What is the nature of the SLS?

There seems to be some confusion about exactly what risks the Bank of England is taking in the Special Liquidity Scheme. Here's my understanding: it is a two way repo of ABS for gilts. Effectively since the gilts are liquid, the ABS is pledged as collateral against a term loan, and the proceeds of that loan are then used to buy gilts which are delivered to the ABS holder. The loan is due and payable regardless of the value of the ABS. If the ABS decline in value, the Bank has the right to (and presumably will) demand more collateral, and failure to post that collateral is a default event. If the counterparty does not repay the loan (by delivering gilts or paying cash? that part is not clear to me but it doesn't matter much) the Bank can perfect the collateral it has and sell it. Any proceeds above and beyond what is necessary to repay the loan belong to the originator counterparty (or at this point their creditors). Any deficit is an unsecured claim against the counterparty.

The Bank is therefore bearing default-contingent market risk: risk on the value of the collateral contingent on default of the counterparty. It only suffers if the counterparty defaults AND if the value it can realise on selling the collateral is not sufficient to make good the loan. This is a real risk since marking the collateral is difficult - so knowing where it could be sold is not straightforward. Moreover since there are various grace periods the collateral may fall in value between the failure of the counterparty to post additional margin and the eventual liquidation of the collateral. Still, it is not a big risk unless the collateral is very illiquid and/or rather small haircuts are taken.

Grand Theft Banking

The next instalment of the popular computer game Grand Theft Auto is out today (or, for you really hardcore gamers, midnight yesterday). Its launch prompts me to consider how gaming could help finance, beyond the extra carry from all of those copies of the game bought on credit cards. So how about this: design a game that's the financial system. It has deposit takers, hedge funds, investment banks, pension funds, the lot. It has a diversity of different asset classes too with real time prices. It also has shareholders, depositors, deposit protection, regulation, the interbank market, whatever you want. Your mission, player, is to set the regulations to prevent bubbles, protect depositors, allow moderate growth, and prevent moral hazard. Covertly of course the BIS will be monitoring your progress and any really good ideas get put into Basel 3.

Excepting VAR

Even S&P think VAR alone is inadequate as a market risk measure. From "Trading Losses At Financial Institutions Underscore Need For Greater Market Risk Capital":

The securities markets changed dramatically in 2007, shaking the trading businesses of banks and showing up in their risk measurements. The main metric, the aptly named value at risk (VAR), was rising in conjunction with soaring market volatility. VAR estimates maximum loss for a certain time period--for instance, one-day--to a given confidence interval--such as 99%. However, many banks posted losses much higher than VAR and even greater than their regulatory requirements for the capital they need to hold against market risks.

This situation illustrates the shortcomings of VAR models. Most notably, they are designed to predict losses under normal trading conditions. In addition, they ignore or underestimate certain risks, notably the increasing amounts of idiosyncratic risk arising from new and complex financial instruments that are a feature of today's trading desks.

[...] To better reflect the magnitude of trading portfolios' underlying risks, we envisage making a series of upward adjustments to capital requirements under Basel II as part of the calculation of our proposed risk-adjusted capital ratio...

Furthermore the increased number of backtest exceptions this year has not passed unnoticed by supervisors. S&P give a useful graphic showing some large firms had more than ten exceptions in 2007: a lot of this information is available in individual firms 10Qs, so it is hardly secret. Rather than applying the 1996 Market Risk Amendment approach and putting these failing VAR models in the 'yellow' or 'red' zone with concomitant small increases in regulatory capital, surely the time has come to revisit market risk capital completely and add in some measure of stress capital.

Hybrid thoughts

Hybrids are hot. Many banks have opted to use securities falling between senior debt and common stock to bolster their balance sheets. We have seen both perpetual and dated prefs, mandatory convertibles, optional convertibles, and much else besides. As the FT points out, the use of hybrids avoids dilution to common stockholders, at least for now. Let them take up the story:

But credit ratings analysts believe that the surge in issuance could increase risks for bondholders and other investors and weaken the long-term health of banks’ balance sheets.

Last week, Moody’s warned it might downgrade the credit rating of Merrill Lynch, which recently raised $2.5bn in preferred shares, unless the bank reduced the percentage of hybrid securities on its balance sheet.

Just this month, banks including Merrill, Citigroup, JPMorgan Chase and Lehman Brothers have issued about $18bn in preferred shares – more than the total issued for the whole of 2006.

This year’s issuance of preferred shares by US companies is on course to exceed the record $52.6bn touched last year, according to figures from Dealogic.

Ratings agencies usually want companies to have less than 25-30 per cent of their total capital in hybrid securities. But the latest bout of issuance has pushed some banks above that limit. At Merrill, for example, hybrid securities account for more than 44 per cent of total capital, according to estimates by Sanford Bernstein analyst Brad Hintz. Merrill declined to comment.

Analysts say that less sophisticated retail investors are attracted to the high interest rates offered by preferred shares and are less aware of provisions allowing companies in later years to exchange them for ordinary shares with no interest. “Firms achieve better prices selling to retail than they ever could get by selling in the institutional community,” Mr Hintz said.

So they are cheap and common stockholders like them. Are they any good?

The problem is that it is hard to say. Structurally hybrids have features that make them equity-like: the ability to defer coupons, subordination, eventual conversion into equity, long life; all of these help to give the hybrid some loss absorption capability. However in practice this flexibility is rarely used. Issuers do not defer their coupons and perpetual securities are not just usually callable: they are usually called.

One insight into the real utility of hybrids is given by banks' economic capital calculations. They are permitted to use a certain percentage of hybrids to meet regulatory capital requirements (aka 'non-core Tier 1' and 'Tier 2'). But for economic capital banks can assess both the capital required and the capital available however they choose. There is a great diversity of models for the calculation of economic capital requirements as a result. However there is little diversity in how those capital requirements are met: banks overwhelmingly take no credit for hybrids in their assessment of available economic capital. Telling, that.

Worried? Good.

According to the Guardian:

The Association of British Insurers [...] attacked the way previous corporate failures such as Railtrack have been handled and accuse the government of undermining shareholders' rights.

However, the investors are particularly concerned about the ability of regulators to take control of a bank's deposits under the special resolution regime (SRR), the cornerstone of the consultation paper.

They believe premature intervention in a potentially troubled bank will destroy shareholder rights and prevent the sovereign wealth funds that have played a crucial part in recapitalising US banks from taking similar stakes in UK institutions.

This shows that the government is doing something right with these proposals. The new insolvency regime for banks should destroy shareholder's rights: never again should common stockholders be able to block or threaten to block the rescue of a troubled depositary institution as the hedge funds did with Northern Rock. Bank stock should be fundamentally different from the equity of other companies in that shareholder's control is subordinate to the needs of financial stability. That is part of the price of having a banking license. The ABI needs to get used to the idea that moral hazard isn't abstract: preventing it means having the ability to screw shareholders as the FED did with Bear Stearns.

Rioja and the European Economy

I have two conjectures for today. The first is that Ambrose Evans-Pritchard needs to drink better Rioja. He presents a bearish blog in the Telegraph, backed by a second class Reserva. I would suggest at least a 904 GR for such musings, and ideally the Murrieta.

Secondly and rather more importantly, it can be suggested that the loss trajectory for European banks will be rather different from their American cousins. Suppose we believe Evans-Pritchard's loss figures: $123bn for Eurozone banks compared to $144bn for the US, and ignore for a moment the rather important distinction between bank and non-bank risk holders. (The US has far more of the latter.) My guess would be that most of the US risk is fair value accounted. So the Americans have taken or are in the process of taking their losses. Most of the European risk is probably accural, so losses will depend on the bank's projected loan loss reserves rather than current fair value. At very least that will spread them out over many years - remember RMBS is often 30 year paper. Moreover if actual experienced defaults are better than the current fair values predict then the losses will be lower.

One could argue that this cancer will eat away at the European banking system for many years, long after the Americans have taken their medicine and moved on. Or one could argue that right now it allows European banks to keep lending and hence to both protect Europe's economy from the worst of the losses and make themselves some money to pay for the losses. But certainly the bearish case for Europe is less convincing than that for the U.S.

What's so great about exchanges?

We are in the middle of a furore about the OTC markets: see for instance here for John Dizard in the FT. Now I can't argue that the OTC markets are perfect. But just moving an illiquid, hard-to-value contract from OTC to exchange-traded won't necessarily make it any more liquid or easier to value. Indeed it may make things worse because a stale or bad mark from the exchange might be credited with a spurious authority. At least with the OTC market you get a sense of the real liquidity of a product.

Lest you think I am making all of this up, here, courtesy of Yahoo (the Bloomberg screens have more data and hence make the point less well) are the June equity options on Dow Chemical, a large liquid U.S. stock.

Notice the volumes: for the far out of the money options, they are tiny. The quotes on the at the money's are fine, as are the slightly out of the money options. But do you really believe that the prices of the 30, 55 or 60 strike calls are correct given the low volume and low open interest? And if these issues arise on something as well known as Dow, imagine what the exchange prices for far out of the money options on less liquid stocks are like, and then tell me putting CDS trading on exchange will cure all the market's ills.

Ambac posts a $1.6B Q1 loss

From Bloomberg:

The first-quarter net loss was $1.66 billion, or $11.69 a share, New York-based Ambac said today in a statement.

That is over 10% of their claims paying ability (as stated in the 2007 annual report) in one hit.

Ambac fell as much as 22 percent in early New York Stock Exchange trading as new business slumped 87 percent after states and municipalities shunned its insurance and the market for mortgage securities dried up.

Looking into the detail, we find two major components of the loss: $1.7B mark to market loss on written credit derivatives held at fair value (primarily CDOs of ABS), and a $1B increase in reserving for written financial guarantees on RMBS accounted for as insurance. What I would really like to know is the balance of Ambac's subprime risk taken via CDS vs. that taken financial guarantees. In other words, how does Ambac's fair value write-down compare with its reserves? If $100M of 'average' (whatever that means) exposure taken via CDS generated $20M of write-down, say, how much did Ambac increase its reserves for $100M of average exposure taken via writing financial guarantees?


If things keep on going down like this it is going to get very messy. Still, at least Bill Ackman had a good day.

Update. Meanwhile other market participants old (FSA) and new are queueing to eat Ambac and MBIA's lunch. The FT reports:

Two companies are considering opening new bond insurance firms – a large US bank and a large private equity firm – according to New York’s insurance industry regulator.

Finally, Calculated Risk has a post on adverse selection in the monoline's portfolio: see also slides 31 & 32 of Ambac's Q1 presentation. I'm not sure what exactly if anything one can conclude from the information, but it is interesting.

The IMF Financial Stability Review: Chapter 3

It is with a heavy heart that I return to the IMF Financial Stability Review. There is an awful lot in chapter 3, and it is worth reading carefully even if on first glance it seems to be forbiddingly dry.

Chapter 3 of the IMF report begins with a fairly stark admission:

The speed and extent of the transition from “market” illiquidity to “funding” illiquidity, and their subsequent interaction, was remarkable and
required unprecedented intervention by mature market central banks to meet banks’ liquidity needs. As a result, important questions arise concerning the extent to which new financial instruments have increased the financial system’s vulnerability to liquidity events and the adequacy of the tools central banks have at their disposal to address such disruptions.

This is true, and I find the distinction between market liquidity (the ease with which one can liquidate a position in an asset without appreciably altering its price) and funding liquidity (the ease with which one can borrow money possibly against collateral) helpful. However it is worth pointing out that the central banks at first had no idea of the magnitude of the funding markets' needs. Remember the Bank of England announcing additional funding of £5B with a great fanfare? Yet a single decent sized SIV or conduit was tens of billions. Is it any wonder that when these came back on balance sheet the banking system needed hundreds of billions of funding.

Next something that we need to take with a pinch of salt:

Given the inherent complexity of managing liquidity risk, bank regulators have adopted a diverse approach.

I guess doing nothing very much in an agitated fashion might count as diversity.

The report points out a couple of interesting phenomema relating to funding liquidity.

Events since July 2007 have revealed weaknesses in funding liquidity management. First, banks tended to hoard liquidity during the period of systemic stress. [...] Second, liquidity-stressed banks were reluctant to use central bank standing facilities or the discount window for reputational reasons.

Hoarding liquidity is clearly bad for the system but no one has a convincing way of making this particular horse drink. The best we have so far is making liquidity cheaper for everyone in the hope that that will restore confidence.

Squeezes in funding liquidity can give risk to market illiquidity:

Runs on markets can occur when there is an increased likelihood of a deterioration in funding conditions, leading to a simultaneous attempt to sell assets by a number of investors. Faced with the decision to sell immediately or wait, speculative investors have to take into account that they could be hit by an unexpected need to sell before asset values recover from fire-sale conditions. The risk of eventual forced selling at a lower price causes a rush to the exit.

Knowing that you will be able to fund an asset therefore reduces the rush for the exit: hence the FED's TSLF and the Bank's SLF.

The IMF points out that liquidity risk might be getting worse. Reasons this might be true include:

• The growth in securitized lending and credit risk transfer mechanisms [...which] has reduced the illiquidity of banks’ asset holdings on average, but made access to liquidity more dependent on market conditions.
  
• The emergence of new complex instruments that are difficult to value and appear prone to illiquidity in times of stress. [I would add here too the use of fair value triggers for sale, for instance in the definition of default of a SIV or conduit.]
  
• The increasing dependence of market liquidity on hedge fund activity. While hedge funds have added generally to market liquidity, their increasing importance means that overall market liquidity often relies on their ability to leverage themselves, which is in turn affected by market volatility determining margining requirements.
  
• The provision of emergency liquidity support, which remains tied to national currencies and payment systems, has not kept pace with the internationalization of financial institutions’ treasury operations.

All of this suggests that firms need to be more aware of liquidity risks, more thorough in their quantification, and more prudent in their management. The IMF concludes:

Firms need to factor in more severe liquidity gapping and correlation jumps in their market risk models and stress tests, making sure that these are well tailored to firms’ particular circumstances and positions...More severe stress testing of funding liquidity should be adopted, taking into account the possible closure of multiple wholesale markets (both secured and unsecured) and wide-spread calls on liquidity commitments, taking into account commitments to off-balance-sheet entities.

Indeed. Stress testing is not quantatively sophisticated - the scenarios chosen are often fairly arbitrary, as is the estimate of their impact - but it is a vital estimate of the impact of a major event.

Where market liquidity can be measured robustly, a liquidity adjustment to market risk measures can be helpful, and its disclosure can usefully focus attention on liquidity risk, especially in “normal” conditions.

Remember though that the 1996 Market Risk Amendment to Basel 1 (defining regulatory conditions for the use of VAR models) sets not just a minimum but also a de facto maximum standard for market risk models. Why have a liquidity adjusted VAR with higher capital estimates than your peers? Regulators need to permit a much wider variety of market risk capital estimates and to raise the bar significantly on VAR.

Finally, a sobering observation from a public policy perspective.

The cost of insurance against liquidity events appears to have shifted from the private toward the public sector.

I'm not sure 'cost of' is the right phrase. 'Responsibility for' perhaps. But certainly Central Banks are finding themselves increasingly concerned with the explicit management of liquidity premiums as well as of rates. They certainly need to get used to this idea and to develop better tools for it.

A frightening picture

From the Economist via Immobilienblasen. This long term trend in the UK vs. other retail housing markets certainly sheds some light on the BOE Special Liquidity Scheme, although it is worth noting that the incentives to originate bad loans were never anywhere near as bad in the UK as in the US.

Some very quick thoughts on the Bank's scheme:

• Is it big enough? £50B feels intuitively too small. Probably it needs to be two or three times the size to have a real impact. More experienced hands than mine are also not convinced: see for instance here for Bloomberg on Charles Goodhart's reaction.
  
• Are the haircuts too penal? Probably.
  
• Finally I still believe it would have been most helpful for these swaps to be assignable. That is, once a bank swaps MBS for gilts, it should be able to sell the MBS with the swap still in place, with the buyer having the obligation to repurchase the MBS at the contractual maturity of the swap and deliver gilts. This would help to liquify the MBS market by allowing them to trade with financing in place.

Amplified mortgage portfolio super seniors: a really bad idea

The UBS shareholder report on the firm's subprime losses makes fascinating reading and I will try to return to it later in the week. Meanwhile however it is worth noting that a major cause of the UBS losses were AMPs. Let the report take up the story:

[AMPs] were Super Senior positions where the risk of loss was initially hedged through the purchase of protection on a proportion of the nominal position (typically between 2% and 4% though sometimes more). This level of hedging was based on statistical analyses of historical price movements that indicated that such protection was sufficient to protect UBS from any losses on the position.

Let's try and tease this apart. The bank is long the supersenior tranche in a CMO. They 'hedged' this position by buying credit protection on the underlying mortgage portfolio in an amount calculated to minimise short term P/L volatility. I think.

Isn't this pure gaming of the VAR model? This 'hedge' dramatically reduce the VAR. But losses build up in the junior and rise through the mezz, the bank will need to short a larger and larger percentage of the underlying mortgages to remain hedged. In other words this position is massively short credit convexity even if it is credit delta neutral. And even that is assuming that you can short more of the underlying pool into a falling market, an assumption that is highly questionable.

Anyway, even if the AMPs position was not designed to game the VAR model, it certainly achieved that effect:

Once hedged, either through NegBasis or AMPS trades, the Super Senior positions were VaR and Stress Testing neutral (i.e., because they were treated as fully hedged, the Super Senior positions were netted to zero and therefore did not utilize VaR and Stress limits). The CDO desk considered a Super Senior hedged with 2% or more of AMPS protection to be fully hedged. In several MRC reports, the long and short positions were netted, and the inventory of Super Seniors was not shown, or was unclear.

(See here for a discussion of negative basis trading.) For something like this there is real danger that the system's view is seen as the only reality. If the VAR model says there is no risk, the firm might actually think that's true.

Next we come to model risk:

The AMPS model was certified by IB [UBS investment bank] Quantitative Risk Control...but with the benefit of hindsight appears not to have been subject to sufficiently robust stress testing. [...] The cost of hedging through a Negative Basis trade was approximately 11 bp, whereas the cost of hedging through an AMPS trade was approximately 5 – 6 bp.

So, a positive carry asset hedged very cheaply but leaving a large short gamma position which was not captured by the firm's risk model. They really were asking to be creamed by a big market move. And then one came along.

My book has just been published

Finally Understanding Risk: The Theory and Practice of Financial Risk Management has appeared. Here's a link for amazon. The high level contents follow:

Part One: Risk Management and the Behaviour of Products
Chapter 1 Markets, Risks, and Risk Management in Context
1.1 Financial Markets Overview
1.2 Trading and Market Behaviour
1.3 Basic Ideas in Risk Management
1.4 Culture and Organisation
1.5 Some External Constraints

Chapter 2 Derivatives and Quantitative Market Risk Management
2.1 Returns, Options, Sensitivities
2.2 Portfolios and Risk Aggregation
2.3 Understanding the Behaviour of Derivatives
2.4 Interest Rate Derivatives and Yield Curve Models
2.5 Single Name Credit Derivatives
2.6 Valuation, Hedging and Model Risk

Part Two: Economic and Regulatory Capital Models
Chapter 3 Capital: Motivation and Provision
3.1 Motivations for Capital
3.2 Capital Instrument Features
3.3 Regulatory Capital Provision

Chapter 4 Market Risk Capital Models
4.1 General Market Risk Capital Models
4.2 Some Limitations to and Extensions of Value At Risk Models
4.3 Risk Systems and Risk Data

Chapter 5 Credit Risk and Credit Risk Capital Models
5.1 The Banking Book: Introducing the Products and the Risks
5.2 Credit Risk for Small Numbers of Obligators
5.3 An Introduction to Tranching and Portfolio Credit Derivatives
5.4 Credit Portfolio Risk Management
5.5 Political and Country Risk

Chapter 6 Operational Risk and Further Topics in Capital Estimation
6.1 An Introduction to Operational Risk
6.2 The Tails and Operational Risk Modelling
6.3 Allocating Capital and Other Risks

Chapter 7 Bank Regulation and Capital Requirements
7.1 Regulatory Capital and the Basel Accords
7.2 Basel II: Beyond the capital rules

Part Three: Treasury and Liquidity Risks
Chapter 8 The Treasury and Asset/Liability Management
8.1 An Introduction to Asset/Liability Management
8.2 Banking Book Income and Funding the Bank
8.3 ALM in Practice
8.4 Trading Book ALM

Chapter 9 Liquidity Risk Management
9.1 The Liquidity of Securities and Deposits
9.2 Liquidity Management
9.3 Contingent Liquidity and Contingent Funding
9.4 Stresses of Liquidity

Part Four: Some Trading Businesses and their Challenges
Chapter 10 An Introduction to Structured Finance
10.1 Contractual Relations
10.2 Asset Backed Securities
10.3 Securitisation Structures and Technology

Chapter 11 Novel Asset Classes, Basket Products, and Cross Asset Trading
11.1 Inflation-linked Products
11.2 Equity Basket Products
11.3 Convertible Bonds
11.4 Equity/Credit Trading
11.5 New Products

Why the long ABS?

Gillian Tett comments on the large supersenior ABS holdings at Merrill and UBS in the FT backed by mortgages on properties like the fine abode above:

Most notably, as these banks have pumped out CDOs, they have been selling the other tranches of debt to outside investors – while retaining the super-senior piece on their books. Sometimes they did this simply to keep the CDO machine running

Absolutely. And also as a funding arbitrage: for a bank that funds at Libor flat and views supersenior as risk free supersenior paying Libor plus ten is a good investment. Tett continues:

[Since] super-senior debt carried the AAA tag, banks were only required to post a wafer-thin sliver of capital against these assets

Again true, but I doubt that the advantageous reg. cap. position of these assets was that important. Any low volatility bond would do in a VAR setting, or any internally highly rated one under Basel 2 in the banking book. And there are plenty of AAAs that yield more than Libor plus ten. The real issue is the risk assessment: some banks managed to persuade themselves this paper was risk free. And that brings us nicely to an article in the WSJ on how exactly the firm got to that assessment. Enjoy.

The French food system

The Credit Crunch is providing more than enough material for musing on how the rules of a system determine the kinds of behaviour it displays, but just for once I'd like to consider another example: food in France. This blog was named partly in honour of the Italian coffee 'system', a set of assumptions, ways of doing business, and historical precedents that results in it being trivially easy to get a wonderful cup of coffee for very little money nearly everywhere in Italy. Things used to be similarly positive for the gourmand in France. Even cheap restaurants were good and most basic food suppliers were competent or better.

A recent trip to Normandy suggests that things are beginning to fail. The average quality of the vegetables and the fruit in the local market I visited was good, but there were a number of examples of poor produce. The local cafe served bitter, thin coffee. I even found an indifferent patisserie.


The thought that this is part of a wider trend is rather troubling. One can forgive the French their contrary nature and chronic under-productivity if they live well and enjoy life. But if the cheese stops stinking and the steak frites don't come with a fantastic Bearnaise, the deal looks rather less attractive. Could it be that the growth of two job partnerships, longer working hours, and changing retail patterns is poisoning the French food system? Is the cancer of German food habits metastatising across Europe? What a horrible thought...

Update. See here for a story from the Guardian about a conflict between large and small Camembert producers. The idea that industrial scale Camembert production is even permitted strikes me as bizarre.

JP's capital raising

Why is JPM raising new capital? Better commentators than me seem confused, but isn't it just the Bear portfolio? JPM's sweetheart deal with the FED amortises over eighteen months and so they need new capital to support the extra Bear assets. And the cost of this capital?

The non-cumulative securities priced to yield 419 basis points more than U.S. Treasuries due in 2018 and pay a fixed rate of 7.9 percent for 10 years.

Yesterday's Basel press release

On Wednesday the Basel committee announced some changes to the Basel II framework. The press release is fairly short on detail, but it does give some insight into the forthcoming detailed proposals. Let's take a look.

The Committee reiterates the importance of implementing the Basel II framework.

This is shorthand for 'please Mr. Fed would you implement our Accord?'

...the Committee will revise the Framework to establish higher capital requirements for certain complex structured credit products, such as so called "resecuritisations" or CDOs of ABS.

Clearly CDO squared products and CDOs of tranched ABS have been a major issue so this is reasonable. But CDOs of pass throughs have much less model risk and behave in a much smoother fashion so I hope these will not be tarred with the same brush.

It will strengthen the capital treatment of liquidity facilities extended to off balance sheet vehicles such as ABCP conduits.

The issue here is implicit support: legally many of these lines were low risk, but reputational concerns forced banks to provide support where it was not contractually required. Rather than charging for liquidity, which will simply encourage the use of non-bank liquidity providers, the committee should cap the benefit available for securitisation.

The Committee will strengthen capital requirements in the trading book... The Committee ... is extending the scope of its existing proposal guidelines for "incremental default risk" to include other potential event risks in the trading book ... (planned 2010).

This is so frustrating. The capital requirements in the trading book are already high compared with the banking book, and the incremental default risk proposals are hardly a model of cogency or risk sensitivity. If the trading book charges are imprudent then the banking book ones are far too low. They should also be revising the correlations in the IRB formula and increasing the risk weights for risk below BBB- in the revised standardised approach. And surely they can get their act together a little faster than 2010?

The Committee will monitor Basel II minimum capital requirements ... over the credit cycle... [and] will take appropriate measures to help ensure Basel II provides a sound capital framework

So no discussion of procyclicality and no acknowledgement of the need for anti-cyclical capital requirements especially for fair value assets. This is disappointing. Basel II seems to have become a self-sustaining industry where wholescale change is almost impossible. The extended timeframes and modest revisions are evidence that major regulatory change will need more impetus than just the biggest banking crisis in a generation.

In July the Committee will publish for consultation global sound practice standards for the management and supervision of liquidity risks.

What about capital for liqudity risk?

Weaknesses in ... valuation practices for complex products have contributed to the build-up of concentrations in illiquid structured credit products and the undermining of confidence in the banking sector. The Committee is taking concrete action to promote stronger industry practices in this area.

What pray might those be? If it doesn't trade, it isn't Level 1. Stronger practices whatever they may be need to acknowledge that fair value is often an estimate and that uncertainty in valuation will always be with us. This is fundamentally an investor education problem: equity holders suffer the same realised earnings volatility whether the asset is fair value accounted or not; hiding that volatility via loan loss provisions in the banking book just turns the spotlight away, it does nothing about the real risk. Supervisors seem to be aware of the issues with structured credit in a fair value context but reluctant to acknowledge that these risks are still there in an accrual context, just concealed by the accounting.


Are these changes going to help? A little, although putting a charity slot in the wall of the BIS might be more effective: there is much more that needs to be done, and done quickly.

The importance of non-deposit-taking financial institutions

I'm away from my desk at the moment so posting volume is reduced, but I do want to draw attention to an excellent piece by David Roche in the FT. Firstly he points out the importance of non banks to the liquidity of the US financial system:

The Federal Reserve has belatedly recognised that investment banks, hedge funds and other non-deposit-taking financial institutions are as vital as banks to both the financial and "real" economies. The Fed is lending them massive amounts of capital through newly created facilities. It is right that central banks should be able to do so; NDFI's create more "asset money" than banks but are much riskier institutions.

NDFIs, though, are not regulated as deposit takers, and in particular the broker/dealers benefit from SEC supervision. As David continues:

What is wrong is that the Fed is doing so without having oversight or supervision of the borrowers.

He then looks at both the size and the velocity of NDFI money:

Investment bank, hedge fund and broker balance sheets are about half the size of the commercial banks in the US and about one-quarter the size in Europe. Both assets and liabilities of NDFIs are dominated by repos, meaning that NDFIs lend and borrow based upon collateral of assets that are constantly marked to market. As asset prices fluctuate, leverage must constantly be adjusted.

This is related to the procyclicality of a leveraged fair value player as I discussed here. As David explains:

In a bear market, as asset prices fall, leverage is reduced. This causes lenders to ask for more collateral on existing loans and borrowers to sell assets so as to reduce the need for such loans and for additional collateral.

The opposite happens in a bull market when rising asset prices cause the balance sheets of NDFIs to expand. The liquidity this creates is used to invest in assets, boosting their prices and creating demand and collateral for more borrowing to make more investments.

So the balance sheets of NDFIs are highly geared to asset price cycles. They act in a pro-cyclical manner, reinforcing bull and bear market cycles and through them economic cycles. So the effect on "asset money" is greater than that of deleveraging by banks, which lend for a wider range of purposes than NDFIs.

Quote of the day

Self-regulation stands in relation to regulation the way self-importance stands in relation to importance

Willem Buiter

Buyers vs. Financers

There has been some discussion recently of the central banks buying assets such as RMBS rather than simply providing financing for them. Intuitively I am less enamoured of this idea. Some of these assets may indeed represent a screaming buy at current levels, but I find it hard to believe any government body would have the expertise to assess that. Moreover many of the sellers are reluctant to trade at the current level, and the moral hazard of buying above the market is evident and insupportable. Perhaps instead the central banks could provide a financing wrapper to encourage liquidity in the market. Much like a bond wrap is a guarantee that if the bond does not pay then the wrapper will, so a certificate of finance would allow the holder of the bond whoever they may be to access the central bank window to finance the asset (with an appropriate haircut). The certificate would be specific to the asset so the central bank could target the financing appropriately, and it could have a reasonable but not excessive life - a year, perhaps.

Update. If the Bank is going to offer 2 way repos, ABS vs. gilts, then just make these repos assignable so the bank can sell the ABS with the repo in place. Job done.

What embarrassment happened...

...to Japan some years ago and now might just possibly be on the cards for the U.S.? Losing their triple A. The WSJ reports:

The performance of government-sponsored enterprises like Fannie Mae and Freddie Mac could have a direct impact on the national economy and, more importantly, U.S. credit standing.

So-called GSEs enjoy implicit government guarantees and could cause the U.S. to lose its sterling triple-A rating if the government were forced to come to their rescue, Standard & Poor's said in a report Monday.

Add the FHLBs into that mix, and you do have a combustible mixture.

Update. FT alphaville has this picture to show the importance of the GSEs portfolios to the banking system.
Just look at how that river of mauve is widening across the page. Meanwhile the WSJ estimates the cost of bailing out Fannie and Freddie at 10% of GDP.

Surviving Gatwick North

If you are ever stuck in the noisy, dirty hell that is Gatwick North and are faced with a queue of 50 people just to buy a cup of coffee, make your way towards Gates 101-114. You will ascend over a spectacular bridge, then find yourself in a quieter waiting area with a much less busy cafe. Of course you might well have to make your way back when it is time to go to your gate, but waiting in this satelite is a good deal less nasty than in shopping centre that is the main hall, at least until the government has the balls to renationalise BAA.

Saturday positions

It is time to look at the blog's fantasy global macro portfolio.

• A short in gold. After a scary moment this came back but now it doesn't seem to be going anywhere. Take it off: the time will come for this position but it is probably later in the cycle.
  
• Long the iTraxx and short the components stock. I still like this and it has performed reasonably but the short is starting to hurt despite the spread tightening. Keep a close eye on it and take the short off quickly if the equity rally seems to be continuing.
  
• Long yen, short dollar. This has done very nicely but with the possibility of concerted intervention it is time to take the money and run. One might even think about a cautious long dollar short euro position at this point.
  
• A modest long MBIA and Ambac stock. This is a weird play because I think fundamentally neither of these companies are worth anything, but on the other hand I did believe that there were enough fools out there that the stock would rise in the short term, especially after the lack of ratings agency action. I was wrong. I'm tempted to keep the position for the moment but with a very tight stop on it.
  
• Long a first to default note on a basket of national champion banks. The yield here is very attractive and a play on too big to fail is attractive. Keep it.

The IMF Financial Stability Review: Chapter 2

Perhaps the most important part of Chapter 2 is a (mitigated) vote of confidence from the IMF in structure finance at the beginning:

Structured finance can be beneficial by allowing risks to be diversified

Before we get into the detail of the IMF report, that comment is worth noting. Now for the 'but's, or rather for my comments on selected 'but's.

• First a remark from the IMF about ratings: In particular, when reliable price quotations were unavailable, the price of structured credit products often was inferred from prices and credit spreads of similarly rated comparable products for which quotations were available. For example, the price of AAA ABX subindices could be used to estimate the values of AAA-rated tranches of mortgage-backed securities, the price of BBB subindices could be used to value BBB-rated MBS tranches. [...] In this way, credit ratings came to play a key mapping role in the valuation of customized or illiquid structured credit products, a mapping that many investors now find unreliable. This is important and has not received that much comment thus far. Many firms are currently marking a lot of ABS, some of it rather different from typical US subprime, as a spread to the ABX. They are doing this because they can't think of anything better to do. But of course this only works if AAA ABX is comparable with AAA something else. So not only were ratings important for some purchasing decisions, they continue to be important for marking inventory. Which is scary.
  
• Credit rating agencies insist that ratings measure only default risk, and not the likelihood or intensity of downgrades or mark-to-market losses, many investors were seemingly unaware of these warnings and disclaimers. True, but really can we have a small does of caveat emptor please?
  
• Next a very sensible observation on fair value: Accounting frameworks require professional judgment in determining the mechanisms for fair value, including the use of unobservable inputs in cases of the absence of an active market for an instrument.
  Such judgment allows the possibility of different outcomes for similar situations, which in times of market uncertainty may compound the risk of illiquidity. As instruments turn illiquid moreover, they move from level 1 or level 2 of the FAS 157 hierarchy to level 3. The IMF notes that some people have drawn the wrong conclusion from this:investors seem to have a perception contrary to what the standard setters intended because a firm risks a negative market reaction with a reclassification of assets from level two to three, as events during the turmoil indicated.
  
• Reasonably enough, the IMF is concerned about SPV assets coming back on balance sheet at the worst possible moment, with no hint prior to that of the exposure. They opine:investors would benefit from more comprehensive regulatory requirements for disclosures about the scope and scale of exposures to OBSEs. [...] Increased disclosure achieved through consolidation or some form of parallel disclosures of an entity’s unconsolidated and consolidated positions also means these entities have a direct impact on the institution’s regulatory capital requirements, funding sources, and liquidity. (OBSE is IMF speak for SPV.) If this suggestion is taken seriously it will mean a huge change to IFRS. My sense is that the regulators will go further and faster than the accountants on this (not least because the accountants are saying “completing a final standard by mid-2011 will be extremely difficult, perhaps impossible”). Certainly caps on the regulatory benefit for securitisation are under active consideration.
  
• Will banks voluntarily take more of the OBSE’s assets onto the balance sheet to provide greater assurance to investors as to the vehicle’s quality? Only if that is the only way to get the securitisation market restarted and/or if regulators make them. Or should banks be required to retain a stake in the performance of these assets, thus having the incentive to conduct better due diligence? Yes.
  
• In general, variations in the regulatory treatment of securitization among different types of financial institutions may provide an opportunity for regulatory arbitrage across financial sectors. Some securitization exposures are evaluated for regulatory purposes differently for insurance companies than for banks. Finally in between congratulating themselves on the level playing field between banks someone in the supervisory community has noticed that the playing field between banks and non-banks is far from level. Basel 2 is flawed in many ways but it looks pretty good compared with insurance capital requirements for the monolines.
  
• Finally it is worth noting that the banks did not play the SIV and conduit game cynically: many of them seemed to have believed that risk really had been transferred. Or as the IMF puts it the perimeter of risk for financial institutions—that is, the risk assessment of all of an institution’s activities, including its related entities—did not adequately take into account the size and opacity of institutions’ exposures to SIVs, commercial paper conduits, and their related funding support. Given the size of the SIV and conduit activity, this failure of risk assessment is a big deal for the banking system.
  

The IMF Financial Stability Review: Chapter 1

I have held off for a couple of days on commenting on this document not least because it is large, dense, and worth reading carefully. There is an awful lot of information in the full text here -- the executive summary is here. In this post I will comment on chapter 1: posts on subsequent chapters will follow later in the week.

My tuppence ha'penny:

• The headline credit crunch loss predicted by the IMF of $1T has received a lot of press, not least because it is rather larger than the $460B some other commentators have been focussed on. Firstly no one really has any idea at this stage, and secondly it is half the estimated value destruction in the 1994 bond market crisis; so while it is a large number, we should not be too freaked by it.
  
• There is a lot of good information in the report. For instance this table showing the dependence of a number of European banks on wholesale funding, may be of use in selecting your next short. Just remember it is hard to make money shorting the Republic of France or its wholly controlled subsidiaries.
  
  
• According to the IMF there has been a massive rise in leverage of global banks. The report has this picture showing the growth of Bank assets and Basel 1 risk weighted assets, which I don't understand.
  
  Here's my problem. Consider the Basel 1 risk weights:
  
  

  Asset Class	Risk Weight
  Cash, Good quality sovereigns, Insured residential mortgages, short term commitments	0%
  Loans to banks and muni risk	20%
  Uninsured residential mortgages	50%
  Loans to banks and muni risk	20%
  All other loans	100%

  
  If assets are above 15T and RWA are at 5T the average risk weight is roughly 35%. How can that be given the preponderance of corporate and retail risk in the system? Remember RWA also includes derivatives risk which is off balance sheet and not included as an asset, so this number makes even less sense. If anyone can explain how the average Basel 1 risk weight for the banking system comes out at less than 50%, I should be very grateful. Certainly if the data above is correct, the IMF's conclusion makes a lot of sense:

  Bank supervisors need to take more account of balance sheet leverage as they assess capital adequacy.

  
  
• The IMF seems to take a rather optimistic view of the effect of the credit crunch on the availability of credit. They forecast a slowing of the rate of growth of credit but not an outright contraction:

  The pace of credit growth in a squeeze would be reduced to a little over 4 percent of the outstanding private sector debt stock in the United States.

  I think that is wildly optimistic. Everything we are seeing from the retail and commercial mortgage markets, for instance, suggests that credit growth will be negative for the next half year at least.
  
• The IMF administers a richly deserved kicking to the monolines and their system of regulation:

  In the United States, the experience of the financial guarantors argues for reforms to U.S. insurance regulation.
  
  Responsibility currently resides with the states, which has impeded coordination of regulatory efforts across states and with federal bank and securities regulators where spillovers are now evident. A new strategy for regulation of the financial guarantor sector needs to be implemented, including a coherent approach to capital adequacy and new limits on financial guarantors’ activities.

  
  

Risk sensitivity bites

We knew in the abstract this happens, but seeing it in the particular is chastening. From FT alphaville, discussing research from Credit Suisse:

Risk weighted assets and capital ratios under Basel I were relatively static. But that is unlikely to remain the case under the new variant. Risk weighted assets will move with the probability of default and the loss given default within a bank’s loan book. A required deduction for “expected losses” from capital will also mean more volatility.

The principles apply across a range of lending, corporate and unsecured, but it is the sensitivity of risk weighted assets to the UK housing market that has got Credit Suisse issuing this alert.

The note then goes on to look at HBOS. In what follows italics are the FT and bold is the FT quoting Credit Suisse.

The movements are significant. A 10% fall in house prices increases both the EL and mortgage risk weighted assets at HBOS by about 50% on our estimates. A 20% fall in prices more than doubles them.

In addition, RWA could also rise as older, lower LTV lending is replaced with new, higher LTV lending, they add, meaning an overall forecast for a rise of 60 per cent if house prices fall 10 per cent, in line with CS forecasts.

At a group level, this would lead to an increase in RWA of about 7%. Simply applying the increased EL and risk weight to the 2007 Basel II figures reduces the equity tier 1 ratio from 5.7% to 5.3%, on our estimates.

Ultimately Credit Suisse argues that the changes under Basel II mean that the market will start to react to movements in banks’ reported capital ratios. That, in their view, is the main threat to share prices, with the impact of an economic slowdown and house price slide on reported ratios becoming as important as that on profits in future earnings rounds.

Anti-cyclical capital ratios anyone?

Respect for the valuation bogie man

The FT has a rather alarmist article about ABS valuation. Unsurprisingly to anyone who has been in the market, but a surprise apparently to a regulator was the fact that for some ABS

There was little confidence about how to value the holdings

The wrong conclusion is drawn from this

To an extent, the valuation problem for CDOs reflects the fact that the frenetic pace of innovation seen in the financial industry this decade has outpaced the development of its infrastructure. [...]

But unless circumstances arise that force a market trade, valuations often remain at the investment managers’ discretion. While managers say they strive to assign honest values, these are often difficult for an outside accountant to verify, since the techniques used are invariably highly complex.

The market infrastructure isn't the problem and neither is the complexity of the techniques used. It is simple old fashioned invisibility of the model inputs. Let's take a German middle market corporate with no issued bonds and privately held equity. What is the fair value spread for a loan? Well, there are things you can do based on discounted cashflows and models of corporate structure and so on, but they are approximate. If you came to try to sell that loan, you might get a different price from your model. It is the same with IPOs (which is why there is a pricing range which is often revised before the company comes to market).

There may well be problems with CDO models - the right choice of copula is unclear in some situations for instance. And market infrastructure is not perfect, particularly on the legal side. But fixing these issues won't give a market price to something that does not trade. It might however help if commentators who are perfectly comfortable with utterly subjective loan loss provisions in the banking book accepted that when the same kind of assets are subject to fair value the determination of those fair values can be problematic. That doesn't mean the assets are bad, just that market participants need to understand and manage valuation risk.

The place this really gets delicate is when actions depend on estimates of fair value, for instance in a SIV where the definition of solvency might depend on the ratio of the FV of assets to the notional of liabilities. Writing that kind of clause is asking for trouble if there is any doubt that the FV of the assets is easily determined.

The backlash continues

Commenting on the Paulson proposals for overhaul of the US system of financial regulation, I said:

I still think the political battles will be prolonged, that they are likely to result in watering down of even these fairly modest proposals, and that this is not nearly enough.

The next round of those battles has started. Bloomberg reports:

Three former leaders of the U.S. Securities and Exchange Commission say the Bush administration's proposed overhaul of financial regulation threatens to weaken the agency, a process that may already be under way with help from the SEC itself.

David Ruder, Arthur Levitt and William Donaldson, all former SEC chairmen, said a Treasury Department push for the agency to adopt the regulatory approach of the much smaller Commodity Futures Trading Commission would be a mistake.

It's ``not useful'' for the SEC to have ``a prudential-based attitude in which regulators solve problems by discussing them informally with market participants and ask them to change,'' Ruder, a Republican SEC chairman under President Ronald Reagan, said in an interview. ``We have to have an enforcement approach.''

Levitt, who led the SEC from 1993 to 2001 under President Bill Clinton and who supports an SEC and CFTC merger, says the terms proposed by Treasury are ``wrongheaded'' because they would give the trading commission ``primacy.''

SEC Chairman Christopher Cox, 55, hasn't endorsed a merger between the two agencies, said SEC spokesman John Nester. ``He would insist on a system of oversight that best protects investors, promotes fair markets and facilitates capital formation.''

Culture wars are inevitable in any merger. Personally I think an old style SEC (rather than the watered down current version) made for an effective conduct of business regulator. Its regulatory capital regime is, however, badly flawed and potentially imprudent, and taking that aspect away from the SEC would make a lot of sense. Presumably none of this is going to happen before Bush departs so the wars will last a while. So talking of old conflicts, here is the church which currently occupies the site where Joan of Arc died.

Towards a quantitative hedonics

It is possible to support the general theme of a body of work without thinking any particular part of it is interesting or successful. Susannah Clapp captures the phenomenon nicely in a Guardian review of the play Contains Violence at the Riverside studios. Here the audience sit on the roof of the theatre and observe the action in adjacent buildings through binoculars.

In Contains Violence the spectators aren't in the same building as the actors. You make up your own long-shots and close-ups, using their binoculars to zoom in and out at will; the headphones, which are designed to lock you into the action (you hear not just conversation but the slosh of water, the ring of a phone, the crackle of paper, the clink of a keyboard), also protect you from the sound of other audience members and from street noise. You are, weirdly, much further away from the actors than usual but aurally much closer up. Beneath the imaginary acts of violence, as in a dreamlike backdrop, buses pass by silently, pedestrians bustle, and ambulances speed to real emergencies. Occasionally, a non-actor - a cleaner or late worker - gets snarled up accidentally in the action.

So far, so illuminating: this inside-outsideness sets you up to look quite differently at your surroundings - which is not something The Importance of Being Earnest will usually help you do. But the exciting stuff has actually all happened before the show begins: this is a concept, an occasion, not a drama. Contains Violence has contrived the most thrilling of settings, but it doesn't manage to convey a real story or any richness of expression.

In other words, great idea, poor use of it. I feel the same way about quantitative hedonics. The idea of trying to use rigourous (OK, quasi-rigourous) economics to argue about happiness without all the usual moral biases or imposition of arbitrary utility functions is a good one. Most of the work in the area, however, disappoints. A good example is given by Jeremy Waldon in his review of Sunstein's Worse Case Scenarios in the LRB:

[Sunstein] is reluctant to abandon a method of measuring losses by how much people would pay to avoid them, even though it is hopelessly flawed by the fact that poor people would pay less simply because they have less. (We measure the value of a life by asking how much people would pay to avoid its loss, under various scenarios. Now, as a matter of fact, a poor person will not pay $100,000 to avoid a 10 per cent chance of death from cancer, because the poor person has no access to $100,000; so a poor person’s life must be worth less than a million dollars; and so it is not clear how the government can justify imposing taxes for a scheme that spends many millions of dollars to avoid this sort of hazard. That’s the sort of argument this book is inclined to defend.)

On this basis preventing jeering at polo matches is a much more important aim than giving clean water to sub-Saharan Africa since polo players are wealthy and will certainly pay a lot to increase their comfort slightly, whereas the citizens of sub-Saharan Africa are mostly (in dollars a day terms) very poor. So Waldon has a point: cash only works as a measure if we are comparing the happiness of people with roughly the same amount of disposable income. Even percentage of disposable income does not mean much to people who don't have any. So how can we compare two regulations or two pieces of charity or whatever rigourously in terms of their outcomes? That, it seems to me, is an important question for quantitative hedonics.

Inadequate broker/dealers?

Bloomberg has an interesting article on Goldman which again highlights the preferential capital position of the US broker/dealers vs. the banks.

Less than 48 hours after a government-backed deal rescued Bear Stearns Cos. from bankruptcy, David Viniar, Goldman Sachs Group Inc.'s chief financial officer, was asked if the crisis would have ``permanent implications'' for Wall Street's appetite for leverage. His answer: ``No, I don't.''

Tell that to his rivals, most of whom are selling assets, raising additional capital and hoarding cash as they grapple with unprecedented losses. The financial industry has booked more than $230 billion of writedowns and losses, as debt securities, mostly held with borrowed money, plummeted in value.

Goldman alone is holding course, refusing to trim its leverage, a measure of how reliant a firm is on debt. The adjusted leverage ratio of assets to equity jumped to 18.6 at the end of February, from 17.5 at the end of November. ``We have no need as we sit here right now to shrink our balance sheet,'' Viniar told analysts on the March 18 conference call.

Now we don't know what the composition of Goldman's BS is. But it is safe to suggest most of it will be assets that are 100% weighted under Basel 1. On that crude basis, Goldman's capital ratio is roughly 5.4% (= 1/18.6) vs. a minimum of 8% for a bank. Surely this at least suggests the possibility of smelling a rat?

Update. Another Bloomberg article puts a more diplomatic version of the same question:

The U.S. has allowed a number of institutions such as Bear to emerge that really are in the business of doing what banks do but haven't been folded into the banking system in a way that affords them the same kind of protection from runs that banks have.

How much do traders care about capital models?

I have written before on the perverse incentive in risk sensitive capital models such as VAR, and on the suboptimal design of the Basel 2 capital accord. Reading a guest post by Avinash Persaud on Willem Buiter's blog, however, I wondered how much this matters. Let me explain. Persaud rightly points out that everyone uses roughly the same sort of market risk capital model and as a result everyone has roughly the same view of the capital against a given portfolio. Moreover this number changes as the models are recalibrated to include more recent data and thus if vols rise, capital does too. But I wonder if Persaud goes too far in what he says next:

Market participants don’t stare helplessly at these results. They move into the favoured markets and out of the unfavoured. Enormous cross-border capital flows are unleashed. But under the weight of the herd, favoured instruments cannot remain undervalued, uncorrelated and low risk. They are transformed into the precise opposite.

In a crisis certainly everyone covers at once, or at least sufficiently many people do in a sufficiently short period of time to cause illiquidity and rapid price falls. Most of the time however most traders do not use VAR to optimise their portfolios. They see VAR as at best an inconvenient limit. So they don't move into markets their firm's capital model favours: they move into markets their gut instinct, their broker or their boss favours. While capital models (and risk limits phrased in the same terms) do create an incentive structure, they are not the only nor even the most important determinant of an institution's risk profile. It would undoubtedly be a good idea to fix these unhelpful incentives. But we should not over-egg the cake by suggesting that capital models actually change bank's behaviour much except at the margin.

Fitch got there in the end

From Bloomberg:

Fitch Ratings cut MBIA Inc.'s insurance unit to AA from AAA, saying the bond insurer no longer has enough capital to warrant the top ranking.

MBIA, the world's largest financial guarantor, would need as much as $3.8 billion more in capital to deserve an AAA, New York-based Fitch said today in a report. The outlook is negative, Fitch said.

Fitch issued the new, lower rating even though Armonk, New York-based MBIA asked the ratings company last month to stop assessing its credit worthiness.

My guess would be that Moody's and S&P won't crack under this news despite the evident fillip to Fitch's reputation. Which is a shame.

JPM can't bear the Bear...

...or at least its assets. They have asked for and received from the FED two waivers:

• One on affiliate exposure between them and the acquisition vehicle (which seems reasonable); and
  
• One on calculating regulatory capital on the Bear's risk weighted assets.

Specifically they can exclude risk weighted assets which came from the Bear for eighteen months in their total risk weighted assets calculation up to a total cap which starts at $220B and decreases by $36.6B (a sixth) every quarter. They can also exclude these assets in their Tier 1 calculation, this time with a straight line amortising cap initially set at $400B.

I asked earlier in a discussion of the small amount of capital the Bear had what capital it would have required had it been regulated as a bank. It seems in the light of the above that we will not find out the answer to this. I find this disturbing. For the FED to grant this exemption with the size of the issue being public is one thing. For them to keep the size of the exemption secret is entirely different and much more worrying. How can the market possibly understand JPM's real leverage without knowing what their true capital adequacy is? At very least the FED ought to require JPM to calculate and disclose their total capital and tier 1 ratios both with and without the Bear's RWAs every quarter.

Under Basel 2 there is no easy way of estimating the size of the problem. Lacking any detail the best we can do is a Basel 1 estimate, which would suggest that the waiver is worth $16B of Tier 1 (8% x $400B x 50% since 50% of capital requirements have to be supported by Tier 1) and $8.8B of Tier 2Assuming a 15% cost of Tier 1 and 10% for Tier 2, that is worth $3.2B a year. That's a nice exemption for JP, and scant crumbs for the rest of us.

The Northern Rock fallacy

The Bear failed for exactly the same reason as Northern Rock it seems. From the FT, reporting Christopher Cox's testimony to the Senate:

Mr Cox said Bear had been hit by an unprecedented situation in which it had been unable to access liquidity. He said that “what [no] … existing regulatory model has taken into account is the possibility that secured funding, even that backed by high-quality collateral such as US Treasury and agency securities, could become unavailable. The existing models for both commercial and investment banks are premised on the expectancy that secured funding, albeit perhaps on less favourable terms than normal, would be available in any market environment.”

Now I can understand Northern Rock thinking that the secured and interbank markets would not shut to them at the same time. But what I can't understand is why, having seen what happened to the Crock, the Bear thought it could not happen to them.

A billion here, a billion there

After the pain comes the recap. Again some of the larger numbers from a table on Bloomberg:

Firm	Capital Raised	Breakdown
Citigroup	30.4	Govt. of Singapore (6.9), Kuwait Investment Authority (5.6), Abu Dhabi Investment Authority (7.5), Public investors (10.4)
UBS	27.2	Govt. of Singapore (10.9), Anon. middle east (2), Public investors (14.8)
IKB Deutsche	13.2	German government, Banking associations
Bank of America	13	Public investors
Merrill Lynch	12.2	Korea Investment Corp, Kuwait Investment Authority, Mizuho, (jointly 6.6), Temasek (4.4)
Soc Gen	8.7	Public investors
WestLB	7.8	Nordrhein Westphalia, Sparkassen
Morgan Stanley	5	China Investment Corp.
Barclays	5	China Development Bank (3), Temasek (2)
Lehman	4	Public Investors
[...]
TOTAL	135.8

Several things are interesting about this. Firstly comparing the total recap, 135B, with the total losses, 231B, we see that there has been a substantial net reduction in wealth of the banking system. Secondly some of the recaps have been larger than the losses sustained (e.g. WestLB, BofA) so either the losses table does not reflect all crunch related losses - a likely explanation - or institutions are choosing to raise new capital in the current environment, perhaps to delever.

There are several indicators for the end of the crunch such as the Base rate/Libor and longer dated swap spreads, the iTraxx IG spread and Libor/GC spreads, but one of them has to be the end of the recaps. Until the banking system has fully recapitalised I think a recovery is unlikely whatever the equity market is saying.

To end, for the visually minded, a slightly trimmed version of a graphic from the NY Times, showing the flow of funds in some of the larger recaps.

The beginning of the end?

Reuters: Some homes worth less than their copper pipes

Bloomberg: Stocks rose in Europe and Asia, led by banks and insurers, as investors speculated financial firms will weather credit-market losses.

Does this make sense?

Capital: breaking the cycle

One possible counter to the problem of procyclical leverage I discussed earlier is countercylical capital requirements. Willem Buiter discusses these in his FT blog, and makes a few interesting suggestions.

1. Regulatory capital adequacy requirements should apply to all highly leveraged financial institutions. Just to get around the obvious wheeze of the treasury department of a bicycle manufacturer being turned into a de-facto financial intermediary, the capital adequacy requirements should be applied to any highly leveraged institutions, whatever its label.

Hmmm. This is slightly problematic because some of these firms, perhaps most of them by number, neither have deposit insurance nor pose systemic risk. Imposing capital requirements on smaller firms reduces the diversity of the financial system and encourages larger firms. I cannot see a fair way of shading between large/systemically risky/should have capital and small/systemically not risky/does not need capital, but certainly applying capital to everyone is not necessarily the best way of ensuring financial stability.

2. Regulatory capital adequacy requirements should be counter-cyclical - they should be raised (by the central bank) during periods of boom and lowered during periods of bust. This will also help remedy one of the problems with the Basel I and II Accords.

Absolutely. And the mechanism to do this is available under Pillar 2. FSA could easily, for instance, have cycle-dependent trigger and target ratios. This is possibly the single most important policy change we need.

3. There should be regulatory leverage ceiling for all highly leveraged institutions. This ceiling should again be varied countercyclically by the central bank: the ceiling will be lower during booms and higher during busts.

If regulatory capital makes sense then this will happen anyway under 2. One important issue is that at the moment off balance sheet leverage is not captured by capital: if you fix that and a few other loopholes, then 2. should imply 3.

4. There should be regulatory maximum liquidity ratios (say ratio of liquid assets net of liquid liabilities to total assets) for all HLIs. This ratio should again be varied countercyclically by the central bank.

Yes, but the devil is in the detail in defining liquidity ratios. For instance backup CP lines were thought to be very low risk until the crunch. Preventing arbitrage of these rules will need careful initial drafting and then regular review to ensure they remain relevant.

5. Maximum loan-to-value ratios for all collateralised borrowing (including mortgages). Again, these ceilings should be raised during a slump and lowered during a boom.

An excellent idea, although these LTVs will have to be asset class specific, and figuring out how to change them in a prudent manner will also require a lot of work. Step function changes might be problematic, so finding a function of macroeconomic variables which automatically determines today's (or at least this month's) maxLTV is important.

[...] My examples are not meant to be exhaustive, just illustrative. They share the feature that they don’t have Fed staff crawling through the darkened corridors of investment banks at night. They require verification that the various credit ceilings are respected, of course. But the ceilings themselves are varied according to macroeconomic conditions, not firm-specific circumstances.

Why wouldn't you want the FED crawling through the banks at night, or indeed during the day? In particular, how can you ensure that a firm is doing the above correctly without supervision? The contract should be If you are a financial institution that either poses systemic risk, or can draw on central bank liquidity, or offers a product that is government insured (such as a bank deposit or certain kinds of insurance) then you have regulatory capital requirements and you are supervised.

The enumeration of pain

Following yesterday's writedown and capital raising from UBS, Bloomberg has a very useful summary of the pain so far. Here are the losses which total over $5B: follow the link for the rest.

Firm	Writedown	Credit Loss	Total
UBS	38		38
Merrill Lynch	25.1		25.1
Citigroup	21.4	2.5	23.9
HSBC	3	9.4	12.4
Morgan Stanley	11.7		11.7
IKB Deutsche	9		9
Bank of America	7.3	0.9	8.2
Deutsche Bank	7.4		7.4
Credit Agricole	6.5		6.5
Credit Suisse	6.3		6.3
Washington Mutual	0.3	5.5	5.8
JPMorgan Chase	2.9	2.1	5
[...]
TOTALS	206	25.8	231.8

The fightback begins

CFTC Commissioner Bart Chilton courageously challenges rogue cop Vic Mackey Treasury Secretary Hank Paulson's plan. First he lauds the success of the CFTC regime:

Since we began using the more flexible principles-based regulatory regime, the worldwide derivatives sector has increased two-fold. But in the US, it has more than tripled.

Wow, what better measure of regulatory success could you find than volumes traded? Forget financial stability, forget public protection, just feel the volume. But I digress. Back to Bart:

It is my firm belief that merging financial regulatory agencies at this time could result in an unmitigated disaster given the vast differences in their diverse and often conflicting regulatory systems.

Ah. That kind of response might be a bit of an issue for Hank. But don't worry. The FT reports that Paulson

conceded on Monday that it could take “many years” to overhaul the US system of financial regulation.

Further trouble comes later in the same article:

In a sign of the difficulties that the Bush administration could face in Congress, Chris Dodd, chairman of the Senate Banking Committee, called the Treasury plan a “wild pitch . . . not even close”.

If this was Hamlet, we would only have got as far as Polonius in Act I, Scene III:

Neither a borrower nor a lender be;
For loan oft loses both itself and friend

Avoiding moral hazard, scandanavian style

Apparently Ikea has started to offer a new product using classic Scandi design, BankiRescu. The FED has been taking a few trips over to Elizabeth New Jersey to stock up. From the Telegraph:

A senior official at one of the Scandinavian central banks told The Daily Telegraph that Fed strategists had stepped up contacts to learn how Norway, Sweden and Finland managed their traumatic crisis from 1991 to 1993, which brought the region's economy to its knees.

It is understood that Fed vice-chairman Don Kohn remains very concerned by the depth of the US crisis and is eyeing the Nordic approach for contingency options.

If this is true, it is encouraging. Even if you don't follow historical precedents, understanding them is important.

[...] there was a major effort [in the Scandi rescue] to avoid the sort of "moral hazard" that has bedevilled efforts by the Fed and the Bank of England in trying to stabilise their banking systems.

To be fair, I would say more the Bank than the FED. For shareholders to get something if the bank is solvent at the time of rescue does not seem unreasonable, after the public purse has been reimbursed for the cost of funding the bank through the rescue. For them to get the share price at the point of rescue, or more, as may well happen in the case of Northern Rock, is pure moral hazard.

Norway ensured that shareholders of insolvent lenders received nothing and the senior management was entirely purged. Two of the country's top four banks - Christiania Bank and Fokus - were seized by force majeure.

"We were determined not to get caught in the game we've seen with Bear Stearns where shareholders make money out of the rescue," said one Norwegian adviser.

"The law was amended so that we could take 100pc control of any bank where its equity had fallen below zero. Shareholders were left with nothing. It was very controversial," he said.

Stefan Ingves, governor of Sweden's Riksbank, said his country passed an act so it could seize banks where the capital adequacy ratio had fallen below 2pc. Efforts were also made to protect against blackmail by shareholders.

Why 2% I wonder? Why not 8%? After all, if you view regulatory capital as providing a buffer for an orderly liquidation/takeover/whatever, once that buffer is breached, the bank's shareholders and management should lose control. In any case, the idea that bank stock is a fundamentally different thing from the stock of other companies, with a different insolvency regime, makes a lot of sense. That regime is triggered by capital inadequacy or liquidity problems, and at that point the management are out and the shareholder only gets something after the costs of the rescue are met.