A letter in Washington Post: Affordable homes or investment assets?

Washington Post: Letters to the Editor December 28

Should houses be affordable homes, or should they be investment assets? They can’t be both.

In 2004, under the Basel II business standards, if securities obtained a AAA rating, European banks and U.S. investment banks regulated by the Securities and Exchange Commission needed to hold only 1.6 percent in capital against them. That created an enormous demand for highly rated securities. The truth of securitization is that, as when making sausages, the worse the ingredients the larger the profits.

And the highly rated securities backed by mortgages to the subprime sector became the primary cause for the 2008 crisis.

After the crisis, ultra-low interest rates and huge liquidity injections fed the price of houses. In the process, houses morphed from being homes into investment assets.

That aspect of the housing market is what I most missed in the Dec. 26 front-page article “Quick to evict, properties in disrepair.”

If you want easy financing to help someone afford a house, then house demand and house prices go up, and you need to give even more help to the next person who wants to afford a house.

Do we want affordable homes or houses as investment assets? There’s no easy answer, because going back to just homes would also cause immense suffering for all those believing they have, with their houses, built up a safety net.

Per Kurowski, Rockville 

PS. “The assets assigned the lowest risk, for which bank capital requirements were therefore low, were those that had the most political support…home mortgages” Paul Volcker 2018

PS. "Lower bank capital requirements against residential mortgages allows easier financing that will cause house prices to increase, and so we bureaucrats can get more in property taxes… and everyone’s happy.”

PS. In the Financial Times, May 2006, I asked: Who on earth has decided that the increase in the price of houses is not inflation?

PS. Here a discussion of this subject with ChatGPT - OpenAI

A tweet: If banks are allowed to leverage their equity/capital twice as much with residential mortgages than with loans to small businesses & entrepreneurs, you will get too many mortgages and too few jobs providing the income to service these. It ain’t science!

A tweet: Economy 101: Allowing banks to leverage capital much more with residential mortgages than with business loans will cause: a) increased house prices, b) decreased job opportunities and, consequentially, more children having to live in their parents’ house.

My letters in the Washington Post on bank regulations:

September 6, 2007: Factors in the Financial Storm
June 20, 2008: An Aspect of the Bubble
December 27, 2009: Another 'worst': Faulty bank regulation
January 6, 2012: Handcuffed by a triple-A rating
May 1, 2013: An American approach to banking
December 23, 2014: Let the market rule on risky trades
November 11, 2015: Reverse-mortgaging the future
August 9, 2016: Banks, regulators and risk
April 16, 2017: When banks play it too safe 
July 11, 2018: There is another tariff war that is being dangerously ignored.

Ten years ago ECB decided to ignore the benefits of a hard landing and go for kicking the can down the road

In August 2006, when we were already hearing worrisome comments about complex securities linked to mortgages, I wrote a letter to FT titled “The Long Term Benefits of a Hard Landing”. At that moment I had not yet been censored by FT and so they published it.

One year later, when panic about the AAA rated securities backed with mortgages to the subprime sector impacted the financial markets, ECB (and the Fed earlier) decided to ignore that option and go for the politically more convenient short-termish option of kicking the can down the road, with QEs and ultralow interest rates.

It could have worked, if only what had caused the crisis and what hindered the stimuli to flow in the correct directions had been removed. But no, the regulators refused to admit their mistake with the risk weighted capital requirements.

And so here we are, a full decade later, still allowing banks to multiply the net margins obtained more when it relates to assets perceived, decreed or concocted as safe, than with assets perceived as risky, and so obtain higher expected risk adjusted returns on their equity financing the safe than financing the risky.

In a historic analogy, regulators still believe the sun to be circling around the earth; in this case that what is perceived as risky is more dangerous to the banking system than what is perceived as safe.

As a result “safe” sovereigns, AAArisktocracy and residential houses still dangerously get way too much bank credit, while “risky” SMEs and entrepreneurs, way too little to keep our economies dynamic.

Every day we allow regulators like Mario Draghi to regulate based on a flawed theory, the worse for all of us.

But what are we to do when there are so many vested interests in shutting up this the mother of all bank regulation mistakes?

Here is the succinct but complete explanation of the subprime crisis. One, which apparently should not be told.

Here's a prologue, on the 10th anniversary of the Lehman Brothers collapse: In 2006 in a letter to the Financial Times I argued for the long-term benefits of a hard landing. The Fed and ECB decided to kick the can forward and upwards, which could have worked; better at least, had they removed the distortions that created the crisis. 

Just four factors explains it all, or at least 99.99%.

Securitization: The profits for those involved in securitization are a function of the betterment in risk perceptions and the duration of the underlying debts being securitized. The worse we put in the sausage – and the better it looks - the more money for us. Packaging a $300.000, 11%, 30 year mortgage, and selling it off for US$ 510.000 yielding 6% produces an immediate net profit of $210.000 for those involved in the process. (Those signing the mortgages do not participate in the profits)

Credit ratings: Too much power to measure risks was concentrated in the hands of some very few human fallible credit rating agencies.

Capital requirements for banks. Basel II, June 2004, brought down the risk weight for residential mortgages from 50% to 35%. Additionally, it set a risk weight of only 20% for whatever was rated AAA to AA. The latter, given a basic 8%, translated into an effective 1.6% capital requirement, which meant bank equity could be leveraged 62.5 times to 1.

Borrowers: As always there were many financially uneducated borrowers with needs and big dreams that were easy prey for strongly motivated salesmen, of the sort that can sell a lousy time-share to a very sophisticated banker. 

Clearly the temptations became too much to resist for all involved.

The European banks, thinking that if they could make a 1% net margin they could obtain returns on equity of over 60% per year, went nuts demanding more and more of these securities; and the mortgage producers and packagers were more than happy to oblige, signing up lousier and lousier mortgages and increasing the pressure on credit rating agencies. The US investment banks, like Lehman Brothers, also participated, courtesy of the SEC.

Of course it had to end bad... and it did!

Can you image what would have happened if the craze had gone on one or two years more?

I have explained all the above in many shapes or form, for much more than a decade. Unfortunately it is an explanation that is not allowed to move forward, because it would put some serious question marks about the sanity of some of the big bank regulators.

Might I need to go on a hunger strike to get some answers from the Basel Committee and the Financial Stability Board?

PS. Here is a somewhat more extensive aide memoire on the mistakes in the risk weighted capital requirements for banks.

PS. And here are some of my early opinions on these regulations, some of them while being an Executive Director at the World Bank, 2002-04

PS. Here’s my recent, 2019, comments sent to the Financial Stability Board

PS. Here’s my recent, 2019, letter sent to the IMF

PS. And here is a very humble home-made youtube comment on it all, from 2010

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?

Scene 6 on the crazy reality lived while “Banking in times of the Basel Committee”

Jr. Credit Officer Martin: “But Sir, how can we put this 30 years, 11 percent, lousily awarded mortgage into a security that aspires an AAA rating?” 

Bank President Wally: “Easy, let me explain it to you Martin. To put a proper AAA quality mortgage, with a proper interest rate into that security, would be absolutely useless, as it would generate no profits for us. But, if we put that very bad mortgage you refer to in a security, and manage to get an AAA rating for it, then we can resell it as earning solely a six percent return… and that would mean an instant profit to be share among us all of $210.000. Irresistible eh?” 

Jr. Credit Officer Martin: “But Sir, would not the bankers find out how bad these AAA rated securities were?” 

Bank President Wally: “Dear Martin, when you are allowed, by your regulator, to leverage your equity more than 60 times, only because an AAA to AA rating is present, and which means that if you believe you can make a 1 percent margin means you expect a 60 percent return on your equity, you do not make a lot of questions. You see, if the ratings only go down to the range of A+ to A, then banks can only leverage those securities less than 25 times. Imagine from more than 60 to less than 25!...

In fact Martin, it is the European banks and our US investment banks who are demanding these AAA securities so much that frankly we have to cut corners… don’t forget that we are a service company… and we do what our clients wants us to do... hi-hi-hi!”

Scene 1

Scene 2

Scene 3

Scene 4

Scene 5

Martin Wolf, by not telling it like it was, is making it much harder to connect the dots.

On page 226 of his “The shifts and the shocks” Martin Wolf writes: 

“The essence of Basel I was risk weighting of assets… Ironically and dangerously these weights treated government debt as riskless and put triple-A-rated-mortgage-securities into the next least risky category… Basel II, initially published in 2004, was an extension of Basel I… In the event, the crisis occurred before Basel II had been fully implemented.”

That is not so! And to present it in this way, impedes the understanding of what happened… it makes it much more difficult to connect the dots.

Basel I had risk weighting but that was in relation to claims on sovereign, claims on non-central-government and public-sector entities (PSEs), loans secured with residential property and banks within or outside OECD.

Basel II introduced the use of credit ratings, Basel I had none of it:

I, then an Executive Director of the World Bank, protested this and in a letter published by the Financial Times in January 2003 I wrote: “Everyone knows that, sooner or later, the ratings issued by the credit agencies are just a new breed of systemic error to be propagated at modern speeds”

And it was Basel II that allowed any private sector bank asset backed by an AAA to AA rating to have a risk weight of only 20 percent. That, since the basic capital requirement was 8 percent, signified banks needed to hold only 1.6 percent in capital against these assets. In other words it was Basel II that authorized banks to leverage 62.5 times to 1 in the presence of an AAA to AA rating.

And Basel II approved in June 2004 was immediately implemented in Europe. In the US it was accepted even before its approval by the SEC and made applicable for those investment banks they were supervising.

And that opened a ferocious appetite for AAA’s in any which form they came, whether as the securities collateralized with mortgages awarded to the subprime sector, or by being able to add an AAA rated company to the guarantees, most notoriously AIG.

Also in order to understand the profits for those developing these AAA rated securities, it is illustrative to consider the following deal:

If you convinced risky and broke Joe to take a $300.000 mortgage at 11 percent for 30 years and then, with more than a little help from the credit rating agencies, you could convince risk-adverse Fred that this mortgage, repackaged in a securitized version, and rated AAA, was so safe that a six percent return was quite adequate, then you could sell Fred the mortgage for $510.000. This would allow you and your partners in the set-up, to pocket a tidy profit of $210.00

Martin Wolf, over a very short period which started when the banks were assured that Basel II was to be approved and many saw this as a buying opportunity for later resale to Basel II covered banks… and that ended sort of early 2007…there was a monstrous demand for these AAA rated securities… and that, and nothing else, detonated the crisis.

Martin Wolf, consider that 62.5 to 1 bank leverage was allowed only because an AAA rating was present! It is clear that our world fell into the hands of real regulatory morons.

And that is not even considering the worst of it, namely that favoring so much the AAA rated they odiously discriminated against the fair access to bank credit of all those not AAA rated.

And so it is our duty to see that such things never happen again… not to wittingly or unwittingly helping regulators not to be held accountable for what they did….

If the solution to planet earth’s environmental problems falls into the hands of something like the experts of the BCBS, then we are all toast! 

PS. Basel I has only 30 pages and though Basel II grew into 347 pages, one should have the right to think that someone writing about the “interactions between changes in the global economy and the financial system” had read these fundamental documents.

PS. Around 2008 I studied and complied with all the exams needed to be a licensed real estate and mortgage broker in the State of Maryland, USA; and that I did so that I could analyze from a closer distance what had happened. And everything I found there only confirms what I have here argued. I heard of: “Give us the worst mortgages you have to package, because when we get a good rating for the security, those are the most profitable ones”.

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!

The confession of a "monstrous" banker

George Banks (the first)

Dear Per

I thought it was a good thing for my bank to purchase AAA rated securities collateralized with mortgages to the subprime sector, and to lend to A+ rated Greece, since in both cases my regulator only required me to hold 1.6 percent in capital against these assets, and which meant that my bank could leverage its capital 62.5 times to 1. 

More so, was my bank not to engage in these operations, it might lose out to other banks who by doing so would earn much higher returns on equity… to such an extent that they might even end buying up my bank, and then I would find myself in the awkward position of having to work for a too-big-to fail bank. 

What should I have done? What would you have done? Did that turn me into a vile bankster? Per, help me some even want to put me in jail!

Your banker friend 

George Banks III

PS. My answer

Dear George

Don't feel bad. I have not held you responsible for any of this mess for even a second. 

As an Executive Director of the World Bank, in a formal written statement in October 2004 I warned: “I believe that much of the world’s financial markets are currently being dangerously overstretched, through an exaggerated reliance on intrinsically weak financial models, based on very short series of statistical evidence and very doubtful volatility assumptions”

And in January 2003 in a letter published by the Financial Times I had written: “Everyone knows that, sooner or later, the ratings issued by the credit agencies are just a new breed of systemic errors, about to be propagated at modern speeds”

And yet I really doubt that, if in your shoes, I could have put a stop to the purchase of the highly rated securities, or convinced any bank colleagues that they should incur in the costs of a special check up to see if their credit ratings were correct or not.

That said I do condemn though the regulators, those who created the temptations of the 60 to 1 or more authorized bank leverages. I can guarantee you that, in the absence of these loony regulations, there would never ever have been such a demand for these so subprime securities which created this crisis, or to indulge in excessive bank lending like to Greece. The Basel bank regulators, hopefully unwittingly, let us at least pray for that, they were the real vile Lucifers in this disaster.

Your non-banker friend that with much fondness remembers your ancestor George Banks

Per

PS. George perhaps this would, way back, have also made your ancestor to go and fly a kite instead.

Dialoguing with ChatGPT on current bank regulations

The regulators, the banks and the sharks and their baits

The world’s bank regulators in the Basel Committee, assumed with unbelievable hubris the role of risk managers of the world; ignoring that perceived risks are not dangerous to the system, only those not-perceived are, authorized the banks to leverage their capital 60 times or more, when investing in or lending to anything related to a triple-A rating.

As should have been expected, the banks, carrying the minuscule life-vests ordained, in pursuit of easy profits, huge bonuses and too big to fail growth rates, entered massively the triple-A rated waters … where the sharks has baited them some triple-A rated securities collateralized with lousily awarded subprime mortgages paying juicy interests… and a true bloodbath ensued.

The saddest part of the story though, is that our banks are still regulated by the same regulators using precisely the same tools applied the same way… just more of it.

The mystery of the unconnected dots!

We have two outstanding pieces of evidence that can help us understand the current financial crisis and therefore help us to avoid repeating the same mistake… and so we could at least give new mistakes a chance to show what they are worth.

The first evidence is the really mindboggling acceleration in demand after mid 2004 for securities rated triple-A and which led to over two trillion dollars from all over the world to be invested and lost in securities which were collateralized with very badly awarded mortgages to the subprime sector.

The second evidence is represented by two dates and one piece of bank regulations:

On April 28, 2004 in an Open Meeting the SEC discussed "Alternative Net Capital Requirements for Broker-Dealers that are Part of Consolidated Supervised Facilities and Supervised Investment Bank Holding Companies" and in both cases it was approved that the respective parties “would be required periodically to provide [their respective] Commission with consolidated computations of allowable capital and risk allowances (or other capital assessment) consistent with the Basel Standards." In other words, that day, the SEC, almost explicitly, delegated some of its fundamental functions to the Basel Committee.

On June 26 2004 the G10 substituted the 30 pages long Basel I adopted in 1988 with the 251 pages long Basel II.

And Basel II, required for instance a bank to hold if it wanted to invest in triple-A rated private securities only 1.6 percent of fairly loosely defined capital, signifying that the bank was there allowed to leverage a quite loosely defined capital 62.5 to 1, signifying that if a Bank bought a triple-A rated security on which it expected to make a margin of .5 percent that it could expect a return on its capital of 31.25 percent a year. Needless to say the banks went berserk demanding triple-A rated securities. And since there were not sufficient real triple-A securities, the market, as markets do, supplied them with fake Potemkin-triple-A ratings.

It should not be difficult to connect the dots for anyone who wants to connect the dots and so the big lingering question about this crisis and its explanation remains… why do so very few experts want to connect the dots? A real mystery!

The financial crisis explained to non-experts, dummies and financial regulators.

The play: The dangerously safe playgrounds!

1st scene: Some extremely wimpy parents concerned so much more with their small children’s safety than with their development picked out three independent surveyors to rate the safety of the playgrounds their children frequented.

2nd scene: In order for their small children to want to go to the safest but somewhat boring playgrounds they presented them with the choice of having some very good goodies if they went there or having to settle for some bad cold porridge if they went to the more fun park.

Kids, this or that?

3rd scene: But since the good goodies were too good, and the cold porridge too bad, and there was a natural lack of safe playgrounds, too many children went to the few rated as "safe" parks… where, unfortunately... they trampled themselves to death.

Epilogue: When will they ever learn? Though the kids need some risk to develop strong and not obese, and though the truly safe playgrounds are a fidget of their imagination, during the funerals, we still hear the parents planning on making the good goodies gooder and the cold porridge colder.

What the play teaches us is that with wimpy, gullible and naïve parents like these, the kids are better off running alone in the street.

The cast:

As the wimpy parents, we have the financial regulators of the Basel Committee.

As the young children, we have the banks.

As good goodies, we have a 1.6 percent capital requirements for any bank lending related to an AAA rating.

As cold porridge, we have an 8 percent capital requirements for any bank lending related to an unrated small business or entrepreneur.
As safe playgrounds turned unsafe, we have the subprime mortgages.

As the playground safety rating agency… if you cannot figure it out for yourself you’re just too dumb.

And as all the grandparents or elder siblings who, because they were not interested or did not want to erode the parental authority, did not warn the parents… we have thousands of financial experts and PhDs.

PS. Oops! Some might now tell me they know their children prefer cold porridge to Wiener Nougat.

 

And from that playground, on to Fraulein Basel’s Chocolate Cake

PS. Now in 2024 I asked AI’s opinion on whether, as a grandfather, I should be concerned with the future current bank regulations might have doomed my grandchildren to encounter. It answered: "You're absolutely right to be concerned, and it's completely understandable to question the decisions that have shaped the financial world your children and grandchildren will inherit." 

Hush! Less we lose the chance to beat on a foe or a convenient scapegoat.

The ABACUS 2007-AC1 flip book states:

“Although at the time of purchase, such Collateral will be highly rated, there is no assurance that such rating will not be reduced or withdrawn in the future, nor is a rating a guarantee of future performance.”

The truth is that had it not been because the investors believed that the credit ratings were correct, they would not have invested, no matter how much Goldman Sachs could have argued with them based on other false statements.

But this is of course is something many do not want to be known, because this would take away all the fun of being able to go after such a juicy foe as Goldman Sachs or such a convenient scapegoat to be used by the inept regulators.

We need to get to the real bottom of this... because that is were the truth can be found.

We can’t shame enough the irresponsible silent experts and the plain lousy regulators

As an Executive Director of the World Bank and a member of its Audit Committee 2002-2004, time and again I repeated what I extract below from my book Voice and Noise, 2006.

“From what I have read and seen, I believe there is a clear possibility that much of the world’s financial markets are currently being dangerously overstretched through an exaggerated reliance on intrinsically weak financial models that are based on very short series of statistical evidence and very doubtful volatility assumptions”

I also frequently spoke out on the risk posed by empowering the credit rating agencies too much and, in May 2003, I even had a letter published in the Financial Times which ended with “I simply cannot understand how a world that preaches the value of the invisible hand of millions of market agents can then go out and delegate so much regulatory power to a limited number of human and very fallible credit-rating agencies. This sure must be setting us up for the mother of all systemic errors.”

Therefore if someone like me, a non-expert on financial markets, could have said the previous back in 2003-2004, I can only conclude that a crime of pure negligence, of sheer monumental proportions, was committed against humanity by an incredibly large number of professionals.

And so even though I agree of course that all those who pulled the triggers should go to prison, like those accused in Goldman Sachs, if proved guilty, in that prison, for true justice to be served, they should be accompanied by all those who kept mum because it was generally convenient for them to keep mum… and of course by the plain lousy regulators.

We must not let the intellectual mum-keepers go free! The world deserves more than some mea-culpa, the world deserves to find how to make the responsible speak up in time… if need be even by law.

The largest moral hazard is not having banks-bailed out… it is not shaming enough the irresponsible silent experts and the plain lousy regulators.

Some argue no one saw the crisis, “20.000 blind economists”, this is pure nonsense. Our biggest problem is how some few egos in a mutual admiration club dominate the debate and sell us what they believe sounds the best.

The day SEC delegated to the Basel Committee

On April 28, 2004 in an Open Meeting the SEC had the following as Item 3 on the Agenda:

"Alternative Net Capital Requirements for Broker-Dealers that are Part of Consolidated Supervised Facilities and Supervised Investment Bank Holding Companies"

The following was considered and approved:

"The Commission will consider whether to adopt rule amendments and new rules under the Securities Exchange Act of 1934 ("Exchange Act") that would establish two separate voluntary regulatory programs for the Commission to supervise broker-dealers and their affiliates on a consolidated basis.

One program would establish an alternative method to compute certain net capital charges for broker-dealers that are part of a holding company that manages risks on a group-wide basis and whose holding company consents to group-wide Commission supervision. The broker-dealer's holding company and its affiliates, if subject to Commission supervision, would be referred to as a "consolidated supervised entity" or "CSE." Under the alternative capital computation method, the broker-dealer would be allowed to compute certain market and credit risk capital charges using internal mathematical models. The CSE would be required to comply with rules regarding its group-wide internal risk management control system and would be required periodically to provide the Commission with consolidated computations of allowable capital and risk allowances (or other capital assessment) prepared in a form that is consistent with the Basel Standards. Commission supervision of the CSE would include recordkeeping, reporting, and examination requirements. The requirements would be modified for an entity with a principal regulator.

The other program would implement Section 17(i) of the Exchange Act, which created a new structure for consolidated supervision of holding companies of broker-dealers, or "investment bank holding companies" ("IBHCs") and their affiliates. Pursuant to the Exchange Act, an IBHC that meets certain, specified criteria may voluntarily register with the Commission as a supervised investment bank holding company ("SIBHC") and be subject to supervision on a group-wide basis. Registration as an SIBHC is limited to IBHCs that are not affiliated with certain types of banks and that have a substantial presence in the securities markets. The rules would provide an IBHC with an application process to become supervised by the Commission as an SIBHC, and would establish regulatory requirements for those SIBHCs. Commission supervision of an SIBHC would include recordkeeping, reporting and examination requirements. Further, the SIBHC also would be required to comply with rules regarding its group-wide internal risk management control system and would be required periodically to provide the Commission with consolidated computations of allowable capital and risk allowances (or other capital assessment) consistent with the Basel Standards."

In other words, that day the SEC, explicitly, delegated some of its functions to the Basel Committee.

That day Goldman Sachs, Morgan Stanley, Bear Stern, Lehman Brothers, Merrill Lynch were authorized to leverage themselves way more than was traditional. In fact 62.5 times to 1 when in the presence of a AAA rating. That day those firms were authorized to use their own financial models to govern themselves. “With that the five big investment firms were unleashed”.

That day a very serious warning by Mr. Leonard D Bole was blithely ignored.

You can hear the New York times commenting more about that highly unfortunate delegation here

As to the financial crisis Paul Krugman does not know what he is talking about.

Paul Krugman in "How Did Economists Get It So Wrong?", September 6 writes “There was nothing in the prevailing models suggesting the possibility of the kind of collapse that happened last year”

Absolutely not! Paul Krugman, in relation to the financial crisis, has no idea of what he is talking about. The collapse was doomed to happen, courtesy of the financial regulations in place.

In January 2003 the Financial Times published a letter I wrote and that ended with “Everyone knows that, sooner or later, the ratings issued by the credit agencies are just a new breed of systemic error to be propagated at modern speeds. Friends, please consider that the world is tough enough as it is.” http://bit.ly/5i1Bu

Also, in February 2000 in the Daily Journal of Caracas in an article titled “Kafka and global banking” I wrote the following:

A diminished diversification of risk. No matter what bank regulators can invent to guarantee the diversification of risks in each individual bank, there is no doubt in my mind that less institutions means less baskets in which to put one’s eggs. One often reads that during the first four years of the 1930’s decade in the U.S.A., a total of 9,000 banks went under. One can easily ask what would have happened to the U.S.A. if there had been only one big bank at that time.

The risk of regulation. In the past there were many countries and many forms of regulation. Today, norms and regulation are haughtily put into place that transcend borders and are applicable worldwide without considering that the after effects of any mistake could be explosive.

Excessive similitude. By trying to insure that all banks adopt the same rules and norms as established in Basle, we are also pushing them into coming ever closer and closer to each other in their way of conducting business. Unfortunately, however, nor are all countries the same, nor are all economies alike. This means that some countries and economies necessarily will end up with banking systems that do not adapt to their individual needs. http://bit.ly/HIi3x

Truth is only some PhD regulators who have never ever stepped outside their offices to walk the real streets of finance could have been as naïve and gullible to believe they could empower the credit rating agencies so much to determine the financial flows without setting them up to be captured.

The sooner the world stops the financial regulations from falling excessively in the hands of the PhDs the better and this, of course, does not mean that I do not recognize the importance of the PhDs.

And, by the way, I am an economist… only that I have walked the streets as a professional for over 30 years.

62.5 to 1!

In 2003, at the World Bank I warned: "Nowadays, when information is just too voluminous and fast to handle, market or authorities have decided to delegate the evaluation of it into the hands of much fewer players such as the credit rating agencies. This will, almost by definition, introduce systemic risks in the market"

The regulators they authorized a leverage of 62.5 to 1!

Uploaded by PerKurowski

PS. My 2019 letter to the Financial Stability Board (FSB)

 

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.

The risks of following the wimps from Basel

Stating that “poor credit-rating practices” have brought on the current crisis is part of what brought us here, because the fact is that the better the credit-rating practices, the more we risk following the practitioners into the wilderness.

The minimum capital requirements for banks based on credit rating of risks, introduces an formal regulatory risk adversion against “risks of default” that will set us up to all other type of much more dangerous risks.

Who dares to tell me that avoiding default risks is all financing is about?

From now on are the bailouts we going to see only to be the result of faultily measured risks and not of those risks that society incurs to move it forward?

Currently our biggest problem is that most have completely bought the silly one track-mind agenda of our financial regulators… the Basel wimps!

Financial regulation is much too serious to be left in the hands of the members of the mutual admiration club of financial regulators.

If we are going to waste taxpayer’s money let us at least assure the crisis has been worth it. Never in life have I seen such a useless crisis than the current one that has only produced millions of people to move in into their homes only to be evicted a couple of months and many tears later.

The question!

On one side, given the very accommodative stance of central banks, there was an ocean of resources.

On the other, side given the honest to good real greed of intermediaries for pushing through deals even if that means bending the meaning of common sense, there were an ocean of homes to be sold and purchased.

The channel that allowed for the two oceans to crash into each other and create this ultimate financial tsunami were the AAA ratings awarded by the credit rating agencies that had been themselves empowered to do so by the financial regulators.

In a letter to the Editor of the Financial Times published May 11, 2003 I said “Everyone knows that, sooner or later, the ratings issued by the credit agencies are just a new breed of systemic errors, about to be propagated at modern speeds".

To me my comment illustrated what should be a natural concern for financial regulators expected foremost to be wise… but they did not seem to care.

To me my comment illustrated what should be a natural concern for influential economists and financial experts… but no one said anything.

How come?

In being able to answer that question, forthrightly, lies the way out of our current financial predicaments and our only chance for not ending up even worse.

In making the truly responsible truly accountable lie our best chances for taking that way out.

Mr. Alan Greenspan and friends. Look at what old soldiers do and learn to fade away. We do not need your search for excuses.

My questions to the World Bank/IMF - Spring Meetings 2008

Risk is the oxygen of development!

It is absurd to believe that the US and other countries would have reached development without bank failures. When the Basel Committee imposes on the banks minimum capital requirements based solely on default risks, this signifies putting a tax on risk-taking, something which in itself carries serious risks. The real risk is not banks defaulting; the real risk is banks not helping the society in its growth and development. Not having a hangover (bank-crisis) might just be the result of not going to the party!

We need to stop focusing solely on the hangovers and begin measuring the results of the whole cycle, party and hangover, boom and bust! The South Korean boom that went bust in 1997-1998 seems to have been much more productive for South Korea than what the current boom-bust cycle seems to have been for the United States.

All over the world there is more than sufficient evidence that taxing risks has only stimulated the financing of anything that can be construed as risk free, like public sector and securitized consumer financing; and penalized the finance of more risky ventures like decent job creation. Is it time for capital requirements based on units of default risk per decent job created?

When is the World Bank as a development bank to speak up on this issue on which they have been silent in the name of “harmonization” with the IMF?

When are we to stop digging in the hole we’re in?

The detonator of our current financial turmoil were the badly awarded mortgages to the subprime sector and that morphed into prime rated securities with the help of the credit rating agencies appointed as risk surveyors for the world by the bank regulators.

If we survive this one and since it is “human to err” we know that if we keep empowering the credit rating agencies to direct the financial flows in the world, it is certain that at some time in the future we will follow them over even more dangerous precipices.

Note: I have just read the Financial Stability Forum brotherhood’s report on Enhancing Market and Institutional Resilience and while including some very common sense recommendations with respect to better liquidity management and “reliable operational infrastructure”; and some spirited words about more supervision and oversight (the blind leading the blind); with respect to the concerns expressed above, bottom line is that they recommend we should deepen the taxes on risks and make certain that the credit rating agencies behave better and get to be more knowledgeable… so that we are more willing to follow them where we, sooner or later, do not and should not want to go.

Do micro-credit institutions make too much use of “predatory ratings”?

Any group of debtors that is charged a higher interest rate because it is considered a higher credit risk is composed by those spending their money servicing a debt that they will finally default on, and those who should have in fact deserved a lower interest rate. Are there any real winners among them?

Who is out there talking about that the extensive use of ratings signifies something like a regressive tax for the poor? Who is out there informing the poorly rated about how very dearly they are paying for their loans? Who is out there analyzing the murdering impact that credit ratings have in chipping away at the minimum levels of solidarity that any society needs to keeps itself a society?

If there is a minimum of things that needs to be done in the world of micro credits that is to focus more on transparent system of incentives that: 1. Stimulates and rewards good group behavior and returns to the compliant borrowers some of the “extraordinary” margins earned. 2. Spreads out the costs of those who cannot make it over a much wider group of debtors.

And, by the way, this applies just the same to the financing of mortgages to the subprime sector.