Capital requirements for banks based on how much “distressed debts” hedge funds raise money?

Sir, Joe Rennison’s and Lindsay Fortado’s “Distressed debt tempts investors in anticipation of the next downturn”, June 19, raises the following question:

Could an index that tracks how “US hedge funds specialising in distressed debt are raising money in anticipation [of] the next economic downturn” be useful to base bank capital requirements on? 

At least it should be much better than current regulations, which allow banks to build up dangerous exposures to what is perceived as safe, against especially low capital requirements, especially when a Jason Mudrick, founder of $1.9bn Mudrick Capital can state “This economy is roaring right now”

@PerKurowski

What would an old days’ bank failure look like with current deposit guarantees and capital requirements for banks?

Sir, John Kay writes about the topic of “other people´s money and one’s own”, and about the power that is “acquired with the savings of the… public” in order to speculate, “Boom, bust and broke trust mark the ages of finance” September 9.

Yes but he ignores those many who manage the relations between “other people´s money and one’s own”, like bank regulators.

Had not regulators allowed banks to leverage their equity and the support given implicitly by taxpayers 60 times or more when lending to sovereigns or the AAArisktocracy, the relations between other people’s money and bank’s own money would have been totally different. For instance when have one seen a hedge fund been able to leverage more than 10 to 1?

Try to imagine the size of an Overend Gurney bank failure in 1866, with current deposit guarantees, and current portfolio-invariant-credit-risk capital requirements for banks? Holy moly!

@PerKurowski

The mission statement for our banks as decreed by its regulators does not make any sense.

Sir, Sebastian Mallaby writes: “Banks are underwritten by taxpayers via deposit insurance as well as the too-big-to-fail safety net; they need to be reined in, and if they shrink, so be it”, “Stringent rules for hedge funds make the financial system fragile” November 17.

Indeed but, why are banks underwritten by taxpayers? What are banks supposed to deliver in return?

The current mission statement imposed by regulators on banks, by means of credit risk weighted capital requirements, seems to be that of lending more and cheaper than normal to all those perceived as “absolutely safe”, and to stay away from lending to the “risky”. Is that what we want? I don’t think so. If it were, there would be no reason for us to underwrite anything.

For example the: “We the people underwrite the banks so that these can lend more and cheaper to our "infallible" sovereigns… in the hope that doing so we don’t have to pay taxes”… sounds more like underwriting the sovereign than underwriting the banks.

No, I believe we taxpayers agreed on underwriting the banks so that these would be better equipped to take on the risks of lending to all those risky small business and entrepreneurs we all know should get credit, so that the economy grows and as a result we all are better off. That was the quid pro quo!

And Mallaby also writes: “Regulators need to remember that financial risk will not go away… there will be difficult judgments about how capital should be allocated. So there has to be a theory of where this risk can best be housed. If hedge funds are part of the answer, regulators make the world less safe by clamping down on them.”

Absolutely, if not the banks, then who is going to house the risk-taking we support and that most of the world, not understanding the regulations, still think is housed in the banks?

No! The real “masters of the universe”, those self-appointed, those full of hubris, are the bank regulators.

Sir, Jonathan Ford refers to the bosses of hedge funds who manage about 10 percent of investment funds worldwide as and that in reference to these “it is hard to avoid the impression that hubris is a factor”, “The master of the universe are playing a loser´s game", August 25. 

Forget it! If there are some who can be defined as masters of the universe full of hubris, that is the bank regulators who play risk managers for the world, and on their own, without consulting with anyone, dole out the risk-weights which determine the capital requirements for the banks. 

In doing so, the regulatory nannies have caused obese and dangerous bank exposures to whatever was considered officially as absolutely “not-risky”, and anorexic bank lending to whatever was considered officially as “risky” like unrated small businesses and entrepreneurs. 

If hedge fund bosses do wrong, their clients lose, but when bank regulators do wrong, massively, and on a massive global scale, as they have done, then everyone loses, starting with those who as a result will become unemployed and those who might never ever get an employment. 

PS. “The Challenge”

It was not the faith based financial institutions who caused it but the “too few to follow”

Sir we know with absolute certainty that had not the regulators empowered some “too few to follow”, the credit rating agencies, and created some perverse incentives that interfered with the risk allocation mechanism of the market, the minimum capital requirements for banks, we could have had another type of crisis, but definitely not this one. In this respect Michael Mackenzie is as right as he can be to argue “It’s a stretch to blame hedge funds for banks collapse”, June 27, and mind you I am not a great fan of these what I call “faith based financial institutions” that charge outlandish fees for their services and keep you mostly in the dark.

And blaming derivatives when the originals, the mortgages to the subprime sector in the US were so badly awarded is just like the robber pointing with his finger down the street and loudly shouting “there he runs that s.o.b!

The hedge funds were just the regulators’ hobby.

Sir Gillian Tett “writes that the bank follies went unnoticed for so long partly because many regulators spent the last decade obsessed with hedge funds.” “Some effects of an unhealthy fixation on hedge funds”, May 7. Though close, she does not really get there.

What happened was that regulators invented some risk weights and then got themselves some risk surveyors, the credit rating agencies, and produced the line of “risk weighted assets” by which they thought their job regulating banks was all done... and so, to find something to occupy their now fulltime spare-time with they started to pick on the hedge funds.

We better not leave bank regulation in sophisticatedly skilled unscrupulous hands.

Sir Martin Wolf in his marvellous “Why today’s hedge fund industry may not survive” March 19, describes how the hedge fund industry by acting as bookies arranging the betting on low probability events manage to profit handsomely while these events do not become the certainty that they indeed must become, at some point; and that this clearly attracts the unscrupulous and the unskilled. Wolf also frets that the hedge fund managers by copying each other could produce a real disastrous stampede of non-events and says “the more one believes this is how an unregulated financial system operates, the more worried one has to become”

What Wolf fails though is in connecting the dots with between the way the hedge funds operate and how our banks are currently regulated. The regulators, exactly like hedge fund managers, have been able to collect their praises upfront for a system that by favouring size tends to unload failures into an even greater accumulation of risks; that by using minimum capital requirements exclusively based on short term default risk leaves us not considering sufficiently all the other risks; and that by imposing upon the market the credit rating agencies as their official risk measuring bureaucrats, will just guarantee that we all will, sooner or later, follow them and fall off the deepest of the cliffs.

We should not fret the unscrupulous unskilled as much as the unscrupulous skilled and sophisticated… the last conform the really dangerous wild bunch. And please, do not tell me that some of our current bank regulators do not have it in them to know this is all true. I sincerely believe that Greenspan knew it all along but he did nothing about it!

Now let us connect urgently the lessons learned with the what to do.

Sir, Desmond Lachman, in “America’s subprime blues have historical echoes” August 3, is absolutely right when he says “At the heart of today’s subprime crisis is the unfortunate interaction of financial innovation gone awry, inept market regulation [by which we might presume he also refers to inept regulators] and a failure of the rating agencies to exercise their fiduciary responsibility to protect the average investor.” By the way the credit rating agencies would probably argue that part about “fiduciary responsibility” since they way they describe it, they only give opinions in accordance with their freedom of expression rights.

Now what Desmond Lachman does not yet do, is to connect the lessons learned with the what to do. As I see it and following that old advice of when in a hole stop digging, the first thing we have to do is clearly to recall all the empowerment awarded to the financial fortune tellers, the credit rating agencies, to dictate so much about where the financial flows can or should not go. Let us pray that the current problems are just a minor tremor that serves us as a warning and that we still have time to runaway from construing a financial system on top of a systemic fault that if we do not amend will produce mind-boggling catastrophes.

PS. "minor tremor"? The 2008 Global financial crisis GFC

Do not ignore that bank regulators have played the leading role in finance over the last fifteen years.

Sir John Gapper in “Now banks must relearn their craft” July 30, describe how the banks that fifteen years ago were financial institution that lent people money moved into the business of investment banks, but are now thrust back to their old business as they find their balance sheet stuffed with loans that could be there for a long time.

There is nothing wrong in Gapper’s recounting of the story but strangely and like most or perhaps even all of his colleagues in the Financial Times, he does not mention the crucial role played by the banking regulators from Basel, who started it all by quite arrogantly thinking they could drive banking risks out of banking.

Well, the bank risks did not disappear; they went into hiding, just like any overly regulated business normally goes underground; and let us now pray that in this hide and seek game the world has not accumulated too many bank losses that it has lost track off.

I mention all this because if we are going to be able to handle some potentially very dangerous circumstances that might loom around the corner, we cannot afford to leave out the analysis of were the regulators went wrong, even though they are among the most respected citizens of our society, because it might be precisely in that area that we need to do a lot of fast and swift backtracking. As an example one of the first things that need to be done is to strip the credit rating agencies from much of the immense powers allocated to them by the regulators… as that can foreseeable only lead the world into worse and worse scenarios.

Have 100% guaranteed incomprehensive financial model…will travel!

This is a great and handy tool for hedge funds when valuating portfolios and that will produce maximum commissions; and for the large US banks that have recently been authorized by their regulators to apply Basel II rules and now need to catch up with European competitors in lowering their capital requirements.

Low maintenance costs with access to an exclusive well churned and pliable data set licensed by the proprietor and that reaches back to 1840 and is equally impossible to scrutinize.

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.

I can’t stand the suspense.

Sir, I once saw a balance sheet of a hotel corporation where they had registered on their balance sheet among their fixed assets the cost of building the hotel rooms but since they had also issued user rights valid over a very long period of time for each of those rooms, and were selling these out as timeshares, they also registered as current assets the inventory of unsold timeshares, valued at the price they were selling them at, and all this duly audited by a recognized name. As you can understand, this have your cake and eat it too balance sheet looked extremely solid and paid bonuses to the executives, while it lasted.

This memory came to my mind when reading Richard Beales’ and Gillian Tett’s “Real risks emerge when Pandora’s investment box is opened” June 29. If what I recounted above could happen with open and transparent audited statements (albeit in a developing country) then what limits could there be to what you could hide in black-box algorithmic proprietary trading models. I pity those judges that tomorrow will have to try to understand the issues, as I pity those that though perhaps totally innocent will be sentenced to jail just because they can’t get anyone to understand their models.

Having said that it is clear that we must face the real possibility that all of our economic numbers could be fictitious since we could already have incurred in real big losses but that are mercifully covered by a lot of untested hot air. When those boxes are opened up who will appear? A beautiful girl or someone with a machine-gun… I can’t stand the suspense, though I must admit that the bliss of ignorance has also its attractions.

Cutting out short term data will not fix it, more important is sending out the right long term signals.

Sir, of course that US economic long term competitiveness could be harmed by the companies and markets excessive short term focus but to believe that US economic long term competitiveness could somehow be helped along by cutting quarterly guidance is to be completely out of focus. Do not get me wrong, I am all for scrapping the quarterly guidance, although there are people making a living out of them, but what I mean is that for the US to be able to link more responsibly with the future, much more important is to start out sending the right long term signals. For instance, may I suggest a gasoline tax that prices gas at the pump at US$ 7 a gallon?

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!

Why not deregulate the banks instead?

Ian Morley from the Alternative Investment Management Association in “Hedge funds and regulators can work together” May 6, tells us that hedge funds are a positive force in markets by providing liquidity while at the same time on the opposite page Roger Merrit, from Fitch Ratings, in “Hedge fund behaviour in credit markets is untested” poses some serious questions about just that, and of course they are both right, for good and for bad.

Having said that when reading Morley’s spirited defence of voluntary regulations and of the fact that regulators should instead help to enforce these instead of coming up with their own I just want to ask where was he when the banking regulators decided for instance to force down the throat of the market, the opinions of a couple of few credit rating agencies. As one could argue that it is the excessive regulation of the banks that has been the main driving force for the hedge fund industry and that banks should in fact be more important than hedge-funds, perhaps what Morley should ask for is some deregulation of banks, but of course that is not what the alternative association is paying him to do.

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?

Stop right there! Who is the real complacent here?

Sir, does the Bank of International Settlements (BIS) really think they will now have done their part by warning the hedge funds?, May 21. BIS mentions problems such as “some erosion of counter party discipline” and “other signs of complacency” on behalf of the investment banks. Well if the regulators in BIS do not know that those risks are a fundamental part of any human behaviour then they are either totally incapable of supervising the banks they have themselves over the last few years fallen into the mother of all the complacency behaviours.

Bank ghostbusters?

Published in FT September 12, 2006

Sir, David Skeel ("The ghost of a crisis in equity funds hides real benefit", September 5), tells us the reason equity funds and hedge funds are "the ghosts of the market's future" is that they "may increasingly assume many of the functions traditionally handled by banks" and "use a wide array of financial instruments now available to hedge the kind of risks traditionally borne by the banks". 

If he is right then that would make them more like the ghosts of banks past and also turn the banking regulators in Basle into some slightly foolish-looking ghostbusters.

PS. Fast forward to dialoguing with AI in 2025 about shadow banking.