If bank regulators in Brussels imply for instance an AAA credit rating for Greece, should Esma not also fine them?

Sir, Nicholas Megaw and Chloe Cornish report that the European Securities and Markets Authority has fined Moody’s for “negligent breaches” of the credit rating agencies regulation “Brussels slaps €1.2m fine on Moody’s” June 2.

As Jim Brunsden and Guy Chazan reported on June 1, Brussels applies a zero risk weight to the European sovereigns. That of course can only be compatible, according to the standardized capital requirements of the Basel Committee, with the absolutely clearest AAA credit ratings.

AAA is clearly a nonsensical credit rating for many European sovereigns, like Greece, and so the question remains should Esma not fine also those European bank regulators in Brussels?

@PerKurowski

The AAA pattern is extremely dangerous.

Sir, John Authers in “The Long View”, July 11, quotes Benoit Mandelbrot (who at least I never heard about before) calling the bubbles and crashes “the inevitable consequence of the human need to find patterns in the patternless”. One is left with the question of whether our financial regulators are not supposed to know that sort of stuff when they regulate. At least I always complained how the regulators were developing their own dangerous patterns... the just follow the AAAs.

The capital requirements for banks as determined by the Basel Committee in Basel II requires a bank to hold 1.6 percent in capital when lending to a corporation rated AAA to AA, and 12 percent when lending to a client rated below BB- .

Sir, how many bank crisis have you seen happening because banks have lend too much to AAA or AA rated clients who later turned out not to merit those ratings? All! And how many crisis have you seen happening because the banks lend too much to those rated BB-? None! If so, can you please explain what the regulators were thinking? If anything, would it not seem that the inverse of these capital requirements would be more valid?

Why should a poor BB-rated company, who surely must find it very difficult and expensive to raise finance, on top of it all, have to pay the banks an additional compensation in order to make up for the competitive advantages awarded by the regulators to the much more dangerous AAAs?

We all need an insurance against what they are going to think they have discovered in our DNA

Sir in “The fallacy of the ‛choice agenda’”, July 18, Sir Samuel Brittan enters briefly into asking what will happen to health insurance when DNA records come to provide detailed health prognosis. I would answer, just what happens when credit records provide detailed information to lenders, that the borrowers often get bunched together into small groups of misfortunate outcasts that have to take care of each other. For instance, among the subprime we find those who are not able to serve a loan at very high interests, and therefore lose out, and those who by being able to serve their loan de-facto evidence they deserved a lower rate, and therefore also lost, making it truly hard to distinguish a winner.

Since Brittan also correctly states that “insurance is well suited to covering events that are unpredictable at the individual level” let me say that for over a decade I have held that the most important new insurance coverage we all need is that of the risks derived from what they are going to think they have discovered in our DNA.

Why do you not make the real problem part of the solution?

Sir in your editorial "Subprime shake-up" December 22, you comment on the Federal Reserve's new proposals for some new mortgage lending practices in exchange for those "that led to this year's subprime debacle" You also recommend that regulators enforce their rules better, for instance by inspecting loans at random… but were not the credit rating agencies supposed to do that?

You must be fully aware that even with much worse lending standards there would have been no subprime debacle at all had the credit rating agencies not blessed the securities backed with these mortgages with their prime credit ratings, and so I must ask why you do not make the real problem part of the solution?

You also mention the risk of over-regulation, but Sir, is not in fact the appointment of the credit rating agencies as the supreme risk overseers in the financial markets the mother of all over-regulations? I believe mortgage bankers are quite capable at handling their job so why not let them get back at it again and get rid of those who fouled it all up?

Do credit ratings stop capitals from going where they should?

Sir Arturo Cifuentes in “Credit of the big rating agencies under fire”, September 12, explains very well some of the problems that arise from that many market participants do not know what the credit ratings really mean. Also and although Cifuentes does not fully enter into that very delicate terrain of explicitly wondering whether the bank regulators who enforce the use of these ratings know what these mean, he at least dares to ask the question of “Under the current regime, is it safe to determine capital requirements? , and for this he should be commended.

Now, having been very critical of how we have substituted the no matter how technically correct still limited vision of a few credit rating agencies for the real biodiversity of criteria of a free market, the most important question we need to ask about the credit ratings is not so much in reference to the calculation of the capital requirements of the banks, but on how these credit ratings can influence the directions of the capital flows in the world. It is of course bad if banks do not have enough capital but let us remember that it is far worse if capitals do not go where they can best deliver results.

We need to eliminate the financial fortune-telling franchise.

Sir I have nothing against the credit rating agencies, in fact I would like to have hundreds of them instead of the current only three. What I do not like though is when investors are forced to act in accordance with what they opine since when someone is told that someone else does the thinking for them, they lose the motivation to think for themselves and they have been empowered with the perfect excuse to hide their own shortcomings.

When you tell a pension fund it is not allowed to invest in anything below a specified level of ratings you are sending two messages. The first, that pension funds should only invest in safe ventures sounds about right but goes against current financial theories that say that a perfect blend of uncorrelated potions could just as well be the safest bet in town. The second message, the truly dangerous one, is that you are implying that there are objectively safe investments in the world and that the credit rating agencies have the tools to spot them.

We have already gone much too far down the road to a systemic risk explosion and we can already smell the subprime gases that have been accumulated. Anyone who lives in an earthquake prone region knows to be grateful for the small tremors that release the build-up of tensions and keeps the big one away. In these days we pray that the current financial uncertainties are only a minor tremor but if we really want to avoid building up the tensions that will lead to a true catastrophe, one of the first things we must do is to dismantle the fortune-telling franchise awarded by regulators to the credit rating agencies.

Some subprime heads need to roll.

Sir, The Lex Column of July 11, with respect to the subprime-mortgage-backed-securities and the rating agencies affaire duly says “Could the rating agencies have acted sooner? Possibly. True, it is not their job to simply react to market moves”. Nonetheless the column opens by citing John Maynard Keynes with “When the facts change, I change my mind. What do you do, Sir?” and this is highly inappropriate and exculpatory since the basic truth coming out is that there has been not one single factual change but only the discovery of some amazing sloppy job, not only by those issuing the subprime mortgages but also by those rating the resulting securities.

I have until now not heard a single word about one single credit rating employee fired because of such an obviously shoddy work and if there is no one made responsible at this stage the future will only set us up to even much worse result. I am not suggesting anything like the recent execution of a regulator in China for what there was a clear case of corruption but, figuratively speaking, some subprime heads got to roll too… and of course some wallets be emptied.

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.

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.

Spanish sayings and subprime woes

Sir, there is a Spanish saying that goes “we were many and then granny gave birth”. It came to my mind when reading Michael Waldorf’s letter “What Paulson and others are concerned about is manipulation of the market” June 11, in reply to some articles in FT that put forward the unkind possibility that some hedge funds could be against “loan modifications” that help mortgage payers, since they have a vested interest in the defaults (a short position). I say this because the market manipulation here denounced by Waldorf, namely that some credit coverage sellers (a long position) are buying up defaulted mortgages at par in order to keep up the value of their portfolio, only indicates another factor to be added to the current messy confusion that surrounds the subprime-affair. Seems that while some do not mind increasing the number of homeless, others are more concerned that we would notice it. The much rumbling and mumbling we hear also reminds of another Spanish saying that says “when the river sounds it is because it brings stones”.

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?

The pastor risk is the risk that investors just share into blissful ignorance.

Sir, Wolfgang Münchau is correct when saying “A risk shared may be more risky, not less”, April 23. As arguments he presents, first the deceased US economist Hyman Minsky’s general pessimism (or may we dare say realism) that instability is an inherent part of the system, and then Raghuram Rajan’s, former director of research at IMF, who argues along the line that the investor’s increased willingness to invest in “tail risk” and their “herd” mentality could lead to a catastrophic meltdown.

I myself have been writing and warning on these specific issues for a long time, though mostly on the risk present in assigning too much market decision power to very few credit rating agencies and which introduces not a herd but a “systemic pastor” risk.

For instance in the ongoing subprime mortgages debacle, the distance between the borrower and the final lender increased too much, just because everyone counted on others to be able to provide sufficient oversight. When we now start seeing how credit rating agencies rated without even sending a team to walk the streets in order to sample how those subprime mortgages originated, we should be able to conclude that the investors besides sharing risks, were also sharing blissful ignorance.

The problem with the sub-prime mortgages is just the tip of an iceberg.

Sir, Gillian Tett when saying that “Subprime proposals could broaden litigation risk all around”, April 13, she mentions at risk those who originate the lousy mortgages that have not considered sufficiently the debtors financial realities, the Wall Street banks that later repackage these in order to resell them to the public, even New York that might lose out in its standing as a financial center, but she does not yet mention the credit rating agencies who have been assigned most of the responsibility for certifying the quality of the final products. The fact that we live in a world were some credit analyst can rate a portfolio of mortgages without even thinking about leaving their desk and go for a field trip to check up on some of the actual individual real loans, points at one of the principal problems of the current bank regulation framework that has been coming out from Basel over the last decade, namely that of wanting to install a system that allows for monitoring from a distance, based on historical risks assessments, without having to get your feet dirty.

Sir, here and there, the financial world is being exposed to some extreme systemic risks, and it behooves us to be aware that this problem with the mortgages is just the tip of one of many icebergs.

Are there triple standards too?

Sir, I have just sat through a two day seminar in Washington organized by the World Bank Institute on the “Effects of mass media on public policy”, listening to conclusions of research papers that, among other, track media bias using tools such as counting how many times some word appears or do not appear in the context of the discussion of some specific theme.

Richard Beales, in “A whiff of double standards”, April 13, assigns the responsibility for the sub-prime mortgage mess in the following way “Some borrowers have no doubt misled by brokers. Some brokers have surely misled borrowers. Some lenders have been lax and some investment banks may have been blasé and glossed over a few risks in selling securities.” That “borrowers and brokers mislead” while investment bankers are merely blasé might raise some eyebrows, but, what the word counters of tomorrows would most notice, is that the credit rating agencies and those that gave the agencies so much power, are not even mentioned. Are there triple standards too?

Let us pray the estimates are wrong

Sir, let us pray for that the estimate that 2.2m of American families could lose their homes and that John Gapper mentions in “The wrong way to lend to the poor”, March 19, is totally wrong. If not, then let us prepare for the worst, as the political consequences of such fallout in the sub-prime mortgage market would by far surpass whatever all other thorny issues such as Iraq and the illegal immigration could all produce, together.

What I miss in this scarily good saddening and scaring article, is some words of how it came about that some 2.2m obviously individual shaky loans could have, when all was said and done, produced the sufficiently good ratings needed to attract so much money. The credit rating agencies sure must have some explaining to do, as has those Bank regulators responsible for giving the credit rating agencies so much power to begin with.