Who prevented the second Great Depression?

Since the beginning of our current financial crisis, policy makers and central bankers have continually used as justification for their policies the claim that no matter how distasteful their policies are necessary to prevent a second Great Depression.

This raises an interesting question.  In response to the Great Depression, did the policy makers in the 1930s put in place a financial system to prevent another Great Depression or not?

Current policy makers would like to claim that the Dodd-Frank Act is all about preventing another Great Depression.  If current policy makers were focused on preventing another Great Depression, there is no reason to assume that policy makers in the 1930s did not have the same agenda.  Particularly because the policy makers in the 1930s were living through and had first hand experience with the Great Depression.

Furthermore, if policy maker in the 1930s did have the agenda of preventing another Great Depression, is it possible that their policy prescriptions alone were adequate to have prevented our current financial crisis from becoming the second Great Depression?

Regular readers know that the 1930s policy makers did in fact put in place all the elements that were necessary for dealing with our current financial crisis and avoiding a second Great Depression.  These policy makers assumed that the lessons of the Great Depression would be forgotten (after all, bankers are very good salespeople) and that another period of excess credit creation could occur.

The 1930s policy makers put in place the elements necessary for dealing with the excess credit in the financial system.  Specifically, they understood that the Swedish Model is the way to deal with a bank solvency led financial crisis.  Under the Swedish Model, banks are required to absorb the losses on the excess debt in the financial system and protect the real economy and the social contract.

The 1930s policy makers designed banks to be able to absorb losses should there ever be a credit bubble and still continue to support the real economy.

Banks can do this because of the combination of deposit insurance and access to central bank funding.  With deposit insurance, taxpayers effectively become the banks' silent equity partners during the years the banks are retaining pre-banker bonus earnings and rebuilding their book capital levels after absorbing the losses on the excess debt.

The 1930s policy makers also put in place the concept of automatic economic stabilizer programs.

So what did our current policy makers contribute to handling our current financial crisis and preventing a second Great Depression?

First, they adopted of the Japanese Model.  Under the Japanese Model, bank book capital levels and banker bonuses are protected at all costs.  As a result, the burden of the excess debt is put on the real economy where it diverts capital needed for reinvestment, growth and the social contract to debt service.

So rather than use the financial system as it is designed and bringing an end to our current financial crisis, our current policy makers chose to maximize both the length of our financial crisis and the damage the financial crisis does to the real economy and the social contract.

Of course, the choices made by our current policy makers haven't hurt everyone.  For bankers and their bonuses, it is close to if not the best of times.

Second, despite our current policy makers' claim to have prevented a second Great Depression, this claim is premature until such time as the excess debt has been purged from the financial system and all programs adopted to deal with our current financial crisis are ended.

An example of the programs that must be ended are monetary policies like zero interest rate and quantitative easing.  What will happen to the real economy and the financial markets when central banks try to unwind these policies?  Will unwinding these policies precipitate the second Great Depression our current policy makers claim to have prevented?

BoE's Mervyn King: time to stop demonizing bankers

The Guardian reports that the Bank of England's Mervyn King thinks that it is time to stop demonizing bankers for their role in the financial crisis.

True.

It is time to shift the focus to central bankers, financial regulators and policy makers for their failure to prevent the financial crisis and adopt the Swedish Model policies needed to end the financial crisis.

Sir Mervyn King is right that bankers behaved exactly as badly as we should have expected them to behave.  Their behavior was no different in the 1990s and 2000s than it was in the 1920s.

Just like the 1920s, bankers used the veil of opacity to hide bad behavior that allowed the bankers to unjustly enrich themselves.  For example, the bankers manipulated the global benchmark interests including Libor and Euribor.

The only reason that the bankers could get away with this bad behavior was that the central bankers and financial regulators failed to enforce the regulations put in place in response to this bad behavior in the 1930s.

This failure to enforce existing regulations makes the central bankers and financial regulators far more guilty of causing the financial crisis than the bankers.  After all, what made the financial crisis possible was the central bankers and financial regulators being derelict in the performance of their jobs.

Regular readers know that the FDR Framework is not particularly difficult to enforce.  What it requires is the regulators ensure that there is transparency throughout the financial system.

Specifically, for each investment, including banks and structured finance securities, all the useful, relevant data must be disclose in an appropriate timely manner so that market participants can independently assess this data and make a fully informed decision.

A quick check of our financial system shows that six years after the beginning of the financial crisis and wide swathes of the financial system are still shrouded in opacity (banks and structured finance securities).

And why have the financial regulators and central bankers brought transparency back to the financial system knowing that sunlight is the best disinfectant?

One reason might be they are so captured by the industry they regulate that they no longer understand their job is to ensure transparency.  A second reason might be because they are busily writing complex rules that make the financial system even more opaque, more dependent on regulatory oversight and far more vulnerable to crashes.

The outgoing governor of the Bank of England has called on the British people not to "demonise" bankers for the financial crisis. 

Sir Mervyn King said on Sunday that the failings of the financial and regulatory system were the root cause of the turmoil which struck the world economy almost six years ago. 

King, who leaves the Bank this summer, told Sky News's Murnaghan programme that there was widespread risk-taking in the runup to the credit crunch, and it had been a mistake to give the banking sector such a lofty status in the good times. 

"Where the banks contributed to the problem was that they themselves had taken too many risks on their balance sheet and they simply didn't have enough capital to absorb the losses that were likely to come along...

"I would say to people though, don't demonise individuals here. This wasn't a problem of individuals, this was a problem of failure of a system. We collectively allowed the banking system to become too big, we gave them far too much status and standing in society, and we didn't regulate it adequately by ensuring it had enough capital."

One of the great ironies of the financial crisis is that central bankers like Sir Mervyn King are highly trained economists yet they do not know how a modern banking system is designed to deal with the issue of excess debt in the financial system.

He puts tremendous focus on the amount of bank capital when in fact bank capital is nothing more than the accounting construct where excess debt in the financial system goes to be written off.

In point of fact, modern banks are designed to continue to operate and support the real economy even when they have negative book capital levels.  Banks can do this because of the combination of deposit insurance and access to central bank funding.

With deposit insurance, taxpayers effectively become the banks' silent equity partners when they have low or negative book capital levels.  For the privilege of having the taxpayers as silent equity partners, banks have the responsibility of absorbing the losses on the excess debt in the financial system and protecting the real economy and the social contract.

Who you gonna bet on to end the financial crisis & fix global financial system?

In his NY Times blog, Professor Paul Krugman once again rises to the defense of the economics profession.  This time, he makes the case for why track record is important when deciding who to listen to for advice on how to end the financial crisis and fix the global financial system.

Peter Radford in his blog, Real-world Economics Review, who examines Professor Krugman's response and makes the case for why the response fails:

In his discussion this morning he is critical of a defense of the hedge fund managers made by Jesse Eisinger. That defense rests on the notion that economists have no clue about the economy as demonstrated by their inability to predict the bubble and subsequent collapse. 

There were, of course, many economists who did predict the bubble, but they were not influential enough to have an impact. They remain mostly without influence due to their being outside the profession’s orthodox traditions.

Please re-read the highlighted text as Mr. Radford has nicely summarized that it was the non-mainstream economists who predicted the bubble and that they lack the ability to influence the profession.

Krugman, however, defends the profession against Eisinger’s criticism, and this is where he goes wrong. 

It does not matter that some economists were correct. 

The central orthodoxy of the profession, the source of most advice to policy makers and business people, and the basis of most commonly taught textbooks, totally missed both the possibility and then the existence of  the bubble. Economics was horribly wrong.

Please re-read the highlighted text as your humble blogger has been saying and ironically Professor Krugman agrees with the notion that policy makers should not listen to economists or business people who totally missed both the possibility and then the existence of the bubble.

As the Bank of England's Robert Jenkins observed, it was amazing to watch policy makers turn for advice to the very bankers who created the bubble.

As I added, it was even more amazing to watch policy makers also turn for advice to economists who rely on models that exclude the financial sector.

In their search for advice, the only individuals the policy makers were unwilling to turn to for advice were individuals like myself who predicted the financial crisis and offered before the crisis began a solution for how to moderate the impact of the bubble's bursting.

It hasn’t recovered since. 

Instead it is stuck in an unproductive self-examination that has yet to have much impact. 

Those who were wrong still pronounce and influence policy. They continue unabashedly to teach and perpetuate their errors. 

The profession, such as it is, is splintered into ideological warring camps making no progress towards a newer or more complete understanding of actual economies where things like asset price bubbles can, and evidently do, exist. 

In short economics is a mess and is completely deserving of the skepticism Eisinger attributes to the hedge fund managers.

After all many of them made fortunes by ignoring economic theory, recognizing the bubble, and shorting sub-prime assets. People who have made fortunes by thinking about the real economy and then risking their assets based upon that thinking [or by predicting the financial crisis], have a right to look down on a bunch of academics who opine about theories whose proof only ever resides in carefully constructed and highly constrained alternative worlds known as models. 

To win the respect of hedge fund managers, and anyone else out there in the real world for that matter, academic economists need to demonstrate a commitment to learning from their errors and toss aside erroneous theories. They need to stop regurgitating the same old stuff – some of which dates back to bygone eras and thus predates the development of our modern economy.

A modern economy that regular readers know is based on the FDR Framework which combines the philosophy of disclosure with the principle of caveat emptor (buyer beware).

This is not to say, naturally, that old ideas are necessarily wrong. But a social science like economics has to recognize that societies change and that the ‘social’ part of a social science provides the relevant context for the ‘science’ part. 

Ideas may, therefore, not be timeless. If economists want us to believe they are, then they need to prove that point, and not simply assume it. 

Economists still are stuck within an anachronistic vision of what they do. They may have stellar reputations as responsible professionals within academia,

Reinhart and Rogoff showed that a stellar reputation as an academic economist is worthless from the standpoint of anyone turning to them for policy recommendations.

Unlike most other academic disciplines, economics has no minimum standard for its peer review articles.  So being published should not be taken as a sign that the authors know what they are talking about.

but, by and large, their relationship with society at large seems amateurish and somewhat naive. Indeed they oftentimes deny its existence, preferring instead to remain engaged in scholarly debate within their respective academic bastions....

Fed Chairman Bernanke best exemplified the economic profession's relationship with society when he became visibly upset with consumers for not spending more when the Fed adopted zero interest rate policies (after all, that's what the Fed's model that failed to predict the financial crisis said should happen) and with investors for not rebalancing their investment portfolios to riskier securities.

Krugman wants us to believe that economics is still deserving of respect. But what about the current mess within the profession is so deserving? 

More to the point, and I have argued this before, given the great fractures and ideological splinters within economics, and given the often totally contradictory nature of different economist’s views, on what basis, exactly, does an outsider rest his or her trust? Who do they turn to for reliable advice? 

And how do they identify an economist’s credentials at all? ...

Please note that economics is one of the few fields of academic study where many of its leading thinkers were not trained economists (see: Adam Smith and the invisible hand; Walter Bagehot and the modern central bank).

Put it this way: in light of the evident failure of economic orthodoxy in recent years, were you in need of advice regarding the real economy would you turn to an academic economist? 

Or would you trust your own experience?  Clearly many hedge fund managers and business people choose their own experience. 

And that says a lot about the state of economics, doesn’t it?

Had policy makers turned to individuals like myself for advice regarding the real economy, they would have been told to adopt the Swedish Model and require the banks to recognize upfront their losses on all the excess debt in the financial system.

The Swedish Model is the only known solution for a bank solvency led financial crisis.  It has numerous advantages including it protects the real economy and the social contract.

Furthermore, the Swedish Model is supported by the design of a modern banking system.

However, the Swedish Model is not an economic model.  It is simply the solution for what ails us.

IMF study calls into question the whole approach to regulating banks

The Guardian reports that an IMF study has called into question the whole approach to regulating banks by asking if this approach is really addressing the real issue.

The authors of the study point out the simple fact that had all the proposed regulations been enacted prior to the beginning of the financial crisis they would not have prevented the financial crisis from occurring.

This conclusion is worth repeating.  For all the sound and fury, the proposed regulations would not have prevented the financial crisis.

Naturally, the authors call for seeing if there might be an alternative approach.

Regular readers know that there is an alternative to the combination of complex regulations and regulatory oversight.  That alternative is transparency.

Remarkably, transparency happens to be "low cost" and has a track record of success.

Transparency is particularly effective when combined with the principle of caveat emptor (buyer beware).  This combination makes the buyer responsible for all losses on their exposures.  This gives the buyer an incentive to use the disclose data to assess the risk of their exposures and limit the size of their exposures to what they can afford to lose.

By limiting their exposures to what they can afford to lose, buyers build robustness into the financial system.

This is the exact opposite of what we had in the run-up to the financial crisis and the adoption of the bury them in complex regulation approach.

The financial crisis occurred because of the fragility injected into the financial system by its opaque and heavily regulated corners (structured finance securities and banks).   So naturally, the response as pointed out by the IMF is to add even more opacity and, one of its chief sources, complex regulations.

The authors said: "The structural measures to reform banks such as the US Volcker rule, the UK's Vickers ring-fence, and the EU's Liikanen proposal, which would create functional separation of businesses, all reflect a deep sense of unease with the risk culture engendered by the assumption of trading and speculative investments by deposit-taking banks." 

But they added that the proposed reforms would not have prevented the crisis a tLehman Brothers in September 2008, the event that brought the global financial system to the brink of collapse. 

"Looking back, however, restrictions on proprietary trading or investments in private equity alone would not have prevented major bank failures such as Lehman Brothers. Nor would reorganising the bank into separate subsidiaries in each host and home country have facilitated its global, group-wide resolution." 

The study said Britain, the US and the EU were important financial centres and that they could bring benefits to the global economy if the structural reforms led to greater stability.

And the critical structural reform is to bring transparency to all the opaque corners of the financial system.

Big banks demonstrate again why regulations won't restrain their activities

The New York Times carried an interesting article on how the big banks managed to undermine any regulation intended to restrain their risk taking.

This provides further confirmation that the combination of complex regulation and regulatory oversight doesn't work to make the financial system safer.  In fact, relying on complex regulation and regulatory oversight makes the financial system riskier and more prone to crashes.  Our current financial crisis being a case in point.

The only proven method for restraining bank risk taking is requiring the banks to disclose on an ongoing basis their current exposure details.  With access to this information, the market then exerts restraint on the banks.

Under pressure from Wall Street lobbyists, federal regulators have agreed to soften a rule intended to rein in the banking industry’s domination of a risky market. 

The changes to the rule, which will be announced on Thursday, could effectively empower a few big banks to continue controlling the derivatives market, a main culprit in the financial crisis. 

The $700 trillion market for derivatives — contracts that derive their value from an underlying asset like a bond or an interest rate — allow companies to either speculate in the markets or protect against risk. 

It is a lucrative business that, until now, has operated in the shadows of Wall Street rather than in the light of public exchanges. Just five banks hold more than 90 percent of all derivatives contracts....

Here is a prime example of why regulation fails.

Did federal regulators think that the problem posed by derivatives was a lack of price transparency?

Hello, the problem posed by derivatives is that the banks can lose a substantial amount of money on them.  Just look at JP Morgan's losses on the London Whale's CDS trade.

The way to restrain banks from exposing themselves to potentially catastrophic losses on a large derivative portfolio is to require that they disclose their current exposure details, including derivatives.

With this disclosure, banks will dramatically shrink their derivative exposures for fear that the market will trade against them.  Jamie Dimon confirmed this when he tried to hide the CDS trade.

In the aftermath of the crisis, regulators initially planned to force asset managers like Vanguard and Pimco to contact at least five banks when seeking a price for a derivatives contract, a requirement intended to bolster competition among the banks. Now, according to officials briefed on the matter, the Commodity Futures Trading Commission has agreed to lower the standard to two banks. 

About 15 months from now, the officials said, the standard will automatically rise to three banks. And under the trading commission’s new rule, wide swaths of derivatives trading must shift from privately negotiated deals to regulated trading platforms that resemble exchanges. 

But critics worry that the banks gained enough flexibility under the plan that it hews too closely to the “precrisis status.” 

“The rule is really on the edge of returning to the old, opaque way of doing business,” said Marcus Stanley, the policy director of Americans for Financial Reform, a group that supports new rules for Wall Street.

So the CFTC's rule making is all about the idea that buyers of derivatives are too lazy to call multiple banks and compare prices.

If buyers cannot be troubled to get competing quotes, they are agreeing to overpay.

Making such decisions on regulatory standards is a product of the Dodd-Frank Act of 2010, which mandated that federal agencies write hundreds of new rules. ...

It is rules like this that further confirm that Dodd-Frank should be repealed (the only worthwhile parts are the Consumer Financial Protection Bureau and the Volcker Rule).

In an interview on Wednesday, Mr. Gensler said that, even with the compromise, the rule will still push private derivatives trading onto regulated trading platforms, much like stock trading. He also argued that the agency plans to adopt two other rules on Thursday that will subject large swaths of trades to regulatory scrutiny. 

“No longer will this be a closed, dark market,” Mr. Gensler said. “I think what we’re planning to do tomorrow fulfills the Congressional mandate and the president’s commitment.”...

Unless market participants know each bank's exposure details, derivatives are a closed, dark market.

If banks are performing the role that they are suppose to, acting as middlemen as oppose to taking proprietary bets, they should have no problem making this disclosure.

While the regulator defended the derivatives rule, consumer advocates say the agency gave up too much ground. To some, the compromise illustrated the financial industry’s continued influence in Washington. 

“The banks have all these ways to reverse the rules behind the scenes,” Mr. Stanley said.... 

Almost 6 years after financial crisis began, consensus emerging there is no sovereign debt crisis in EU

In his Reuters Macroscope post, Pedro da Costa explains how a consensus is emerging that the EU is not facing a sovereign debt crisis, but rather a bank solvency led financial crisis.

This is very important because the cure for a bank solvency led financial crisis is well known: adopt the Swedish Model and require the banks to recognize upfront all their losses on the excess private and public debt in the financial system.

Modern banks are designed to absorb these losses and continue operating and supporting the real economy.  Banks can do this because of the combination of deposit insurance and access to central bank funding.  When banks have low or negative book capital levels, deposit insurance effectively makes the taxpayers the banks' silent equity partner.

Instead, argues Blyth, it is merely a sequel to the U.S. financial meltdown that started, like its American counterpart, with dangerously-indebted risk-taking on the part of a super-sized banking sector.

In a new book entitled “Austerity: The history of a dangerous idea,” Blythe writes that sovereign budgets have come under strain primarily because taxpayers of various nations have been forced to shoulder the burden of failed banking systems.

Taxpayers have been forced to shoulder the burden because they are being called on to bailout the banks when the banks are perfectly capable of rebuilding their book capital levels through retention of future earnings.

Taxpayers have also been forced to shoulder the burden because the banks have not been required to recognize the losses on the excess debt in the financial system.  As a result, the taxpayers and the real economy are called on to make the debt service payments on this excess debt.  This diverts capital that is needed for reinvestment, growth and support of the social contract.

"The way austerity is being represented by both politicians and the media – as the payback for something called the ‘sovereign debt crisis,’ supposedly brought on by states that apparently ‘spent too much’ – is a quite fundamental misrepresentation of the facts.  

These problems, including the crisis in the bond markets, started with the banks and will end with the banks. 

The current mess is not a sovereign debt crisis generated by excessive spending for anyone except the Greeks. For everyone else, the problem is the banks that sovereigns have to take responsibility for, especially in the euro zone. That we call it a ‘sovereign debt crisis’ suggests a very interesting politics of ’bait and switch’ at play."

No surprise that bankers and politicians would engage in 'bait and switch'.  After all, the policies that have been adopted were designed to protect bank book capital levels and banker bonuses at all costs.

This has meant putting the bankers ahead of honoring the social contract or serving the best interests of the taxpayers.

So why all the misunderstanding? Why has the crisis become conflated with a government debt problem in the public imagination? 

According to Blythe, this is a convenient way for Wall Street to again saddle the state with massive banking sector losses.

Please re-read the highlighted text as Blythe it is simply marketing by Wall Street to avoid the consequences of its losses and to keep its bonuses flowing in an uninterrupted fashion.

The cost of bailing, recapitalizing, and otherwise saving the global banking system has been, depending on how you count it, between 3 and 13 trillion dollars. 

Most of that ended up on the balance sheets of governments as they absorb the costs of the bust, which is why we mistakenly call this a sovereign debt crisis when in fact it is a transmuted and well-camouflaged banking crisis.

Please re-read the highlighted text as Blythe provides an estimate of how much money the bankers should be reimbursing governments and taxpayers for as a result of their management of the banking system.

Bank of France turns to "super" transparency to restart securitization in EU

Bloomberg reports that the Bank of France is rolling out what it believes is the model for restarting securitization in the EU.

The distinguishing feature of the Bank of France's model is the reliance on making these deals "super transparent" so that market participants can know what they are buying and know what they own.

This is precisely what your humble blogger has been calling for since the earliest days of the financial crisis.

Why would the Bank of France feel the need to roll out deals that are "super transparent" when the ECB has already endorsed the level of transparency provided by the EU DataWarehouse?

Because the Bank of France sees that the EU DataWarehouse doesn't bring transparency that would allow an investor to know what they own or a buyer to know what they are buying.  Rather, the EU DataWarehouse is the industry's effort to retain opacity at the levels associated with opaque, toxic subprime mortgage-backed securities.

Please note, that the Bank of France recognizes that the only way to reduce, if not totally eliminate, the rating firms' role in securitization is to make the deal "super transparent".  When a deal is "super transparent", reliance on rating firms is greatly reduced as investors can do the analysis for themselves or hire a third party expert.

Regular readers know that your humble blogger has defined what it takes for a structured finance deal to be "super transparent".

First, the deal must provide observable event based reporting under which all activities, like a payment or delinquency, involving the underlying collateral are reported to market participants before the beginning of the next business day.

Second, the deal must make available all data fields tracked by the originator of the underlying collateral and the servicer of this collateral.  These firms are experts and would only track data fields that are relevant for valuing or monitoring the underlying collateral.  There is no legitimate business reason for depriving market participants of the right to piggy-back off this expertise.

The Bank of France wants to help banks package loans to businesses into tradable securities with the creation of a special-purpose vehicles, in what could become a template for the euro area. 

As the European Central Bank looks for ways to improve the flow of credit to small and medium-sized enterprises, or SMEs, the project started by the French central bank in July last year could provide one possible solution, the head of its markets division, Alexandre Gautier, said in a telephone interview. 

He’s in talks with the Frankfurt-based ECB and other national central banks on the initiative, which would ideally create securities that qualify as collateral in ECB refinancing operations. While banks can currently securitize SME loans and use them as collateral at the ECB, the process is complicated and not centralized. 

“We want a vehicle that is super simple and super transparent,” Gautier said. “We’d very much like these securities to be eligible in the euro system, but it’s not a condition. We’ll go ahead on our own if we have to to show that it’s doable.”... 

The aim is to make it easier for banks to re-finance existing loans and incentivize them to extend credit to small businesses. That would especially be the case if the new securities were eligible as collateral with the ECB, said Gautier. 

“The banks were very interested but they said that to make it really attractive, any securities should be eligible as collateral for refinancing within the euro system so that they would be liquid in the event of a crisis,” he said. “That’s now what we’re aiming for.” 

ECB President Mario Draghi said on May 2 that policy makers will start consultations with other European institutions on initiatives to promote lending to SMEs in the euro area using asset-backed securities.

As market for asset-backed securities rebounds, ratings shopping resumes

In yet another sign that zero genuine financial reform has occurred since the beginning of the financial crisis, Bloomberg reports that as the market for asset-backed securities rebounds, credit ratings shopping has returned.

Regular readers will recall that in the run-up to the financial crisis, rating firms were willing to put a AAA-rating on securities that the firms admitted they did not have adequate information monitor prior to issuance of the securities and after the securities traded in the secondary market.

In fact, structured finance securities developed a nickname: opaque, toxic.  Where the opacity of the security hid its toxicity.

Here we are almost 6 years after the financial crisis began and policymakers and financial regulators have done nothing to bring transparency to the structured finance market.

As regular readers know, the only way to bring transparency to structured finance securities is to require that they disclose on an observable event basis all activities like payments or delinquencies that occur with the underlying collateral before the beginning of the next business day.

It is only with observable event based reporting that investors know what they own and potential buyers can know what they are buying.

Here we are almost 6 years later and policymakers and financial regulators have not brought observable event based reporting to structured finance.

In fact, policymakers and financial regulators have gone out of their way to keep these securities opaque.  For example, the ECB puts its blessing on a data warehouse that provides disclosure on the same frequency as opaque, toxic subprime mortgage-backed securities.

Almost six years after the start of the worst financial crisis since the Great Depression, bond issuers are again exploiting credit ratings by seeking firms that will provide high grades on debt backed by assets from auto loans to office buildings considered inappropriate by rivals. 

Fitch Ratings isn’t grading a deal linked to a Manhattan skyscraper after saying investors needed more protection. The securities won top grades from Moody’s Investors Service and Kroll Bond Rating Agency Inc. 

Blackstone Group LP’s Exeter Finance Corp. got top-tier ratings from Standard & Poor’s and DBRS Ltd. in the past 15 months on $629 million of bonds backed by car loans to people with bad credit histories, even as Moody’s and Fitch said they wouldn’t grant such rankings.

Borrowers are finding more options than ever to get the top ratings that many investors require after U.S. regulators doubled the number of companies sanctioned to assess securities to 10 since 2006.... 

Issuance of bonds linked to loans and leases are staging a comeback as the Federal Reserve (FDTR)’s unprecedented stimulus, including a pledge to keep benchmark interest rates close to zero into a fifth year, pushes investors into riskier assets. 

Banks have arranged $31.5 billion of commercial mortgage-backed securities this year with issuance poised to climb 50 percent from 2012 to $70 billion, according to Credit Suisse Group AG. Issuance of bonds tied to subprime auto debt of $7.7 billion this year compares with $5.7 billion in the first four months of 2012, according to Wells Fargo & Co.... 

“Nothing’s really changed” in the ratings business, David Jacob, former head of structured finance at S&P, said in a telephone interview. Regulation “changed some of the processes that they do, but what led to a lot to this bad behavior hasn’t really changed.”

The only way to bring about true change is to require the structured finance securities to provide observable event based reporting.

With this information, market participants can assess for themselves the risk and value of these securities.  Market participants can either do the due diligence themselves or hire third party experts to do the due diligence for them.

This ends any reliance on the rating firms.  With transparency, rating firms become just another third party expert offering an opinion.

Debt graders led by S&P and Moody’s helped ignite the credit seizure that began in August 2007 by lowering their standards to win business before defaults soared on home loans to subprime borrowers, the Federal Crisis Inquiry Commission said in a January 2011 report. 

“My plea today is that you take action,” Franken, a Democrat from Minnesota elected to the Senate in 2008, told participants at the SEC roundtable today. “If we maintain the status quo we are leaving ourselves far too vulnerable to another catastrophe.”...

Where the status quo is opacity.  Bringing transparency to opaque securities like structured finance reduces our vulnerability to another catastrophe.

Simon Johnson asks if the Fed is afraid to regulate banks

In his Bloomberg column, Professor Simon Johnson asks if the Fed is afraid to regulate banks and if it is not afraid, why doesn't it require banks to hold a much higher level of capital.

Professor Johnson observes that

capital regulation needs to be about the true ability to absorb losses relative to total assets. Regulators should focus on this measure -- known as leverage -- and its implications for what happens when a financial company faces failure.

It is interesting that Professor Johnson says this because the adequacy of a bank's capital to absorb expected losses is the principle focus of the Fed's bank examination function.  Bank examiners ask the question of do banks have enough capital to absorb the potential losses on the risks the banks are exposed to.

If yes, then the bank examiners think the bank is adequately capitalized.

If no, then the bank examiners write up the bank and require that it raise additional capital.

Apparently, Professor Johnson doesn't think that the Fed's bank examiners are up to the task of evaluating capital adequacy.  He would like someone else to determine when a bank has enough capital.

There are two potential ways to make this determination:  the market or regulatory fiat.

Regular readers know that your humble blogger favors having the market determine if a bank is adequately capitalized.  What is necessary for the market, which includes the bank examiners, to perform this task is having banks disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

With this information, the market can use its valuation expertise to determine if each bank is adequately capitalized or not for the risks that it is taking.

With this information, the market can also exert discipline on the banks so that the banks hold enough capital to absorb their potential losses.  Recall that when banks provided ultra transparency at the beginning of last century, banks maintain a 15+% equity to total asset ratio.

Alternatively, we could have regulators write a regulation requiring banks to hold more capital.  Not only does this involve overcoming the Too Big to Fail bank lobby, but it also means the regulators publicly saying that their bank examiners are not up to the task of evaluating the adequacy of each bank's capitalization.

Ironically, in making the case for the regulators to require the banks to hold more capital, Professor Johnson actually makes the case for doing so by requiring the banks to provide transparency.

Global megabanks are profoundly complex, and intentionally so. Investors and regulators don’t know what risks are being taken. Board members also are usually in the dark. 

Whether top management understands what is happening is an open question: Chief Executive Officer Jamie Dimon is adamant that he had no real knowledge of JPMorgan’s Whale positions, which eventually had a notional value in the trillions of dollars.

Simply requiring banks to hold more capital doesn't address the fact that no one knows what risks are being taken.  Without knowing the level of risk, it is impossible to know if the regulated level of capital is adequate.

The starting point for determining capital adequacy is ultra transparency.  With disclosure comes the ability to assess the level of risk and then exert discipline to ensure there is enough capital to absorb losses.

Spanish prelate sides with Elliott's Paul Singer to tell Paul Krugman that response to financial crisis destroying society

As reported by the Telegraph's Ambrose Evans-Pritchard, the Spanish prelate has weighed in on the side of Elliott's Paul Singer against Paul Krugman and called for a change in the policies adopted to deal with the bank solvency led financial crisis so that society does not collapse.

Professor Krugman wrote a post in his NY Times blog in which he defended the policies run by Ben Bernanke, the Fed and other central banks as

just what the textbook says you should be doing.

As regular readers know, the economic textbooks are wrong.

This fact is not surprising because leading up to our current financial crisis the models used by economists did not include the banking sector.

This fact is not surprising because even though the global central bankers claim to have read Walter Bagehot's Lombard Street, in which he "invented" the modern central bank, their response to the financial crisis has broken a number of the rules he laid out.  For example,

• Central banks are suppose to lend freely at high rates of interest against good collateral; or
• Central banks are suppose to keep interest rates at or above 2% as rates below 2% bring about a change in the behavior of savers.

Regular readers know that there is one response that works every time when dealing with a bank solvency led financial crisis.  That response is to adopt the Swedish Model and require the banks to recognize upfront their losses on the excess debt in the financial system.

The Swedish Model protects society as the banks absorbing the losses spares the real economy from diverting capital needed for reinvestment, growth and the social contract to debt service on the excess debt.

Regular readers know that under the FDR Framework, banks are designed to absorb these losses and continue to support the real economy.  Banks can do this because of the combination of deposit insurance and access to central bank funding.

Unfortunately, the Swedish Model has not yet been adopted to deal with our current financial crisis.  Instead, policymakers and central bankers have adopted the Japanese Model for handling a bank solvency led financial crisis.

Under the Japanese Model, bank book capital levels and banker bonuses are protected at all costs and the burden of servicing the excess debt in the financial system is placed on the real economy.

The results have been predictable (I know, I predicted them).  The global economy is in a Japan-style economic slump and the social contract is being rewritten to the benefit of the rich at the expense of the poor.

As the Spanish prelate said,

"We have to change direction, otherwise this is going to bring down whole political systems," said Braulio Rodriguez, the Archbishop of Toledo. 

"It is very dangerous. Unemployment has reached tremendous levels and austerity cuts don't seem to be producing results," he told The Telegraph.

Austerity will never produce a positive result when facing a bank solvency led financial crisis.  I have been making this point since the beginning of the crisis.

"There is deep unease across the whole society, and it is not just in Spain. We have to give people some hope or this is going to foment conflict and mutual hatred." 

Europe's Catholic bishops have been careful not to stray into the political debate or criticise EU economic strategy but the Archbishop said the current course is untenable.

There are two reasons that the current course is untenable.

First, it is not fixing the underlying problems.

Second, it is causing untold damage to society.

"The Vatican has always been an enthusiast for Europe, but a Europe of solidarity where we help each other, not a Europe of coal and steel. Whether this is possible depends on Germany and Chancellor Angela Merkel," he said. 

Unemployment in Spain has reached 6.2m, or 27pc, despite a growing diaspora of young Spaniards seeking work in Britain, Germany, Brazil, or the Gulf, and an exodus of immigrants returning home. Spain's population fell by 0.7pc last year. 

The jobless rate in the Toledo region of Castilla-La Mancha is 31pc. The rate for youth has jumped to 64pc from 14pc at the peak of the credit bubble. 

Spain has largely avoided the sort of street clashes seen in Greece. People have coped with stoicism, drawing on the deep strengths of Spanish family support. Yet the authority of the state is eroding. A new Metroscopia poll shows that 87pc of voters have lost confidence in premier Mariano Rajoy.

Confidence in the state should erode because it is being run for the benefit of the bankers and not for the benefit of its citizens.

El Mundo fears a slow-fermenting 'crisis of the regime', with almost every institution -- including the monarchy -- in disrepute. It likens the mood to "pre-revolutionary" France in the late 1780s. 

The Archbishop, speaking in the austere episcopal palace of Spain's ancient capital, said the current crisis is doing far more damage than the recession in the mid-1990s when unemployment briefly spiked above 24pc. On that occasion peseta devaluations let Spain regain competitiveness and recover gradually despite austerity cuts. 

This time the country seems trapped in slump. The long-term jobless rate is much higher. 

Unemployment benefits taper off after six months, and stop after two years. There are almost two million households where no family member has a job. 

Europe's Catholic bishops know first-hand from their Cor Unum charitable network just how desperate it has become. "We can try to mitigate the effects by giving basic help to people left totally unprotected, but we can't create jobs," said the Archbishop. 

"We are seeing families who used to middle class needing help. This is totally new. As a matter of honour, they won't come to us until they have exhausted everything,"

As we approach the sixth anniversary of the beginning of our current financial crisis, it is time to acknowledge that the response to the financial crisis has been a failure.  If it were a success, policies like zero interest rates and quantitative easing would no longer be pursued.

The time has come to adopt the Swedish Model.  

History shows that within a year of adopting the Swedish Model the bank solvency led financial crisis is over and growth has returned to the real economy.