You can take and tan my hide - just let me live!

Do you remember this time last year? Banks were down 12-18% compared to all stocks and had been falling since February and by the Summer short-sellers were on message. The Sub-prime crisis was deemed to have started in July. By November, writedowns totaled a few tens of $billions with total loss forecasts of $2-400bn. The ratings agencies had downgraded only a $100bn or so,unyil following Moody's new models announced August 16, after which it became clear that the vast bulk if not all mortgage backed assets were to be severely downgraded. Bankers were scrambling to uncover what their own exposures were and guilty colleagues were no doubt hiding the figures. But then, when they could agree the totals, how to mark them to market? The illiquid ABX index covering maybe $1.3tn of ABS and CDOs circulating but not getting many deal prices was showing falls in 3-4 months of as much as 60% for AA when junk-rated was 80% off! That just seemed to reflect forced-selling, so clever guys said let's examine the fundamentals; where are they? Delinquency rates were up but 90-day overdues had not yet risen much, doubling or tripling from 0.3% or so for some banks did not seem like a whole lot, except steep compared to any earlier known recession shocks!
A Bank of England study said guys, the models pricing these bonds are extremely sensitive - if you tweak one tiny part hey presto the value is up 35% and maybe you've just gamed the rating! It was clear that to tinker on fundamental and values would just crash to the bottom. Ratings agencies could keep an eye on a load of SIVs but found that so far none were yet threatening collapse until Moody's new model (to reflect fast rising mortgage defaults) based downgrades from August onwards (causing a tsunami of asset values wiped out) and when one hedge Fund, not a bank, bravely said it was valuing all its basement tranches to zero. Maybe that was part of a short-selling strategy or let's torch it and claim on the insurance - but I doubt that. The big monolines had seen their shares crash, but not because of claims so much as their balance sheets don't make sense! Yes indeedy, the accounting for all this was shot. If you are using 30 year old accounting systems that have long exhausted their capacity for more details and definitions, then the real stuff is somewhere in the front or middle office accounts, or just in spreadsheets. Recall yesterday Barclsy going to court to get a bunch of contracts excluded from the spreadsheets (28,000 cells) that formed the basis of their purchase from the undertakers of Lehmans US.
Then through the Winter and into the Spring, banks were adjusting their reported exposures, re-vising massively the mark-to-toxic numbers just days or hours before Q407 and Q108 result releases. The Japanese had a strong right not to M2M and use fair value based on hold-to-maturity so US and European firms followed suit and found various ways of doing similar that continued to be argued back and forth with the regulators warning about taking all that's off balance sheet back on or formally moving the toxic from trading to banking books. Shareholders all the while got little of transparent detail in the published accounts covered over with confident assurances. But, all knew that the market was dead. Some said let's just bury the toxic and dig it up again in maybe a few years from now. Those banks like UBS who put their hands up when the value of ABS performance was publicly reported in its retail investment funds, and then Citigroup, whose collateral managers grabbed Bear Stearns ABS/CDO collateral and sold the stuff at fire-sale thereby busting their own bank's assets too, these got slaughtered in their equity capital. With all the uncertainty about true accounting and risk downgrades threatening no wonder interbank liquidity dried. But in the last quarter the quality of detail in banks reporting their toxic exposures has not improved and does not seem to be doing so even now! Is this not also at the heart of the problem?
Today, analysts and FT and others look at CDS spreads as indicators of likely revival of interbank lending. And good to hear the outgoing Chairman of RBS (slogan: "make it Happen")say it is very likely that existing shareholders will take up their first refusel of £15bn new 12% preference share issue (after £5bn goes to governemnt) because they represent a great opportunity for profitable investment (subject to general shareholder vote who have mixed feelings?). When the deal was struck between bank and government it took a bunch of Credit Suisse analysts hours to figure out on a little plastic table in a corridor of No.10 working into the night going through RBS's books on laptops with spreadsheets! We trust adequate and true detail is now in the prospectus. We also have to await the responses of the ratings agencies to see if government stakes in banks (subject to shareholder approval) will result in risk upgrades despite the onrush of recession and 30% falls in banking activity and capacity that is reducing bank profits considerably, if the most recent quarterly results can be thus aggregated. Some profits are only that thanks to tax credits and some losses only that because of further toxic asset writedowns.
Can shareholders confidently buy, or the ratings agencies up-grade, banks before knowing exactly what is happening to the toxic assets and what precise exposure types those 'assets' are? They may be CDO tranches or derivatives thereof. They may be actual securitization tranches or loans to SIVs, guarantees, underwriting, insurance, potential legal risks including over toxic assets that were transferred off the books into customers' accounts, investment funds, and of course whatever is in arm's length remote vehicles that banks originated or added to with bits and pieces of other firms' securitizable assets. Is US TARP still going ahead now that the funding for it is down $250bn for US SARP?
The light at the end of the tunnel will only be when banks' reserve capital gets reinflated with shareholders' equity in ordinary shares and that seems far off until the toxic assets are Tarp'd, buried, sold or quarantined and legal and reputational risks are clarified and quantified. Everywhere flexibilities are creeping in to how banks mitigate or dilute mark-to-market prices wih hold-to-maturity, not-for-trading, turbulence-adjusted, fair values. Apart from the light at the tunnel's end being an oncoming R-train, or merely another better lit tunnel, there are also, to stretch the analogy, tunnels within tunnels. This may be a good time to be a money-broker. Money-brokers sit in the innermost tunnel of the interbank markets broking at narrowest spreads between banks anonymously until settlement details are exchanged when done deals may get cancelled or not once the lender knows the risk grading identity and name of the borrower. And therefore the moneybrokers may know better than others if interbank liquidity is improving?
The not so plain fact is that all round the wholesale financial markets are shredded whereby we cannot really know what explains the directions of cash markets in terms of investors real views and requirements. Much of the blame for the present crisis had been laid at the door of liberalisation such as Bill Clinton's repeal of Glass-Steagel and of banks thereafter engaging in conflicts of interest between investment and traditional banking and shifting too far into consumer credit and mortgages and asset securitization because corporates borrowed less and also went off-piste when borrowing by doing so via bond issues rather than bank loans, and when deposits failed to grow as households and corporates savings rates fell with falls in government borrowing, and then came the vast growth of shadow-banking and banks' determination to get a share of that action and engage more aggressively in proprietary trading.
What then of classic rules for shareholder investment fundamentals when so much is going on out of the glare of regulatory transparancy or of economic assessments of the banking sector when so much is off-balance-sheet and in alternative investment funds of the shadow-banking community? Equities are least traded OTC unless one counts as OTC markets that are internal to large instutional investors, trading internally between portfolios. Regulators and stock exchnages at one time tried to ban this, along with institutions having direct access to broking markets, crossing networks, dark pools, and tried to ban algorithmic black box trading, now supported by low latency arbitrage networks. Shadow and dark and black box stuff are so-called by being unregulated, not volume measured or quality reported, but at least in traditional OTC markets like money markets and FX counterparties usually know each other in the back office settlement if not always on the deal tickets. They cannot know all the day and own-account private traders who have access to derivatives and short-selling instruments and who may be proxies for bigger fish gaming and arbitraging end of day and just after closing prices. There are so many modern 'dark pools', internal and external crossing networks and exclusive club high tier private exchanges for transacting large sizes away from the main regulated markets to minimise market impact and hide market signals. Market impacts are also reduced but may be signalled ex post to the rest of the market in regulated derivatives exchanges. A great deal of portfolio restructuring is by buying and selling contracts in derivatives exchanges to avoid resort to the underlying cash market. Then too we learn that short-sellers via puts, EFDs, and inverse ETFs are worth about 30% of stock market turnovers and that a few $trillion a year or 40% of hedge funds' $3tn are devoted to shorting and that double-figure percentages of bank stocks have been regularly loaned out to short-sellers in recent weeks by money market funds, custodians, and institutional investors, which is like renting apartments to people you know will trash the premises at a cost to you way above the rent and deposit.
Stock exchanges and Regulators have tried over the years to defend the quality of markets, but for the last two decades these quality issues have all been disregarded in the interest of greater competition in market infrastructure to encourage innovation and ever lower transaction costs. Exchanges, banks, broker-dealers, market-makers, the major well-establish OTC markets, all are disintermediated and shredded to the point that even when Bloomberg and Reuters and the biggest Exchanges can still report reliable market prices, the fact is that we can no longer know what the quality of markets are generating those prices. Brokers and analysts read the crib sheets and media newss and give interviews to the FT and WSJ and join the talking heads on the tv about what sentiments pushed or pulled prices but much of this is just circular and almost subjective with insufficient or timely post-trade clearing and settlement data to know what was really happening - was the buying or selling by institutional investors, or private investors or hedge funds, short-sellers and day-traders? Is the sell-off due to a few big guys or lots of little guys, or delayed fed-through from derivatives markets or banks' de-leveraging? Does it matter if we don't klnow precisely. We knew better when market-makers and other broker-dealers spoke to buyers and sellers by phone.
In principle the more reasons that investors and traders have for buying and selling and the more choices on offer and the more regulated news the better because it is less possible for one or a few alone to move the market. But we need to be able to check that market quality is within acceptable bounds and that has certainly moved beyond today's regulators to ensure. The SEC is very impressive, but when it tried last time out to get more hedge funds transparency it was defeated in Federal court.
All that may have changed now that the general public and politicians are angered by what they see as dysfunctional amrkets and irresponsible players in those markets. The scope for legal remedy is enormous, and the sums involved are huge. We may now be entering a period of a decade or so when regulators who have hitherto deployed guidance principles and been reluctent to fix rules or make civil or criminal laws will be led by what the courts decide and even try to pre-empt those decisions now that governments share the liability of the banks and others.
Against all this turgid background, it seems to me and I'm sure many others, that a bigger priority has to be urgently given to TARP solutions and others directly related such as money market and credit derivative exchanges. Payouts of Lehmans CDS liabilities may be currently estimated at $6bn only, but law suits on CDS and the underlying concerning Lehmans are estimated by some lawyers to be hundreds of $billions, in fact nearly $1trillion! Luckily when JPM took over Bear it could cancel a lot of the liabilities between them. Precedents for what happens when this is not done includes Japan in the '90s. The Japanese and SE Asian banks took years to work through loss provisions after their crises in the '90s. If the the litigation culture and legal system of Japan had been anything like the US, the motivation to do more and faster to salve the problems would have been immense. In Japan the economy continued to suffer because household mortgage borrowers remained saddled with enormous lifelong and even triple-generation debt.
We do not have a functioning TARP system anywhere yet, though in the US new clearing standards have been written for CDS and DTCC, Chicago exchanges and others are intending to clear CDS as is Euex in Europe, and others. Handling the underlying toxic waste that TARP was intended to do appears to be languishing. It may be revived given Paul Volker's strong support for it, given that he is one of Barack Obama's innermost circle, in a speech in Singapore on Tuesday, but just as a third of the TARP money was grabbed for SARP style bank bailouts. John McCain, if he wins on 4 Nov, will kill TARP. Meanwhile, various writedowns, settlement, fire-sale auction and accounting flexibilities are handling the toxic assets. In Switzerland,
UBS's $3.9bn Gov pref share money goes into a work-out vehicle for the bank's remaining $60bn toxic assets. In Belgium, Fortis's Eur43bn toxic assets were left behind when the bank was dismembered by 3 governments and given to the remaining rump of the bank's board. The Fortis bank's spreadsheeting risk team simply wrote senior tranches off by 75%, and mezzanine & basement tranches by 90% to a total of Eur10bn for the board to work-out on! But, in these and other such cases also no-one is yet looking publicly at the toxic assets in detail. Are they sub-prime ABS total return instruments such as UBS dumped into pensioners' and other retail investment funds! No details either are forthcoming from banks as to precise details of the various types of exposure they have to toxic assets. Banks' quarterly and annual accounts treat these as notes to the accounts in crude tables even though from a shareholder's point of view they remain the single biggest factor determining the banks' share prices. Here again is where the regulators, in this case the accounting standards bodies, should be insisting on more public detail - after all there has been plenty of time to get models and systems fixed and reporting sorted. After the carnage by now what more is to be gained by not fully explaining the toxic parts of the accounts and showing fair value model and stress test and over-the cycle and point-in-time revenues and forecasting fundamental valuations if held to maturity?

Cygnus Crises

That the current sub-prime crisis is a “black swan” event, a metaphor for induction logic not working after black swans were discovered in Australia, not if you choose to believe all swans are white (or indeed white or black?) Recession is easy to find precedents for going way back, but the sub-prime crisis - is that an improbably 'black swan'. Well yes, if you blame modern financial engineering, and no, if it is comparable to what happened before somewhere - such as in the late ‘80s and through the ‘90s in Japan, and again at the end of the ‘90s in SE Asia. Oh, yes, you know about those? They are topics our latest Nobel prize-winner in Economics, Paul Krugman, worthy successor to G.K.Galbraith, and others at Harvard wrote a lot about. But, just maybe they only got the picture half right? The consensus view in 'the West' was that Japanese banks were insolvent because of their own unique mistakes. They were accused of being under-regulated and even of having weak accounting and poor regulatory reporting standards (only partly and certainly not entirely true). And the Asian crisis was a currency misjudgement caused by de-pegging from the US dollar. That is therefore black swan stuff - couldn’t be repeated in the white swan world of US, UK, Europe etc. not when we knew about it. Did we learn about it?
The Japanese banks’ insolvency was discovered by noticing that Japan’s banks were borrowing at high rates on the international money markets – a sure sign of trouble. But the experts got it wrong by simply blaming the banks and not looking for deeper sectoral causes, not for some years anyway. Is there a lesson here too? Was it just irresponsible bank lending or also irresponsible property markets that the authorities failed to control? Insofar as if we should regulate the former maybe we need to do more thorough zone planning to regulate the latter? The facts of the matter became clear in the US media in the noughties. I recall reading an insightful warning in the New York Times in December 2005 that was news for many Americans at the time. I remember reading the NYT in the Palm Court at New York Plaza, but not a lot of the people I discussed the paper with took too much notice, or of any doom-mongering on Wall Street back then even though it was clear from official stats that property values were now turning south. That’s when I learned how important in world economic history the New York Plaza Hotel actually was! Anyway to return to the main story, property prices rose much faster and more steeply in Japan in the ‘80s than in the US (and UK, Spain, Greece, but similar to Ireland) in the noughties, because speculators used paper profits from a booming stock market to invest in property, leveraging the prices of both higher and higher. Folks made their own complex structured products. Japan’s growth had enjoyed a long one-way trend and deep-pocketed corporations plumped up commercial property market as home prices too were inflating. Export-led economies need construction and property growth to deepen and broaden their domestic economies when, like China this decade, everyone works such long hours and live in such small homes that consumer spending is low.
American readers may dislike being compared to Japan at any time, but it was then and remains still the world’s second biggest economy. That said, there are, of course, differences. Construction alone was for many years over 20% of Japanese GDP when elsewhere in OECD countries 5% or less was the norm. Land values in central Tokyo had increased in every year except two since 1946, with double digit increases since 1983. They tripled in 1986/7 and were forecast to more than triple in the coming decade. The value of all new construction in Japan in 1989 was 150% that of the whole of the USA. In a country only the size of California all of Japan’s building land values in 1991 could be estimated as $18 trillions or almost four times the value of all building land in the United States at that time! This was a bubble bursting to burst, which it did spectacularly in 1991 and continued deflating for years. Even 15 years later properties were worth only half of their values in 1991 even though construction remained at about 12-14% of GDP! The biggest loans that local retail banks make are for construction and property. These banks were in turn guaranteed by the big City banks who traded in international markets and invested the surpluses of major corporations. When construction suddenly halted as property crashed all retail banks became insolvent and this in turn bust the big banks. Because of all the corporate speculation, the collapse wiped also out many company balance sheets. In the US in recent years, although construction was much smaller in the total economy, the leverage applied via property, via mortgage backed assets especially, fed through the financial system to greatly enhance the sector’s economic scale. Property (not construction) is always a huge dependency anyway as a major collateral for household and property development borrowing. US households, like some European countries too, built up consumer spending by annual borrowings on average equal to 60% of annual earned incomes, and from 2003 on much of US growth was supported in this via equity release, and continued even after property values began falling in 2005. Property rises and falls had hotspots however, like CA and FLA and major cities generally. This is also a familiar problem in Asian economies. The countries like Thailand, Malaysia, Philippines with one dominating megalopolis funnel central city property speculation to dizzying levels. Remember when some wag estimated that the Imperial Palace in Tokyo was worth more than Manhatten or all of California? Well soon after that the property market burst and so did the Japanese stock market, after which it never recovered its previous highs (a problem that caused index arbitrageur Nick Leeson to lose $1.5bn fatally for Barings Bank, double it capital, and a situation many western banks are in today). This was a result of 20 years of export success (like the Asian Tigers later before the Asian Crisis of the late ‘90s) growing in a decade as much as the US or Western Europe was growing in 50 years! All this was until the Plaza Accord meeting of 22 September 1985 at the New York Plaza Hotel, when G5 nations agreed to increase the Yen against the US Dollar to rebalance US-Japanese trade. By late 1987 the Dollar ceased falling, at around half its value relative to the Yen. That appreciation of the Yen, allowed Japanese consumers and corporations to buy more overseas. Imports soared in 1986/7 and the Finance Ministry and Bank of Japan, reduced interest rates down to 2.5%. The conjunction of sustained low real interest rates, the hollowing out of industry (particularly SMEs squeezed by major manufacturers) and a multiplied real estate prices - increasingly on a speculative basis, with a shift via zaiteku ('financial engineering') into property and away from manufacturing – sound familiarto you? When mortgages defaulted and property companies crashed, banks had enormous loan loss provisions and write-downs that bankrupted them. The Bank of Japan stepped in with $trillions and it was a decade before banks recovered entirely and have even now not yet regained the credit ratings they once enjoyed when half of the world’s top 10 banks were Japanese. Pumping money into the banks was arguably the wrong end of the food chain, because consumer confidence was not restored and domestic spending remained low and household savings high for 15 years and will probably continue now for another 10! The Japanese property crash by value was bigger than the US is so far today, but in the US the effects are amplified more through the financial system, internationally as well as nationally. When the Bank of Japan aggressively raised rates, investors sold stocks to cover property losses, and vice versa, plunging prices into a 15-year trough. Real estate in Japan is worth less than half its 1991 peak, while over the same period property in the US tripled in value, to about $60 trillions before falling 15% since 2005. In Japan's six largest cities, residential prices dropped 64% from 1991 to last year. By most estimates, millions of homebuyers took substantial losses on the largest purchase of their lives. The image above is not offices, but social housing in Tokyo. In the US peak to trough which is the long term trend of property prices is expected to be 30-35%, but this will vary from place to place. In the US, property values were driven by internal migration to CA, TX and FLA and some other states. The experience contains many warnings. One is to shun red-hot real estate markets, or when doing so to use risky or exotic loans to borrow beyond one's means. Another is to avoid property that’s hard to unload when a market cools. At the top of the list is to learn from the failure of Japan's central bank to slow the rise of the country's real estate and stock bubbles, and then its failure to soften their collapse and failure to deliver any domestic growth impulse to the economy; export-led growth alone doesn’t do it. These are lessons for the new incumbent of the White House from January. Desperate speculators who are late entrants into property bubbles take the biggest risks.
During the boom years Japanese homebuyers felt comfortable about taking on huge debt by using exotic loans that required little money upfront and that promised low monthly payments, at least for a time. A similar pattern formed in the US. Japan had three-generation loans i.e. 90- or even 100-year mortgages to spread payments out over the lifetimes of children and grandchildren! From 1994 to 2003, the number of personal bankruptcies rose six-fold to an annual record of 242,357. In the US, John McCain’s idea of a £300bn subsidy to help distressed homeowners survive their mortgages is not unrealistic. Lawrence Summers idea of infrastructure spending was tried in Japan for years to resuscitate the market and other parts of the economy with expensive public works projects, but they were so poorly planned that they succeeded only in inflating the national debt.
In the late 1990's did the government try a new tack: deregulation. To kick-start the economy, Tokyo started loosening restrictions on the financial industry just as the US abolished Glass-Steagal. While aimed at reviving the banks who responded by merging securities firms and traditional banks, it also allowed investors to create REITS, mutual funds to invest in commercial property. The government also eased building codes, such as height limits, and cut approval times for building permits. Such restrictions were blamed for the high property prices in CA when actually the problem was more one of a lack of new social housing, low-income homes. Japan showed this when despite deregulation, house prices barely moved despite new builds and more money; the problem remained that homeowners could not afford to move if this meant realizing the losses on their existing homes which would match or exceed the lower prices of new homes. Japan’s economy basically continued to flounder because while the banks were saved the debt burden on ordinary folks was not lifted. Prices recovered in cities by less than the population growth of those cities. Western economists believed Japan and Asia to be a black swan while white swan USA would be extremely unlikely to suffer such a decline as severe or long-lasting as Japan's, because the USA is more skilled hand at managing the financial tiller of the American economy e.g. Greenspan and Bernanke’s Federal Reserve. An unlikely or unprecedented event is called a black swan. We have to conclude that the subprime crisis is not a black swan event, though the resultant credit crunch may qualify, why, because all the events and factors leading up to the current crisis were known to those who chose to know them. I preached the lessons to many bankers, but bankers don’t like economics. The Asian Financial Crisis too.
From a macro perspective, the Asian financial crisis and the sub-prime debacle share similar causes and symptoms – namely a prolonged period of low interest rates leading to accelerated lending, after the fact regulatory oversight, concentration risk (low risk diversification) and asset bubbles that remained very dangerous bubbles even when the risk could be insured or sold on. Financial service firms could not differentiate their individual risks understood merely in balance sheet terms and systemic risk when all counterparties would default together (so called double default risk). And the advent of financial derivatives has made the sub-prime crisis more complicated still. The US current account deficit ballooned to above the crisis threshold of 5% of GDP before the sub-prime crisis broke, just like in Asia before the 1997/98 financial crisis. Notably, Thailand, where the Asian crisis started, had a current account deficit of over 8% of GDP prior to the crisis; the US had a current account deficit of 6% in the year before the sub-prime crisis. These are not the highest around. Greece has a trade deficit into double figures. These deficits had to be financed and that meant selling financial assets to the export surplus countries. When credit boom Governments’ bonds were insufficient, private mortgage-backed bonds filled in and grew and grew. The blow-out in US loan-to-deposit ratio resembles SE Asia prior to its regional crisis ten years ago. SE Asia financed its excessive spending by foreign borrowing, and so did the US, a problem issue Barack Obama is now very conscious of. Foreign debts in US and the three Asian countries that needed bailouts by the IMF (Korea, Thailand and Indonesia) all soared before their respective crises. The IMF role is now being reconsidered for similar emergency action again and this time the countries in need will include many emerging markets including some in Europe experiencing currency crises.
Asia’s role in the US/Europe financial crisis is not a black swan. Cheap goods from Asia, notably China, arguably helped to keep down US inflation though the effect was really to shift spending from goods were inflation is measured to services and property where inflation is not measured. Nevertheless, using a narrow household inflation measure the Fed was relaxed about spending levels and household debt so long as households had net property assets. $4.3 trillion of dollar reserves held by Asian central banks, combined with $trillions of petrodollars from the Middle East, recycled back into the US maintained the economy’s liquidity. This poured into US Treasuries and mortgage-backed securities, lowering US bond yields and narrowing government and non-government risk gradings and spreads, encouraging households to seek the higher returns of property price rises to maintain high consumer consumption. This of course was a benefit to emerging markets like China, whose total GDP is only twice the US trade deficit and a quarter of which depends on exports to the US. Export growth-led frugal Asians, notably the Chinese and Japanese who account for over 40% of the world’s central bank reserves, lived below their means with savings flowing westward to allow the spendthrift Anglo-Saxon economies plus a few continental European states to live (arguably) beyond their means. While it lasted, this cross-Atlantic saving-spending became a stable dis-equilibrium. Now that party is over, Japan and the BRIC economies will suffer too as the pattern of world trade goes into reverse gear. US growth in the last year was mainly explained by export growth and falling imports, while China and Japan’s growth rates were led entirely by domestic demand until their recessions kicked in following stock market and other asset price collapses. Japan has already announced it is in recession while China will follow some time in the near future. The crisis is getting more global and yet also closer to a full-scale governments-led bailout and a U, if not L-shaped recovery, but not a V-shaped rapid bounce. The global leadership in this will be USA first, Europe second, and in this respect the USA needs to recognise that its present crisis is neither white swan nor black swan, but both.
My thanks to Chi Lo, Dir. Research at Ping An (China Asset Management, HK) for some of the ideas in this essay. Note that white swans are Northern Hemisphere, black are Australian and SE Asian, while black-necked are South American. There are many sub-species. Some analysts have several times argued publicly about sub-prime crisis and recession, notably Nassim Taleb whose book The Black Swan: The Impact of the Highly Improbable is a US best-seller just now about randomness and uncertainty including in financial risk matters. Aristotle's Prior Analytics used example syllogisms involving "white", "black" and "swan." Aristotle used White Swan as accepted fact and Black Swan as improbable, demonstrating deductive or inductive reasoning, though neither is infallible since premises of an argument may support a conclusion but a false premise leads to false results, and inconclusive premises to inconclusive results. John Stuart Mill our first social scientist used the black swan narrative to discuss falsification.

Ship of State in storm votes new orders

The Presidential election is like voting for a new captain of a ship out at sea during a severe gale. Some of the crew want less canvas and to make for nearest landfall while others want more sail to try and outrun the strengthening stormforce winds. There are uncharted waters ahead and hidden reefs; so more sail or less? Which way to go is a practical probability choice, and that means ideology. Obama appears ready to outrun the storm at all costs and face the unknowns, while McCain, the ex-Navy flyer, wants to go only with what he knows from his own past, to make for the nearest inshore waters however rugged the shoreline.
In Europe, there is a committee on the poop deck; today the EU President Sarkozy and European Commission President Barroso told the Brussels press pack they while they EU states had previously been for all going their own way they now had come together (thanks to PM Brown) in recognition that the financial crisis is everyone’s problem and this extends to all of the world beyond Europe and the USA too. Therfore, they (all 27 states) are inching toward the idea of a Bretton Woods II to decide a new role for the IMF. A week back when IMF was being debated as a new global central bank it was to deal with the financial crisis (no-one mentions BIS for some unknown reason) into which all countries would put funds. Now, this has moved on to looking to the IMF as a recession-busting solution, a big money savvy UN? No details yet; conference at the weekend. Also, Sarlozy made clear there are big fish to fry in the forms of new regulations to tackle shadow-banking (whatever in financial markets is lacking in regulated transparency), hedge funds and ratings agencies, but as yet no clear steer on directly tackling toxic assets. What Sarkozy made clear is that as circumstances changed so too should ideas change about what to do especially regarding Europe acting collectively from now on; no more indidividual initiatives. That is a bit hard on the Irish and the British whose flair for innovation, if a bit late in the day, had turned round everyone else’s way of thinking again in history to a Keynesian solution, even if that is not yet a fully respectable term to use among the highest rungs on the political ladder. In the US, we may recall that Richard Nixon once said, “We are all Keynesians now,” in an acknowledgement of J M Keynes’s influence on reflation measures, but he was only half-serious at the time. The oil shocks and high inflation of the 1970s actually kicked the great British economist out of fashion in favour of Monetarists and their very much simpler explanation for inflation that it is to do with excess domestic supply of money. Now Keynes is back bigtime and on a global level.
Governments globally have announced and partially implemented about $5 trillions worth of guarantees and liquidity swap windows, which is more than the $3 trillion or so in sub-prime, CDO etc. writedowns. Little of this is actual cash and should not be equated with directly compensating or making up for losses in bank asset writedowns, share falls and property falls. These currently amount to about $40 trillions worldwide (two thirds ratio to world GDP) which should take roughly a full decade of positive world growth to reinflate back.
In this context, the debate between the two candidates vying to gain control of 25% of the world economy, and thereby powerful influence over most of the rest appears more like a city hall debate than one to decide a leader of the world? The debate was on domestic issues, but what is domestic to the US is global to the rest of us. Whether Obama proposes a $170bn economic stimulus package (that he kinda hinted might be mostly funded from higher tax on the richest 5%), that his party in Congress is upping to $300bn mostly deficit, or a McCain administration’s $300bn corporate tax cuts and taking $300bn from TARP to buy folks’ defaulting mortgages, both also have to recognise that Federal now means owning major equity in the US banking sector, the very same folks who will have to buy whatever Government treasuries the Middle East and Chinese and Japanese don’t buy. Yet, Obama made it clear that it made no sense to borrow from China to pay for Middle East oil, while McCain wants to import zero oil from every country that doesn’t like us, and that means everyone, except Canada, and if oil why not a lot of other stuff too? But McCain is a free trade marketeer and Obama is a friend to blue collar (US middle class) and wants to save Detroit Auto, but is also keen on internationalism and helping poor countries, and so maybe they just got their liberal and neo-liberal ideologies a bit mixed up.
Ideology of what George Soros calls “market fundamentalism” is another kind, and like budget deficit matters, at least temporarily, this is ceding ground to Keynes. A few months back, Mr Obama would have found it too risky to propose a lot of new spending so close to 4 Nov. He was following the example of Clinton in ’92 and ’96, promising social programmes investing directly in human capital while also promising to balance the budget Under Clinton in the ‘90s, the social programmes got delegated to the states who were given more deficit spending lee-way (an approach McCain wants to follow) and they didn’t make a lot of headway (not with a Republican Congress) while, against all expectations, he actually first balanced the budget and generated a surplus. He could not do both it seems. McCain wants to make big tax cuts, not social programmes, a spending freeze, and still balance the budget in his first term!
To understand how determined he is ideologically you have to appreciate his personal history. In October ’67 he was shot down on a (arguably illegal under international law) bombing mission over Hanoi , badly injured and spent 6 years as a North Vietnamese POW until the Paris Peace Treaty in January ’73. On an amazingly strong principle of honour he refused early repatriation, and therefore missed the whole of the anti-war movement years to emerge a hero blinking with incomprehension that the US lost the war! The ‘70s were a time when conservatives worked fearlessly long and hard to restore faith in American values after the misery of Vietnam, and upped the ante in the middle of the Cold War, with Soviets in hot wars in Africa and military coups and revolutions in Central and South America, and then Afghanistan, a misbegotten period like so many in the twentieth century that culminated in even President Carter (Dem.) being the first to tell the Soviets that NATO was prepared to use “First Strike” folowed by 3 years of spooking the Soviets right up to DefCon2. Reagan’s election was the culmination of this reactionery time, but he turned out to be fiscally unconservative and recognised passionately how much he hated and feared nuclear weapons, and a true hero in this at least, he effectively negotiated the end of the Cold War. Except for Iran-contra and some other stuff all was fine for US ultra conservatives after that, except for Bill Clinton stealing their fiscal policy, until Bush II’s dot com, Enron, Iraq and Sub-prime, when now America’s financial and industrial might (as well as its political military problems) are severely discredited. For McCain this must be like the ‘70s reprised and he is sticking by his lifelong fundamentals, small government and balance the budget and win the war in Iraq, and he means it. He doesn't like countries that don't like him.
Obama’s history is a generation later and is far more academic and involved in social issues, legislation at State and then Federal level, and less mired in the twentieth century's battles. For details read the Wikipedia entries.
My view is that this makes him a less ideologically fixated and more flexible candidate to deal with the complexities of the crises he will have to manage. The Bush presidency bequeathes an explicit recognition that markets are not good at self-regulation or self-policing – a working assumption central to Keynesian theory. One is reminded of the quip, “Just as there are no atheists in a foxhole, there are no market fundamentalists in a Depression,” and the same applies to fiscal spending, finance sector restructuring, managing out of a global recession and ending wars. To balance budgets now would repeat the mistakes of the Great Depression from which Keynes produced his General Theory.
Lapses into Keynesianism however takes different forms. For Republicans, it is a time to propose new tax cuts for business, including waiving capital gains tax, which many believe would help stimulate economic activity, while others recognise this as a green light to carpet-baggers, vulture funds and short-sellers. For Democrats, the preferences are for an extension of unemployment insurance, food stamps, health care, school and college education and assistance to delinquent homeowners. Others such as Lawrence Summers, the architect of much of New Democrat (and New Labour in the UK) economics, recommends investing in infrastructure and other measures to raise long-term growth. There is a complete hodgepodge of economic reactions to the crisis, like arguments over which direction to go in when the first priority is to bale the ship. Many new directions were not in circulation only months, weeks, even days ago. Keynes would have recommended getting everyone on the pumps, as much cash to the cash-poor as quickly as possible, though today cash-poor includes the banks and stock investors (down to 2003 levels and heading for P/Es of less than 7), and he would agree we cannot afford not to spend more public money faster. Keynesian demand theory, some say, would have told the Bush administration to have aimed for budget surplus by 2005, but the Iraq War and other considerations put that idea on the side-burner. Other economists worry that the habit of public largesse in the style of Hoover and FDR or Reagan and Bush snr who doubled the Federal Debt might sink deep roots in both parties. Fiscal policy should be counter-cyclical – but that requires the help of banks who are currently de-leveraging, and therefore the only reflator left standing is government and genuine long term equity investors at least until the economy recovers. Many social programmes run by charities are being hit by falls in their endowment investments and therefore without big new private charity donations, again it is to government that these programmes will look for support.
Washington’s moves on supervising previously unregulated areas of the financial markets, such as derivatives, and the decision to take $250bn of federal stakes in large private banks, might also prove to be more enduring than expected. It also places a great burden on Government to rigorously plan; the hidden hand of capitalism is cuffed to Goernment's hand, as surely as the 400 bankers who got cuffed by the FBI so far. After years of Congress and White House having less and less say in economic affairs they now have most to say including widespread caps or bans on bonus culture $billions. Legislators or Presidents who cannot get their minds around the multi-dimensionalities of political-economy and Keynesian ideas better take a big step back and leave matters to others who can!
In Europe, Brown, Sarklozy, Merkel and other political and financial leaders, and in the US Bush, Bernanke, Paulson and others have all reassured the markets that the SARP embrace of nationalisation does not equate with Socialism, which by definition is long run and this taking over the heights of the economy is only temporary. Mr Bush pledged yesterday in his 22nd statement on The Crisis in four weeks, “These measures are not intended to take over the free market but to preserve it.” An Obama or McCain administration both say they would divest those stakes one or two years from now. But as Keynes said: “Long run is a misleading guide to current affairs. In the long run we are all dead.” Or as Milton Friedman – Keynes’ ideological foe – remarked: “There is nothing so permanent as a temporary government programme.”

The Wurzelbacher Falls

The final Presidential debate between Obama and McCain was about the Joe Wurzelbacher economy. CBS’s Bob Schieffer presiding opened with expert opinion that the 2009 budget will be a deficit of somewhere between $400bn and $1,000bn (which is 3%-7.5% ratio to GDP!) added to which (or of which?) the economic plans of both candidates requires $200bn deficit spending. This was a measure of the economic and financial crises; requiring between 1 & 4 times as much deficit as the candidates need for their own plans. Similarity ends there. Confirming the statements made in the second debate, McCain wants an across-the-board spending freeze, a $2-300bn corporate tax cut plus capital gains tax cut in order to head for the same 11% profits tax as the Republic of Ireland (which corporation tax is 12% and just raised capital gains tax from 20% to 22% though capital gains in 2009 is unlikely to amount to much, if anything). Both candidates want to cut all spending on ‘earmarks’ (also called ‘pork’) and any programs that are not working. Obama wants to raise taxes on the 5% top earners (corporations and households earning over $250,000) and deliver tax cuts (zero increases) to everyone else plus provide universal health insurance for the uninsured and more for education. Obama supports TARP, but McCain has decided to kill it. He wants to use £300bn of Congress’s $350bn to buy out defaulted mortgages of 11m homes (a massive public housing investment that would leave mortgagees in occupation paying rent). TARP may be dead, or just dead until January at the earliest, other than for $100bn of it left to the discretion of President Bush. If a CDS and CDO clearing system gets going in November and experts to run TARP are selected there is a faint hope of TARP beginning to transact before Christmas, but I deem this to be unlikely. In the debate there was much about voting records. Obama has voted 95% of the time with his party and 5% across the aisle. He wants to reach across the aisle on key issues. McCain marks himself out almost as if a one-man third party, a maverick Republican, but not to left and centre. If McCain is elected the White House will be occupied by the most committed neo-liberal since Calvin Coolidge, 13th President, 1923-1929, oops!, (Ronald Reagan, who is McCain’s hero, talked the talk but let the deficit balloon, while Bill Clinton talked liberal yet balanced the budget!). The ideological differences are a yawning gap between Obama and McCain. McCain says he will balance the budget in 4 years. Obama says 10 years (implying this is his trough to peak period estimate, probably informed by his adviser Paul Volker). McCain wants smaller Federal government, Obama wants a Federal government that invests directly in human capital. McCain’s investment in health and education is to be by private sector third parties e.g. insurance companies and charter schools with households getting education vouchers and $5,000 health subsidies (refundable tax credits, when even if, as Obama says, average insurance cover is $12,000, for many if not most taxpayers this is an income gain). Obama seems to understand the liberal basics of a Keynesian redistributive fiscal stance over an economic cycle, while McCain has the opposite neo-liberal view that government borrowing and taxes depress growth. Both candidates intend to back alternative energy and expect to reduce dependency on energy imports (except from Canada) by up to 100% reduction within 10 years, which is bad news for the Middle East and may mean oil prices falling faster than alternative energy can afford?). McCain is unambiguous in his enthusiasm for nuclear and offshore drilling. Obama is ambiguous on this. Obama only smiled broadly and derisively at McCain during the economics part of the debate. McCain smiled at Obama like a cat at the cream during the Roe v. Wade part of the debate. Both candidates opposed the policies of the Bush White House over the past 8 years and stand for change. All commentators agree that since stock markets began falling steeply in The Fall, Obama’s lead grew decisively, currently 14% (with enough States and electoral college votes still teetering either way for McCain to yet win, if only by a whisker). Commentators said Obama won the debate strategically by looking cool and collected in a crisis, while McCain appeared the more nervous and desperate to the extent of low-balling Obama repeatedly to knock him off the economics including the dirty tactic of implying guilt by association with an ex-Weatherman Professor. When Obama mentioned Joe Wurzelbacher, a plumber he met at a rally, McCain jumped on this and Wurzelbacher got famous (24 mentions in despatches) with McCain at the end talking as if he had met Wurzelbacher and Wurzelbacher was his supporter and he’d make sure Wurzelbacher got rich and a tax cut and could job-hire and fulfill his capitalist dream of owning his own business. If Joe’s not in hiding he probably gets to decide a few million votes just by telling the media which candidate would serve the Wurzelbacher economy best – that’s democracy, when the small guys get the votes! If Obama v McCain over Wurzelbacher may be compared to Sherlock Holmes v Moriarty at Reichenbacher Falls (not so far fetched as McCain supporters at his rallies had been chanting "kill Obama", and as Obama said Joe Biden, who is a bit like one imagines Dr. Watson, would make a very good President "should God Forbid something happen to me". At Reichenbach both Holmes and Moriarty apparently died and it was some time before one of them was found alive, so too will the growing economic crisis drown all budget plans and it may be some time before we really know what the Presidential Race or TARP has achieved for the world economy?
Late in: Reached by Huffington Post at his home in Toledo, Ohio, Mr Wurzelbacher refuses to say which way he'll vote. But he was clearly surprised: “It’s pretty surreal, man, my name being mentioned in a presidential campaign."

FLASH GORDON saves the banks...for now

The British media coined a new coin for Gordon Brown. Even diehard worry warriors at the FT now say, for example Gillian Tett, there may now be "light at the end of the tunnel" after she established only the day before that tumbling markets respond rationally to a crazed world. Today, with stock markets falling across the globe by 7%, we are reminded again that the ultimate bellweather of confidence are stock markets, but they remain nervous, volatile, uncertain, pulled between short run good news and longer run recession fears, which all are convinced we are in now (falling corporate profits, rising unemployment, fire-sale asset prices, and governments discounting private share-holders of banks and their dividends). The financial crisis losses currently measurable are huge. We have to consider what happens when malfeasance can be proved and shareholders and investors demand win compensation and damages? These will be many times that of Enron or Abestos or Tobacco. Oh to be a corporate lawyer! I suspect that key to the outcome of these will be shareholder and general public support (a complex issue). Let's take each of the shareholder issue further. Fresh equity that the UK government (and about 20 other copycat governments) and some other investors (not just Buffett) will invest, must now take banks’ Tier One ratios to assets (risk assessed loans minus loan collateral) to between 11 & 13%. These ratios are dictated regardless of how well loans (assets) are covered by deposits (liabilities). No-one can remember banks being this solid. But, unless banks buy 100% of the shares, the solidity remains based on stock markets trading those shares! And if governments buy 100% of major banks how can their share values rise? The inspiration for Flash Gordon was Ireland's Brian Lenihan, and it is instructive that since he guaranteed all bank deposits and bondholders the risk spread on government debt has soared above that of banks which have fallen - a worrying reversal just in time for the government issuing bonds that it will expect the banks to buy? One fear for governments, for some governments, is that the public will have an anxiety attack about the credit-worthiness of treasury paper!? Given the scale of banks' assets relative to GDP however well the exposures are recoverable and netted against collateral the capital reserves required are enormous and will desperately need the asset inflation power of stock markets. This is because reserves are not static; they will get eaten into by further writedowns and provisional losses, ultimately by fully realised losses, and in a recession these can easily mean that almost all of banks' reserve capital will need replenishing once more before the recession slump is history. Share values have always been recognised to be subject to confidence factors and not just technically precise valuations. Expectations and confidence factors are quantified by surveys, but remain in essence qualitative judgements, but have long been seen as increasingly important in economics, becoming classic forward indicators. This does not mean that stock markets efficiently translate these at every moment, and therefore stocks can be readily described as overbought or oversold. Today, they are being oversold for arguably exaggerated fears of recession as fast as grocery shelves would clear and cities empty if a meteor was heading for earth. That is Flash Gordon's next challenge, one that he faced very successfully, even brilliantly, in 2001/2002 (another story). If there was a Dr hans Zharkov of the financial economics world it was Prof. Dick Dale of Southampton (according to BBC Radio 4) who in 1993 predicted a 1930s style systemic banking collapse stemming from deregulation of the banks that culminated in Bill Clinton repealing the Glkass-Steagal Act as his very last Presidential Bill before exiting office. This allowed banks to engage in securities according to Prof. Dale and be subject to the very conflicts of interest (issuing and underwriting securities) that had caused the 1930s crisis after which Glass-Steagal was enacted. I would say it was less that than banks engaging in proprietary trading in securities for their own account to the extent of issuing and trading in their own assets without appreciating the illiquidity of the market for these. Securitised assets and other structured products were illiquid in the same way that fine art is illiquid, luxury items for the only the very rich. Again, the oversight was to neglect packaging these in such a standardised plain vanilla manner that all equity investors of whatever size could invest or speculate in, and do so in transparant regulated markets. But Prof. Dale's and actually many others' similar warnings were deemed irrelevent because, after all, the 1930s is so well-understood history that no-one of all our institutions and regulators will allow to return for a second time. Well, if we compare 1929-1938 with 199-2008, sure looks similar. Some commentators are even venturing to say a comparison of 2008 with 1914 could be equally sobering! The FSA and other Basel II regulators tried to get banks to focus on 1 in 25 year shock events with little practical success. Trying to get them to focus on the possibility of a 1 in 100 year event would have been treated with total satirical disbelief, and yet here we are! The regulators like the FSA believed firmly in the vital importance of banks relying on equity for most of their own capital reserves. This is why Standard Life in the UK (once it also owned a bank) was pressed to de-mutualise and be publicly quoted. Other mutuals like Nationwide, Co-operative Bank and Britannia must be very glad they resisted this idea, just as Halifax if not Abbey might regret it, just as many building societies regret allowing themselves to be taken over by banks. Why this pressure to de-mutualise, because the markets would value the banks' and building societies' solvency better than even the most expert risk auditors. That stock markets are indeed the best measure was the same mindset that believed in securities markets as the most true valuation reference for all of banks' assets, supported in this by AISB's IAS & IFRS insistence on marking-to-market. I am not saying these views are wrong, merely that they are not always right? Flash Gordon has saved the beautiful banks from the stormy river, got the goods back onto a raft. With more help from disabused shareholders the raft might have a few tow-ropes to the river bank or some strong poles to steer by. The raft is otherwise still headed downstream to the recession rapids! Governments are seeking to restore trust, stability and capital restructuring and inspire shareholders to buy bank stocks and banks to lend to banks. This trust and the rest is clearly incomplete when governments insist on 10% minimum yield preference shares and control over key aspects of strategy in the name of tighter regulation. Most important for shareholders and interbank lending may be Flash Gordon's assurance that no more major banks will be allowed to fail! The confidence that these banks will not topple over, no matter how bad the recession or what toxic fall-out is yet to be discovered. This (not just carrot but also the stick of nationalisation) should, it is claimed, bring the credit markets to their senses. But what about the ordinary shareholder market? They are told that the benefit – meltdown averted – outweighs any cost, a cost still there for shareholders if for no-one else! Shareholders must suffer falling returns, mainly because of the slurry of toxic “dead” capital that their banks cannot use to support lending. I do not doubt the necessity of governments to save banks. I doubt that they can do so without something for shareholders who include general insurance, life, pension and other investment funds. The US now too is copying the example of Europe. In two other equally important aspects, Europe is not yet copying the USA. One, is that there is still no plan in Europe for treating toxic assets head-on. In the USA the plan exists but it is potentially unworkable because of the conditions attached. After spending $250bn on SARP like bailouts, there is only $450bn left and $350bn of that is subject to Congressional discretion which is unlikely to back-track on the onerous conditions. Two, in the US over 400 bankers have been arrested by the FBI and 32 banks and other financial service firms are under criminal investigation including AIG, Fannie and Freddie, Lehman Brothers, Citigroup and Bear Stearns. More will follow. At the same time there are hundreds of mass action law suits and coprorate law suits. These all focus on misrepresentation of the facts to the public, to investors, counterparties, pension funds etc. Nothing like this is happening yet in Europe. One reason is that European financial markets remain national insofar as they think of themselves as small fish in a big pond and governments are loath to undermine confidence in the stability of their financial markets anymore than they are already discredited. There may be differences in legal remedies, but most major European banks have US branches where most if not all will face legal uits of some kind or other. The USA as the biggest single national financial market in the world by far has no fears for its international credibility; whatever happens everyone will continue to have to do business with it. A BBC Radio 4 "File on 4" (Tuesday October 14) examined this and reported that, for example, Barclays is being sued for $hundreds of billions over claims it moved loss-making investments from its own accounts to outside investors. Similar claims are arising for many banks including charges of moving toxic assets into retail investment funds, for assets that were AAA one week falling 17 risk grades by the following week and so on! (click on file on 4 'Listen' on this page: http://www.bbc.co.uk/radio4/news/). Countrywide (taken over by Bank of ASmerica) is accused of gaming or misrepresenting what was prime and what was sub-prime - this is extremely serious. Banks and ratings agencies are not above the law, not in the USA, and with governments taking large shareholdings of banks they will be liable for damages (after no doubt years of litigation) and taxpayers will ultimately pay.

One thing in public; another in private

“These steps will allow us to restore more normal market functioning and encourage private capital to further support the reinvigoration of financial markets” - Federal Reserve chairman Ben Bernanke (like Theodor Roosevelt leading the charge up San Juan Hill)
US government is about to unveil a $250bn (£143bn) bank rescue plan today, as world shares rise dizzingly in anticipation and some short-sellers got burned. The plan represents TARP's replacement with SARP as the money will come from the $700bn bail-out package approved by Congress and represents all but $100bn that is available at the discretion of the Fed, US Treasury and the White House. The FT jokes about Brownian Motion. The US SARP copies steps taken by the UK and other European countries (together worth about twice TARP) whereby the US will buy stakes in its largest banks including Citigroup, BoA, Wells Fargo (+Wachovia), Goldman Sachs and Morgan Stanley. This plan was agreed or dictated to US banks at a special meeting last night. The aim - as in the UK - is to increase the banks' depleted reserve capital ratios in the hope that banks can then resume normal lending patterns and end the continuing credit crunch. As with SARP, the US Treasury will announce temporary insurance cover for loans between banks (paid for by much increased fees demanded by FDIC from under 1% to over 2%, which will moderate any fall in LIBOR).
Own Capital reserves of the banks should be a minimum of 8% ratio to risk adjusted assets (assets less collateral with both assets and collateral risk-rated), which typically means a ratio of 4% to gross assets. Regulators are insisting on Economic Capital buffers, however (to take account of economic and systemic conditions), that will roughly double the minimum capital reserve requirements. That means if banks do not get a relatively free or low cost own capital top-ups, they would have to halve their assets and that means drastically cutting back on outstanding loans just as the world is into a period of domino recessions! The Credit Crunch crisis had various triggers that I have explained elsewhere in these blogs. One threshold was the middle of last year when securitised assets originated by banks (to get them off the books) matched or exceeded assets remaining on their books. Ironically, it was Basel II regulatory regime (8% /RWA reserve ratio etc.) that majorily prompted banks to rapidly refinance their retail banking. They foresaw competitive consolidation of banks in the US and Europe as some banks would find themselves constrained from maintaining asset growth while those with spare reserves could become predators in the M&A of banks. Securitisations typically had three tiers or tranches, senior (AAA), mezzanine (AA-) and basement (usually held by the banks with 'first loss' exposure defaults in the underlying loans, while Mezzanine and Senior were more secure, covered by insurance and CP). By the first half of 2007 many banks (in their anxiety to maximise capital and minimise on balance sheet exposure) had sold off even the basement tranches (arguably, to unwitting investors). This was as serious, or more serious in hindsight, than the so-called 'irresponsible lending' i.e. 'irresponsible selling'. When these lowest quality tranches were used as collateral or sought to sell-on their price fell dramatically as it became apparent that defaults in sub-prime mortgages (and credit cards) were rising and that recession conditions appeared imminent. The knock-on effect was collapse in the market prices and risk ratings of the whole asset class, an asset class worth as much as all of banks' retail assets! Banks had to shore up these (with insurance, derivatives and/or other collateral), buy them back on balance sheet or let the Special Purpose Entities in which they had been vested simply go bust. The scale was so huge and the uncertainties so great that banks lost confidence in each other and the ratings agencies responded by progressively down-grading almost everyone - having rated these complex instruments AAA in the first place and taking huge fees for this from the issuing banks! The irony includes that those banks with large off balance sheet exposures that expected to to be winners in a recession and related shock events turned out to be the losers as any above average exposure to mortgages especially (typically one third of all commercial banks' assets) was punished by ratings agencies, in the interbank money markets, and eventually by equity markets (equity being typically two thirds of banks' own capital).
What would have happened if Basel II had been complete and well-imbedded before this among all the banks. Basel II after all had as a major aspect prudential treatment of off balance sheet exposures and of securitisations generally, whether on or off the books? Given time operating under the new prudential rules would banks have stopped originating further securitised assets and traded their way out of their off balance sheet exposures with far less fatal disruption to interbank lending? Governments efforts inspired by Gordon Brown and Alistair Darling's equivalent of the Thin Red Line (Crimean War) are currently focused on holding and repairing the line of re-capitalising banks to meet and exceed minimum Basel II ratios.
The excess over the minimum ratios are called 'buffers' - dictated by regulators, advised by Central Banks, and agreed with banks on the basis of internal shock scenario stress tests. Before, the credit crunch (before it became public knowledge from Summer 2007 onwards) banks employed rather moderate stress tests that rarely resulted in more than a third of banks' own capital being threatened. This irritated the regulators, but they lacked any precisely detailed prescriptions as to how to do this modeling and how severe to set the shocks. Relating banks to underlying economies was an unknown or dark art. What was a theoretical conundrum however, rapidly became a current reality with levels of liquidity risk no banks were prepared for. Like boy scouts caught with their pants down when a storm blows over their badly sited tents, the banks literally panicked not knowing what to do first. Perhaps a yachting race is a better analogy. Do you trim sail and stop to help others or decide this is just a squall and try to outrun it? Those with tents or sails intact mostly laughed at the others and took commercial advantage (not realising that the gales were bigger and getting worse), all being equally bad at weather forecasting (risk accounting). No banks that have proved to be stronger than others have survived better only because they knew better: a matter of good luck as much as good judgment (or as the Northern Irish say, 'bad luck, good luck and look out').
Could regulators have examined risk systems, accounting and scenario forecasting more assiduously in time? The job of risk auditing a bank is akin to a full financial audit. The regulators do not have the skilled manpower no matter how hard they tried to build it up (banks paid more, and anyway ,there were nowhere near enough true experts), but regulators also did not delegate the job to the audit firms, who are not trained or tasked with assessing risk cultures and systems. Therefore, banks, all of whom did less than they should, could not expect severe regulator's supervisory reviews, especially not if your bank is a national treasure, a champion on whom depends much of the reputation of the whole of the national financial sector. Very few envisaged that the markets might do the audits instead?
BIS, ECB, FSA and all other national regulators stated clearly that Basel II is a requirement necessary to keeping your banking license. It is designed by experienced senior bankers and will be the hard core of how banking is done in the future, as essential and basic as double-entry bookkeeping, and something that the executive boards of banks are personally liable for! Yet, of all the senior bankers I have met, few could bring themselves to see all this as anything more than irksome, comparable to a tax liability, a peripheral compliance matter, eminently delegated to the lower orders in the engine room; why take an interest in anything without a bonus attachment; career death (so true!). I preached the contrary to 100s of disbelieving suits e.g. get this bit wrong and the losses on your securitisation issues and cost of capital will break you; many times the cost of getting it right! Or, reputation risk alone here and here will cost half your own capital. Or, how will or can you replenish 150% of your own capital over say, 4 years? I also told banks that so long as their balance sheet profiles were typical of the market with no inexplicable spikes then when recession strikes and your bank is insolvent the regulators cannot blame you because all banks will be in the same boat! I was wrong on that, for while the general principle is true, it is only now being recognised by government and regulators, and in any case there is a domino sequence to events; some banks become basket cases before others do!
To know big banks you have to know the somewhat arrogant and supremely comfortable trust that exists within the corporate culture. 'Too big to fail' is not merely an external assumption. To the professionally curious one might test these beliefs by examining research by the central banks of Spain, England, Ireland, Sweden, Finland, Germany and France on specific techniques of risk assessment with the aptly named Old Lady of Threadneedle Street more focused on macro-systemic conditions of risk. The abiding problem, akin to the pre-war question of how do you get a shared sense of urgency until War is actually declared, was that
central banks & regulatory supervisors could not prescribe models and precise remedies – not enough epistemological certainty about modeling techniques and accounting data (competing academic camps at work) and not enough John the Baptists out there preaching the only road to salvation; life's too short for Greek mathematics.
I know of banks whose whole insolvency has been caused by very few individuals far below decks far more effectively than even the most commanding of commanders on the bridge could achieve. The biggest irony is perhaps that banks have been brought to their knees as much by IT nerds as by T-shirt wearing structured product traders, by grey-faced collateral managers in back offices as by Champagne Charlie, bonus-enriched financiers, by office politicians as much as by market traders. Points of failure do not correlate with authority and salary, though ultimately responsibility begins and ends at the top. Edinburgh Evening News today is hand-wringing over the “loss of RBS” even more than was the case only days ago about HBoS. Inevitably about to become 60% government-owned, the working assumption is that RBS will be unsentimentally and unceremoniously sold off soon! The trauma can hardly be comparable, however, to the feelings in Belgium about the fate of Fortis (about which I know a great deal more than can be stated here). If there is a long term story about the fate of banks as national institutions it starts long ago, a generation back, when banks decided that automation (computerisation) could supplant how banks relate to their customers. Banks lost the ethical and moral superiority they relied upon for centuries in times of economic crises; they traduced the loyalty of customers and before long the ethical motivation disappeared within the banks that no amount of 'we are a family', 'your friend for life' etc. rhetoric could repair. RBS's current advertorial strap-line is “making it happen”. Like any perusal of Chairman's statements even in recent months will show there was a head in the sand bs that was transparently a misrepresentation of the reality everyone else recognised. It is noteworthy that of the 400+ bankers already arrested by the FBI in the US, over 90% of the charges concern saying one thing in public and something entirely opposite in private!

What happens to UK big banks now?

If existing shareholders (institutional investors and/or private equity and hedge funds as well as private individuals) do not take up the bulk of preference shares issues by RBS, HBoS and LTSB, government will end up with controlling or dominant stakes. The banks will then be subject to paying 10% to preference shareholders plus conditions curtailing the current bonus culture (though there is a prospect of FSA applying new remuneration rules more widely) plus pressures to refocus the banks on traditional banking (serving Main Street and away from City and Wall Street investment banking), with the anti-cyclical requirement that these banks maintain 2007 levels of lending to SME businesses and mortgages (especially first time, key workers etc.) As loan defaults double and triple maintaining 2007 levels may not be easy to do or to compute, to 10-11% Tier 1 from 6% recently (a big jump)? But, just as spectacularly, what happens to the foreign branches and the banks' investment banking arms? Will they be sold off? Will they have to be sold off because they will not be able to compete effectively in global capital markets? I am reminded of the calumny experienced by NatWest Markets and BZW ten years ago.
Both banks, the biggest investment banks in London at the time, were under enormous pressure from analysts pressing for break-up. Both banks sought to dismiss concerns that globally medium- sized investment banks such as NatWest Markets and BZW were unable to compete with better-capitalised rivals. Attributes needed to be a global players included balance sheet strength and ability to deliver a wide range of finance solutions, for which fully integrated groups combining commercial and investment banking expertise seemed essential. NatWest wrote to the bank's largest investors, offering to meet to explain the bank's strategy. Both banks were under increasing pressure from shareholders to improve the returns from their investment banking arms to match those of the retail arms. They also argued that to succeed in investment banking requires the highest quality senior management. In the end major parts of both NWM and BZW were simply shrunk and sold off cheap, after which NatWest became a relatively simple target for RBS.
Both banks had important global market shares in certain lines of business, NatWest in capital markets, especially FX, and BZW in securities (both were the UK's finance sector national champions at the time and for many years until 1997), and yet, one way or another, with undue haste to please the analysts it seemed, these banks were grossly and ineptly dismembered by the retail bankers much like they might simply deem delinquent loan agreements. They banks had, in my opinion good systems and above average "leadership and vision", good enough to attract the best with superior internal training and audit regimes, though NatWest's CEO at the time said of his bank that top quality management was lacking at NWM. In fact, the demise of the investment banking arms of both banks appeared to me at the time to be partly an internal political victory, however pyrrhic longer term, for the banks' retail management over the high-flying investment bankers. The mutual dislike and misunderstanding between retail and investment bankers is age-old, cultural and visceral. I foresee something like that happening again now.
There is no doubt that major problems exist in the risk management and internal dysfunctionalities (silo-thinking profit centres) of large investment banks. The accounting systems alone are inordinently complex as are the range and balance between human and computerised decision-taking. These issues have been tested brutally to destruction by the wholly unexpected severity of the credit crunch (a 1 in a 100 event). But, these issues can be fixed (subject of next blog). The calumny would be the simple expedient of drawing a line under the debacle and simply letting go of the problem or selling off to willing buyers in a buyer's market!
Can big banks survive without investment banking arms? Over years, Barclays after several changes of top management re-built investment banking as Barclays Capital. NWM had its investment banking rebuilt under RBS, inheriting the major structured finance arm Greenwich Capital that arguably lies at the heart of much of its present problems (alongside the 'bridge too far' purchase of ABN AMRO's investment banking).
The destruction of NatWest Markets and BZW was a great mistake. I hope the same does not happen again, under government pressure this time, though I fear that for technical reasons that may prove unavoidable? HSBC and JP Morgan and others will be the major beneficiaries and they and others must already be running the rule over what of especially RBS's enormous assets and investment banking teams they could buy cheap. HBoS will be merged/sold to LTSB and RBS looks like its new leadership will have sell-offs as a top priority?