Sunday, October 26, 2008

We need brand new bank-regulations

In Against the Gods Peter L. Bernstein (John Wiley & Sons, 1996) writes that the boundary between the modern times and the past is the mastery of risk, since for those who believe that everything was in God’s hands, risk management, probability, and statistics, must have seemed quite irrelevant. Today, when seeing so much risk managing, I cannot but speculate on whether we are not leaving out God’s hand, just a little bit too much.

If the path to development is littered with bankruptcies, losses, tears, and tragedies, all framed within the human seesaw of one little step forward, and 0.99 steps back, why do we insist so much on excluding banking systems from capitalizing on the Darwinian benefits to be expected?

There is a thesis that holds that the old agricultural traditions of burning a little each year, thereby getting rid of some of the combustible materials, was much wiser than today’s no burning at all, that only allows for the buildup of more incendiary materials, thereby guaranteeing disaster and scorched earth, when fire finally breaks out, as it does, sooner or later.

Therefore a regulation that regulates less, but is more active and trigger-happy, and treats a bank failure as something normal, as it should be, could be a much more effective regulation. The avoidance of a crisis, by any means, might strangely lead us to the one and only bank, therefore setting us up for the mother of all moral hazards—just to proceed later to the mother of all bank crises.

Knowing that “the larger they are, the harder they fall,” if I were regulator, I would be thinking about a progressive tax on size.
From Voice and Noise, 2006

What is lacking in the Sarbanes-Oxley Act

Requiring all senior management and board members of companies to disclose publicly what they understand and what they do not understand of the business they are in charge of would do wonders for corporate governance, especially when we start hearing so many cries of “I did not know”. For instance, when using sophisticated financial instruments such as derivatives, we could suddenly realize that no one upstairs has a clue of what they, the experts downstairs, are up to, and this could be a quite instructive for the market and the credit-rating agencies when they assess the risks of a corporation.

By having clues I do of course not refer to any specific know-how needed to take apart and put back a carburetor, as very few would be able to do that, and in fact I am not even sure carburetors any longer exist. No, what I refer to is whether they to have a good working knowledge of some basics, like how a car drives, how it brakes, how much gasoline it consumes, and what to do if a tire explodes or an airbag suddenly inflates.

To oblige recognition and acceptance of where the buck really stops both in theory and practice and before mishaps occur could also be useful for shedding light on some systemic risks that, like lava in a volcano, might be building up dangerous pressures underneath the world of finance. It could also provide immediate relief to all those executives living out there, burdened with the constant stress of having to feign that they are in the know.
From Voice and Noise, 2006

Monday, October 20, 2008

In a truly free market this particular financial crisis would never have happened

I am not against regulations but when looking at how to re-regulate the financial markets after this crisis it really behooves us all to acknowledge the fact that in a really free financial market this particular financial crisis would never have happened.

In a free financial market there would have been no official endorsement of the illusion of safety like the one generated by the bank regulators when they created the minimum capital requirements for banks based on risk and that led many to believe that, as far as the risks goes, the banks had been equalized. And of course neither would the market have suffered the distortions that originated in the regulatory arbitrage of these capital requirements.

In a free financial market no one would have given so much credibility to some few credit rating agencies paid by the issuers of debt and therefore there would have been no opportunity to peddle in the market such an extraordinary amount of such extraordinary lousy awarded mortgages to the subprime sector.

Sunday, October 19, 2008

In hindsight the bankers behaved rationally!

The September issue of Euromoney we Georges Pauget of the Crédit Agricole saying “Now if you go back over the decisions that were taken, and the context within which they were taken I have to say that, even with the benefit of hindsight they appear rational. We took triple-A-rated assets, reinsured with triple-A-guarantors and concluded that they carried zero risk”

And I ask:

Q. Who gave those triple-A-ratings? A. The credit rating agencies.

Q. Who empowered the credit rating agencies to have so much influence? A. The banking regulators of Basel.

Do we now want to really change things or do we just want to dig ourselves deeper in the hole of the over-trusting-some risk-information-oligopolies that we’re in?

Saturday, October 18, 2008

The financial engineering bubble!

If you have been able to convince Joe to take a 300.000 dollar mortgage at 11 percent for 30 years and if then, with a little help from the credit rating agencies, you can convince Fred that the risk structure of this mortgage is such that it merits an investment at a rate of only six percent, then you can sell him the mortgage for 510.000 dollar, and pocket a tidy profit of 210.000 dollar.

We then have Joe, with a real liability of a mortgage of 300.000 dollar guaranteed with a house that might o might not be worth it, and Fred, with a 510.000 dollar investment in the willingness of Joe to service his original mortgage at 11 percent for 30 year.

And so, when all is sliced and diced, 210.000 dollar of this 510.000 dollar toxic asset has little to do with easy money or a house bubble, and all to do with the wizardry of an immense structured-finance-endorsed-by-the-credit-rating-agencies bubble.

Monday, October 13, 2008

The Financial Stability Forum has read and learned from Il Gattopardo!

In the best traditions of what Giuseppe Tomasi di Lampedusa’s says in Il Gattopardo about that "Everything must change in order to remain the same" the Financial Stability Forum in their Report on Enhancing Markets and Institutional Resilience, dated October 10, announces “Changes in the role and uses of credit ratings”, only to proceed digging us even deeper in the hole we are in.

FSF spells out these changes to be:

1. On the quality of the rating process… presumably meaning the CRAs will be better in the future… allowing the markets to trust the credit rating agencies even more.

2. Differentiated ratings and expanded information on structured products… presumably meaning that the CRAs will in the future provide the markets with more precise and tailor made information… allowing the markets to trust the credit agencies even more.

3. An enhanced assessment of underlying data quality… presumably meaning that in the future the CRAs will make sure they work with more relevant data… allowing the markets to trust the credit agencies even more.

4. Telling investors to address their over-reliance on ratings…meaning that investors associations should consider developing standards of due diligence for CRAs… allowing the markets to trust the credit agencies even more… while preparing the terrain for an “I told you to do it!”

5. And finally that the authorities will review their use of ratings in the regulatory and supervisory framework to address the excessive reliance on credit ratings… by launching the stocktaking of the uses of ratings in legislation, regulations and supervisory guidance by its member authorities in the banking, securities and insurance sectors… as if they already should not know that.

From what we read the FSF says, and the so little said about the credit rating agencies during the IMF/World Bank meetings, it would seem that the only ones who really had their institutional resilience strengthen these last weeks were the credit rating agencies… Why? How come?


I do not know of anyone who knows anyone who knows anyone that has lost a single dollar giving a subprime mortgage on too generous or outright stupid terms to anyone who classifies as belonging to a subprime sector. Neither do you, I bet.

But I do know of many persons or institutions that have lost fortunes investing in securities collateralized with mortgages just because these securities were rated AAA by one two or even three of the only three credit rating agencies that are to be used by all of us, including by the financial regulators. And so do you, I bet.

Therefore, without any doubt, this crisis is a direct result of the credit rating agencies issuing the wrong ratings, and since these agencies were so much followed because they were excessively empowered by the financial regulators, we should have even less doubts about whom we really should blame.

The Axis of the credit rating agencies and the financial regulators has already cost the world trillions of dollars.

Saturday, October 4, 2008

It is in the Basel-Consensus that the fault lies!

Forget debating about a Washington Consensus turned sort of irrelevant when it is the Basel Consensus that is really breaking into pieces.

If you set up a system that is composed of a.- minimum capital requirements for banks that are based on risk; b.- the empowerment of few agencies to measure the risks; and c.- the need to immediately respond and mark to market the consequences of any change in the perception of the risks, then you have gathered up the necessary and sufficient elements to guarantee that, sooner or later, you will suffer a financial tsunami, along the lines of that one we are currently seeing.