Regulators placed delicious cookies on the table and only banks are being punished for falling for the temptation

Sir, again, December 24, we read on your front page about banks being hit with penalties for the subprime mess, and still not a word about the responsibility of regulators creating the temptations they should have known that, sooner or later, some would not resist.

Here are four factors that explain the subprime mess, or at least 99.99% of it.

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 higher the profits. 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 to be shared among those involved in the process.

Credit ratings: Too much power to measure risks was concentrated in the hands of some very few human fallible credit rating agencies. The systemic risk with using credit ratings so much should have been anticipated by regulators.

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.

So, clearly the temptations became too much to resist for many of those 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.

Of course it had to end bad... and it did… in sort of less than 3 years.

Financial Times, is this a version of the real truth that is not to be named?

PS. “DoJ penalties hit $58bn. If banks leverage 12 to 1, that means $696bn in credit capacity. Why do they not collect these fines in bank shares?

@PerKurowski

Bank regulators have set their highest bank capital requirements for what poses the least dangerous tail risks

Sir, I refer to your “World economy of so-so growth and fat tailed risk” January 4, and your reporters “Unlikely suspects are in the wings for 2016” of January 2.

The latter states: “Some risks are quotidian. Will a company struggle to generate cash flow, or will a particular asset fall out of vogue. Then there are outcomes that exist in the narrow, far reaches of statistical probability distributions, known as “tail-risks”. A hefty blow to investments is usually the result when such shocks occur.”

And with respect to current bank capital requirements, those that are supposed help cover for unexpected losses I have two questions for your reporters.

First, what can cause more unexpected losses, quotidian risks like credit risks, or the kind of events that they exemplify as some possible dangerous tail risks?

Second, in the case of credit risks, what has the capacity to produce the most sizable unexpected losses, what is perceived as safe or what is perceived as risky?

The correct answer to those questions should indicate the absurdity of setting the highest capital requirements for that that in terms of a quotidian credit risk is perceived as risky.

Think of it. The risk weight for a private sector asset rated below BB- was set at 150 percent, while that of an AAA to AA rated was only 20 percent. Is below BB- rated, something which scares away any risk adverse banker, really more dangerous to the banks than what is AAA rated? 

Sir, how long will your reporters ignore this sad truth? Is there a tail risk they personally have to be afraid of?

Laura Noonan in “EU board budgets for 10 bank failures” December 4, writes that the Single Resolution Board is seeking €40m in accounting advice, economic and financial valuation services and legal advice, to be used in the resolution of struggling Eurozone banks from 2016 to 2020.

Sir, have any of the possible big shot candidates for that consultancy ever informed bank regulators that their capital requirements make no sense? Sorry, just asking.

@PerKurowski ©

Often unanswered emails speak much louder than those answered… as well as help to build a case.

Sir, I refer to Lucy Kellaway’s “My solution to the maddening silence of ignored emails” February 2.

You know that in my case I have thousand of unanswered emails of those I sent to the Financial Times and its journalists over the years. And most of these have to do with that regulatory asteroid that hit the earth in 1988, the Basel Accord, and that have ever since distorted the allocation of bank credit to our real economy.

Am I mad because of that? Absolutely not! Quite often unanswered emails speak much louder than those answered.

I know that my criticism and my warnings about what the Basel Committee is doing are based on realities, and so I just have to bide my time. When the truth finally comes out, FT’s silence merits a chapter of its own in the book that will result… and Sir, may I predict you will hope you had answered many more emails.

Meanwhile let me heed some of Kellaway’s advice: “There is no shame in pestering: in a world in which people have largely given up answering at all, it is moronic to ask only once. If the answer was always going to be no, nagging can’t make things worse. And there are enough people… who allocate their time not to those they want to see most but to those who persist longest.”

Current bank regulators are so dumb… and FT’s journalists do not even seem curious about it

Sir, Evelyn de Rothschild ends her “Banking must pursue the holy grail of confidence”, June 25, with what amounts to a blistering indictment of all involved writing: “To maintain its global stature, it is vital that Britain’s financial sector be understood to have rules and regulations that are effective deterrents of bad behaviour, but that also promote the dynamism our economy needs. To achieve this requires a transformation in skills and ethics from bankers, regulators and politicians”.

And I fully agree, but, the list of those who require transformation should also include financial journalists… That, because it is important that the financial sector is covered by journalists capable of questioning and not prone to get derailed by thoughts like: “No, that can’t be, the regulators can’t be so dumb”.

Because yes, and as I have explained in hundreds of letters, our current bank regulators have been unforgivable dumb.

Since ex ante perceived risks are already cleared for by banks by means of interest rates, the size of exposure and other terms, there is absolutely no reason to clear again for exactly the same perceptions, in the capital requirements for banks. But that is what the Basel Committee mandates, and that produces a distortion which endangers the real economy and the financial sector.

And yet, since your journalists cannot seem to muster even the curiosity to ask the regulators for an explanation that counters my argument… I must conclude they are… well you tell me!

“No ordinary man could be such a fool”

My daughter Alexandra, an art fanatic, on hearing my explanation about the mistake of the Basel Committee pointed me to “The forger’s spell”, a book by Edward Dolnick about the falsification of Vermeer paintings. Boy was she right! 

In that book Dolnick makes a reference to having heard Francis Fukuyama in a TV program saying that Daniel Moynihan opined “There are some mistakes it takes a Ph.D. to make”. And he also speculates, in the footnotes, that perhaps Fukuyama had in mind George Orwell’s comment, in “Notes on Nationalism”, that “one has to belong to the intelligentsia to believe things like that: no ordinary man could be such a fool.” 

And that comprises about the most appropriate explanation I have yet seen so as to understand why our bank regulators were able to commit their huge mistake that got us into this financial and economic crisis that threatens the Western World. No “ordinary man” would have told his children to beware about what he knew his children were afraid of, and stimulated them to go more where they wanted to go as it seemed safe… which is precisely what the current capital requirements for banks do when they are quite sizable whenever the perceived risk of default is high and small or even inexistent whenever the perceived risk of default is low. 

And then, just like to force down our throats, Dolnick writes “Experts have little choice but to put enormous faith in their own opinions. Inevitably, that opens the way to error, sometimes to spectacular error.” All of which now leaves me with the problem that also “no ordinary” FT reporter can come to grips with believing that experts could be such fools.