This would be my brief testimony about what caused the 2008 bank crisis… if ever allowed

Sir, John Authers writes: “This week, Senator Elizabeth Warren, said the next president should reopen investigations into senior bankers who avoided prosecution, and that the FBI should release its notes on its investigations. The failure to punish any senior bankers over the scandal angers the populist left and right, the world over.”, “We are still groping for truth about the financialcrisis” September 17.

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 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 delivered 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; with subjecting it too much to the criteria of few; with the profit margins when securitizing something risky into something “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 low equity loving bankers, 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?

Sir, John Authers, tell me if you believe I at least have a point, should that not merit a discussion?

@PerKurowski ©

By giving weight to credit rating forecast that already had weight, bank regulators poisoned these Pringles.

Sir, I refer to Tim Harford’s “Why predictions are a lot like Pringles” January 9.

He argues than when we hear a forecast because “we imagine it happening… other scenarios, equally plausible, fade into the background” and also that “forecasts offer us a lazy way to understand a complex world… it will probably be wrong. But at the instant it is consumed, it gratifies… a lot like Pringles

And Pringles, although they can seriously dent your losing weight plans, basically just gives you “the fleeting pleasure of consuming them”, and that’s it.

But what if you bet on the predictions, like on credit ratings, if you then see an AAA and the rest of possibilities “fade into the background” and you use them as a “lazy way to understand a complex world” then those Pringles carry poison.

For instance bank regulators, with Basel II, set the risk weight of an AAA rated asset at 20 percent while the risk-weight of a below BB- rated asset was 150 percent… which (with a basic capital requirement of 8 percent) meant banks were allowed to leverage their equity over 60 times with AAA rated asset but only around 8 times with assets rated below BB-.

First there is no way below BB- rated risks are riskier to the stability of banks than what is AAA rated. But also since banks already considered the ratings when setting interest rates and size of exposures, the regulators de facto poisoned the AAA Pringles the ratings agencies offered, and the whole world suffered as a consequence.

PS. I now need to reference often Emma Jacobs’ “Teachers who make risk child’s play” January 8. In it Jacob’s describes how Daniel Kish, he himself blind, teaches blind children how to manage risks they cannot see. And I beg you to compare that, to bank regulators who, with credit risk weighted capital requirement for banks, try to help bankers to manage the risks they already see. What a crazy world!

PS. January 2003, in a letter published in FT I wrote: “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. Friends, as it is, the world is tough enough.” Unfortunately the world wanted Pringles.

@PerKurowski ©

FT, be brave, confess, is it not that not so deep down in your heart you all carry a little statist agenda?

Sir, I refer to Elaine Moore’s “Sovereign borrowers fall behind on record sums of debt” September 6. Indeed, and as long as bank regulators insist in their pro-government borrowing bias, it is only going to get so much worse

Anyone who believes that with regulations such as those derived from the Basel Accord in 1988, which assigned a risk weight of zero to the sovereigns of G20 and a risk weight of 100 percent to the citizens of the G20, would not sooner or later result in much excessive sovereign borrowings, is ether blind, dumb, or pushing a statist agenda.

In a letter published by FT in October 2004 I wrote: “We wonder in how many Basel propositions it will take before they start realizing the damage they are doing by favoring so much bank lending to the public sector. In some developing countries, access to credit for the private sector is all but gone, and the banks are up to the hilt in public credits.”

And in a letter published by the Washington Post in December 2009 I wrote: “Your Dec. 20 Outlook compilation of the decade’s worst ideas did not include the one most to blame for the loss of most of the past decade’s growth: regulations that allowed banks to hold absolute minimums of capital as long as they lent to clients or invested in instruments rated AAA, for having no risk. This launched a frantic race to find AAA-rated investments wherever and finally took the markets over the cliff of the subprime mortgages.

The most horrific part is that it seems likely to endure because regulators can’t seem to let go of this utterly faulty regulatory paradigm. Let me remind you that banks are allowed to hold zero capital when lending to sovereign countries rated AAA and that there are already many reasons to think that the credit quality of many sovereign states has been more than a bit overrated.”

Sir, on the subject of the distortions produced by these regulations, since you published my letter in 2004, not only has the Greek tragedy taken place but you have also ignored way over a hundred letters I have written to you on it. Should I guess that is because not so deep down in your FT heart you all carry a little statist agenda?

@PerKurowski

But our besserwisser bank regulators express no doubts about what banks should do.

Sir, Henny Sender asks: “Which is better - to invest in the debt of lower-rated issuers because they offer more attractive absolute yields; or, to invest in the debt of higher-quality companies but do so with leverage in order to generate acceptable returns?”, “When investing is all about second-guessing the Federal Reserve” February 15.

I don’t know the answer… but bank regulators, with their portfolio invariant credit risk weighted equity requirements, imply they know that very well. They have definitely instructed the banks to go for high-quality-very-high-leverage... like for AAA-rated-securities and sovereigns. 

By the way Sir, with respect to second guessing the Fed: If I now bought a10-year US government bond which pays 1.97%, and the Fed’s declares its inflation target to be 2%, would that imply I am buying a preannounced haircut?

Someone needs to put some order on this noise about Greece and its public debt to GDP.

I have held bank regulators responsible for Greece’s excessive debt. That because anyone authorizing banks to lend to a sovereign against 1.6 to zero percent in equity, meaning being able to leverage their equity from 62.5 to infinite times to 1, must know that sovereign is doomed to end up with too much debt.

And to bet that would not happen, sooner or later, is about as a high-risk gamble on a country’s future as these gambles come… and seemingly Greece was one of the first to loose that (someone could argue fixed) bet.

And Sir, that is why I could not really make heads or tails of FT’s editorial titled “A high-risk gamble on the future of Greece” December 10, since having or not a Samaras winning or not a presidential vote seemed, in comparison, like a very minor gamble on Greece’s future.

But now in FT I also see today a full two pages advertisement by a: www.freegreece.info who states that Greece public debt to GDP, after rescheduling and concessions, is only 18%, and not some 175% purportedly reported by Maastricht Treaty.

If so, great news, but then lets pray for that some credit rating does not give Greece an AAA rating, and so that banks and other lenders find it attractive to raise Greece’s debts to, for instance the levels of Germany.

18% and 175% clearly indicates much more than a simple tomayto and tomato issue...and so can somebody put some order here, please?

With no ​​jobs to pay mortgages or utilities, at least we are living in great houses. Thank you bank regulators!

Sir, I refer to Tim Harford’s “Why a house-price bubble means trouble” November 22.

In it Harford writes “Booming housing markets attract bankers like jam attracts flies, sucking money away from commercial and industrial loans. Why back a company when you can lend someone half a million to buy a house that is rapidly appreciating in value?”

That is far from being the whole story.

Regulators, because they thought or wanted to think about the financing of houses as something absolutely safe, also allowed the banks to do it against very little bank capital, meaning very little equity… especially if someone managed to dress up the mortgages in AAA ratings.

And that allowed banks to earn much higher expected risk-adjusted returns on equity when financing houses than when financing the “risky” small businesses and entrepreneurs, those who could create jobs, and for which their regulators required them to hold much more equity.

And so here we now find ourselves… living in expensive houses with too few good jobs to allow us to pay the mortgages and the utilities. Is that not sort of bad planning?

Regulators who darkened the banks in the sun, should not be allowed to shine light on those in the shadows

Sir, I refer to your “Regulators shine a light on the banking shadows” October 15. Therein your argue: “FSB’s rules on short-term securities lending are a sensible start” since “The shadow banking system was at the heart of the financial crisis” and then you refer to “the meltdowns of Lehman Brothers and AIG”

Quite a distorted view I would say… both Lehman Brothers and AIG troubles had little to do with the shadows and most to do with the regulations that applied to the banks in the sun.

On April 28, 2004, two months before Basel II was formally approved, SEC decided that " for Broker-Dealers that are Part of Consolidated Supervised Facilities and Supervised Investment Bank Holding Companies… computations of allowable capital and risk allowances (or other capital assessment) consistent with the Basel Standards" should apply.

And that meant that, for instance Lehman Brothers, would be able to leverage its equity 62.5 times to 1 when investing in AAA rated securities, such as those that detonated the disaster.

And the same Basel Standards implied that, if a company like AIG, proud bearer of an AAA rating, puts its name to a debt instrument, banks would be able to leverage these investments 62.5 times to 1… and so of course everyone wanted to hire AIG’s AAA rating… at a reasonable price.

And, if someone does not understand the temptations a 62.5 to 1 leverage implies for a financial company, he knows nothing about finance and less about regulations. As a reference, hedge funds, those animals of speculation, these can rarely leverage their equity more than 10 to 1.

Sir, I am not at all sure that current regulators, those who so much helped to darken the prospects of our banks, should even be allowed to try to shine a light on the banks in the shadows… they done enough damage as is.

May I here remind you of some minimum terms we need to lay down before we allow regulators to regulate any banks?