The AAA bomb… or how I brought down the Capitalist Empire

Read the memoirs of a central planner who to avenge his defeat in Russia entered the bank regulatory system in Basel and created a formula of minimum capital requirements based on something titled default risks which allowed the build up of immense leverage for "risks" perceived as low; and thereafter managed to empower his credit rating moles to strike with nuclear force at the heart of the capitalist Empire.

A book dedicated to all those doing their utmost to provide the financial regulators with cover.

Tentatively published in fall 2009 by the Voice and Noise Foundation

Does the First Amendment protect the right to freely express a lie?

The bank regulators of the world decided over the last decades to give some few credit rating agencies an immense role channeling the financial flows of the world and, as was doomed to happen, sooner or later, such an information oligopoly led us into a disaster, in this particular case the badly awarded mortgages to the subprime sector.

Currently, defending themselves, the credit rating agencies argue, apparently with great success, that all they do is opine and that their opinions are protected by the First Amendment to the US Constitution.

To anyone knowledgeable about these issues, may I ask a simple question?

Suppose the credit rating agencies were giving opinions that were not really their firm opinions, or in fact might even have been opinions contrary to their own real opinions, does the First Amendment equally cover the right to express non-opinions or outright lies?

Bank regulators, why, why, why?

If all bank crisis in history have resulted from the build-up of excessive exposures to what was perceived as “absolutely safe”, or at least very safe, and none ever from the build-up of excessive exposures to what was perceived as risky… what is the rationale behind capital requirements for banks which are much lower for what is perceived as absolutely safe, or at least very safe, than those for what is perceived as “risky”? 

Some questions today to The Masters of Risk

The Joker on the Basel Committee

I can hear now the free market answering a confounded citizen by describing the bank regulators with the same words the Joker used in the movie The Dark Knight, 2008:

"You know, they're schemers. Schemers trying to control their worlds. I'm not a schemer. I try to show the schemers how pathetic their attempts to control things really are. So, when I say that … it was nothing personal, you know that I'm telling the truth. It's the schemers that put you where you are. I just did what I do best. I took your little plan and I turned it on itself. Look what I did to this city with a few…" AAA rated collateralized debt obligations and MBS, and some of their 0% risk weighted sovereigns

When I think of a small group of bureaucratic finance nerd technocrats in Basel, thinking themselves capable of exorcizing risks out of banking, for ever, by just cooking up a formula of minimum capital requirements for banks, based on some vaguely defined risks of default; and thereafter creating a risk information oligopoly empowering the credit rating agencies; and which all doomed, sooner or later, to take the world over a precipice of systemic risks; like what happened with the lousily awarded mortgages to the subprime sector, or to Greece when regulations assigned it only a 20% risk weight and doomed it to excessive public debt... I cannot but feel deep concern when I hear about giving even more advanced powers to the schemers.

PS. Years later I found out that even if Basel II would initially have risk weighted Greece 20%, European authorities assigned it a 0% risk weight, which meant European banks could lend to Greece's government without having to hold any capital against that exposure. Unbelievable! What champion schemers!

PS. Here is an updated aide-mémoire on some of the many mistakes with the risk weighted capital requirements for banks.

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

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.

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?

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.

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?

Friends,

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.

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.

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.

Global public bads!

The credit rating agencies are currently the number one example of a global public good having turned into a global public bad.

On the discrimination based on the financial profiling and risk-based pricing

Risk-based pricing actually requires creating the misinformation that allows for making borrowers who should get lower rates agree to pay the higher rates that cover the losses of those that should not have been given credit… at least not at these high impossible rates.

Risk based pricing, which is similar to placing persons that after some doubtful genetic test are presumed to be especially exposed to an illness in a separate insurance pool, could be causing much of the growing social inequality that is currently attributed by some to globalization. Risk profiling, for a discriminatory purpose, is prohibited in most spheres of our social relations, except in lending where it is very much cheered, by most.

John, Paul and Peter, because of their opaque FICO have to pay high interest. John, though he might have been able to do so at lower rates, is not able to service the debt and loses. Paul, utterly responsible, services it, barely, and Peter who is in this group because no ones no why meets the payments with ease. Question: Any winners?

John should for a starter not have been given the credit, at least not at the high rate, and both Paul and Peter, having been able to service the debt at high rates evidenced de facto they merited lower rates. Answer: No winners! Except of course those who are not to be named!

How libertarians can shut up about the financial information cartels that chain the markets to neo-non-transparent-regulations, I have never understood.

How developed countries’ progressives can shut up about the discrimination implicit in risk based pricing and that could be introducing more inequality in the societies than what they sometimes attribute to globalization, I have never understood.

The financial markets are not free

We will not have free financial markets while our financial regulators insist on supporting and empowering the financial risk information cartel that puts up traffic signs all over the word, supposedly showing the route to different risk areas.

A letter in Washington Post: An Aspect of the Bubble

An Aspect of the Bubble

The June 17 installment in the front-page series "The Bubble," though comprehensive, missed one vital piece of the subprime mortgage puzzle. The accompanying glossary defined a "credit rater" as "a company that Wall Street and investors rely upon" to provide analysis but did not tell us that a credit rater's credibility is foremost based on the rater's having been appointed by bank regulators. This arrangement sent the market the loud, clear and false message that risks could be precisely measured and that these entities were capable of carrying out this mission.

Nothing whetted the appetite for securities collateralized with plainly lousy mortgages as much as the combination of high returns and prime credit ratings. Using a regulatory system for banks that is based on following the credit rating agencies will, given that it is human to err, lead us into even greater danger.

Published in Washington Post

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.
December 30, 2018: Affordable homes or investment assets?
April 19, 2020: The capacity to borrow is a valuable sovereign asset.
November 28, 2022: Before the debt ceiling is lifted
August 22, 2023: The economic revolution

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.

Why we cannot leave bank regulators to regulate on their own!

Nout Wellink the Chairman of the Basel Committee on Banking Supervision declared in the Financial Time on April 10 2008 that “Basel II is sophisticated and sorely needed”; and it is a splendid confirmation of why we cannot leave the traditional bank regulators regulating banks on their own. The just are digging ourselves deeper in the hole we are in!

Of course there is nothing wrong with sophistication as long as it does not take away from our understanding of what is going on, which it will be the end result, which makes further mockery of market transparency; and as long as it does not create new artificial market advantages, which it will by favoring the big banks and the continuation of our craze of putting ever more eggs into fewer basket; and as long as it does not create new systemic risks, which it will as long as “to err is human” applies, just like it applied in the case of the credit rating agencies.

But, what I most object to is that “there will be greater differentiation in the capital requirements for high risk and low risk exposure”. Who on earth told the bank regulators that the only role of banks was to avoid failing and that for that purpose you had to create an additional regulatory bias against risks, more than the natural bias against risk that already exists in the market? No, we do not need the banks to increasingly finance only securitized consumers and public sectors around the world just because that could be construed as having a lower risk of default. To do so could lead the world to default. If we are going to use default risk as a basis, then we better design the minimum capital requirements in terms of units of risk per decent job created.

Tax the bank-baskets on the number of eggs they carry!

To tweak and refine the current bank regulatory systems, for instance by further professionalizing the credit rating agencies, in order to get us to foolishly trust them even more, will just increase the systemic risks of a global failure.

The best and safest way is to follow the prudent tradition of not putting all your eggs in the same basket and to that effect create a progressive tax on the size of the banks. The larger the bank, the more it will hurt if it fails, so the more it should have to pay in insurance premiums.

Marx prophesied “a progressive diminution in the number of the capitalist magnates” and the best way I know of fighting Marxism is to stop this prophecy from becoming a reality.

Stop the bank regulators!

It behooves us all to see what our bank regulators are up to, now when they have been caught with their pants down.

The more sophisticated our financial system gets the less we will understand it and the more we will have to place ourselves in the hands of experts; and thereby run the risk that our supervisor’s oversight degenerates because of the incestuous forces at work.

I do not purport to have the right answer but having seen how peddlers of supposedly prime potions poisoned the world’s financial system while bank supervisors were congratulating themselves on a job well done I have a feeling we should not let them dig us deeper in the hole we’re in, just because they want to save face.

We must require than non-bankers and non-supervisors are in majority in the bank regulating bodies and that our representatives are selected among persons humble enough to publicly accept that they don’t understand it when they don’t understand it.

If knowledge suffices then wisdom is worthless

If knowledge suffices then wisdom is worthless and sure enough our bank regulators placed more value on knowledge than on wisdom; which is the only way how you can explain such foolish behavior as empowering the credit rating agencies with so much power over the financial flows of the world.

See where this has gotten us. All the very sub-prime awarded mortgages to borrowers that classified as subprime would have not been able to go anywhere had they not been blessed as prime collaterals for other securities.

One reason that stops the world from realizing the foolishness of it all is that the credit rating agencies are private, and we have all been Pavloved into establishing a connection between private and free efficient markets. The truth though is that the private credit rating professionals are only outsourced bureaucrats working for some pompous Ministry of Financial Risk Elimination.

P.S. God make us daring!