enough invites another round of Bear Stearns. The whole scheme of creating credit as surety with such little at stake flies in the face of legitimacy. A bank is supposed to be able to cover the credits on their balance sheet in event of the failure to collect what is due them. The funds are transferred to other parties.
This is why the reserves mean nothing. Banks are limited by their capital reserves. Banks shouldn’t even be in some of the lending schemes they enter this day and time because money and capital don’t match. Borrowing short and lending long work when the structure of rates are normal or when the central bank can steal the savings of depositors and transfer it to the banks as we presently have. But, there is not enough liquidity to move out should things reverse. Bernanke misses the point that the Fed raised rates to stop monetary flight from the US back in 1931, else there would have been no money left in the country. Bernanke will have to do the same thing before this is done and 3% capital will evaporate like water on a red hot stove. Witness the papered over S&L mess from the early 1980’s due to a sudden decline in value of loans on the books and a rapid increase in rates outside the norm. The only purpose for Bernanke’s current actions is so the big banks don’t have to borrow what they have overextended. The entire world is over extended in credit. We need conversion of bank liabilities to capital, not the reverse. Next, they will be buying back stock, the fatal flaw of the TBTF banks coming into this mess, namely BAC and C.
Yves,
I don’t understand where the 100 billion USD per institution comes from, whereas the IMF paper from Manmohan Singh estimates the impact of initial margins at CCP at 200 billion USD for the whole market.
The 2 Trillion number mentionned earlier in the paper reflects the aggregate of Derivatives payable by the financial institutions. It is perfectly normal for a FI to have significant derivatives payable as it acts as a buffer against counterparty default (from its point of view) and it is a legit source of financing (in most of the cases, the opposite hedging transaction, which generates a receivable, is marginned). This is what prime brokerage business is all about.
I am also highly dubious that undercollateralization is concentrated on CDS, I would rather put the bulk of it on derivatives which are hedges of retail structured products, mostly equity/fx/interest rate derivatives.
What is your basis for assuming retail structured products are broadly undermargined, and that that adds up to a lot of exposure? Retail complex derivatives are a small market compared to institutional products. Not that didn’t happen (the Lehman mini-bonds being a prime example).
Freshfields disputes your contention that this sort of structured product was sold much to retail:
Minibonds are structured derivative products linked to the credit of certain specified reference entities…Structured products having a similar structure to that of minibonds were commonly sold to institutional investors as credit-linked notes in many jurisdictions. However, it was not very common for such structured products to be sold to retail investors.
http://www.freshfields.com/publications/pdfs/2008/dec08/24820.pdf
This piece also suggests it was not a very big market. $15 billion a quarter does not add up to a ton of exposure:
http://www.businessweek.com/blogs/money_politics/archives/2009/08/retail_derivati.html
Like Charles 2 I am skeptical about CDS as a source of undercapitalisation. Unlike him, I don’t believe it is retail either.
My favourite bet? IRS held for trading purposes. The once mighty (how we laugh) Anglo-Irish bank had at peak a derivatives book of 270 bn euro; 90% of it IRS, 80% of that held for trading purposes. Most of the cash calls have been, I believe, as a result of downgrading of the bank’s FSR (so more cash collateral had to posted on losing positions). This is akin to AIG where each downgrade vastly increased the cash call.
Why IRS? Look at the movements in exchange rates in the run up to and immediately post Le Crunch (September 2008). First interest rates increased sharply on the back of rising inflation. The two-bit players rushed to bet one way and probably over bet. The cruch caused rates to collapse at astonishing speed. Now the two-bits are holding a load of ‘protection’ against high rates and rates have collapsed. So they have sold a mass of fixed and bought a mass of variable…
Then with the collapse of interest rates the opposite happened…
From 2006 to 2007, Anglo’s derivatives book increased in notional size by 70%; from 2007 to 2008 it increased by 70% again…
Guess what happens when commodity price inflation starts to feed into inflation again…
The danger of all this is the asynchronous risks. The pedants will tell us that all that notional nets out to near zero. Great. Just like insurance then. Except with insurance, you carry assets to reserve against risks and then a bit more. Not just in aggregate (i.e. you can’t say, I’m fine because Brian over there is over-reserved).
And just like insurance, if there is a big localised problem, you can have big localised failures. At the moment, the derivatives markets seem to be like the Names system at Lloyds. Get a big disaster and a rake of sellers will go bust. The buyers will be left short which will ripple through.
Why did the Names system fail? Because they were the last link in the pass the parcel-bomb chain. Someone somewhere has only written IRS and has not bought any. Someone else has only bought and not written.
I completely co-sign this, though I think Yves has a differing opinion on the subject.
We’ve pointed out that properly valuing second mortgage and commercial real estate exposures would put a serious dent in the reported equity of the four biggest banks. They have additional, yet to be determined liability as servicers and trustees of residential mortgage backed securities… [and] under-collateralisation in the OTC derivatives market…
I agree that Banks resuming dividends doesn’t make sense. And their ratios would already look terrible if they recognized the losses and liabilities that you describe.
But I also think TPTB recognize that Banks need more capital. It seems to me that The Plan(tm) is for Banks to raise equity – probably before the 2012 campaign season heats up. An equity raise would strengthen the Obama Administration’s case for having “saved the economy.”(Similarly, GM was not truely “saved” until it did its IPO.)
In addition, it occurs to me that at a 10x multiple, $10+ billion of QEn-sourced “earnings” could allow Banks to raise well over a hundred billion dollars of (additional) equity and preferred (maybe as much as $200 billion over what they would’ve been able to raise otherwise?)
In fact, a skeptic might believe that QE2’s main purpose was to pump up bank earnings in preparation for just such a raise because a) there isn’t much benefit otherwise(*), and b) a large capital raise helps the Fed to pull back their politically unpopular support of the TBTF banks.
* Interest rates have risen, not fallen; and the danger of inflation counterbalances the benefits to Main Street.
The fascist crazies are alive and well over here, as demonstrated by ‘Tom Hickey’. Good job Yves.
I can almost hear the devil saying, “Shhhhh! How dare you point out one of my current locations, hiding here in the details.”
“one can only conclude that they are not insane but are either in denial or deeply corrupt.”
Having talked to a few regulators recently my guess would be that there are probably some in each category. Probably some also who see the way the world is and think that in time they can address the problems. I wish them luck.
I would like the following points regarding MERS to be clear to all:
1) It’s not a PAPERWORK issue – it’s an OWNERSHIP issue. Whenever we see the word ‘paperwork’ describing the MERS scam, we should know that the correct word is ‘ownership’.
‘Paperwork’ is defined as: written or clerical work, as records or reports, forming a necessary but often a routine and secondary part of some work or job.
That is not the issue with MERS. The issue is one of fundamental ownership – which is determined by signed and recorded paper.
2) The most significant and basic nature of the MERS scam has not been discussed. It is, quite simply, that the obfuscatory nature of the MERS system allows the originating lender to sell the initial mortgage MORE THAN ONE TIME. I will demonstrate the implications with a simple example.
Now, it may never be possible to prove that the same mortgages were sold repeatedly. In fact, because of the very nature of MERS, it is likely that it would not be possible to show clear evidence. The point is, however, that by flaunting the existing, centuries-old state property laws, MERS allows for this to happen. It does not guarantee that it happened but it allows for it to happen. It may well be the real reason the chain of titles were broken and the ‘paperwork’ has all gone missing.
An example of the situation MERS allows and the financial implications:
Consider a pre-MERS/pre-securitization scenario for a real estate loan. Bank A originates a $500,000 loan. The $500,000 is used to pay the seller of the house. In exchange, Bank A will receive monthly payments for the next 30 years at (for example) 6 percent. If Bank A decides that it does not want to collect small amounts each month, then it may sell the rights to the bank that will pay them the highest price, Bank B. For whatever reason (its own belief on what constitutes a ‘good interest rate’) – Bank B may pay $525,000 for this loan. The assignment of the loan is done based on the stable, ancient property laws of the state, and Bank A has then made $25,000 profit on this transaction. Bank B then owns the loan and there is no ambiguity.
It would be hard to imagine Bank A being tempted to then sell the exact same loan to Bank C. The reason is that there is very clear evidence at the county recorder’s office that the loan was already sold to Bank B.
Now consider the same situation with the MERS system in place.
Bank A makes the same original loan for $500,000 which is used to pay the seller of the house. Now, when it is interested in selling this loan to the highest bidder, Bank A realizes that because the way things operate now (regardless of state laws), it will not be selling the loan directly to another bank (Bank B above). Instead, it has become customary for Bank A to ‘bundle’ hundreds of loans together and sell them all to ‘investors’ who are probably made up of entities such as mutual funds, city governments, foreign governments, etc. Each of these entities likely represents many people’s money – none of whom really have any idea of which individual loans they are purchasing.
Well, after all the bundling and selling to entities and stuff, it may turn out that, on average, Bank A gets $525,000 for each loan – and so in that way it made the same profit.
In this scenario it is not at all hard to imagine Bank A being tempted to sell this same loan again. Unlike before, when there was ‘Bank B’ and ‘Bank C’ and very clear records at the county recorder’s office, there is no ‘Bank B’ but only a mish-mash of bundled loans sold to investors/entities who do not know which loans they have bought — and by the way — the documents have been ‘lost’. In this scenario, it is all too tempting to sell this same loan to the securitized version of ‘Bank C’ – which is the same loan bundled with hundreds of other loans – sold to vague entities who do not know what they have really bought.
Comparing the two scenarios, one might think that Bank A has just doubled its profit. It has just sold the loan twice after all. Wrong! In the second scenario, Bank A has made more than 20 times its profit. In the original scenario, Bank A’s profit is ($525,000 – $500,000) = $25,000. Of course, if the loan is fraudulently sold a second time, then all of the $525,000 from that sale would be (illegal) profit because there would be no transfer of $500,000 to the original seller of the house, as was done with the initial loan. Therefore, Bank A’s profit would be ($25,000 + $525,000) = $550,000.
Bank A has increased its profit by 22 times simply by bundling/schmundling. Is that possible to prove? Probably not, given the destruction of so many documents and the entire system of banks/lawyers/politiicans/lobbyists, etc. But it is not necessary to prove any of this. It is only necessary to realize that the system allows for this, it encourages it, and it is likely the key driving dynamic to all we are seeing unfold. It is far more likely than the latest explanations in the media that banks “wanted to evade fees at the county recorders’ offices”.
It explains why we are where we are. The remedy, of course, is to adhere strictly to the state property laws which have been the same for centuries. These laws require clear, recorded, signed documents which do not allow the above confusion to exist. The courts must simply enforce these laws and let the chips fall where they may. If past foreclosures need to be voided, then so be it.
Fred Smith
Here’s a question: we all know the rampant fraud means the megabanks are gonna blow up the themselves and the economy again.
Anyone know how to figure out WHEN?!? Timing is important, but seems to be practically impossible to figure out. Yves?