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 

Here other of my letters in the Washington Post on this issue:
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.

September 2, 1986 was the tragic night when Paul A. Volcker, in London, gave in to (insane) European bank regulators.

Paul A. Volcker in his autography “Keeping at it” of 2018, penned together with Christine Harper, valiantly accepted that the risk weighted bank capital requirements he helped to promote, had serious problems. In pages 146-148 he writes:

"The travails of First Pennsylvania and Continental Illinois, the massive threat posed by the Latin American crisis, and the obvious strain on the capital of thrift institutions had an impact on thinking over time, but strong action was competitively (and politically) stalled by the absence of an international consensus.

An approach toward dealing with that problem was taken by the G-10 central banking group meeting under the auspices of the Bank for International Settlements (BIS) headquartered in Basel, Switzerland. A new Basel Committee would assess existing standards and practices in a search for an analytic understanding.

Progress was slow… 

The US practice had been to asses capital adequacy by using a simple “leverage ratio”-in other words, the bank’s total assets based compared with the margin of capital available to absorb any losses on those assets. (Historically, before, the 1931 banking collapse, a ten percent ratio was considered normal)

The Europeans, as a group, firmly insisted upon a “risk-based” approach, seemingly more sophisticated because it calculated assets based on how risky they seemed to be. They felt it was common sense that certain kind of assets –certainly including domestic government bonds but also home mortgages and other sovereign debt- shouldn’t require much if any capital. Commercial loans, by contrast, would have strict and high capital requirements, whatever the credit rating might be.

Both approaches could claim to have strengths. Each had weaknesses. How to solve the impasse?

At the end of a European tour in September in 1986, I planned to stop in London for an informal dinner with the Bank of England’s then governor Robin Leigh-Pemberton. In that comfortable setting without a lot of forethought, I suggested to him that if it was necessary to reach agreement, I’d try to sell the risk-based approach to my US colleagues.

Over time, the inherent problems with the risk-based approach became apparent. The assets assigned the lowest risk, for which capital requirements were therefore low or nonexistent, were those that had the most political support: sovereign credits and home mortgages. Ironically, losses on those two types of assets would fuel the global crisis in 2008 and a subsequent European crisis in 2011. The American “overall leverage” approach had a disadvantage as well in the eyes of shareholders and executives focused on return on capital; it seemed to discourage holdings of the safest assets, in particular low-return US government securities."

September 2? From here


I ask: Insane? I answer: Absolutely! 

How can one believe that what bankers perceive as risky is more dangerous to bank systems than what bankers perceive as safe? 

Should it not be clear that dooms our bank system to especially severe crises, resulting from excessive exposures the what ex ante is perceived as especially safe, but that  ex post might not be, against especially little capital?

These self-nominated besserwisser experts had (have) just not the faintest understanding of conditional probabilities.

Here a list of the many mistakes with the risk weighted bank capital requirements

Basel III - sense and sensitivity”? No! Much more “senseless and insensitivity”

I refer to the speech titled “Basel III - sense and sensitivity” on January 29, 2018 by Ms Sabine Lautenschläger, Member of the Executive Board of the European Central Bank and Vice-Chair of the Supervisory Board of the European Central Bank.

“Senseless and insensitive” is how I would define it. It evidences that regulators have still no idea about what they are doing with their risk weighted capital requirements for banks.

Ms Lautenschläger said: With Basel III we have not thrown risk sensitivity overboard. And why would we? Risk sensitivity helps align capital requirements with actual levels of risk and supports an efficient capital allocation. It prevents arbitrage and risk shifting. And risk-sensitive rules promote sound risk management.

“Risk sensitivity helps align capital requirements with actual levels of risk and supports an efficient capital allocation” No! The ex ante perceived risk of assets is, in a not distorted market aligned to the capital by means of the size of exposure and the risk premium charged. Considering the perceived risk in the capital too, means doubling down on perceived risks; and any risk, even if perfectly perceived, if excessively considered causes the wrong actions.

“It prevents arbitrage” No! It stimulates arbitrage. Bankers have morphed from being diligent loan officers into too diligent equity minimizers. 

“It prevents risk shifting.” No! It shifts the risks from assets perceived as risky to risky excessive exposures to assets perceived as safe.

“It promote sound risk management” No! With banks that compete by offering high returns on equity, allowing some assets to have lower capital requirements than other, makes that impossible.

Ms Lautenschläger said: “for residential mortgages, the input floor increases from three basis points to five basis points. Five basis points correspond to a once-in-2,000 years default rate! Is such a floor really too conservative?”

The “once-in-2000 years default rate on residential mortgages!” could be a good estimate on risks… if there were no distortions. But, if banks are allowed to leverage more their capital with residential mortgages and therefore earn higher expected risk adjusted returns on residential mortgages then banks will, as a natural result of the incentive, invest too much and at too low risk premiums in residential mortgages… possibly pushing forward major defaults from a “once-in-2000 years default” to one "just around the corner". That is senseless! Motorcycles are riskier than cars, but what would happen if traffic regulators therefore allowed cars to speed much faster?

I guess Basel Committee regulators have never thought on how much of their lower capital requirement subsidies are reflected in higher house prices?

Then to answer: “Does this mean that Basel III is the perfect standard - the philosopher's stone of banking regulation? Ms Lautenschläger considers “What impact will the final Basel III package have on banks - and on their business models and their capital?”

Again, not a word about how all their regulations impacts the allocation of bank credit to the real economy… as if that did not matter… that is insensitivity!

Our banks are now financing too much the “safer” present and too little the “riskier” future our children and grandchildren need and deserve to be financed.

PS. In 2015 I commented another speech by Ms Lautenschläger on the issue of “trust in banks”.

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 and immediate profit of $210.000 for those involved in the process. (Those who are being securitized 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.

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. 

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.

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

The banks, like the Europeans, 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. 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?

Please, let us not favor financing our houses more than the jobs our kids and grandchildren need

I refer to Avinash Persaud’s “Breaking the Link between Housing Cycles, Banking Crises, and Recession”

Avinash Persaud correctly states: “This story is not just about mortgages but also about the overall allocation of liquid and illiquid assets across the financial system” March 2016

Yes, indeed it is. I have for soon two decades criticized that the Basel Committee's concept of risk-weighted capital requirements for banks, dangerously distorts the allocation of bank credit.

Persaud writes: “Under Basel I, in the calculation of the amount of risk-weighted assets a bank had to fund with capital, securitized mortgages had a risk weight of 20 percent while nonsecuritized mortgages had a risk weight of 50 percent.” And Persaud translates that into “This allowed banks to earn fees and net interest margins on holding 2.5 times more credit”

A more precise description is that Basel I assigned a 50% weight to loans fully secured by mortgage on residential property that is rented or is (or is intended to be) occupied by the borrower, and Basel II reduced that to 35 percent. And Basel II also introduced that security or any financial operation that could achieve an AAA to AA- rating, was assigned a 20 percent weight.

And I translate that as: With Basel I and II’s standard risk weight of 8 percent, anything that has a risk weight of 100%, like loans to unrated SMEs and entrepreneurs, means banks can leverage its defined capital 12.5 times to 1 (100/8). 

But if it has access to a 20 percent risk weight, the bank can leverage its defined capital 62.5 times to 1 (100/1.6)

And banks, naturally, operate to maximize risk-adjusted returns on equity (and bonuses to the bankers).

And so there can be no doubt banks will allocate much to much credit, in much to easy conditions to mortgages and AAA rated securities (and to sovereigns with a zero percent risk weight) and much too little credit, in much to harsh relative terms, to what is risk weighted more than that like, SMEs and entrepreneurs.

And so, while I fully share Persaud’s argument about preferring insurance companies to banks to finance mortgages, so as to minimize maturities mismatches, my concerns go much further than his.

I do not want to favor, in any way shape or form, the “safe” financing of mortgages, whether by banks or insurance companies, over the “risky” financing of the job creation our children and grandchildren need.

PS. What would houses be worth if there was no financing available for buying houses? I ask because mortgages might now be financing more the credit available for buying houses than the real intrinsic value of houses. Oops!

PS. A memo on the many mistakes of current risk weighted capital requirements for banks

Is this what you really want?

If banks are allowed to hold less capital against mortgages than against loans to SMEs and entrepreneurs… something that they are allowed now.

Then banks can leverage their equity, and the support they receive from society, by for instance deposit insurance schemes, much more with mortgages than with loans to SMEs and entrepreneurs. 

And then banks will earn higher ex ante perceived risk adjusted returns on equity when lending to those buying houses than when lending to those who can generate the next generation of jobs.

And then banks will lend more to home buying than to job creation.

And then the citizens are doomed to end up sitting in expensive houses, with low salary jobs or no jobs at all to pay their utilities and their mortgages with.

Is this really what you want?

Prioritizing the financing of residential property over the financing of job creation is not the smartest thing to do

Based on Basel II’s standard capital requirements for banks, these are required to hold 2.8 percent in capital when lending secured by mortgages on residential property and 8 percent when lending to SMEs and entrepreneurs. 

That means that the adjusted for risk net margin paid by a residential borrower can be leveraged 35 times by the bank (100/2.8), while the same margin can only be leveraged 12.5 times (100/8) if paid by SMEs and entrepreneurs.

And that means banks can obtain much higher risk-adjusted returns on equity when lending secured by mortgages on residential property than when lending to SMEs and entrepreneurs. 

And that means that banks will find it much more interesting to finance residential property than to finance those who can help to create the jobs to help residential mortgages and utilities to be serviced.  

That definitely sound skewed the wrong way. If I was the regulator I would much rather prefer banks financing more the creation of jobs, so that people could better afford to buy their homes with less financing… but that’s just little me.

“But building homes creates jobs?” Indeed, but once everyone has a home, and a mortgage to service, which diminishes their available income, where are our grandchildren to work?

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.

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 too safe playgrounds, too many children went to too few 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.

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.

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

Let us set the historical records straight

Yes! … keep blaming the housing market and the mortgages and the over lending for the mess and you will not see what is happening in front of your eyes.

And the real culprits are:

The arrogant financial modelers that thought they could predict the future based on quite brief statistics and that lost or forgot all the inhibitions as time kept postponing calling their bluff.

Greedy fund managers whose profitable business model was based on charging commissions on profits derived from their own valuation models and that were so handy in lieu of the non existing markets for their own investment products.

The credit rating agencies that enthralled were so busy celebrating how good their own business was doing so that they completely forgot the bolts and nuts of credit analysis, like walking the streets to see how the mortgages were awarded.

The banking regulators that behaving like former central planners from soviet looked to drive banking risks out of banking, having these risk go underground; and that managed to impose on the market so much obedience to the credit rating agencies, that much of the market forgot or found no need to do its own due diligence.

Finally the spreading of the mantra that the financial risks have finally been conquered, when the real truth was that the risks had only gone into hiding, to gather forces.

Clearly we need to understand very well that at this moment that there are a lot of incentives for the experts to try to take shelter behind “a slowing economy” though in fact the reality is that the economy will now be slowing because of them.

It is up to the rest of us to set the historical records straight.

The dark side of knowledge

We heap praises on our knowledge economy but we must not forget that in some circumstances not knowing might be blissful for the society, or at least easier for it to handle. Let me briefly illustrate what I mean by referring to health insurance and credits. 

If we all share the same health insurance plan then we do all, in solidarity, share in our respective good or bad health. But if insurance companies are allowed to discriminate between us then little by little we will be divided in many groups depending on our health prospects, as determined by what we could call the health-rating agencies. 

When the health market limits itself to segment for instance between smoking and not smoking this does not have any serious implications since smoking is (supposedly) a voluntary decision and so the deterrent effect of having to pay a higher insurance premium because you smoke might not be that bad. Of course the volunteerism argument can also become exaggerated as currently there are insurance companies that offer even hefty discounts depending on how many hours you work out at the gym. 

But, if the health insures would be allowed to use all those genetically mapping discoveries that are just around the corner, then we might dangerously end up with some citizens insurable at very low rates, some at higher and some not insurable at all. And the question we will then have to answer as a society, is how to counteract the logical desperation of the latter. 

Something of the same happens with credits, like mortgages. It used to be that depending on your income, as a potential home buyer you could classify for more or less of borrowings, but the interest rate to be paid on the loan did not differ much or even anything at all between a “good” borrower and a “not so good” one. Not any longer. The knowledge economy now classifies the market in many different type of credit risks and although this is has been sold as something that creates more opportunities for poor buyers it might not necessarily be so. 

A thousand dollars paid each month servicing a mortgage during 15 years, when discounted at 11 percent per year, because the borrower is deemed “risky”, is worth 88.000 dollars today. Exactly the same payments, discounted at only 6 percent because the borrower is deemed creditworthy, are worth 118.500…35 percent more! And here lies one of the real problems of the subprime debtors… not only do they have less money, but the little money they have is also worth less. 

Now add to the above that the credit ratings might not even reflect correctly the repayment capacity of the borrowers and we can see how as a society we might be drawn into a totally unsustainable structure. 

And so what are we to do about this fact that knowledge in some cases works as a regressive tax in our society? Are we better off going back into obscurity? Of course not! What we need to do though is to arm us with a lot more with the humility we need to be able to recognize that handling all this new found knowledge requires a lot of wisdom…of that sort that can not easily be purchased in any databank or by accessing any experts with a PhD.

PS. Human genetics made inhuman
PS. If knowledge suffices then wisdom is worthless