The risk weighted capital requirements for banks, put the “Minsky moments” on steroids.

Sir, you write “A period of stability leads to rising investment, financed by borrowing, which drives up asset prices until cash flows generated by those assets can no longer support the debt taken on to buy them. Eventually there is what has been dubbed the “Minsky moment”: a dash for the exits as asset prices plunge. After the bubble bursts, the debt burden remains and can depress activity for a long time. “The challenge posed by oil’s ‘Minsky moment’” March 29.

But the regulators, with Basel II, told banks “If you think that something is safe then you can hold less capital against it”. And, in their Standardized Approach to Credit Risk, the regulators allocated the basic capital requirement of 8 percent according to the following risk weights: zero percent for loans to AAA-rated sovereigns; 20 percent on loans to the AAArisktocracy, 35 percent risk weight on the finance of residential mortgages; and 100 percent risk weight on exposures to unrated citizens.

And that translated into banks could leverage equity unlimited times when lending to AAA rated sovereigns; 62.5 times to 1 when lending to the AAArisktocracy, 35.7 times when financing residential housing 35.7, and only 12.5 times to 1 when lending to the unrated citizens.

And of course that allowed banks to earn different risk adjusted returns on equity not based on what the market offered, but much more based on what the regulators dictated.

And since “Minsky moments” never occur in areas ex ante perceived as risky but always in what is perceived as safe, that is of course equivalent to putting the “Minsky moments” on steroids.

You also end with: “As Minsky argued, booms and busts are endemic to capitalism. Sensible policy strives not to abolish the cycle but to mitigate its effects.”

But the risk weighted capital requirements signifies banks will have especially little capital precisely when the busts occur. And that has nothing to do with “mitigating” its effects, just the opposite.

Sir, I must have written to you and your colleagues well over 2.000 letters trying to explain the dangerous distortions caused by the risk-weighted capital requirements for banks, but apparently it has not yet been understood.

Sir, between us in petit committee, although I understand that it probably has to do with you wanting to sound sophisticated, I do not think you have earned the right of referring to Minsky into your editorials.

PS. This is not a critique directed solely to you Sir. For example, out there, the less many seem to understand what is really going on with our banks, the more they express concerns about “derivatives”, only because that word sounds so delightfully sophisticated.

Without the endorsement by regulators, banks would never have leveraged their equity 60 times to 1 with any asset.

Sir, Gary Silverman writes: “exempting the derivatives known as credit default swaps from more rigorous federal regulation…[was] one of the biggest mistake leading to the financial crisis”, “Why it is wrong to forget Lehman’s fall” September 20.

That is not so. Again, for the umpteenth time, I will explain prime cause of the financial crisis, namely the capital requirements for banks, and this by using the examples of Lehman Brothers, AIG and Greece.

The regulators in June 2004, with Basel II, decided that against AAA rated private sector assets, and against any sovereign rated as Greece was until November 2009, banks needed to hold only 1.6 percent in capital, meaning banks could leverage their equity with those assets over 60 times to 1. In comparison, when holding “risky” assets like loans to entrepreneurs and SMEs, banks were only allowed to leverage 12 times to 1. 

On April 28, 2004 the SEC decided that what was good for the Basel Committee was good enough for them, and so allowed Lehman to leverage over 60 times to 1 with AAA rated securities guaranteed with mortgages to the subprime sector… Since Europe were allowing their banks to do the same… the demand for these AAA securities became so huge that it overpowered all the quality controls in their manufacturing and packaging process… and Bang!

If AAA rated AIG guaranteed an asset, banks could also dramatically reduce the capital they needed to hold against that assets, and this overwhelmed AIG’s capacity to resist selling “very profitable” loan default guarantees… and Bang!

And Greece was of coursed offered loans in such amounts, and in such generous terms, so that its governments could not resist the temptations… and Bang!

As can be seen the above has nothing to do with deregulation, or with exempting anything from rigorous federal regulation, and all to do with imposing extremely bad and distorting regulations. On their own, and without the direct endorsement of regulators, banks would never ever have dreamt of leveraging their equity 60 times or more, with any asset… no matter how safe it looked.

If we are not going to spell out the real reasons why Lehman Brothers fell, then we better all forget Lehman’s fall.

PS. Here are 7 questions US Congressmen and Governors should ask bank regulators.

@PerKurowski

A Leverage Ratio makes banks hold equity on all exposures, to cover specially for unexpected losses, like cyber attacks

Sir, I refer to the letter signed by financial sector representatives: “Leverage ratio threat to the cleared derivatives ecosystem” August 27.

What is argued, that segregated cash margins, held to guarantee the commitments of clients, should be deducted from a bank’s actual exposure, sounds quite reasonable since the current construct of the leverage ratio “fails to consider existing market regulations that mitigate…losses”.

But when it is said that: “The leverage ratio is designed to require banks to hold capital against actual exposures to loss”, that is wrong. The leverage ratio is there to cover for any exposures to losses, most importantly any unexpected losses.

It would for instance be easier for regulators to just state that the leverage ratio is to cover against cyber-attacks… so as to clear the air, while moving towards a completely different Basel IV.

@PerKurowski

On bank regulations why can’t we get to the heart of its problems? Why can’t we keep political agendas out of it?

Sir, I refer to Edward Luce’s “Too big to resist: Wall Street’s come back” December 14.

Anyone who with an open mind reads Daniel Kahneman’s “Thinking, Fast and Slow” 2011, or this years “World Development Report 2015: Mind, Society, and Behavior” issued by the World Bank, should be able to understand the following with respect to current bank regulations:

Regulators (and ours) automatic decision-making makes us believe that safe is safe and risky is risky; while a more deliberative decision-making would have made us understand that in reality very safe could be very risky, and very risky very safe.

And so when so many now scream bloody murder about the influence of big banks in the US congress, because these managed to convince legislators to allow “banks to resume derivative-trading from their taxpayer insured arm”, they posses very little real evidence of what that really means… except, automatically, for the fact that it all sounds so dangerously sophisticated.

No, if there is something we citizens must ask our congressmen to resist, that is the besserwisser bank regulators who, with such incredible hubris, thought themselves capable of being risk-managers for the world, and decided to impose portfolio invariant credit risk weighted capital requirements for banks.

These regulations distorted all common sense out of credit allocation, and cause the banks to expose themselves dangerously much to what is perceived as “absolutely safe”, while exposing themselves dangerously little for the needs of our economy to what is supposedly “risky”, like lending to small businesses and entrepreneurs.

If we, based on what caused the current crisis should prohibit banks to do, it would have very little to do with derivatives, and all to do with investing in AAA rated securities, lending to real estate sector (like in Spain) or lending to “infallible sovereigns” like Greece.

Does this mean for instance that I do not agree with FDIC’s Thomas Hoenig’s objection to US Congress suspending Section 716 of Dodd-Frank? Of course not! But, before starting to scratch the regulatory surface, something which could create false illusions of safety, or even make it all much riskier… we need to get to the heart of what is truly wrong with the current regulations… Sir, enough of distractions!

And also enough of so many trying to make a political agenda and election issue out of bank regulations… as usual it would be our poor and unemployed or under employed youth who most would pay for that.

Most of the concern with derivatives derives only from the fact that “derivatives” sounds so deliciously sophisticated.

Sir, Tracy Alloway and Michael Mackenzie when reporting on the “Dangers to system from derivatives´ new boom", August 20, might not understand the most important differences between underlying markets and the derivatives traded based on these.

In a derivative, there is a buyer and a seller, and so whatever happens someone wins and someone loses and in essence it’s a wash out… of course as long as all can live up to their commitments.

But, in a real market loss, like that of a lower value of a stock, a lower value of a painting, or a lower value of a real estate, there is at that time only a loser… and no winner… that is unless you count he who might have way back earlier sold the stock.

And in this respect the trading in derivatives will depress much less the market than a depression of the values of the underlying vanilla assets.

The big fuss that is raised around the issue of trading of derivatives, again, besides the possibility of one side of the trade not living up to his commitments, has much more to do with the fact that “derivatives” sounds so deliciously sophisticated.

Ms Tett, in the case of “derivatives”, their biggest danger lies in how delightfully sophisticated they sound!

Sir, Gillian Tett writes about “the mortgage credit derivatives that proved so deadly in that credit bubble”, “The female face of the crisis quits the spotlight” April 4.

One of the problems with understanding our way out of this crisis, are all those who wants us to chase anything they cannot explain, like the sophisticated sounding derivatives. And that stands in the way of attacking the real easy straightforward “vanilla” problems which caused the crisis.

As an example, that which “proved so deadly”, were real securities backed up with different tranches of very real though utterly badly awarded mortgages, something which has nothing to do with derivatives. And the reason these securities, if AAA rated, became so attractive they blinded the markets, was that banks, according to Basel II, could hold these against only 1.6 percent in capital… meaning being able to leverage their equity 62.5 time to 1.

Again what had problem loans to Greece, Spain’s real estate sector, Cyprus’ banks and much else to do with derivatives?

Let me try to explain the issue in my words. In derivatives you always have a winner and a loser, and in this sense, with exception made for the very serious counterparty risk, and which in itself is not a derivative risk but a normal credit risk, what derivatives do, is to redistribute the profit and the losses… in other words they are a wash out.

It is only the losses in the values of real assets which can create the real losses which can cause serious recessions. We should never forget that… while we keep allowing our banks to incur into dangerously large exposures to “ultra-safe” real assets… like infallible sovereigns and the AAAristocracy.

Bank risks needs to be reflected in its overall capital requirement and not through distorting specific requirements.

Sir, Paul J. Davies makes good arguments when discussing capital requirements for foreign exchange swaps in “Basel’s market clean-up has the wrong swap in mind” January 30. 

Unfortunately, when he writes that the Basel Committee method is “to penalise uncleared swaps with higher capital charges… in most cases rightly so”, and therefore just wants to exclude the foreign exchange swaps, he shows not having understood the fundamental mistake of current regulations, and which is that, when you penalise some you are de facto favoring others, and so de facto distorting. 

If regulators are concerned, for instance with the risk of uncleared derivatives, it is one thing for them to order the bank to increase the capital it holds against all not risk weighted assets, let us say from 6 to 6.2 percent, and quite another, to target specific assets with a higher capital requirements. The first adjusts the capital to the overall risk level of that banks activity, the second just distorts and discriminates against what the regulator perceives is risky.

It is high time to work on how banks, risk-takers and risk-taking can contribute net to taxpayers

Sir, Manmohan Singh, of the IMF, but in his own name, writes “It’s time to land the levy on risk takers, not taxpayers”, October 18, and he might be right and he might be wrong. Personally I lean towards the second because, if you really do not know what you are taxing might be producing it is hard to avoid any unforeseen consequences.

First of all, what we have to do is not to concentrate blindly on minimizing the direct cost for taxpayers of any financial failure, but instead analyze how to maximize the net result of what the financial sector produced was to the taxpayer. 

In fact one of the saddest aspects of the recent crisis is that the costs of cleaning it up might very well have been surpassed by all that opportunity cost which resulted from regulations that favored bank lending to “The Infallible”, and discriminated against “The Risky”, the small businesses and entrepreneurs. Who can swear that had the bank regulators not done that we could not perhaps have tons of good jobs for all our unemployed youth? 

In this respect I would appreciate regulators, IMF economists, and alike, first define to us with clarity what they believe is purpose of our financial system, and only thereafter opine how his proposal can better help us for that sector to fulfill its purpose. Most often than not, I am sure the answer would be, by not distorting its functioning like for instance with special levies. 

As a taxpayer let me be clear. I do not mind paying plentiful taxes if I am making plentiful income… so please do not try to save taxes by reducing my income. 

That of course does not mean that I would not oppose all the regulatory subsidies that help make some sophisticated bank dealings so sophisticatedly profitable, as these just distort just as much as taxes, sometimes more 

By the way, a reminder, the most severe real losses sustained the last years, have not been in derivatives but in plain vanilla operations, like securities backed with very real but very badly awarded mortgages to the subprime sector and which managed to get an AAA rating, the Spanish real estate sector, or loans to some “infallible sovereigns”.

By the way, a reminder, AIG would never have become a problem, had not the regulators enriched the value of their AAA rating so much.

To achieve a sensible pricing of risk, you need to avoid any opaque risk discrimination

Sir Francesco Guerrera writes “In the post-crisis world, risk must be sensibly priced” April 26 and of course he is right, because it was not sensibly priced risk that created the current crisis.

It would seem though that Guerrera might not understood it all yet, because, as he discusses the need for margins to be put up by corporate counterparties when dealing in derivatives with the bank; and he accepts that “banks adjust the cost [of derivatives] based on the credit profile of the buyer”, he does not mention the certain risk that margin requirements, if applied in any discriminatory way, will make the price discovery of risk, much more opaque, and wrong.

Why should George Soros be licensed to kill and not the bankers?

Sir George Soros in “America must face up to the dangers of derivatives” April 23 describes these as “a licence to kill” and he is wrong.

Just as a gun a derivative can do good or bad depending on who pulls the trigger on what and with what accuracy. In this respect, and given that in matters of investment George Soros could also readily qualify as just another gunslinger perhaps he should hand in his licence to kill too.

What derives from what?

Sir we used to believe derivatives derived from the market but each day that passes, with articles such as "Derivatives law sheds light on the financial ripple effect" Aline van Duyn, August 29, we suspect that it could equally be that it is the market that derives from derivatives.

This reminds me of what I have always felt about the issue of immigration and securing the borders, namely that whenever you build a wall you cannot be absolutely sure you end up on the right side of it.

A myth or a plain vanilla fraud?

Sir Tony Jackson in “Myth that could undermine credit derivatives”, July 2, describes the possibility that the traders on both ends of a deal could, by using their own models, show themselves to be making a profit for years and collect bonuses on these. Jackson describes these mark to market mechanisms in terms of myths, though I would read them slightly more like frauds. Anyhow it all makes me think that the hedge-fund-derivative traders could in a near future be facing the same type of difficulties a tourist has when he needs to talk himself out of a serious problem in a language no one understands... well until now they have all at least gained a lot in the translation.

100% organic pure corporate vanilla bonds.

Sir in your “Global credit woes” June 29 you mention that “subprime problems need not cause a wider market slump and this agrees well with what Tim Bond of Barclays Capital says in “View of the Day” of the problems being more the excess leverage of the lenders, not of the borrowers. As I see it any corporation that in the future wants to issue a wholesome 100% organic and all the fibres included and no risk return deriveated away pure vanilla bond, might find a market much willing to give up some on some returns just in order to lay their hands on something they can understand better.

Whistling in the dark

Sir, Gillian Tett wrote in “Collateral values thrust to the fore by woes at Bear Stearns” June 21, about the problem of discovering hidden losses in assets that are rarely traded and that are valued through financial models when they have to be sold and most especially if in the case of a fire sale. In the respect I would like to make two innocent questions? First, how much value do these assets that are rarely traded and only valued by models represent? Through the answer we might get a better appreciation of what could happen if real life came around and forced upon us its usually brutal mark to market.

Second, are these gaps not what used to be registered as losses? With all the derivatives and hedge funds flying around is not really our problem that the financial crises, while already been happening have not been noticed as they have gone underground or informal.

If it could be said that Italy based only on its formal growth rate would have long since disappeared but that they are alive and well thanks to the informal sector, could not the opposite be held; that the formal sector that looks to be doing well could in fact have disappeared because of what is going on underground? Thinks are indeed quite scary, and so we better keep on whistling in the dark!

There’s just been a change of shackles.

Sir, Martin Wolf writes so intelligently about the “Risks and rewards of today’s unshackled global finance”, June 27, that I almost feel ashamed about raising the question of whether the global finance really has been unshackled, as I believe that it has only had a change of shackles.

We have shackled much of the market to the opinions of some few credit rating agencies; we have shackled the market into the belief that risks can actually be derivated away and will not reappear elsewhere; and we have shackled the financial reward structure to something more akin to the time-share industry, rewarding those that are in fact restructuring the long term realities of our portfolios with success fees paid out immediately, based on the vendors own valuation models, and which most certainly do not bear much relation to our true long term results; and finally, the mother of all the shackles, the mind-boggling financial positions that have been built up around the world without really knowing how to get out of them, in an orderly way.

Whistling in the dark

Sir, Gillian Tett wrote in “Collateral values thrust to the fore by woes at Bear Stearns” June 21, about the problem of discovering hidden losses in assets that are rarely traded and that are valued through financial models when they have to be sold and most especially if in the case of a fire sale. In the respect I would like to make two innocent questions? First, how much value do these assets that are rarely traded and only valued by models represent? Through the answer we might get a better appreciation of what could happen if real life came around and forced upon us its usually brutal mark to market.

Second, are these gaps not what used to be registered as losses? With all the derivatives and hedge funds flying around is not really our problem that the financial crises, while already been happening have not been noticed as they have gone underground or informal.

If it could be said that Italy based only on its formal growth rate would have long since disappeared but that they are alive and well thanks to the informal sector, could not the opposite be held; that the formal sector that looks to be doing well could in fact have disappeared because of what is going on underground? Thinks are indeed quite scary, and so we better keep on whistling in the dark!

Caveat emptor rules in derivatives too

Sir, Mr Harvey L. Pitt in “Subprime confusion that leads to a lack of confidence” June 18, (graciously?) agrees with “loan modifications” in individual mortgages that allow subprime debtors a better chance to service their mortgages, but lashes out at “market manipulation” that artificially alters the underlying cash flow to credit protection buyers, which could happen either by supplementing or replacing these flows. Mr L. Pitt sounds very much like someone who has just discovered a small print clause that shows there is risk in risk coverage too, and I guess he is just a trailer for the avalanche of surprised investors we will soon see as a consequence of the boom in the hide-and-seek-risks game provided by hedge funds, primarily through derivatives. Since Mr L. Pitt mentions he was a Chairman of the Securities and Exchange Commission (2002-2003) he should be quite familiar with the term Caveat emptor. Next time he takes a position in these derivatives he might choose one that does not allow for these specific set of “market manipulations” but he could then also discover that any risk coverage this way comes with a quite different price tag attached.

Where is everyone?

Sir, Roger Merritt the Managing Director of Credit Policy of Fitch Ratings, one of the three and only credit rating agencies, now tells us that “Hedge fund behaviour in credit markets is untested” June 6, even though he knows that when you for instance rate the adequacy and safety of a boat you must do that in reference to the waters where it is suppose to navigate. Merritt, in response to a report in FT, now mumbles about some new paradigms in the global credit markets and then goes on to explain some century old facts that we all know and that he should have known. Where are the regulators willing to regulate when we need them?

What is new though, perhaps only because it is so shocking we did not even want to think about it, is that this diversify-your-risk driven market and that I prefer to call the hide-the-risk market has now developed some financial products, formally traded among formal participants, that create a vested interest (which means they profit) in the default of mortgages. What is this? A financial coliseum? Although I do no profess to understand it all (who can) I am no stranger to the fact that this type of derivatives could help people to get easier access to mortgages but now try to explain to someone being evicted that you cannot help him because someone has a legitimate profit motive that stops you from doing so. Where are our leaders when we need them?

Investing in people losing their homes?

Sir, June 1 Saskia Scholtes reported of hedge funds' "Fear over a helping hand for home loan defaulters¨ and June 5 Richard Beales says that Fitch ratings could downgrade bonds backed by subprime mortgages if the loan's terms are changed to help borrowers keep their homes. It takes some time for the implications of such news to set in but when it does it really knocks you down. Do they mean that in all the risk diversification (or risk hiding) that has been occurring through derivatives we have now actually created a group of investors with a vested interest in people losing their homes? Sorry, something sounds wrong and this surely must be something more than your regular moral hazard. Can I go long on a nuclear missile index?

Let us pray it stays with a headache

Sir, after reading Gillian Tett’s “A headache is in store when the credit party fizzles out” May 19, it is clear we should all go down on our knees and pray for that she is right, in that it is only a headache that is in store for us.

As for myself I have serious doubts that the consequence of this blissful-ignorance-bubble resulting from our hide-and-not-seek the risks with derivatives, is unfortunately going to be much more painful than that. When that day comes though, before putting the sole blame on the poor bankers earning their luxurious daily keep, I suggest we look much closer at the responsibility of our financial regulators.