If ever allowed, the following would be my brief testimony about what caused the 2008 bank crisis

The following, if I am ever allowed to give it, as so many would not like to hear it, would be my brief testimony on what caused the 2008 bank crisis 

Sir, as I have learned to understand it, the 2008 crisis resulted from a combination of 3 factors.

The first were some very minimal capital requirements for some assets that had been approved, starting in 1988 with Basel I, for sovereigns and the financing of residential housing; and made extensive in Basel II of 2004 to private sectors assets with good credit ratings.

These allowed banks then to earn much higher expected risk adjusted returns on equity on some assets than on other, which introduced a serious distortion. After Basel II the allowed bank equity leverages were almost limitless when lending to “sound” (or friendly) sovereigns; 36 times to 1 when financing residential housing; and over 60 to 1 with private sector assets rated AAA to AA. Just the signature, on some type of guarantee by an AAA rated, like AIG, also allowed an operation to become leveraged over 60 times to 1. 

The second was Basel II’ extensive conditioning of the capital requirements for banks to the decisions of some very few (3) human fallible credit rating agencies. As I so many times warned about (in a letter published in FT January 2003 and even clearer in a written statement at the World Bank) this introduced a very serious systemic risk.

The third factor is a malignant element present in the otherwise beneficial process of securitization. The profits of that process are a function of how much implied and perceived risk-reduction takes place. To securitize something safe to something safer does not yield great returns for the securitization process. Neither does to securitize something risky into something less risky. 

What produces BIG profits is to securitize something really risky, and sell it off as something really safe. Like awarding really lousy subprime mortgages and packaging them in securities that could achieve an AAA rating. A 11%, 30 years, $300.000 mortgage, packaged into a security rated AAA and sold at a 6 percent yield, can be sold for $510.000, and provide those involved in the process an instantaneous profit of $210.000

With those facts it should be easy to understand the explosiveness of mixing the temptations of limitless, 36, and more than 60 to 1 allowed bank equity leverages providing huge expected risk adjusted ROEs; with subjecting the risk-assesment too much to the criteria of too few; with the huge profit margins when securitizing something very risky into something “very safe”. Here follows some indicative consequences:

As far as I have been able to gather, over a period of about 2 years, over a trillion dollars of the much larger production of subprime mortgages dressed up in AAA-AA ratings, ended up only in Europe. Add to that all the American investment banks’ holdings of this shady product.

To that we should also add Europe’s own problems with mortgages, like those in Spain derived in much by an excessive use of “teaser interest rates”, low the first years and then shooting up with vengeance.

And sovereigns like Greece, would never have been able to take on so much debt if banks (especially those in the Eurozone) would not have been able to leverage their equity so much with these loans.

Without those consequences there would have been no 2008 crisis, and that is an absolute fact.

The problem though with this explanation is that many, especially bank regulators, especially bank bashers, especially equity minimizing bankers, especially inattentive finance academicians, especially faulty besserwissers (those who love the sophisticated taste of words like "derivatives"), they all do not like this explanation, so it is not even discussed.

The real question though is: Who is the guiltiest party, those who fell for the temptations, or those who allowed the creation of the temptations?

I mean how far can you go blaming the children from eating some of that deliciously looking chocolate cake you left on the table, at their reach?

PS. Please do not categorize misregulation as deregulation. 

PS. A 2008 GFC tweet summary:
The pushers: Those harvesting mortgages in subprime fields; packaging these in MBS and getting rating agencies’ enthusiastic thumbs up.
The addicts: The banks
The drug, the hallucinogen: The Basel Committee's ultra-low bank capital requirements. 

PS. Here's a letter published by the Washington Post, December 2009

P.S. Here’s a 2010 YouTube explanation

PS. Here is a current summary of why the risk weighted capital requirements for banks, is utter and dangerous nonsense.

PS. And here is my letter to the Financial Stability Board that was officially received. Will it be answered?

Public letter to King Felipe VI of Spain, on his first day of work, about banking regulations that discriminate against many of his subjects.

Dear King Felipe VI of Spain.

I am not your subject, but inasmuch as for two brief years I was honored to occupy as Executive Director the chair that together with seven other countries represented Spain in the World Bank, and for many other reasons, I am concerned about the welfare of Spain.

Today, after having heard a few paragraphs of your speech yesterday and that indicates that you may be interested in the topic I will touch on, I post this letter on the web with the same hope that it will reach you that you might have of putting it in a bottle and put her to navigate the oceans ... but who knows :-)

The message I want to convey to you is that all those of your subjects who cannot obtain the best credit ratings, among others because of the cost that this process alone implies, are being hideously discriminated against in their access to bank credit, not only by bankers, which would be natural and traditional, but in this case, and without any justification, by banking regulators.

This occurs inasmuch as regulators allow banks to maintain a much lower share capital when they finance an "infallible" than when they finance a "risky" ... which means that banks obtain a much higher risk-adjusted return on their capital financing the infallible than financing the risky ones… which results in the infallible ones obtaining more credit at lower rates than normal, while the risky ones receive fewer credits and at rates comparatively higher than normal.

And such regulatory discrimination becomes especially heavy in times when banks are extremely short of social capital, especially because they have suffered large losses in activities considered non-risky and for which they were allowed to have very little capital.

And as a direct consequence of all this, a multitude of medium and small companies, as well as entrepreneurs, do not have that fair access to bank credit that would allow them to create the jobs that the youth of Spain need so much, so as not to become a lost generation.

I do not want to take more time, if you want you can find much more on the subject on this site, and of course I am at your service. However, before I say goodbye, let me explain why I previously argued that this regulatory discrimination is totally unjustified.

It just turns out that no significant banking crisis has ever been unleashed in history as a result of over-lending to what was considered risky, all such crises have resulted from over-lending to what was viewed as very safe from a point of view credit, such as the real estate sector, the AAAristocracy or, forgive me for having to remember, one or another infallible sovereign.

Your Majesty, just ask the regulators to explain to you where the heck they find causation between a lender being rated ex ante as risky, from a credit point of view, and a bank failure.

Why don't I speak directly to regulators? I have dealt with it for over a decade… hundreds of times… by all means possible… but those who think they are geniuses don't like to hear about the possibility that they are totally wrong. Perhaps you could be luckier… at least as you begin your first day on the job as King.

By the way ... Good luck!

Sincerely,

Per Kurowski

Note: While this letter travels the web, any suggestion is appreciated so that, if it reaches the hands of Felipe VI, at least it complies with the most basic formalities.

I'm not in the habit to write to kings, but I've done it before, in 2009

Translated from my letter in Spanish 

In Europe banks no longer finance the future

These just refinance the past [and present]... (and so Europe is going down, down, down)

Let me refer again to the tragically misguided banking regulations in the world, designed by some who do not care one iota for the real economy, that which are not the banks.

The main principle of such regulations are capital requirements (equity) based on perceived risks. More risk more capital, less risk less capital.

And that results in the bank can expect to earn much higher expected risk-adjusted returns on equity , when financing the safe (refinancing the past) than when finance the risky (the future).

And that results in that the economies do not take enough risks to produce its absolutely-safes of tomorrow ... but will dedicated itself to milk the cows of yesterday, to extract their last drop of milk.

And all sheer stupidity. Regulators ignored, and still ignore, that perceived risks, such as those reflected in credit ratings, have already been cleared for by banks and markets when setting interest rates, the amounts of the loans, duration and other clauses, And so when the same perceptions of risk, are reused, now to determine the required capital, this only ensures that the banking system overdoses on perceived risk.

They also forgot that their regulatory risk with banks has nothing to do with the perceived risks of the bank's customers ... and everything to do with how the bankers perceive and react to these perceptions.

And that the above causes distortions in the allocation of bank credit in the real economy, still nothing is discussed.

For an older person, retired, with barely sufficient savings, a financial advisor must recommend a super safe conservative investment strategy which provides liquidity, traditionally bonds. But, in the case of a young professional, who is saving for retirement in 30 years, the obligatory advice is to take much more risks, such as buying stocks.

And so you can say that bank regulators follow rules adequate for the old, and not for the young. I assure you that if the European youth, such as that in Spain, Italy, Portugal and Greece, lifted their eyes just a little while from their iPads, or similar devices, and realized what was being done to them, many sites would burn...like Troy.

Worse yet, the regulators require banks to have an 8% capital when lending to an ordinary citizen entrepreneur, but allow these to lend to their governments, holding no capital at all. This has quietly introduced a perverse communism, and disrupted all price-risk equations in capital markets. Of course, all in close association with other beneficiaries like the members of the AAAristocracy.

But, you might say ... "At least we will have safe banks". Do not delude yourself. All banking crisis, whenever not a case of outright fraud, have been unleashed by excessive lending to what ex ante was perceived as absolutely safe, and which, ex post, turned out to be risky, and no banking crisis in history, has resulted because of excessive loans to what was correctly [and timely] perceived as risky.

As a young man, in Sweden, in the churches where from time to time I went, they sang psalms which implored, "God, make us daring". European regulators, with respect to their banks, are now rewarding cowardice... (and so Europe is going down, down, down)

Translated from El Universal

PS. My 2019 letter to the Financial Stability Board

PS. And the Academia kept silence

David A. Stockman’s “The Great Deformation” did not include what is perhaps the greatest deformation.

David A. Stockman’s The Great Deformation is a truly great book, except for the fact that sadly it misses out on what in my mind constitutes the greatest deformation… namely allowing for much much lower capital (equity) requirements for banks on exposures that are considered as “absolutely safe”, than what they are required to hold for exposures considered as “risky”.

That allows the banks to grow so as to end up as Too Big To Fail, and to earn much higher risk-adjusted returns when lending to “The Infallible”, than when lending to “The Risky”.

And that distorts completely the way credit is allocated within the real economy, so that too much at too low interest rates of it goes to the "The Infallible", like the sovereign and the AAAristocracy (or AAArisktocracy) and too little to at too high interest to "The Risky", like medium and small businesses, entrepreneurs and star-ups.

And that effectively increases the de-facto risk-adverseness of banks, in the home of the brave, and in all other countries were these truly lamentable regulations are applied. And if that is not a deformation, what is?

Stockman does not mention that because of Basel II, approved in June 2004, and what SEC approved for US investment banks, April 2004, the European banks and the US investment banks could hold AAA rated securities, or lend against these securities, holding only 1.6 percent in capital, meaning leveraging their equity a mind-boggling 62.5 times to 1. 

And a result, though Stockman, in Chapter 20, “How the Fed brought the gambling mania to America’s neighborhoods”, explains splendidly the tragedy of how extremely bad mortgages were awarded to the subprime and other sectors in the US, and then packaged into dubious AAA rated securities sold all over the world, he misses out completely on the main reason for why the world demanded these securities and all other “supper-safies” so much, that it completely lost its common sense.

Let me assure everyone that if the banks had needed to hold the 8 percent they have to hold when lending to their “risky” citizen, then the current US subprime, Greek sovereign, Spanish real estate, Cyprus' banks, and similar tragedies, would not have happened. It is as easy as that… which of course does not make it any easier to swallow.

I hope that in the next edition of “The Great Deformation” David Stockman at least rewrites his chapter 20 so as to include these considerations. It would be a shame not to do so in such a good book.

And I need to repeat it again: A nation were banks need to hold 8 percent in capital when lending to the citizens, but are allowed to lend to their government against zero capital, is a deformed nation.

PS. The risk weights of 0% for the Sovereign, 20% for the AAArisktocracy and 100% for We the People, is anathema to America.

God make us daring!

Do we need a witness protection program for European bank regulators?

Would Europe be in such troubles had their banks not purchased too many Potemkin rated securities, or lent too much to sovereigns like Greece, Spanish real estate or Irish banks? No way! 

Would the banks have done all that if they had been required by their regulators to hold as much capital for it than when lending to an ordinary unrated European citizen? No way! 

And so there can be no discussion of that those primarily responsible for all current hardship in Europe are the bank regulators who allowed it all. 

But they have all circled their wagons so that no one can get close to them asking for an explanation, and anyone of them willing to offer a mea culpa would clearly be labeled a traitor by his colleagues.

And if for instance all the European youth got hold of how these regulators, by discriminating against the risky and thereby favoring what is safe, are blocking their future, they better hide. 

And so we might need to offer a witness protection program to some regulators, in order to break this dark spell. Because break it we must. Otherwise Europe is toast. 

Would Mario Draghi be a taker?

Damn you bank regulators

When I see this hopeful Spanish youth doing the best it can to hold their heads up high, and at the same time I know we have bank regulations that go against job creation, I am so sad and so mad.

The current capital requirements for banks, more capital when the perceived risk of the bank asset is higher and less capital when the perceived risk of the bank asset is lower, sounds so logical, but is in fact so dumb. 

First, never ever have bank crises resulted from excessive bank exposures to “The Risky” they have always resulted from excessive exposures to what was believed to be “The Infallible”

Second, these capital requirements discriminates against “The Risky”, those actors like small businesses and entrepreneurs and who try to create a living-room for themselves on the margin of the real economy, and who are one of the most important sources of the next generation of job.

And the regulators are completely unwilling to accept they are so profoundly mistaken and be held accountable for it. Damn you bank regulators!