Tuesday, May 31, 2011

Regulators' information monopoly is an impediment to investors

A Wall Street Journal Heard on the Street column provides yet another example of how the financial regulators' information monopoly causes investors difficulty in evaluating and properly pricing the risk of banks.
Here's a lesson for the government and Ally Financial in particular: With bank investors fretting about the potential costs of soured-mortgage claims, it is best to get the details out in the open. 
That's the opposite of how Ally and Freddie Mac handled a payment last year of $325 million by the firm to the mortgage company to settle mortgage-repurchase claims. Neither Ally, General Motors' former financing arm now majority-owned by the government, nor government-owned Freddie disclosed the amount of the settlement when it occurred. The fact that a deal was struck at all was only disclosed by Ally and Freddie in quarterly securities filings. 
The $325 million payment has now come to light only in an exhibit tucked deep within an amended offering document recently filed by Ally as part of a planned sale of shares to the public. And that disclosure only happened after prompting by the Securities and Exchange Commission. 
This episode underscores the challenge for bank investors trying to assess risks posed by demands that banks repurchase soured mortgages. Concerns over legal risk, along with fears of a weakening economic outlook, have weighed on bank shares of late. 
... The problem is the lack of detailed disclosure. Even now, neither company has disclosed the amount of loans covered by the settlement. That makes it hard for investors to know how to interpret the deal and how tough a negotiating stance the government took. 
The government's role is central. It controls Freddie and Fannie, which guaranteed trillions of dollars in loans originated by banks and, with their value sinking, have demanded that banks repurchase billions of dollars of them. And investors have to question how the government is balancing the need to lessen taxpayer losses at Fannie and Freddie against a desire to avoid actions that may destabilize banks, like playing hardball on soured-loan repurchases. 
This has broad implications. Fannie and Freddie's regulator, the Federal Housing Finance Agency, is nearly a year into an inquiry of private-label mortgage securities sold by banks to investors, including Fannie and Freddie. While banks already have settled some claims for repurchases of soured mortgages with Fannie and Freddie, the FHFA could decide banks need to repurchase more. Bank of America, for example, has $222 billion in at-risk, private-label securities that weren't covered by past settlements with Fannie and Freddie. The bank hasn't said how much of these are owned by Fannie or Freddie. 
Understanding the economics and rationale behind settlements such as the Ally deal are, therefore, important for both bank investors and taxpayers. The lack of disclosure cuts both ways. In January, some members of Congress questioned whether mortgage settlements with BofA and between Ally and Fannie actually were back-door bailouts. In other words, the deals may have been too favorable to the banks. The FHFA's response that the deals were in Fannie's and Freddie's best interests hasn't resolved the uncertainty. It said detailed information concerning the agreements is proprietary. 
That may be the case for normal companies. But Fannie and Freddie, which have received $138 billion in taxpayer funds, aren't normal. As Democratic U.S. Rep. Maxine Waters said in a letter to the FHFA, loan-repurchase agreements involving them are "a matter of critical importance to the public interest," and so "transparency is therefore essential." 
It's bad enough the government is influencing the market in so many ways. The least it can do is be clear about its actions.

Monday, May 30, 2011

WSJ doubts bank capital is a panacea

A Wall Street Journal Heard on the Street column expressed doubts about bank capital as a solution.
Higher levels of capital aren't a panacea for banks. 
That is a lesson from this week's release of the Federal Deposit Insurance Corp.'s quarterly banking profile. The FDIC noted that 96% of the nation's banks "met or exceeded the highest regulatory capital requirements." 
In other words, only 303 institutions—the other 4%—failed to meet the highest capital requirements. But the FDIC also reported that the number of institutions on its "Problem List" increased by four during the quarter to 888. Banks placed on the problem list are in greater danger of failing. 
This means that there are 585 problem institutions that ostensibly have more than enough regulatory capital, a measure of loss-absorbing equity adjusted for a variety of factors. How can this be? The FDIC looks at more than just capital levels when deciding whether an institution is at risk. This illustrates why investors should use measures of regulatory capital only as a starting point in assessing bank strength. 
This paragraph highlights everything that is wrong with the financial regulators having a monopoly on all the useful, relevant current information on banks and why the focus on regulatory capital is misguided.

The starting point for an investor determining if a bank is solvent is to look at the current value of its assets and the book value of its liabilities.  A bank is solvent if the current value of its assets exceeds the book value of its liabilities.  It is insolvent if the current value of the assets is less than the book value of its liabilities.

This starting point is also the same starting point that investors use for exerting market discipline on banks.  If the risk of a bank's assets increases, investors adjust both the amount and pricing of their exposure to the bank.  This is market discipline.

However, because of the regulatory monopoly on current asset level data, investors cannot analyze the solvency of a bank or exert market discipline.  Instead, they have to rely on the financial regulators to do this.

Unfortunately, financial regulators do not do this.  For example, look at the 585 problem institutions referenced above.  Instead of closing these institutions, the financial regulators have adopted the policy of gambling on redemption.  This involves hiding the fact that the banks are highly likely to be insolvent and hoping that something will occur that will restore the banks to solvency. 
A paper last week by Thomas Hoenig, president of the Federal Reserve Bank of Kansas City, and Charles Morris, a Fed economist, also pointed out the danger of overreliance on capital levels. The two argued that new, tougher, international standards governing capital rules for banks won't be enough to curtail the risk posed by too-big-to-fail banks. 
Messrs. Hoenig and Morris cited "the complexity of the largest financial companies and the variety of their activities." Their solution? Break up big banks by splitting one group of businesses—lending, asset management and underwriting and advisory work—from activities such as brokerage and market-making activity as well as trading for their own accounts. 
That is a radical Rx. Then again, it would acknowledge that even the best-crafted capital requirements aren't always enough to make sure banking boats won't capsize in a market storm.
Your humble blogger has been advocating a far less radical Rx that has passed the test of time.  The solution is to make each bank's current asset and liability-level data available to all market participants.

With this data, market participants can evaluate the risk of each bank and adjust the pricing and amount of their exposure relative to this risk.  This brings market discipline to bear on banks as investors understand that they are at risk of loss of their investment if a bank were to become insolvent.

With the disclosure of the current asset and liability-level data, it also ends the era of financial regulators gambling on redemption and forcing investors to guess which banks the regulators are gambling on.  For example, are the regulators gambling on the Too Big to Fail banks today?

Saturday, May 28, 2011

The Race to the Bottom in Capital Requirements Begins

Contrary to the financial regulators' claims, the race to the bottom in capital requirements has begun.

According to a Telegraph article
Michel Barnier, the Commissioner responsible for the internal market and services, said suggestions that he would not fully impose Basel III were "unjustified and factually wrong". "Europe will implement Basel III: we have said it before and I confirm it to you today, the Commission's proposals to implement Basel III will respect the balance and level of ambition included in Basel 3," said Mr Barnier on Friday. 
... Mr Barnier said he would "not be swayed" from imposing the rules, despite warnings that they could harm Europe's economic recovery.
"A few weeks ago, some people were accusing us of damaging the economic recovery by implementing rules which would be too tough for banks because they would impede their lending to the real economy. 
Today, others seem to accuse us of the opposite with suggestions Europe would not be implementing Basel properly, thus not learning all the lessons from the crisis," he said.
Experience shows that regulators can be swayed.  If we look at disclosure for structured finance securities, we see the regulators embracing the disclosure practices that gave these securities the moniker "opaque" when their goal was to allow investors to know what they own.

Friday, May 27, 2011

You know it is bad when ...

Bloomberg carries an interesting article on even FINRA fining Credit Suisse and Bank of America for failing to disclose all the useful, relevant information in an appropriate, timely manner to investors in RMBS securities they underwrote and sold.

Credit Suisse Group Inc. will pay $4.5 million and Bank of America Corp. (BAC)’s Merrill Lynch unit will pay $3 million to resolve Financial Industry Regulatory Authority claims that they misrepresented delinquency data in issuing residential subprime mortgage securitizations. 
Credit Suisse Securities failed to inform clients of misrepresentations on 21 subprime RMBS it underwrote and sold in 2006, Washington-based Finra said in a statement today. In a separate case, Merrill Lynch negligently misrepresented delinquency rates for 61 subprime RMBS, though it corrected the errors on its website in June 2007, Finra said. 
Firms must provide accurate information about the products they offer,” Finra enforcement chief Brad Bennett said in the statement. “Credit Suisse and Merrill Lynch failed to monitor and supervise the reporting of historical delinquency rates, depriving investors of information essential to assessing the profitability of mortgage-backed investments.” 

The two companies agreed to resolve the claims without admitting or denying wrongdoing. 
Issuers of subprime RMBS are required to disclose historical performance information for past securitizations that contain mortgage loans similar to those being offered to investors, Finra said. Because there are different standards for calculating delinquencies, issuers are required to disclose the specific method they used, the brokerage regulator said. 
... For six of the securitizations from Credit Suisse and eight from Merrill Lynch, Finra said the errors “were significant enough” to affect investor assessments. 
The agreement between Finra and Zurich-based Credit Suisse said the bank’s outside servicer of the 21 securitizations “had provided inaccurate delinquency data” between January and September of 2006. The data was “variously underreporting and overreporting delinquencies for different securitizations within this period,” according to the letter, which was posted on Finra’s website. 
Bank of America’s agreement with Finra also said that the Merrill Lynch errors both understated and overstated delinquencies in various mortgage pools.

Thursday, May 26, 2011

Buy-side Responsible for Losses Under the ECB's ABS Data Warehouse

The Market Group informed your humble blogger that his firm was not on the short list to build the ECB's ABS Data Warehouse.  This was not surprising given that the selection criteria were not:
  • Have you built the envisioned ABS data warehouse before (to date, only my firm has); 
  • Are you free of the conflicts of interest that the European Union's Competition Committee finds unacceptable in any firms who have or could control a financial information vendor (my firm is notably free of conflicts of interest);
  • Do you need funds from investors to build the data warehouse (my firm did not);
  • Is the data warehouse you are going to operate going to provide all the useful, relevant information on a current basis for free to all market participants or is it going to charge market participants for access to stale information that guarantees Wall Street retains the equivalent of an insider informational advantage when valuing and trading ABS securities (my firm was going to offer current information for free and eliminate Wall Street's informational advantage)?
Given that these were not the selection criteria, the question the comes to mind is:
What if the ABS Data Warehouse does not restore investor confidence because it is riddled with conflicts of interest from its controlling ownership through its constructor/operator and lacks all the useful, relevant data in an appropriate, timely manner so that an investor could know what they own?
Then the ECB will get to see if it adhered to the advice of Walter Bagehot who said over a century ago that central banks were suppose to lend freely against good collateral.

If the ABS data warehouse fails to restore investor confidence, the ECB will continue to hold almost 500 billion euros of ABS securities of which almost 300 billion euros worth are securities from Greece, Ireland, Portugal and Spain.  The passage of time will show if this collateral is good or not.

Why should the ECB's proposed ABS data warehouse end the buyers' strike?  After all, investors have plenty of investment opportunities other than ABS securities where they do have access for free to all the useful, relevant information in an appropriate, timely manner.

Why invest in securities which have a track record of showing that Wall Street is willing to use its information advantage for its benefit and to the detriment of investors [think shorting sub-prime mortgage backed securities]?

But what if the ECB's ABS data warehouse does end the buyers' strike?  Then, I would have a long and lucrative career as an expert witness.

I would be able to go from case to case where investors lost money on their structured finance investments and testify in their lawsuits against the money managers.  This opportunity would be available because I strongly doubt that any money manager would disclose the following to a perspective investor:
Due to a lack of current information on the underlying collateral performance, investing with me in structured finance securities is asking me to blindly bet on your behalf as there is no way for me to actually know what I am buying or selling.  Without actually knowing what I am buying, I do not know how to tell if the price Wall Street shows represents the bigger fool as a buyer or seller.  Therefore, I cannot make informed investment management decisions.
So long as money managers are investing their clients' money without this disclosure, they are guaranteeing their investors that the investors will not lose money.  How could it be otherwise?

  • The money managers know that the disclosure in the ECB's proposed ABS data warehouse is the same level of disclosure that was not adequate for BNP Paribas to value sub-prime mortgage backed securities in August 2007.  

  • The money managers know that under Article 122a of the European Capital Requirements Directive they have an obligation to know what they own.  No amount of lobbying by the sell-side or regulatory incompetence changes the legislative intent.  The European Commission and European Parliament knew what level of disclosure was inadequate for BNP Paribas and they did not intend to set this level of disclosure as adequate for knowing what you own.
Common sense tells money managers that if the level of disclosure was not adequate for BNP Paribas to value securities, it is not adequate for knowing what they own.

It is simply not a defense to say "well other money managers were buying these securities".  Money managers have a fiduciary duty.

The suggested investment management disclosure by is necessary because without the current data I proposed the ECB's ABS data warehouse should collect and distribute for free, buying an ABS security is just betting on the value of the contents of a brown paper bag.  For any money manager who believes otherwise, I invite them to take the Brown Paper Bag Challenge!

Wednesday, May 25, 2011

'Dark Forces' fighting financial reform really oppose FDR Framework

Bloomberg ran an article in which Tim Geithner observed that there were 'dark forces' fighting financial reform.

As you can imagine, the FDR Framework, with its call for disclosing to market participants all the useful, relevant information in an appropriate, timely manner, is a lightning rod for the dark forces' fight.

The dark forces know that if the FDR Framework is fully implemented, the ability to profit from opacity is eliminated.

Unfortunately, the dark forces have an ally in the fight against the FDR Framework.  Their ally is the information monopoly on all the useful, relevant current asset and liability-level data held by the global financial regulators.

The dark forces know that financial regulators are reluctant to give up this information monopoly because it implies significant changes in what the financial regulators can do.

Giving up their monopoly implies that gone are the days when financial regulators can put the financial system at risk for a credit crisis like we just experienced and rush in with taxpayer money to bailout the financial institutions.

Instead, financial regulators would be held responsible for

  • making sure to error on the side of 'too much' disclosure when ensuring that market participants have access to all the useful, relevant information in an appropriate, timely manner; and
  • analyzing this information with the help of market participants so that the price and amount of the government exposure to any financial institution reflects the riskiness of that institution.
As reported by Bloomberg:

Treasury Secretary Timothy F. Geithner said “dark forces” are waging a “war of attrition” against efforts to strengthen regulation of the financial system. 
“You’re seeing some people run a war of attrition against the reform act,” Geithner said at an event today in Washington, without identifying the people. “They’re trying to starve the agencies of funding so they can’t enforce protections for investors.” 
Geithner also said opponents of the Obama administration are trying to block presidential appointments to regulatory agencies “as a way to get leverage over the outcome, and they’re trying to slow down so that they can weaken over time the thrust” of the Dodd-Frank financial overhaul law. “We’re not going to let that happen.” 
... Asked by a moderator at the breakfast held by Politico to identify the “mysterious forces” working against the administration, Geithner said, “dark forces, I would say.”

Tuesday, May 24, 2011

Where is Europe's John Reed? [updated]

Where is Europe's John Reed?  Where is the head of a major European bank who will shake the European financial regulators out of their cover-up mode and stop the governments where the lenders are based from putting enormous political pressure on the borrowing countries to adopt austerity?

John Reed was the Chairman of Citicorp during the mid-1980s.  Among his many achievements was overseeing the first write-downs of loans to less developed countries.  For this, he was put on the cover of the mainstream media weekly news and business magazines.

Why was this such a big deal?

Because until he publicly acknowledged that the value of the loans to less developed countries on Citicorp's balance sheet was not the 100 cents on the dollar they were carried at, but rather the 60 cents on the dollar that a Bloomberg terminal showed they traded for, financial regulators acted as if this valuation problem did not exist.

Financial regulators justified their cover-up by saying they were concerned that when the capital markets found out how bad the losses on the banks' balance sheets from loans to less developed countries were, it would spark a financial crisis.

As everyone who is familiar with the FDR Framework knows, stability in the financial system comes from market participants having all the useful, relevant information.  

Instability in the financial system comes from regulators using their information monopoly to cover up a problem that the market knows exists, but in the absence of the useful, relevant information the market participants cannot quantify and price the risk.

A fundamental prediction of the FDR Framework, which has proven true for 75+ years, is that financial markets do not implode when market participants have access to all the useful, relevant information.  

The corollary, which has also been proven true with the most recent credit crisis, is that financial markets do implode when market participants do not have access to all of the useful, relevant information.

It is a matter of fact that Citicorp's stock price went up significantly on the day John Reed announced the write-downs and for several days thereafter.  It is also a matter of fact that the rest of the global banking system followed his lead and that they too saw their stock price increase.

In fact, with the issue of the valuation of the loans to the less developed countries addressed, many of the banks were able to tap the capital markets for more equity.

One of the financial firms that followed John Reed's lead was Security Pacific Corp, at the time a Fortune Top 10 US bank holding company.  It had a significant portion of its loan portfolio concentrated in loans to less developed countries.  In fact, had Security Pacific matched the percentage write-down taken by Citicorp, it would have had negative equity.

Did this fact cause a run on the bank at Security Pacific?  No.

Did this fact cause Security Pacific's stock price to drop to zero?  No.

Market participants understood that Security Pacific would need to rebuild its capital and factored that into the price and amount of their exposure to the bank holding company.

What does this have to do with Europe?

The situation in Europe is virtually the same as John Reed faced.

  • A quick check of a Bloomberg terminal would show that like the loans to the less developed countries the debt of Greece, Ireland, Portugal and Spain are not trading at par.  
  • For their part, financial regulators are engaged in a cover-up.  They are not a) disclosing each financial institutions' asset-level exposure or b) requiring financial institutions to write-down the value of their exposure to market prices.
  • Governments where the lending financial institutions are located are working feverishly to promote austerity to try to keep the value of the debt at par.
  • Market participants do not have the information they need to assess the risk of and properly price the securities of the financial institutions.
There is no reason to believe that the financial markets will not react in the same way to a European financial institution CEO stepping up and announcing a write-down of their exposure to existing market price levels.

Hence the question, "Where is Europe's John Reed?"

China on path to requiring current asset-level disclosure by banks

The Wall Street Journal carried an article on China's bank regulator taking steps to establish a leverage ratio as part of its efforts to curb credit risk in its banking system.  This is the next step along the path that will ultimately lead to requiring the banks to provide current asset level disclosure.

As discussed in an earlier post in which the Economist Magazine called for a new model of bank supervision, requiring current asset level disclosure is necessary to overcome the shortcomings of what China's bank regulator calls inadequate traditional bank supervision.

In addition, once market participants can see the quality of a bank's current on- and off-balance sheet assets, they can adjust both the price and amount of their exposure to the bank so they are properly compensated for risk.  This market discipline acts as a constraint on the riskiness of the bank's asset portfolio.
China's banking regulator has proposed that banks have a 4% minimum leverage ratio to curb credit risk, and analysts said the nation's banks are likely to take the requirement in stride. 
But some analysts said that tighter regulation and looming risk could point to slower growth in the medium term. 
The China Banking Regulatory Commission said late Friday in a statement that it is seeking public opinion on the proposed regulation, which requires that the leverage ratio for commercial banks, including both on and off-balance sheet assets, shall not be lower than 4%. The leverage ratio is generally calculated as core capital as a proportion of total adjusted assets. 
"It is now widely agreed that we should introduce a simple, transparent and non risk-sensitive leverage ratio tool -- in addition to the current capital adequacy tool -- to effectively control the degree of leverage in the banking system," the CBRC said in a statement. 
It went on to say that the financial crisis showed that traditional supervision is inadequate because some Western commercial banks were over-leveraged despite having high capital adequacy ratios. 
The leverage ratio is an additional tool to complement minimum capital adequacy requirements, and thereby reduce the risk of excessive leverage building up in individual banks and in the financial system as a whole. 
"The new regulation is likely to create pressure for some banks to replenish capital, but most listed commercial banks will basically meet the requirements," said Li Shanshan, a banking analyst at Bocom International in Beijing. 
"Some banks will meet the requirements after they complete capital-raising exercises by the end of this year," she said. 
Four commercial banks--the China Merchants Bank, Everbright Bank, Shenzhen Development Bank and Huaxia Bank--do not meet the requirement now, but are likely to meet the requirement after their refinancing plans are completed later this year, she said. 
The CBRC issued new regulations early this month to bring management of the country's banking system in line with new global banking requirements that are known as the Basel III rules. 
It stated that systemically important financial institutions will have to comply with a minimum capital adequacy ratio of 11.5%, while non-systemically important financial institutions will face a capital adequacy ratio of 10.5%. 
The regulations will start to apply in 2012 and banks will be expected to meet all requirements by 2016, two years ahead of the Basel III schedule, the CBRC said at that time. 
China's banking authority has repeatedly raised the minimum capital adequacy ratio for banks to slow loan growth and rein in credit risks amid a lending binge of around CNY18 trillion over the past two years. 
However, analysts have been warning that massive loans to local government financing vehicles and the property sector may hold risks for China's banking sector in the coming years despite its current bumper earnings. 
Lu Lei, vice president of Guangdong University of Finance, warned in an article in the Century Weekly magazine Monday that China's banking sector is facing a downturn. 
He estimated that Chinese banks may need to raise as much as CNY4 trillion over the next four years to boost capital if their assets double and if the government doesn't change the current requirement on capital adequacy. 
"A downturn is unavoidable if under credit tightening there is a fall in asset quality, the banking system could become a 'black hole' for capital," he said. 
Banks will also be required to have a loan-provision ratio of at least 2.5%, meaning that percentage of the total loan book must be set aside to guard against losses. The provision coverage ratio, or the amount of non-performing loans that are already covered by provision, will be at least 150%. 

Monday, May 23, 2011

The Economist Magazine lays out the problem with existing bank supervision model

The Economist Magazine ran a special report in which it discussed a number of shortcomings of the current system of regulating banks and the need for a new model of bank supervision.

As this blog has previously discussed, the current model of bank supervision gives regulators an impossible task.  The Economist lays out why the task is impossible.
In the old days, in so far as they worried about the risk of banks going bust, regulators usually relied on simple measures of health, concentrating on making sure the right paperwork was in the files, says one senior regulator. “It was a wood-and-trees problem,” says another official. “You would go in and come up with a list of 45 things a bank could do better, but you would not be saying: ‘What are the five important things that could threaten this bank?’” 
In the new world of regulation, supervisors are still doing some of the things they have always done. They are tightening capital standards and looking far deeper into the inner workings of banks, down to the plumbing that connects them to one another. “Regulators have gone from saying ‘tell me all your [payment] systems work’ to saying ‘show me how they work’,” says Simon Bailey, of Logica, a technology firm. “They are shining a pretty bright light on parts of the banking system that are massively complex and, if I’m being polite, slightly dusty.” 
Far more controversially, though, regulators are now also tentatively stepping over a long-standing divide between enforcing basic rules and playing a part in business decisions. In regulator-speak the difference is between “conduct regulation” and “prudential regulation”. Under the old rules supervisors were simply referees trying to ensure that the game was played fairly.... 
At first glance it seems sensible that regulators should pay attention to banks’ health as well as to their conduct. Regulation, after all, is the price that society demands, and banks pay, in return for the implicit promise of a government bail-out if the worst happens. The reason banks are regulated and hairdressers are not is that a badly run barber poses little danger to outsiders. Banks, on the other hand, cause widespread chaos when they collapse. One sick bank going broke can destroy confidence in the entire banking system and start runs that could bring down healthy banks too. Most advanced economies try to prevent that by offering deposit insurance to savers. They also regulate banks to make sure they do not gamble with savers’ protected deposits. 
But it is not easy to stop banks from making bad decisions. In the past regulators have tended to leave it to the market to judge the health of banks, not least because they themselves did not feel up to it. Legions of clever, well-paid investment analysts and investors failed to see the crisis coming. Those who did are remembered mainly because there were so few of them.
Under the FDR Framework, it is not the job of regulators to stop banks from making bad decisions.  By making sure that market participants have access to all the useful, relevant information, when banks make bad decisions, the market quickly disciplines them.

Under the FDR Framework, it is not the job of the regulators to replace the wisdom of the market.  Instead, by making all the useful, relevant information available to the market participants, the regulators can tap competitors and credit and equity market analysts for insights.

A primary reason that almost all analysts did not see the crisis coming was they did not have access to all the useful, relevant information.  
Now central bankers and supervisors are expected to make a better job of it, but most would prefer not to get too involved. “We don’t want to get into the business of making very close business judgments,” says one American official, but “we are making a judgment of our own about whether they have a coherent strategy and coherent risk management.” 
Under the FDR Framework, regulators also have the role to act like investors and protect their investment, deposit insurance.  As an investor, they should not try to run the bank.  Rather, they should adjust the price and amount of exposure based on the riskiness of the bank.  As the risk goes up, so too should the effective cost of deposit insurance to the bank.  This increase in cost can take many forms including higher capital requirements.
One problem is that rules and laws are written with the benefit of hindsight. The good ideas that might well have prevented the last crisis, however, can make regulators dangerously overconfident about being able to predict and prevent the next one. 
Actually, the FDR Framework came out of the last major crisis.  Had it been fully implemented, it would have mitigated the severity of the recent credit crisis.  Where the financial markets failed in the valuation of banks and structured finance securities was where there was opacity that prevented market participants from accessing all the useful, relevant information.
Besides, the regulators’ reluctance to second-guess bank executives was well founded, because it can take them onto dangerous ground. If regulators underwrite certain strategies that seem safe, such as lending to small businesses or helping people buy houses, they may encourage banks to crowd into those lines of business. That can drive down interest rates and lending standards and push up asset prices. If enough banks pile into these markets, downturns in them can affect not just a few banks but the whole system. Paradoxically, the very act of signalling that a market is safe can make it dangerous. It also introduces a form of moral hazard, because banks and their creditors may assume that the government would be duty-bound to bail them out if a closely monitored institution were to fail. 
This moral hazard speaks very clearly on why disclosure of all useful, relevant information is necessary. 
On the other hand over-strict regulation can also be harmful if it stifles financial innovation and squeezes all appetite for risk out of the banking system. In Japan, a banking crisis that started more than two decades ago still lingers on, in part because the country’s bankers have become gun-shy and tend to buy government bonds rather than lend money.
Over the last three decades, the focus of financial innovation has been to create opaque products that are difficult for market participants to analyze, assess the risk of and accurately value.  While adherence to the FDR Framework would stifle these innovations, it would not effect valuable innovations like the invention of the ATM.
And even if supervisors rule wisely, they have to keep it up year in and year out to remain effective. “I worry that supervision is an endless process of having to get better,” says a senior regulator in Britain. “You have to keep hiring lots of clever people and you have to avoid atrophy over time.”
By disclosing all useful, relevant information in an appropriate, timely manner, the regulators can leverage off the market, its clever people and its endless process of analyzing all the available information. 
Most regulators are doing all they can to mitigate these risks. Many are concentrating on changing incentives in the banking system, in the hope that this will change behaviour. Yet they also know that in the new world of intensive regulation the very need for it is an admission of failure.
The failure of the old system where regulators have a monopoly on all useful, relevant information in an appropriate, timely manner.

The Economist Magazine calls for new model of bank supervision

The Economist Magazine ran a special report in which it discussed a number of shortcomings of the current system of regulating banks and the need for a new model of bank supervision.

BANKING CRISES OF the sort that affect a large part of the world, slowing global economic growth, freezing finance and crimping international trade, are mercifully rare.... The costs of any such meltdowns are difficult to estimate... It is not just a question of totting up the direct costs of bailing out the banks or transferring debt from private balance-sheets onto those of the state. There is also the toll of broken lives, lost homes...
Most of the time, though, banks do not blow up. When things go well, they help to produce growth and wealth. They also make people’s lives easier.... 
Regulators and their political masters now have to ensure that the benefits of a vibrant and innovative banking system are ever more widely spread and meltdowns become ever rarer. ...
Yet there are still fundamental flaws in the global financial system. All the measures that regulators are putting in place to try to make banks safer, such as higher capital requirements, stricter regulation and limits on risk-taking, need to be tested against a simple question. If all other safeguards have come to naught, can big financial institutions be allowed to go bust (or be saved without asking taxpayers to stump up)? ....
Regulators are finding it hard to crack this problem... because they are being excessively cautious, seeking certainty before they act. Like a jury in a criminal trial, they are looking for evidence that is beyond reasonable doubt. 
Actually, the FDR Framework has 75+ years of evidence that shows it solves the regulators' problem.

As this blog has documented on several occasions [see here, here, here, here and here for example], it it the regulators' monopoly on all useful, relevant information for financial institutions that is the source of financial instability and the reason that it is impossible to let big financial institutions go bust.

This monopoly forces market participants to be dependent on the regulators.  This monopoly prevents the market participants from performing their risk management function and properly adjusting both the price and amount of their exposure based on the risk of a financial institution.  

If the regulators were to give up their monopoly on all the useful, relevant information, they would be able to let banks go bust again.  The FDR Framework explains why through its combination of disclosure to market participants of all useful, relevant information in an appropriate, timely manner with the principle of caveat emptor [buyer beware]. 

With access to all useful, relevant information, market participants can now evaluate the riskiness of an investment in a financial institution.  With the ability to do their homework, the market participants accept all the gains or losses on any investment knowing the investment was made under the principle of caveat emptor.

It is the ability to control exposure combined with the acceptance of losses that allows financial firms to go bust without causing a financial crisis.  Financial firms can go bust again because market participants only have as much exposed to a financial firm as they feel comfortable losing.

Negotiated banking standards vary in implementation

A Reuter's article demonstrates why current asset and liability-level disclosure required under the FDR Framework is the only standard that can be applied globally on a consistent basis.

Implementation of Basel III and liquidity rules is subject to interpretation by national bank regulators.  Disclosure is not subject to this interpretation as it applies equally everywhere.
Seven European Union finance ministers have written to the EU executive saying its plan for implementing Basel III capital and liquidity rules for banks were too soft, a German newspaper reported on Friday. 
Ministers, including those from Britain, Spain and Sweden, also said the European Commission's proposal for a binding, unified set of rules crimped an individual country's ability to demand higher capital quotas from banks, the Financial Times Deutschland reported, citing the letter. 
The proposal also curtailed national financial watchdogs' ability to take account of differences in banking systems. 
The plans as they now stand would "damage European financial stability and the EU's credibility in this area," the paper quoted the letter as saying. 
International financial regulators have hammered out the Basel III accord to tighten rules on banks to avoid a repeat of the financial crisis. The deal was endorsed by world leaders last November and will phase in tougher bank capital and liquidity requirements over six years from 2013. 
EU financial services chief Michel Barnier will publish a draft EU law in July based on the global agreement. 
The paper said Germany did not sign the letter and appeared to have been successful in its demand that joint-stock and non-joint-stock banks be treated the same under the new rules.

Sunday, May 22, 2011

Reason the ECB is pushing for the creation of an ABS data warehouse revealed

As discussed previously on this blog, one of the reasons that the ECB has been pushing an ABS data warehouse in the hopes of restarting the structured finance market is that it has a significant amount of exposure to structured finance securities on its balance sheet.

The Dow Jones Newswire reports that according to Der Spiegel,
Skeleton risks amounting to several hundreds of billions of euros are on the balance sheet of the European Central Bank, magazine Der Spiegel writes in a preview of its edition to be published Monday. 
Those risks arise because banks, above all from Greece, Ireland, Portugal and Spain, have provided as collateral asset-backed securities that are unfit for central bank loans as their debt rating is low or non-existent, the magazine says. 
That way, the banks are able to receive more financing from the ECB, Der Spiegel says. 
We now find out that there are several hundred billion euros of asset-backed securities that are unfit for central bank loans regardless of the size of the haircut on the collateral.  Hence, the ECB has a very large incentive to get the market going so that these securities can be purchased by investors from the issuing banks and the ECB can stop funding the banks.

Given this incentive, the ECB should be doing everything in its power to make sure that the ABS data warehouse is successful.  Where success is not simply that a database is constructed, but rather that investors trust the data and are willing to end their buyers' strike.  If investors do no trust the data, they will not return to the structured finance market.

To date, your humble blogger is the only one in the world talking about a database that is likely to be trusted (no conflicts of interest with existing market participants and availability of all the useful, relevant data fields).

NovaStar Financial makes the case for embracing the FDR Framework

The NY Times ran an excerpt from Gretchen Morgenson and Joshua Rosner's new book, "Reckless Endangerment:  How Outsized Ambition, Greed and Corruption Led to Economic Armageddon".  The excerpt focused on NovaStar Financial and a short-seller's efforts to have the SEC look into the firm's business practices.

The excerpt presents a compelling case for why the FDR Framework needs to be embraced and fully implemented.

MARC COHODES had heard the stories.  Heard how these guys would give a mortgage to anyone — even to a corpse, the joke went. 
... So Mr. Cohodes, a money manager in Marin County, Calif., decided to bet against one of the big names of the subprime age: NovaStar Financial. 
NovaStar was part of a crop of new lenders that had sprung up in the 1990s.... 
Like others in the subprime industry, NovaStar used aggressive accounting that obscured its increasingly precarious finances. As far back as the 1990s, it had to underwrite loads of new loans to offset losses on older mortgages.
Under the FDR Framework, the damage to the financial system a NovaStar could cause would be minimized.  This is a direct result of NovaStar having to disclose to market participants all the useful, relevant information in an appropriate, timely manner.  In the case of NovaStar, this would have included its current loan-level performance data.

The disclosure of this data would allow market analysts to better understand the risk of NovaStar and its book of business.  With this better understanding of the risk, market participants could do a better job of setting both the price of and amount of their exposure to NovaStar.

Hiding behind the opacity of current disclosure practices, NovaStar was able to obscure the true risk of its business.  As a result, market participants under-estimated the risk and over-invested in the company and financial securities backed by loans originated by the company.
... Although NovaStar was not a household name in lending, in 2003 the company boasted 430 offices in 39 states. With headquarters on the third floor of an office building in Kansas City, Mo., it was fast becoming one of the top 20 home lenders in the country. 
NovaStar was also becoming a Wall Street darling,..., Thanks to aggressive management, unscrupulous brokers, inert regulators and a crowd of Wall Street stock promoters, NovaStar’s stock market value would soon reach $1.6 billion. 
... Mr. Cohodes knows every trick executives use to make their companies look better than they are. He prides himself on being able to spot trouble.... and he often shared his research with regulators at the Securities and Exchange Commission
... So in February 2003, Mr. Cohodes started corresponding with the S.E.C. about NovaStar. He began “throwing things over the wall,” as he put it, to Amy Miller, a lawyer in the division of enforcement.  
Among the questionable practices that are the easiest to find are those that appear in a company’s own financial statements.... “They made their numbers look however they wanted to,” he recalls. “Not even remotely realistic.”
One tactic gave the company lots of leeway in how it valued the loans held on its books. Another allowed it to record immediately all the income that a loan would generate over its life, even if that was decades. This accounting method ignored the possibility that some of the company’s loans might default. NovaStar assumed that losses on all of its loans would be nonexistent. 
Both of these tactics would be absurd in the face of having to disclose current loan-level performance data.
... NovaStar’s rosy assumption not only padded its profitability but also encouraged the company to make more mortgages, regardless of quality. The more loans it made, the more fees and income the company could record.
With disclosure of current loan-level performance data, the market would have seen the deterioration in credit quality.  The result would have been market discipline on management as investors charged more for the funds provided to NovaStar to be compensated for the risk.
... Mr. Cohodes and other NovaStar critics believed that they had found a company whose success was built on deceptive practices. What they did not recognize was that NovaStar was a microcosm of the nationwide home-lending assembly line that would lead directly to the credit crisis of 2008. 
IN Atlanta, Patricia and Ricardo Jordan learned the hard way how NovaStar’s freewheeling lending practices imperiled unsuspecting borrowers.

The Jordans sued NovaStar in 2007. As part of the lawsuit, their lawyer found that their loan had been placed in a mortgage securitization trust assembled by NovaStar and sold to investors in November 2004. More than half of the loans in the pool were provided with no documentation or limited documentation of borrowers’ financial standing. 
But the Jordans had given NovaStar bank statements and other documentation of their income. The lawsuit would show that NovaStar had inflated their monthly income by $500 to make the loan work. The lender had given the Jordans a loan that went against its own underwriting guidelines and that overrode federal lending standards. 
The Jordans’ was just one loan. There were literally thousands more like it. (NovaStar settled with the Jordans in 2010. The terms were undisclosed.)
Again, had there been current loan-level disclosure for the structured finance security, analysts could have seen what was occurring and the true riskiness of the underlying mortgages.  If NovaStar could not access funds through securitization at an attractive or any price, it would have cut back on its lending and the associated deceptive practices.
... Although some of the S.E.C. people he spoke with seemed to recognize the problems in NovaStar’s operations, their investigation did not appear to be gaining traction. 
The phone calls with the regulators went over the same material repeatedly, Mr. Cohodes recalls, leading him to conclude that Ms. Miller and her colleagues did not understand what was happening at NovaStar. 
“Whenever they seemed to get it, they would either call up or make contact frantically saying, ‘Can you please go over this again?’ ” Mr. Cohodes said. “It was almost like someone was presenting a case to the higher-ups and they would say, ‘Are you sure? Go back and make sure.’ ” 
This sort of behavior by regulators is not limited to the SEC.  In an earlier post, I discussed how bank examiners face the same issue.  They might uncover a problem, but they have present a case to convince the higher-ups.  In the meantime, the financial institution also got to present its case for why it was not a problem.
... But while NovaStar executives high-fived each other, a unit of Lehman Brothers, Wall Street’s largest packager of residential mortgage loans sold to investors, was discovering serious problems in a review of NovaStar mortgages. The findings were so troubling to the Lehman executives overseeing the firm’s purchases of NovaStar loans that they ended their relationship with NovaStar in 2004.
According to documents filed in a borrower lawsuit against NovaStar, Aurora Loan Services, a Lehman subsidiary, studied 16 NovaStar loans for quality-control purposes. What the analysis found: more than half of the loans — 56.25 percent, to be exact — raised red flags. “It is recommended that this broker be terminated,” the report concluded. 
Among the problems turned up by the Aurora audit were misrepresentations of employment by the borrower, inflated property values, transactions among parties that were related but not disclosed, and unexplained payoffs to individuals when loans closed. 
... S.E.C. rules require the disclosure by company management of information considered material to the company’s prospects or an investor’s analysis. In a 1999 S.E.C. bulletin, the commission defined materiality this way: “A matter is ‘material’ if there is a substantial likelihood that a reasonable person would consider it important.” Two Supreme Court cases use the same standard. 
Surely, Aurora’s findings that more than half of the sampled NovaStar loans were questionable would have been an important consideration for the S.E.C.’s “reasonable person.” 
Still, NovaStar failed to alert investors or the public at large to the Aurora analysis. Nor did NovaStar publicize the fact that Lehman Brothers had stopped buying its loans.
The analysis done by Aurora is the type of analysis that disclosing current loan-level performance data would allow all market analysts to do.  Without this type of disclosure, NovaStar was able to hide the Aurora analysis and resulting decision. 
... To keep its money machine running, NovaStar regularly issued new shares to the public. Between 2004 and 2007, for instance, the company raised more than $400 million from investors. To those critical of NovaStar’s practices, this was money the company should never have been allowed to raise from investors who were kept in the dark by the company’s disclosure failings. 
Mr. Cohodes reckons that over roughly four years, he conducted hundreds of phone calls with the S.E.C. about NovaStar. Each time, he would walk them through his points. Sometimes, a higher-up would get on the phone and contend that while NovaStar’s practices were indeed aggressive, the company did not appear to be breaking the law. 
NovaStar’s selective disclosures — it was quick to report good news but failed to own up to problems on many occasions — seemed to be infractions that the S.E.C. should have dealt with. But its investigation went nowhere.

Fundamental to the FDR Framework is the principle that market participants have access to all useful, relevant information in an appropriate, timely manner.  Had there been disclosure of current loan-level performance data, that would have been sufficient to limit the losses associated with NovaStar and the structured finance securities its mortgages were included in.

The story of NovaStar also highlights the role of regulators in ensuring access to all the useful, relevant information.  This is the regulators' responsibility.  A responsibility for which the regulators must error on the side of "too much" rather than "too little" disclosure.

Leading up to the credit crisis, decisions on disclosure were subject to a cost/benefit analysis.  If the cost of disclosure exceeded the regulator's estimate of benefit, useful, relevant information was not disclose.  With the hundreds of billions of dollars of losses taken by investors during the credit crisis as a result of inadequate disclosure, the cost/benefit analysis now permanently justifies providing disclosure.

Finally, the decision of what is useful, relevant information is driven by what market participants think is all the useful, relevant information and not what the disclosing party thinks is all the useful, relevant information.  As NovaStar showed, the disclosing party may have an incentive to hide useful, relevant information.

... As is its custom, the S.E.C. declined to comment on the NovaStar inquiry or the agency’s discussions with short-sellers. But documents supplied by the S.E.C. under the Freedom of Information Act show the extensive communications between Mr. Cohodes and the agency. Ms. Miller, still at the S.E.C., declined to comment. 
“It would be interesting to see who exactly dropped the ball, and why,” Mr. Cohodes said. 
“It would be interesting why nothing was ever brought. The S.E.C. should have sent a plane for us to come to D.C. and say: ‘How do we make sure this doesn’t happen again?’ ”
Fully implement the FDR Framework.
 ...At the end of 2009, NovaStar management concluded that the company’s financial reporting was “not effective.”
NovaStar had, in essence, confirmed what Mr. Cohodes had been telling the S.E.C. all along. The company’s financial reports just couldn’t be trusted.

Saturday, May 21, 2011

UK's Prudential Regulation Authority Plans to Rely on Own or Market's Judgment

The Telegraph carried an article in which Hector Sants, the individual who will run the UK's Prudential Regulation Authority, laid out his vision for how the PRA would operate.
The Prudential Regulation Authority (PRA), which will take over the supervision of the banking sector from the Financial Services Authority within 18 months, will take a "judgment-based" approach to financial regulation that Hector Sants, the chief executive of the FSA who will run the new PRA, said could have lessened the impact of the financial crisis. 
"Central to this supervisory model is the presumption that regulators cannot rely on the judgment of the firms they supervise, and must take their own view formed from their own analysis about the significant issues which affect the safety and soundness of the firm. Furthermore, where that judgment differs from the firm's management, the regulator must act," said Mr Sants. 
This statement suggests that the pre-credit crisis method of supervisory regulation in the UK consisted of calling each bank, asking if everything was okay, being told it was and then going out to lunch.

Based on my experience with the bank examination model, which the FSA also was using, examiners were physically located in the largest banks every day looking for issues that wold affect the safety and soundness of the firm.  If they found any issues, they would report them both through the reporting channels at the regulator and to the firm's management.

It is at this step that supervisory regulation breaks down.  Management has the opportunity to correct or explain why it is not a problem.  If management does not think it is a problem, they document why it is not a problem.

Then the regulators have to decide if it is a problem worth pursuing based on what the examiner and management have to say.  Who should the regulators trust in making the decision that it is a problem worth pursuing?

In this decision process, the odds are stacked against the examiner and therefore it is unlikely that problems will be addressed.  As Mr. Sants says, regulators relied on the judgment of the firm's management.  This reliance means that the examiner would have to convince a significant number of people at the regulator why the examiner was right and management was wrong (the Nyberg Report on the Irish Crisis also makes this point).

Mr. Sants appears to be proposing that going forward the PRA will assume that the examiner/supervisor is right and it is up to the firm's management to convince the regulator otherwise.  This also does not work.

It cements in the concept of moral hazard. When the regulators have the final say in the management of risk at a financial firm, how can a financial firm be allowed to fail?

It also substitutes the judgment of the regulators for the judgment of the market.  No one believes that the regulators can do a better job of assessing risk than the market.  The common sense test of this is asking the question of who do you think would de a better job of assessing the risk of Citi - a competitor like JP Morgan or the regulators?
Outlining his plans for a PRA, which will be far smaller than the FSA with less than 1,000 staff, Mr Sants said he was hoping to attract "high-quality, experienced supervisors" to the regulator. 
Andrew Bailey, an executive director of the Bank of England who will be Mr Sants' deputy at the PRA, said hiring staff with the clout to deliver judgments on some of the country's largest banks would not mean paying large amounts of money. 
"To just say it is about money isn't right," said Mr Bailey, adding that the type of people who would want to work at the PRA would have to be interested in "policy issues".
Based on my initial read of the BoE's approach to bank supervision under the PRA, I observed that under principle 10, the PRA was adopting current asset and liability-level disclosure so the market could make judgments of risk and return.  These comments confirm that observation.

It makes sense not be be paying large amounts of money to hire the best analysts when financial firms have to disclose their current asset and liability-level data.  This disclosure allows the PRA to leverage off of all the best analysts regardless of where these analysts are employed.

Rather than pay for an in-house analysis that the PRA may or may not use, the best analysts will produce their analyzes but instead will make them available to market participants.  It is the market participants who have the clout and incentive to deliver judgments based on these analyzes on some of the country's largest banks.  This is the very definition of market discipline.

Thursday, May 19, 2011

UK's Prudential Regulation Authority Adopts Current Asset-Level Disclosure

On May 19, 2011, the Bank of England published its approach to bank supervision under its Prudential Regulation Authority (the "PRA").

In discussing the Principles Underlying the PRA's Approach, the Bank of England and the Financial Services Authority observed under principle 10
That firms should be allowed to fail, so long as failure is orderly, reflects the view that financial firms should be subject to the disciplines of the market.  Consistent with its statutory objective, the PRA will not view the failure of an institution in an orderly manner as regulatory failure, but rather as a feature of a properly functioning market. This is an important change to the statutory basis of prudential supervision.  The PRA will seek to ensure that firms disclose sufficient information to enable the market to make judgements about risk and return.
As regular readers of this blog know, the only way for market participants to have sufficient information to make judgements about risk and return is if the market participants have all the useful, relevant information in an appropriate, timely manner.

When it comes to financial firms, the useful, relevant information is the firm's current asset and liability-level data.
  • This is the data that market participants need to analyze to determine if a firm is solvent [that the market value of the firm's assets exceeds the book value of the firm's liabilities].  
  • This is the data that market participants need to analyze to see if the risk profile of a financial firm is changing and to adjust both the price and amount of their exposure to the change in the financial firm's risk profile.  It is through the adjustment of price and amount of their exposure that market participants exert market discipline on financial firms.
  • This is the data that market participants require if they are going to be willing to once again absorb losses in the case of the failure of a financial firm.  
    • In the absence of this data and the presence of financial regulators issuing assurances about the solvency of a financial firm, investors are unwilling nor is it reasonable to expect them to absorb solvency losses.  
    • In the presence of this data, it is no longer necessary for financial regulators to opine on the solvency of a financial firm.  Under the principle of caveat emptor [buyer beware], investors will use this data to determine the price and amount of their exposure knowing they could lose their investment to insolvency.
For those who would argue that there is a middle ground between what financial institutions disclose now and full disclosure of their current asset and liability-level data, the question is "Why should there be a middle ground?"
  • How can investors exert market discipline without all the useful, relevant information? 
  • Why would investors be willing to absorb solvency losses without the opportunity to analyze all the useful, relevant information prior to making an investment?  
  • Why would investors not expect a bail-out from all solvency related losses when regulators are running stress tests and saying the financial institutions are adequately capitalized? 
  • What benefit is there to the financial markets of not disclosing all the useful, relevant information?
    • Financial institutions would prefer opacity because it limits the market's ability to properly judge and price risk and therefore makes them more profitable.  Why is this good for the financial market and the economy?
  • Why would the financial system be more stable in the absence of disclosure of all the useful, relevant information?  
    • Are regulators better at judging the risk and solvency of a financial institution than its competitors and the market's credit and equity market analysts?

The FDR Framework passed the test of time

Recently, this blog has spent a considerable amount of time discussing the ECB's ABS data warehouse.  This data warehouse has served as an excellent example of the problems, like opacity and conflict of interest, in our financial system that result from the failure to adhere to the FDR Framework.

As regular readers of this blog know, the FDR Framework, with its philosophy of disclosure combined with the principle of caveat emptor [buyer beware], has been with us for almost 80 years.

Your humble blogger never tires of pointing out that the financial markets did not stop functioning during the recent credit crisis in those areas that adhered to the FDR Framework.  In these areas, market participants had access to all the useful, relevant information in an appropriate, timely manner.  Market clearing prices may have declined, but there were investors standing willing to buy the securities being offered.

The financial markets failed in those areas, structured finance and unsecured debt securities of regulated financial institutions, that did not adhere to the FDR Framework.  In these areas, market participants did not have access to all the useful, relevant information in an appropriate, timely manner.  Market clearing prices in these areas disappeared as there were few investors standing willing to buy the securities being offered.

Your humble blogger out of necessity keeps reminding economists and regulators that the FDR Framework has an incredibly good predictive track record.  This track record applies to both predicting market failure before the credit crisis as well as predicting the failure of different regulatory responses to restore investor confidence (see posts on Irish banks and Spanish Cajas) subsequently.

Perhaps more importantly, the FDR Framework lays out a coherent explanation for why the financial crisis occurred (no need to ignore any inconvenient facts) and what has to be done to fix the financial system.

The FDR Framework is parsimonious.  It is the model of how the financial system works that requires the fewest assumptions and has the best predictive value.

Wednesday, May 18, 2011

A Simple Proposal that eliminates the need for tougher credit-rating rules

The WSJ carried an article on the SEC's 500+ page proposal to reform the credit rating system.

Your humble blogger would like to offer up a simple proposal from the FDR Framework that would probably be more effective than all of the SEC's proposed reforms.  The proposal is
Each rating agency should make available all of the data, including assumptions, that it used in developing its rating for a specific security.
Disclosure of this data would dramatically improve the transparency of credit ratings.  It would also let market participants compare their own analysis against the rating agencies.

Donald Kohn and the BoE's Financial Policy Committee could use a lesson in the FDR Framework

Testifying before British MPs at a confirmation hearing for the Bank of England's new Financial Policy Committee, Mr. Kohn demonstrated why he and other financial regulators could use a lesson in the FDR Framework.

According to a Financial Times article,
Speaking to British MPs at a confirmation hearing on Tuesday, Mr Kohn nevertheless said his experience would be valuable for the Bank of England, where he has been appointed to a new committee with powers to guide UK financial stability
“I believe I will not make the same mistake twice,” he said. 
This suggests an acknowledgement of what mistake he made is coming...
Mr Kohn has been appointed to the Bank’s new Financial Policy Committee, which will soon have powers to change system-wide UK financial regulations and even limit borrowing by households and companies if it thinks there are threats to financial stability. 
Having been a strong advocate of the Greenspan doctrine not to burst asset bubbles but to mop up any mess after a crash, Mr Kohn recanted much of his previous view in front of MPs.
Apparently the mistake was in not bursting the asset bubbles but instead waiting to mop up any mess after a crash.

However, the alternative of central bankers and financial regulators popping asset bubbles sooner is a non-starter.

As this blog has gone to great lengths to document (see discussion of the Nyberg Report on Ireland) and explain, there is an institutional reason that central bankers and other financial regulators do not burst asset bubbles sooner.
  • First, the regulators have to come to a consensus that there is a bubble.  Some analysts in one part of the regulatory bureaucracy might think that there is, but it is a long way from their belief to convincing the entire regulatory body to share their view and take action. 
  • Second, the regulators need evidence that the bubble is harmful.  Without this, politicians are likely to crackdown on the regulators as all that is visible to the politicians is the benefits of the asset bubble.
Returning to the FT article
He said he had “learnt quite a few lessons – unfortunately” from the financial crisis, including that people in markets can get excessively relaxed about risk, that risks are not distributed evenly throughout the financial system, that incentives matter even more than he thought and transparency is more important than he thought
And here is where the lesson in the FDR Framework comes in.  These are not separate, but issues that are all linked logically together under the FDR Framework.

As regular readers of this blog know, the FDR Framework makes the financial regulators responsible for ensuring that market participants have access to all the useful, relevant information in an appropriate, timely manner.  This is the transparency that he learned is important.

Under the FDR Framework, market participants, particularly investors, are responsible for analyzing this information to assess the risk of any investment knowing that it is buyer beware for any investment they make.

The requirement to ensure transparency is placed on financial regulators because there are market participants who benefit from opacity.  This is where incentives matter comes in.  The way these market participants benefit from opacity is that opacity makes it impossible for investors to properly analyze and price risk.
Similar to Mr Greenspan’s 2008 comment that the former Fed chairman had erred in presuming banks were able to act in their shareholders’ interests, Mr Kohn said: “I placed too much confidence in private market participants to police themselves”.

Actually, the financial crisis did not show that confidence in private market participants to police themselves was misplaced.

What the financial crisis showed was that since the financial regulators have an informational monopoly on all the useful, relevant information for each financial institution, other financial market participants are dependent on the regulators' assessment of the risk of the financial institutions.  When the financial regulators under-estimate the risk of the financial institutions, so do the other market participants. 

As predicted by the FDR Framework, without the useful, relevant information, the other market participants cannot exert any market discipline or police the financial institutions themselves should the risk profile of the financial institution change. 

The former Fed official was willing to offer an apology... 
“I deeply regret the pain that was caused to millions of people in the US and around the world by the financial crisis ... Most of the blame should be on the private sector: the people that bought and sold those securities, on the credit rating agencies that rated them. But I also agree that the cops weren’t on the beat,” he said 
“The regulators were not as alert to the risks as they could have been and, to the extent they saw the risks, were not as forceful in bringing them to the attention of management, or taking actions, as they could have been. All this with 20/20 hindsight obviously.”
Actually, it is a matter of public record that your humble blogger using the FDR Framework saw the problems in the financial system before the financial crisis and recommended steps that would have reduced the severity of the crisis.

Your humble blogger would be willing to sit on or consult with the BoE's Financial Policy Committee as it is clear that the committee could benefit from the insights of the FDR Framework.

The FDR Framework and Ending The Looting of Banks

The other day, Bloomberg ran an interesting column by William Black.  One of the main observations in the column was

Nobel laureate George Akerlof and Paul Romer wrote a classic article in 1993. The title captured their findings: “Looting: the Economic Underworld of Bankruptcy for Profit.” Akerlof and Romer explained how bank CEOs can use accounting fraud to create a “sure thing” in the form of record short- term income, generated by making low-quality loans at a premium yield while making only minimal reserve allowances for losses. While it lasts, this fictional income allows the chief executive officer to loot the bank, which then fails, and walk away wealthy.
The necessary conditions for this fraud to take place are the limited access to the asset-level data made possible by the financial regulators' information monopoly combined with the regulators' inability to effectively analyze the information.

Everyone knows that the first condition exists as financial institutions are not required to disclose their current asset-level data.  For confirmation that the second necessary condition exists, see the WSJ article in which

[A] top Bank of England official, Andy Haldane, said the new regulator will curtail the FSA's practice of dispatching dozens of examiners to banks to collect loads of granular information... that ... rarely yield much useful information for regulators, who can find themselves overwhelmed by the quantity of data.
As regular readers of this blog know, the FDR Framework would prevent this type of accounting fraud.  Under the FDR Framework, market participants have access to all the useful, relevant information in an appropriate, timely manner.  This is asset-level data for banks.

With access to the asset-level data, market participants, including competitors and credit/equity market analysts and investors, will do their own analysis of the risk of the assets.  It is this analysis that will show that the reserve allowance is not sufficient for the risk of the assets.

This type of accounting fraud is another way that the regulators' monopoly on all the useful, relevant information on financial institutions is harmful to the financial system.

Tuesday, May 17, 2011

EC Puts Up Stop Sign for the Market Group's Involvement in the ECB's ABS Data Warehouse [Update]

Bloomberg published an article on the European Commission's probe of financial market data vendors who control essential infrastructure.

As discussed previously on this blog (see here), the ECB is acting as a catalyst to spur the creation of a centralized ABS data warehouse.  The data warehouse will process, verify and ultimately distribute standardized loan-level information on all existing and future structured finance deals to all market participants.

In a recent International Asset-Backed Strategy report, an RBS analyst observed of this effort
[W]e would see an ECB-endorsed (even if “non-exclusive”) data provider as an effective market monopoly in the ABS data aggregation business.
Hence, it will be on the European Commission's radar as essential infrastructure.

The report continues
The ECB’s letter of intent states that “To the extent possible, market participants will have the opportunity to use and invest in the Data Warehouse subject to entering into appropriate legal arrangements” – while this statement appears to encourage a ‘market-owned’ data provider, we think the difficult practicalities of creating such a socialised venture will mean that the project likely ends up going to a private firm(s). 
This was in fact directly indicated by a press release issued on April 28th from a group of market participants (originators and investors) stating that they will oversee and manage the selection process for the construction and administration of the Data Warehouse, which according to the press release will allow ABS issuers to submit loan-level data electronically, which will then be verified and audited for compliance with the ECB’s criteria requirements for repo eligibility. 
Every member of this group of market participants, the Market Group, has a conflict of interest.  Another big, red flag for the European Commission.
European Union regulators, who are investigating 16 investment banks over the swaps market, will examine the “control and dissemination” of financial-market data for possible antitrust abuses. 
The European Commission will investigate whether data providers are engaging in abusive behavior by “attempting to leverage privileged access to information,” Joaquin Almunia, the EU’s competition commissioner, said in a London speech today. “I also intend to discuss the legitimate scope of intellectual property rights claims on such data,” Almunia said.
Almunia is increasing the EU regulator’s scrutiny of financial markets. Last month, he announced a probe into whether 16 banks ... colluded by giving data to Markit, a financial information provider.  
The commission is also checking whether nine of the banks struck deals with ICE Clear Europe, a clearinghouse for derivatives, that prevent other clearinghouses from entering the market. 
This should be a stop sign for the ECB and its involvement with and potential endorsement of the Market Group's version of the ABS data warehouse.
The commission is ramping up antitrust enforcement in the financial services sector,” Suzanne Rab, a lawyer at King & Spalding in London, said in an e-mail “An underlying theme is the transparency of and access to data.” [emphasis added]
Almunia, who is set to examine Deutsche Boerse AG’s bid for NYSE Euronext, said he is opposed to “essential” market infrastructure being controlled by a small number of companies. 
“We should prevent that any one entity or group controls essential infrastructure -- be it a trading platform, a clearing platform or a pre-trading service -- to the benefit of a restricted few,” he said.
This problem is particularly acute if the companies all have conflicts of interest in the control and dissemination of the data.

This problem is mitigated if the firms that construct and operate the ABS Data Warehouse and therefore control the essential infrastructure are verifiably free of conflicts of interest with existing structured finance market participants.

This requires that any firm that is involved in either the day-to-day operation of the ABS Data Warehouse or the Coordinator role should be required to make a full disclosure of all competitive and financial interests in the design of the database, the presentation of the data, the analysis of the data, and the use of the data, including:

  • Is the firm engaged in a related business that could gain a competitive advantage from its role? Examples of such related businesses include data distribution, pricing services, trustee services, monitoring, analytic solutions, loan servicing, collection services, consulting, ratings services, investment as a principal or agent or portfolio manager, and underwriting.
  • Does the firm have investments that could benefit from its role, such as long or short positions in ABS transactions?
So long as these firms, like your humble blogger's, do not have conflicts of interest with existing market participants, they are motivated to do what is best for the structured finance market.  After all, they make money by seeing that the structured finance industry is successful.

The Bloomberg article highlighted another type of anti-trust concern.

... Standard & Poor’s offered to change its pricing policy in Europe to overcome antitrust concerns over licensing fees for securities identification numbers, the commission said earlier today.
This type of anti-trust concern will not be a problem for the ABS Data Warehouse your humble blogger would operate as the data warehouse will provide loan-level data for free to all market participants.


The following are the highlights from a May 16, 2011 speech by Mr. Almunia, the Vice President of the European Commission responsible for Competition Policy to the Cass Business School in London.

The speech touches on many of the themes addressed on this blog under the FDR Framework.  This includes the need to replace opacity with transparency so that all market participants have access to the useful, relevant in an appropriate, timely manner.  This includes the need to eliminate conflicts of interest so that investors can trust this data.
Let me start by talking about the challenges we are facing. Promoting competition, cross-border integration, and transparency in the financial markets has been part of the European Union’s efforts to build and strengthen the Single Market for many years. The need for EU-wide oversight of the financial sector became apparent in the 1990s as the Union moved towards closer economic integration and the single currency. 
This recognition led to the adoption of the Financial Services Action Plan of 1999, which comprised 42 separate measures on securities, banking, insurance, mortgages and pensions. The plan resulted in major pieces of legislation, including the Capital Requirements Directive, the Markets in Financial Instruments Directive – or MiFID – and the Market Abuse Directive. As our first wave of legislation was being implemented, financial markets were changing fast.
  • Technological innovation brought new organisations and practices such as broker crossing networks, systematic internalisers, and algorithmic and high frequency trading.
  • Ever more complex financial products and derivative instruments were being introduced, and
  • There was a massive rise of over-the-counter trading, which is now estimated at around 40% of all equity trades.
More importantly, the spectacular growth of trade in new financial products took place in a very opaque environment. In that environment, too much risk was being taken, also because risk was being mispriced. In addition, the crisis generated suspicions of market manipulation and abuse which contributed to damage investors’ trust in financial markets – and these suspicions have not dissipated yet. 
The EU has responded to these conditions by launching a comprehensive review of its existing legislation. The goals are to bring more transparency and stability to financial markets and to extend the scope of regulation to new financial instruments and infrastructure. 
Almost three years since the crisis erupted, financial markets are the scene of dramatic consolidation of trading platforms and infrastructure. This is due to a recovering environment for financial trading and to the imperatives of globalisation and technological change. 
... These are some of the current challenges in the financial services industry; now I would like to talk about what the joint action of competition policy and regulation at EU level can do to address them. 
... The regulatory measures taken by the European Commission will shed more light into the way financial markets operate and will prevent a dangerous accumulation of risk. But regulation alone is not enough. Whereas regulation tackles broad structural market failures, you need competition policy to tackle the harmful behaviour of individual market participants. 
Competition control should ensure that the actual evolution of the market does not lead to structures that harm users and legitimate market participants. In particular, we should prevent that any one entity or group controls essential infrastructure – be it a trading platform, a clearing platform or a pre-trading service – to the benefit of a restricted few. 
I am aware of the debate on inter-operability and the question of whether increased competition and the proliferation of market actors can undermine stability, but I cannot see a problem here. I believe that competition and stability are not at odds. If market participants comply with strict prudential requirements, I see no risk in having many of them supplying services to investors. In fact, I see potential gains. The level of concentration in the markets should reflect the search for optimal efficiency; it should not reflect the actions of powerful market players that have excluded potential competitors. 
So, in my view this is not a real danger. Let me tell you what I believe is one of the major problems in wholesale financial markets. Regulatory initiatives have gone a long way to increasing transparency of over-the-counter trade vis-à-vis regulators. But for a market to function well there must also be transparency vis-à-vis all market players. Market data that are necessary for a good appreciation of market conditions and for the efficient supply of information, trading and clearing services are not sufficiently available to market participants for many financial products. 
I think it is time we examined the control and dissemination of market data to establish whether there is abusive behaviour on the part of their owners attempting to leverage privileged access to information to foreclose rivals or distort the market. I also intend to discuss the legitimate scope of intellectual property rights claims on such data. 
... Now I would like to move to the third and final part of my presentation and give you a quick update of our current work in competition enforcement. The first two cases I will mention are those against Standard & Poor’s and Thomson Reuters. These two cases involve financial data or market infrastructure that may be important for the operation of markets. 
Our case against Standard & Poor’s regards the distribution of International Securities Identification Numbers developed by ISO, the International Organisation for Standardisation. S&P holds a monopoly position in the assignment of these ISO numbers to new securities issued in the US and in their distribution to the whole financial community. 
European investors have complained that S&P imposes license agreements and demands fees for the usage of the data even if they are downloaded from other vendors, something which is contrary to ISO rules. 
Our concern is that S&P may be abusing its dominant position by charging excessive prices.  
... The case involving Thomson Reuters is about the restrictions the company imposes on the use of Reuters Instrument Codes – or RICs. For example, customers of Thomson Reuters cannot cross reference them with identifiers of other vendors to retrieve data from them. That makes switching to an alternative data feed vendor costly and difficult. We are concerned that the practice could amount to an abuse of dominant position.
... Finally, I would like to talk about two new antitrust investigations into the markets for Credit Default Swaps; which are the first cases we have opened in the market for derivatives. 
The first case involves 16 investment banks and Markit, the leading provider of financial information in the CDS market. We want to find out if the banks are jointly coordinating the control of the information flow on CDS trade to prevent other providers and data vendors from developing competing services. Our preliminary investigations suggest that Markit may receive de facto exclusive information on the transactions and positions of many of these dealers. In addition, Markit’s licence agreements may be restricting the development of the market. 
The second case involves nine large banks – all of them also part of the first investigation – and the agreements they concluded when a company called The Clearing Corporation was sold to Intercontinental Exchange, or ICE. In this operation, the nine banks gave themselves preferential fees and a profit-sharing mechanism which gives them strong incentives to use ICE’s services with a de facto foreclosure effect on other clearing houses. Finally, we are investigating ICE’s fee structure, which may give an unfair advantage to the nine banks and discriminate against other dealers. If confirmed, this could be an abuse of dominant position to the detriment of potentially efficient competitors. 
... Over the past twenty years or so, the financial services sector has become increasingly larger and complex. No one knows this better than you, given that the wider industry accounts for around 14% of Britain’s GDP. Today, overseeing a few investment banks and specialised traders is simply not enough. We need to extend oversight beyond traders and banks to cover infrastructure owners, intermediaries, information services providers and possibly more. 
Competition enforcement and regulation must not saddle the industry with an unnecessary burden and must not stifle innovation. But we must make sure that the market develops in ways that are compatible with long term stability and efficient growth. We need deep and liquid financial markets. We need a system that gives participants all the information they need to fully understand the risks they are taking when they invest in a product and to fully appreciate the price they are paying. Participants need to know who their counterparties are and what their exposures are. Above all, we need to promote a system that participants can trust. 
I will continue to enforce EU competition law against collusion between firms and the undue influence of powerful players. I will also use every opportunity – such as our meeting today – to remind everyone to play by the rules. This is a responsibility that every player in these markets has towards their competitors, their customers, and towards society at large.