Yes, let’s put a damper on size!

Sir John Kay is of course right in “Why ‘too big to fail’ is too much for us to take.” May 27.

In May 2003 at a Risk Management Workshop for Regulators at the World Bank, as an Executive Director, I said: “A regulation that regulates less, but is more active and trigger-happy, and treats a bank failure as something normal, as it should be, could be a much more effective regulation. The avoidance of a crisis, by any means, might strangely lead us to the one and only bank, therefore setting us up for the mother of all moral hazards—just to proceed later to the mother of all bank crises.

Knowing that the larger they are, the harder they fall, if I were regulator, I would be thinking about a progressive tax on size.”

There is a zero capital requirement for banks on AAA public debt

Sir, some define systemic risk simply as the risk of collapse of an entire financial system or entire market, as opposed to risk associated with any one individual entity, but, that is in fact more the result of the systemic risks that originates from the interdependencies and the failures of the system itself.

John Taylor, in “Exploding debt threatens America” May 27, writes that he believes the debt projected level of US debt to be systemic. Yes indeed, the debt could be so large that it could bring us an awful inflation but, what really propels it as a systemic risk, is not so much its size but the fact that the current minimum capital requirements for banks, in the case of public debts rated triple-A, is an astonishing zero. This not only subsidizes the growth of public debt but also leaves the system totally unprotected.

This type of systemic risk led us to the precipice of the badly awarded mortgages to the subprime sector ,just as it will help to lead us to the precipice of governments too much in debt.

Regulations are systemic risks.

Yes Sir you are absolutely right when in “Regulation Time”, May 26, you say “This crisis was born of gambles with systemic stability, not of weak investor protection”. In fact it was by trying to overprotect banks and investors from risks, by means of minimum capital requirements for banks that rewarded risk adverseness and the naming of some few credit rating agencies as the world’s official risk surveyors, that the regulators gambled away the systemic stability.

In order for current regulations to stand a chance of being corrected the first thing that has to happen, is for the regulators to acknowledge that regulations are by themselves a prime source of systemic risks.

Should used bank salesmen be trusted?

Sir Henny Sender “This year’s model for cash raising – the GMAC way” May 23, begs the question whether we should trust the used bank salesmen; a question that is difficult to answer when it is so hard to assess what’s under the hood of a bank, especially now when their assets are disclosed in “risk-weighted” terms.

GMAC is reported to have $173.bn of risk weighted assets, but taking away the impact of the weights, the real nominal asset exposure could easily be ten times that amount. For $173bn of risk-weighted assets an additional need of $11.5bn sounds “so reasonable”, but then it could just all be a mirage produced by that dangerous cocktail of faulty credit ratings and arbitrarily imposed risk-weights and that have hit and obscured the financial sector ever since Basel II got going.

The fact though is that while in Germany the sales of new cars are subsidized by a payment to scrap old used cars, in the US it is the financiers of used cars that are receiving government support and that sort of reflects quite different workout strategies.

The safe-haven is always in the eyes of the beholder

Sir you conclude “Dollar worries” May 23 with “currency traders are pricing in the tail risk that the US will be forced to resort to the printing press”. Sir whether forced or not the fact is that with the Fed’s quantitative easing they are already using the printing press, a lot.

Do you have any idea where the rates would be if it had not been for the quantitative easing? It sure puts a big question mark when it needs to recur to quantitative easing in order to sell itself as a safe-haven. The greatest mistake made by the US government and Congress in their current handling of the crisis is that they might have taken the world’s wish for a temporary safe-haven as a wish for a permanent home.

Behind our backs bank regulators in Basel decided that lending to a triple-A rated government required zero bank equity while lending to an ordinary non-rated private company required 8 percent... and the governments loved it... wouldn’t they? The markets though requires x percent return for lending 100 to triple-A rated governments and y percent return for lending exactly the same 100 to a non-rated private company all without any reference to capital requirements.

Therefore though you can subsidize governments and temporarily confuse the market by means of arbitrary regulations in the long term you cannot simply instruct markets to behave as if a dollar lent to the government is any different than a dollar lent to a private company. Having then to reduce the current implicit subsidy to the governments contained in the minimum requirements for banks will also put further pressure to increase the interest rates on public debt... just when the world seems least to afford it.

The gorilla is there in the room roaring and pounding his chest... let’s pray we’ll never have to pay him off, informally, over the counter, with some gold coins.

Go City of London go!

Sir what caused this crisis, as I have so repeatedly written to you about over the years, were the regulators in Basel executing the mother of all interferences in the risk allocation process of the markets. 

Not only did they appoint the credit rating agencies as Thee Official Risk Surveyors but they also empowered them by concocting minimum capital requirements for banks that covered an incredible range from 8.3 to 1 to 62.5 to 1 with all of it depending on the ratings. 

In this respect when Martin Wolf in “Why Britain has to curb finance” May 22, refers to UK regulators having “an influence on the world economy out of proportion to the country’s size” he is either too parochial or he still completely misunderstands what has happened. 

Also a sheer reference to a “light touch” in the context of financial regulations would be almost laughable if not for the sad and serious consequences of the very heavy handed and truly relevant regulations that from Basel hit the world, London included.

Frankly the UK cannot afford to curb anything, less it wants to be left out completely. And the Financial Times should be the first to know that. 

Go City of London go!

Could there be value to be unlocked in the one-year ownership of shares clause?

Sir you are so right in that the recent minimalistic step taken by the SEC to allow the true owners, the shareholders, to name who should be at the Board of their companies was “A much needed victory”, May 22.

What I cannot comprehend though is how the SEC can get away with the one year of ownership criteria... how on earth does one year of ownership change ownership? Could there now be an opportunity to sell the shares but keep them in your name, so as to offer the one year ownership on record? I mean in this severe crisis one has to look under every stone for any value to be unlocked.

But let the markets’ see more with their own eyes

Sir as you must know by now I full heartedly agree with William Poole’s proposal of introducing more market discipline for banks by forcing them to issue substantial amounts of long term subordinated notes “A market solution to secure the future of banks” May 21.

That is of course as long as some of that fog that comes from having the assets reported as seen through the eyes of the credit rating agencies and risk-weighted arbitrarily by the regulators is dissipated. As is everyone, regulators included, might keep on focusing on the wrong exposure where a real 40 to 1 leverage is reported as only a 10 to 1 assets to capital leverage. Let the markets have a better look at what’s really in the banks… otherwise we will just have the blind leading the blind.

Are some doing their best for the market not to regain confidence?

Sir Martin Wolf in “This crisis is a moment, but may not be a defining one” May 20, writes “The willingness to trust the free play of market forces in finance has been damaged.” Of course, how could it be otherwise, when even the Financial Times (notwithstanding my over 200 letters on the subject) refuses to describe in detail the amazing interference with the risk allocation processes in the financial markets made by the bank regulators in Basel.

Through their minimum capital requirements for the banks the regulators allowed for a 62.5 to 1 leverages (and that in some cases can even reach 179 to 1) and all based on the credit rating agencies’ triple-As. How on earth could the free play of market forces in finance stand a chance to correctly handle that?

If you really want the market to regain confidence then you have to explain what really happened.

Rasputins versus Oligarchs

Sir John Kay in “Beware the bail-out kings and backbench barons”, May 20, refers to “Simon Johnson’s comparison of corporate financiers with Russian oligarchs”. Kay should not forget though that Simon Johnson, as a former chief economist at the International Monetary Fund, is part of that regulatory technocracy which played God and interfered with the risk allocation processes in the financial markets, in the most amazing way, by allowing for a 62.5 to 1 leverages (that in some cases can even reach 179 to 1) all based on some credit rating agencies awarding their triple-As... and helped to cause this mess.

In this respect the Rasputins have now a clear and vested interest in blaming the oligarchs in order to protect themselves. John Kay rightly says “We need to reassert the notion that roles of authority are positions of responsibility rather than declarations of personal merit and routes to personal enrichment.” And that should apply equally to bankers and regulators.

Please, may we have a small but growing capital charge on governments?

Sir if your bank lends your government 100 pounds then it is not required to have any equity but, if it lends that amount to your unrated neighbour, then it has to put up 8 pounds in equity. That might sound very reasonable to you I do not know your neighbour, but be sure that in the long term it will just mean we will all end up more and more entangled in the web of the government.

In this respect when we read Aline van Duyn and Francesco Guerrera report in “Geithner plan fuels cost fears”, May 19, that “companies face capital charges against hedges” one wonders when they will start imposing some capital charges on what seem runaway governments. A small increasing capital charge on anything to do with governments is probably an essential element to help stimulate the banks into lending more to the private sector again.

Just for the record

Sir in “Taming derivatives” May 19, you write about “a jungle where companies such as AIG were able to use derivatives to avoid capital requirements”. Just for the record, that was never the real problem with AIG. The problem with AIG was that because of its AAA rating it overextended itself by selling immense amounts of derivatives that allowed others to avoid capital requirements.

How long do you intend to play this charade?

Sir day after day, week after week, month after month, year after year the Financial Times indicates the currency rate of Venezuela 2.1473 Bolívar Fuerte per Dollar and provides the additional vital footnote of “New Venezuelan Bolívar Fuerte introduced on Jan 1st 2008. Currency redenominated by 1000.”

Are you not aware that this currency rate in that it does not by far reflect the FX rate that applies to the whole Venezuelan economy is totally fictitious. That is has been fixed there since February 2003 and that those not favoured by having the government receive their Bolivar Fuerte in order to convert them into dollars, need currently to use at least 3 times as many Bolívar Fuerte to get a dollar.

For how long does FT play along in this charade of the Venezuelan government? If you want to put an end to it I suppose you have two alternatives the first to simultaneously publish an estimate of the rate in the unofficial market, which would provide your readers with more information, and the second not to publish any rate at all.

This crisis is indeed far from being a pure failure of markets

Sir Leszek Balcerowicz writes “This has not been a pure failure of markets” May 14 and the most extraordinary thing about it is that there is a real need for his article.

If a bank regulator decided that the minimum capital requirements for the banks depended on how much some few specially designated fashion experts fancied the colour of the tie that the borrower´s chief executive officer wore; and that capital requirements so determined could then vary between a high of 12% of the loan and a low of 0.56% would you call this a free market? Of course not, not even if instead of the colour of ties what was used were the ratings of some vaguely defined credit-default risks.

But, if even Martin Wolf, the chief economics commentator of the Financial Times, almost two years into the crisis, can still write about “why free-market capitalism went off the rails” and that the “era of financial liberalisation has ended”, “Seed of its own destruction” May 12, when one could very well argue that free-market capitalism was actually placed on rails heading over cliffs, then clearly Balcerowicz’ article is still much needed and appreciated. Clearly those from Poland have a clearer or at least more recent concept of what state dirigisme really means.

Risk is risk is risk!

Sir David Walker with “America’s triple A rating is at risk” May 13 gives new evidence on how dangerously the world has got itself trapped by some erroneous concepts about risk. Of course, America’s triple-A rating is always at risk, there is no absolute quality or anything inherently permanent with a credit rating, this no matter how much the financial regulators want us to think so.

That the US, and the dollar are in trouble, that there can be no doubt about, but the truth is that the US and the dollar could still remain for a very long time the most de-facto triple-A in the world, because, at the end of the day, risk is always relative, except of course, when we really reach the end of the day.

Now on the rest of David Walker’s message I could not agree more. Last year, during the annual meeting of the World Bank and the IMF, I went around asking “how are we going to pay for it all?”, and proposing a new generation of taxes, such as taxing income from protected intellectual property rights, only to be met with a “what is he talking about?”

The bottle that now matters is the one containing bank equity.

Sir Tony Jackson in “Is the liquidity bottle half-full or half empty” May 11 writes “If the banks can only hold Treasuries rather than private securities... The less the scope, too, for securitisation- the vital form of lending that has yet to recover”.

In other circumstances looking at the Treasury versus private securities from a liquidity angle might be correct but, at this particular injunction, the bottleneck for the banks is equity and not liquidity.

In this respect let me remind you that the minimum capital requirements concocted by the Basel Committee holds that in contrast to claims on private assets that do require holding some equity, although in some cases ridiculously small, claims on sovereigns rated AAA to AA- do not, as they are given a 0% risk weight.

As food for thought just think about what are fore-bankers would have thought of making a zero-reserve when lending to a Crown. But of course, a zero equity requirement is what the Basel Committee had to stipulate in order for the finance ministers in their AAA or AA- countries to cheer them on. Now if a sovereign were to be down-rated to A+ to A- then the risk weight goes up to 20% and if that would happen they would either have to change the minimum capital requirement or face the mother of all demand for bank equity.

Unfortunately Tett misses what turned a snowball into an avalanche

Sir another great chapter by Gillian Tett though again she misses the most fundamental point. If it had only been the loss in the market value of the “super-seniors” that had to be covered with new equity, that could have been manageable, but the fact was that as the risk ratings of the whole exposure to super-seniors were down-graded then like rubbing salt on the wounds they had to find additional equity to cover for higher capital requirements.

Assume that Citibank had one of those super-seniors rated AAA and that according to paragraph 615 of the Basel II: International Convergence of Capital Measurement and Capital Standards: A Revised Framework - Comprehensive Version of June 2006 carried a risk weight of only 7%.

This meant that a $1430 investment was going to show up as only $100 in risk-weighted assets, which in fact believe it or not, signified an authorized leverage of (1430/8) of 179 to 1, and therefore required only $8 in equity (8% of 100).

If the market value of those $1430 then fell 2 percent to $1401 the bank would first have to register a $28 loss but if that “super-senior” was also concurrently down-rated to an “awful” A, then the new risk weight applied was 20 percent which signified that the risk-weighted assets increased to $280 (20% of $1401); and therefore requires $48 in additional equity ($280 times the 8 percent equity minus the $8 of previous equity).

And so we not only have $28 in mark-to-market losses that must be covered but the bank has also to find additional equity of $48 to cover for the higher equity requirements... and so the bank is induced to sell those super-seniors but for which there is now not a market since buyers have been scared off by a credit rating downgrade... and so down and down it goes... not so much because of the intrinsic quality of the super-seniors but because of the minimum capital requirements for the banks

The above describes the most vicious part of the current vicious circle in the bank sector and the Basel Committee is fully responsible for it. Never ever has the financial regulators and the financial experts been so gullible and naive like when they believed that “risk-weighted assets” were correctly risk-weighted assets.

By the way when reading the recent stress tests prepared for the largest 19 bank holdings in the US the possibility of this misconception still being in existence is what frightens me the most.

What a stress!

Sir now 19 large bank holdings companies (BHCs) have been told what to should do in order to hang around and so they should at least be a little bit less stressed... but what should we do with these stress-test results?

First it hard for us to interpret the results of the stress test because they all refer to risk-weighted assets” and this we know that no matter its pompous name this does not mean anything absolute. Not only are the weights completely arbitrary, like for instance 20% for triple-A rated assets, but also those weighing, the credit rating agencies, have clearly shown themselves not to be the most very trustworthy risk surveyors. It also makes any comparisons between BHCs impossible since the differences between the risk-weighted assets could be larger than between apples and oranges.

But second and most importantly the stress test does not include any type of recommendation. Do we want to strengthen the weaker BHCs so that these survive or are we looking to show who are weak so that we can strengthen the stronger to make sure that some of the BHC survive? Why do we not put all our money in the group outside the BHCs? What a stress!

You pay for what you paint!

Sir Benedict Mander in “Venezuela’s state oil company gears up for a $2bn bond issue” May 8, quotes experts with “expected to be a two year zero-coupon bond yielding about 16 per cent” and that it “will not affect the yields on existing PDVSA or sovereign debt – one of the best performers in emerging markets this year”. It is hard to understand how they would get away with that.

That said PDVSA with all the richness that it controls, if it was well run, should have to pay only some basis points more than the risk free rate and so, in order for your readers to understand better what is going on, perhaps you should have translated what was painted on the PDVSA oil tanks in the photo. It says "Fatherland Socialism or Death"… hence 16 percent.

The Global Coalition of Oil-Cursed Citizens

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.

Do not undercut in any way the disciplinarian role of the market

Sir as an Executive Director at the World Bank 2002-2004 and as member of its Audit Committee I remember as one of my biggest frustrations continuously warning about counterparty risks and always ending up being answered along the lines of... “What counterparty risks? Don’t you know that a triple-A is a triple-A is a triple-A?”

This is why I take strong exception when Matthew Richardson and Nouriel Roubini in “Insolvent banks should feel market discipline”, May 7, though correctly advocating more of Schumpeterian creative destruction, are surprisingly lenient in the case of counterparty risk. They even write “But unlike with Lehman, the government can stand behind any counterparty transaction”. No!

What is counterparty risk? The risk that for example the insurance company you have insured yourself with cannot pay up when it should. This risk is clearly not a risk that an ordinary citizen should have to bear but for the financial system’s overall health it is an absolute must that all the qualified institutional participants bear with the full consequences of it.

In fact, in case they have not read it, current third pillar of the otherwise so discredited bank regulations from Basel – named the market discipline, “aims to encourage market discipline by developing a set of disclosure requirements which will allow market participants to assess key pieces of information on the scope of application, capital, risk exposures, risk assessment processes, and hence the capital adequacy of the institution.” And that of course means the evaluation and the taking of counterparty risks.

And by the way, just as the markets would benefit from more creative destruction, let me also remind you that so would our financial regulators

The marginal authorized leverage was then 125 to 1!

Sir John Gapper in “How banks learnt to play the system” May 7 is slowly identifying the AAA-bomb that set of this crisis. He writes about how regulatory bank equity, by not being real hard cash equity, and how assets, by being minimized through regulatory risk-weighting, made “some investment banks enter this down-turn with capital ratios of 30 times or more.”

But Gapper is not there yet since he seems to forget that in economics as well as in finance, the most important price is not the average but the marginal. If I am allowed to assume what Gapper seems to do that only the 4% equity of tier 1 capital was for real, and consider the fact that loans or investments to corporations and securities that were rated triple-A were risk-weighted at only 20 %, then he should be able to calculate that the marginal authorized leverage for the banks on some operation were 125 to 1... or more, if as Gapper holds, that even the tier 1 capital was partly made up of illusions.

P.S. I just wonder. If I had been a PhD, from a well known university, would I have not been referenced as someone who has warned and argued over this problem over and over again for years? After 258 letter to the Financial Times labelled “subprime banking regulations”? Not including this one.

We need liquidation and inflation and growth

Sir, Martin Wolf in “Central banks must target inflation” May 6 writes: “for clearing up the mess and designing a new approach to monetary policy... we have three alternatives: liquidation, inflation; or growth”, though he knows, of course, that we need all of them all: liquidation so that we stand on firm ground; inflation to grease the wheels; and a lot of hard and clever work at growth. 

Wolf also considers the possibility that our children “in despair...will even embrace... the absurdity of gold”. I do share Wolf’s feeling since they, and we, deserve more than that; in fact one of the most worrisome aspects of this crisis is how often one finds oneself on the side of those gold-bugs one has always considered being somewhat nuts. 

Now, what I do not agree with Wolf is when he writes of “inflation targeting”, as a holy gray, since one of the problem could be that the inflation was not adequately targeted. 

In a letter published by FT in May 2006 I wrote “inflation as they, our monetary authorities know it, is just obtained by looking at a basket of limited consumer goods chosen by bureaucrats and that although they might be highly relevant to the many have-nots, are highly irrelevant to measure the real loss of value of money. For instance, who on earth has decided for that the increase in the price of houses is not inflation? And so what should perhaps be argued is that really our monetary authorities have not been so successful fighting inflation as they claim they have been.” 

And then of course we have the financial regulations, and that Wolf does not even want to mention. Would a runner be a bad runner just because someone trips him up and he falls? In just the same way must a monetary policy be wrong, just because some financial regulations, risk weighted bank capital requirements, went haywire?

China would collapse too if it loses faith in the dollar.

Sir Andy Xie is of course right saying that “If China loses faith the dollar will collapse” May 5 but he should also remember that because of the Ying-Yang relation between China and the US, if so happens, China would also collapse. We are all riding on an illusion where we need to feel sorry for him who gets off to early and sorry for him who gets off to late…never before with respect to currencies have the “In God we trust” seemed so appropriate.

Do not save us from the embarrassment... it was sheer stupidity!

Sir John Kay in “A boom based on little more than a bezzle”, May 5, with all this talking of “embezzlement or “febezzlemnt”... is he trying to console us? The embarrassing truth is that the crisis originated from sheer stupidity, that of trusting too much the triple-As that never were. If anyone febezzled themselves that was the Basel Committee when it came up with such nonsense as believing they could and should drive out risks from banking, and that the credit rating agencies were just the right ones do to it for them.

Just pay for what you want and you have a slightly better chance of getting it.

Sir John Coates makes quite a disservice by giving a way too simplistic version on the problems with rewarding the much needed risk-taking in “Time to tackle this culture of rewarding the risk-takers” May 5. He sets us up to choose between the hare and the tortoise forgetting completely that the hare can produce tortoise results and vice versa. Those tortoises that have only been able to produce the $20 million in profits the first 4 years can be those giving us the $500 loss in the fifth year.

There is really nothing like a perfect incentive plan though for an investor who is looking for a five year return he should clearly be better off paying an incentive based on the five years results as easy as that. Diversity is also good... if the whole world starts looking for five year results that will be just as bad as the current one year structures... you see humans, and especially traders, they do adapt.

Which bring us to the most important part of all... knowing what the incentives are. Coates refers to the traders but perhaps more important yet is to refer to the trader’s bosses.

Iceland: Financial System Stability Assessment—an Update completed August 2008.

Sir may I invite you to read: “The update to the Financial System Stability Assessment on Iceland"

It was prepared by a staff team of the International Monetary Fund as background documentation for the periodic consultation with the member country. It is based on the information available at the time it was completed on August 19, 2008 and provided background information to the staff report on the 2008 Article IV consultation discussions with Iceland, which was discussed by the Executive Board on September 10, 2008, prior to the recent Board discussion on a Stand-By Arrangement for Iceland.”

It makes fascinating reading, especially in these times when the regulators now want to tackle systemic risks while ignoring that their regulations are in fact the prime source of systemic risk.

In it, dated a month before the crisis exploded at the end of September 2008, we can among other read the following: “The banking system’s reported financial indicators are above minimum regulatory requirements and stress tests suggest that the system is resilient. Bank capital averaged almost 13 percent of risk-weighted assets between 2003 and 2006, dropped to 12 percent in 2007 and to approximately 11 percent in the first half of 2008, but remain above the 8 percent minimum. Liquidity ratios are likewise above minimum levels. Notwithstanding the positive indicators, vulnerabilities are high and increasing, reflecting the deteriorating financial environment”

To me once again, this just proves that no one had the faintest idea of what the “risk-weighted assets” really meant and, if they did, they had no will to question the significance of risk-weighting.

Instead of allowing the sceptics to have a voice the regulators forcefully correlated the financial markets to some few credit rating agencies.

Sir from “Genesis of the debt disaster” May 2, an extract from “Fool’s Gold: How Unrestrained Greed Corrupted a Dream, Shattered Global Markets and unleashed a Catastrophe” it is clear that Gillian Tett has written a great book that starts going to the root of the issues. It is sad though to think that a great reporter like her might now have become useless by correlating herself to what she wrote in her own book. (The same way another opinion-maker has correlated himself to explaining all in terms of the economic imbalance among surplus and deficit countries.)

Tett does indeed tell us a lot about one of the seeds of the debt disaster but, as someone who has recently even acquired a license as a mortgage loan officer in the US in order to better understand what happened, I believe that it was really the environment that mattered for that seed to bloom into something really bad. More detailed information on the amounts of mortgages awarded to the subprime sector and that were securitized on year by year or even better month by month basis is useful to understand it all and I hope Gillian Tett has provided that in her book.

My explanations for the crisis is much simpler. In synthesis, the financial regulators in Basel correlated the world to the opinions of just three credit rating agencies… and with that they weakened or even displaced from the market the voice of all the many healthy sceptics like Terri Duhon and Krishna Varikooty and the reduced the market weight of more careful individual investors.

The International Convergence of Capital Measurement and Capital Standards in July 1988, even though the minimum capital requirements there are based on risk, they do not even mention the credit rating agencies and the risk weight for all claims on the private sector is 100% and they therefore require the 8% of capital.

By contrast the International Convergence of Capital Measurement and Capital Standards of June 2006 1988 is all about the credit ratings… and for instance the corporations that are rated AAA to AA- are risk-weighted at 20% and so do only generate a capital requirement of 1.6%. And, from that moment on the road to “fool’s gold” was determined to go thru the credit rating agencies.

The safe-haven must recycle its waters.

Sir you write of the need to “Reopen the taps of global finance” May 1, but that must surely be the responsibility of the current borrower of last resort, the USA.

Ricardo Hausmann, during the spring meetings of the World Bank, at a conference titled “Latin America and the Global Crisis: Towards a Rapid Regional Recovery” argued that the US should take on debt and relend to the world. Hausmann, coming from an oil rich country must have remembered that this was exactly what the oil countries did during the 1974-79 oil bonanza when foreign bankers virtually forced credits on them… and the oil exporting countries recycled and imported and recycled and imported... until.

But is this politically viable? Perhaps not, but even so there are major troubles brewing down the line.

First the US, as the safe-haven par excellence, cannot expect to crowd out the rest of the world from the financial markets, for a lengthier period, without its own waters becoming stale or even having the rest of the world starting to think in terms of sabotaging that safe-haven.

Second if the US, in order to reflate its own economy and which might also help to stop the world from deflating too much, for a while, does so by investing only in its own back-yard, then the returns from those overcrowded back-yards will not be sufficient to repay what will be owed, and so the US taxpayer will start to seriously object having to become the taxpayer of last resort…and with that, again, waive bye, bye to the sweet dollar safe-haven.

Let us not forget that in truth the dollar bill should have imprinted on it “In the American Tax Payer We Trust” but that the US Mint, more pragmatic, more marketing minded and much wiser preferred the much more fundamental “In God We Trust”.

In this crisis, many wish for the cloak of invisibility.

Sir there is no way you could understand what happened in this financial crisis if you do not read what Basel II contains. It is not only that the banks now have to make up for the many write downs after all the losses they incurred but that they will also have to make up for all the undercapitalization that Basel allowed for.

When the bank lend to a company or invests in a security that has managed to get a triple A-rating Basel II has authorized this exposure to be risk-weighted at only 20% which means that 500 of it will count as only 100 which (500 exposure divided by 8 in capital requirement) results in a leverage of 62.5 to 1.

And so Martin Wolf in “Fixing bankrupt financial systems is just the beginning” April 29, should also have acknowledged to begin with the need of “fixing” the intellectually bankrupt regulators who came up with such insane regulatory permissiveness just because they trusted the credit rating agencies so much.

Is it really surprising that now “investors burned by more sophisticated risk-adjusted ratios increasingly trust... the ratio of common equity to total assets’? Of course not, though the real question that needs an answer is how the regulators could have been so naive and gullible to design these ratios and then go to sleep believing in them?

Clearly the IMF, a staunch supporter and marketer of the Basel regulations, would prefer the world to ignore this whole issue… but why should a Financial Times that proudly champions a “without fear and without favour” also do so?

The regulators they authorized a leverage of 62.5 to 1!
Uploaded by PerKurowski

Am I obsessed? You bet! You should be too!

How could AIG have resisted?

Sir, though Eric Dinallo is right in saying that “Marriage not dating, is the key to healthy regulation” April 27, it is at the same time extremely worrisome to read how he, the New York insurance superintendent, still seems to believe that what brought AIG down was the lack of regulations.

What brought AIG down was that its credit rating of AAA became dangerously super-empowered, when the financial regulators decided that any risk that AIG offered to cover transmitted to the underlying securities a permit for the banks to leverage these 62.5 to 1. I ask. What kind of corporation could have resisted the temptation of not waving that magic AAA wand too much?

The dollar is the whole world’s s.o.b.

The last of my 15 letters that the Financial Times published before I was silenced was the following dated October 4, 2006 and which said the following.

“Sir, Martin Wolf’s “America could slow us down” (September 27) somehow ignores the possibility that just as the Americans did when they accepted the “In God we trust” printed on their bills as an act of faith when the dollar abandoned its convertibility into gold, the world is now willing to live with an “In America we trust”, at least while there is such a world shortage of better alternatives. If this is so, one could argue that we have still far to travel on the roads of the American current account deficit currently used by the world to dollarize since the fact is that, if you want to lay your hand on a dollar, you have to sell or give something for it. Frightening? Yes, but is not the world itself a frightening place that needs many acts of faith in order to make life bearable?”

Today, after all what we now know, and seeing the world still placing so much trust in the dollar I would probably want to rephrase it by paraphrasing Roosevelt saying “The whole world knows the dollar is an s.o.b but (at least for the time being) the dollar is the whole world’s s.o.b.”

Who is then going to be the bad cop?

Sir, the world needs a good cop and a bad cop, but can really do without a wishy-washy cop. Listening, during the spring meetings in Washington of the World Bank and International Monetary Fund, to the intents of the Fund to recast itself as a good cop, the big question is... who is now going to play the bad cop?

Come on, you just robbed hugo chávez of Bush... are you now going to take the Fund away from him too? What popular enemies that can be exploited will he be left with?

We deserve something different than the current crop of regulators

Sir Timothy Geithner in “We must keep at the process of repair and reform” April 24 mentions that “the Financial Stability Forum, renamed the Financial Stability Board (FSB) and expanded to include all of the G20 nations, should be given greater responsibility for the stability of the international financial system. And that is the problem with the current crop of regulators. Who told them that the only thing we look for is stability? We want a well functioning financial sector with a much more meaningful purpose that stability.

Look at what the search for stability and lowering of risks with the minimum capital requirements designed by the Basel Committee and the appointment of the credit rating agencies as the risk sentries of the world has taken us? The Basel Committee and the members of FSB all come from exactly the same regulatory incestuous gene-pool. We deserve better results, and this can only be achieved by a new and much more diversified set of regulators.

Mark-to-market?

Sir William Cohan’s “Clever wheezes will not mend the banks” April 23 touches on one of the hardest questions to answer… namely should we mark to market in a crisis like this?

Without the mark-to-market we can never be that sure we already reached a bottom, but with the mark to market, we might reach an even deeper bottom.

From Basel II into Solvency II… has the European Parliament lost it?

As reported by Nikki Tait and Paul J Davies, April 23, not only do the higher risks have to pay higher insurance rates because the market so demands it, but now they have to be additionally penalized in order to compensate for the higher capital requirements for higher risks that will be imposed on the European insurers by the European Parliament; as a result of something called “Solvency II” and which sounds and reads frightfully similar to Basel II.

Do they never learn? Now again, what will result from all this is increasing the incentives for disguising as being of lower-risks and for having the regulators go to sleep in the belief that all has been taken care of. Who is going to measure the risks? The insurance risk rating agencies? Start praying!

The regulators changed the odds at the casino... surreptitiously

Sir, John Kay in “How economics lost sight of the real world” April 22, writes that “grossly imperfect information have led us to where we are today”. He is more right than he knows.

On June 26, 2004 Ministers and central bankers from the G10 endorsed the publication of the International Convergence of Capital Measurement and Capital Standards: a Revised Framework. Those regulations authorized banks to have a leverage of 62.5 to 1 if they lent to corporations to which human fallible credit rating agencies had awarded AAA-ratings. With that the regulators send out the message, loud and clear, that risks could be measured with much more preciseness than previously thought possible and that there were agents capable of doing so.

And the regulators also naively ignored that the measurement of risks would itself alter the realities of risks, and so those regulations amounted to something like fooling around with the odds at the casino without informing the players. Markets that wanted to play it safe, on black or red, were unknowingly lured into placing their bets on a number.

Those regulations contained in sum the most dysfunctional financial regulatory innovation in history and no one said a word. Shame on the tenured professors, the think-tanks, the press and all the others the society counts on to keep it informed.

P.S. https://subprimeregulations.blogspot.com/2012/12/the-basel-ii-roulette-manipulation.html

The regulatory innovations are the ones to blame, not the financial.

Ben Bernanke in his most recent speech, April 17, 2009 said “Where does financial innovation come from? In the United States in recent decades, three particularly important sources of innovation have been financial deregulation, public policies toward credit markets, and broader technological change. I'll talk briefly about each of these sources.”

As for the public policies Bernanke mentions the Community Reinvestment Act of 1977 (CRA) and the government-sponsored enterprises, Fannie Mae and Freddie Mac. Nowhere does Bernanke mention the greatest source for the financial innovations that proved disastrous, namely the regulatory innovations that were put in place during the very last decade. Could it be because he also is among the ones to blame?

The regulators in Basel innovated as regulators never innovated before, and thought they could control for default risk, and therefore allowed incredible leverages as long as the default risks of borrowers were perceived as low or non-existing by the official risk sentries the credit rating agencies. After that the regulators being so sure about the value of their innovations went to sleep… but that is of course nothing new or innovative.

At the end of the day the simple truth is that the costs of regulatory innovations far exceeded the costs of financial innovations, and that the benefit from financial innovations far exceeded the benefits from regulatory innovations. Try to live with it FT!

The value of the CDS depend a lot on who contracts them

Sir Henny Sender in “CDS derivatives are blamed for role in bankruptcy filings” April 17 reports on how this type of instrument changes the behavior of creditors. One way I have found useful explaining the pro and con of the CDS is with a simile to life insurance.

Supposed Henny Sender took out a life insurance for a million quid to take care of her loved ones in case anything would happen to her. That should be a quite good responsible and tranquilizing thing to do. Now imagine instead that many of Henny Sender’s extended family and friends and even some total strangers took out million quid life insurance policies on her. Not so tranquiliz, baning eh?

You need to stress-test the American taxpayer first

Sir in “America’s fate is not in its hands” April 16, you mention the stress tests of the financial sector. Much more important than that would be to stress-test the American taxpayer.

What the US dollar bill really should state is “In the American Taxpayer We Trust” and so the more pragmatic Americans have printed the “In God We Trust” on it.

There is no way that the current American generation, having been brought up as the consumers of last resort in the world, would now turn around and accept to be the world’s taxpayers of last resort… at least not with the current taxes and any stress-test of them would show you that.

The US government should be much more conscious of this before launching itself on a fiscal spending stimulus binge which, if allowed by the markets, will build up its public debt to a totally unsustainable level.

That said I believe the market is going to say NO much earlier than that, since one thing is to be searching for a safe temporary haven and another quite different to be trapped in a permanent home.

And that is why, before the US Dollar loses its AAA rating, that the US, and the world, should work hard in developing a totally new generation of taxes that can be perceived as legitimate, that are aligned with the new global realities, and that interfere as little as possible with the functioning of a competitive economy.

What bedevilled the world was the belief in certainty.

Sir Edmund Phelps writes that “Uncertainty bedevils the best system” April 15 and though I agree of course with that uncertainty is part of any system, what has really bedevilled us lately has been the belief in certainty. In this respect Mr. Phelps would do well reading the basic first pillar of the bank regulatory system that emanated from the Basel Committee and in the minimum capital requirements for the banks he would find that the regulators formally authorized an astonishing 62.5 to 1 leverage if banks lent to corporations rated AAA to AA- by some human fallible credit rating agencies.

If there ever was a dysfunctional, naive and gullible regulatory system that arrogantly believed it had the risks under control, this was it. Our current problem is that the same regulators that came up with this are still in charge of regulating.

Do not just blame some financial oligarchs but follow the profits instead

Sir Martin Wolf is right in that “Cutting back financial capitalism is America’s big test” April 15, but this has much less to do with cutting back powers of a “financial oligarchy” as argued with an unhealthy dose of populism by the previous IMF chief economist who-said-nothing-then Simon Johnson, and much more with cutting back on the use of some dubious non-market instruments that have helped to tilt the market too much in favour of the financial sector. Follow the profits!

The financial sector first lent to risky clients and then waved that magic wand of the credit rating agencies, which allowed them to generate immense profits reselling those same loans as having much less risks. What on earth does this has to do with oligarchs? It seems much more the fault of lousy regulators (among which we find the IMF) who empowered the credibility of risk surveying so much that even they fell for it and authorized an astonishing 62.5 to 1 leverage for banks when they lent to corporations rated AAA to AA-.

The financing of the consumer and home buyer in the USA lives and dies with the use of some non-transparent credit scores and which allows charging many consumers much higher interest rates in order to compensate for those that should never have been given credit in the first place. What on earth does this has to do with oligarchs? It is a basic fault of the US society that has allowed itself get trapped in a position where sometimes American parents give more importance to their children credit scores than to their school grades.

There is nothing so risky than what is seen as risk-free

The basic capital requirement for the banks established by the Basel Committee is 8% which results in a 12.5 to leverage. But since assets are then risk weighted, for instance at 20% in the case of loans to corporations rated AAA or AA-, the officially permitted bank leverage can increase to 62.5 to 1.

AIG’s whole business model was based on exploiting its supposedly risks free AAA rating which was precisely what led it to take on unimaginable risks. Since most investors in fact abhor risk and naturally go for anything perceived as having less risk we now, courtesy of the Basel Committee are seeing how the losses incurred in supposedly risk free investments are many times the losses incurred in what supposedly was risky.

The sole concept that risk-free investment opportunities can be determined makes the “first pillar” of our current bank regulations fundamentally flawed. Instead of acknowledging this problem the running wild and free regulators seem intent to dig us even deeper in the hole we’re in thinking themselves also capable of determining what the systemic risks are. Please, will someone save us from this lunacy?

PS. That FT, after so many letters I have written about this and well into the second year of the deepest financial crisis has yet not once picked up on this issue and much less mentioned the truly astonishing 62.5 to 1 leverage that is still allowed, makes me sadly conclude that there is a fundamental flaw in FT too.

What we have is a genetically modified Black Swan

Sir if you throw a coin, betting on head or tail, and then suddenly it lands on its side then that is a real and natural Black Swan event. But, if you alter the coin in such a way that it must land on its side, more sooner than later, then when that happens can no longer be referred to as a real and natural Black Swan since it is a manmade event. At best we could perhaps refer to it as a genetically modified Black Swan.

The current financial crisis would not have happened had the regulators not empowered some few credit rating agencies as their official risk surveyors and these had not with their AAA signs guided the risk adverse herds of capital in an absolutely wrong direction.

In this respect it is truly surprising that Nassim Nicholas Taleb, a scholar on Black Swans, does not include among his “Ten principles for a Black Swan-proof world”, April 8, the importance of not forcing or stimulating the world to follow the opinions of just a few.

A chance for many bankers to be much better bankers

Sir my eldest daughter works for a large Canadian bank and so I have a vested interest in Gillian Tett’s “A chance for banker to refocus their talents” April 7. I have another take on this issue.

If there is one thing to be learned from this crisis is that the world is much better off with hundreds of thousands of credit analysts that get to know and truly understand their clients, look them in their eyes, decide and shake their hands, knowing that though they will be personally accountable for their mistakes they will not risk bringing down the world, as some very few high paid credit analysts in the only three credit rating agencies did.

That these good credit analyst won’t make as much money as their supercharged predecessors is clear but they will have the possibility of earning a decent salary in an interesting and worthy carrier instead of just stupidly staring into their monitors looking at what the credit rating agencies opine.

Understanding how the banks dismantled their credit analysis departments as a consequence of the regulations that emanated from Basel helps you to understand the immense potential for recreating the jobs that were.

PS. Though I have a couple of other individual articles that I favour it is clear that based on the full production Gillian Tett deserves the title of Journalist of the Year. Bravo! That said, as an anthropologist she had perhaps an unfair advantage in these times.

The sincerity of the authorities matter more than their commitment to stability.

Sir Martin Wolf in “Credibility is key to policy success” April 3, writes that “a central bank’s unconventional monetary operations are reversible” but says little on the issue that the distributional effects for the citizens of such operations are most probably not reversible at all.

At this moment for many private persons and entities any “quantitative easing” dilutes effectively the current value of their cash, with no guarantee of reversal, making it thereby a very non-transparent tax, and so countermeasures will be taken by the market, for sure.

Keeping up any government’s credibility while it plays hidden games under the table is not an easy trick, for any magician. This is not so much about the “sincerity of the authorities’ commitment to stability” as it is about authorities’ general sincerity.

The worst part though might be that “quantitative easing” makes it also difficult for the government to be sincere with itself as it really does know what the market would look like in the absence of such easing, just like a company cannot be really sure of the price of their shares during a stock-repurchase plan.

The value of our cash is diluted in an ocean of cash, which effectively makes of “quantitative easing” just another tax.

Sir, Krishna Guha in “Easing by world’s central banks take a variety of forms” April 2, mentions that “Expanding the money supply creates relatively little inflation risk in the short term. But this could change when the crisis turns.”

The above is right of course but, let us not forget that however we dress it up “easing” signifies an easing only for those whose instruments are being bought, whether it is the government or the holders of the distressed securities. For the rest of us it just signifies that the real value of our cash gets to be diluted in the ocean of cash produced by the “quantitative easing”, which effectively makes it just another tax, though a much less transparent one.

What we foremost need are capital requirements that cover for the risks that what is rated AAA is not really AAA.

Sir in Chris Giles’ “Harmony is main item on the agenda” April 2 mentions “Banks will be required to hold more capital in future and everyone agrees that capital requirements (for financial institutions) need to become stricter in good times to provide a greater cushion for downturns”. That is of course right yet it behoves all of us to remember that our current predicament had much less to do with “good times” and much more with having incurred in vanilla type plain old fashioned bad investments. In this respect the first thing to do, whether for good times or bad, is to place some capital requirements to cover for the risk that what is rated AAA is not AAA.

Eerie!

Sir Just on word comes to mind when reading your pre G20 summit reports April 2... Eerie!

It feels like sitting in a cellar waiting for the hurricane to come or pass knowing that your cellar is utterly inappropriate for such an event.

To reduce the too many cars it might be better to eliminate some infrastructure, like some roads.

Sir you use as an illustration for Mathew Green’s report on lacking infrastructure a photo from Lagos from which one could conclude that it is not infrastructure that is lacking but the cars that are too abundant, “Crisis puts the brakes on”, April 2. Have this financial crisis already made us forget the energy and climate change crisis?

And then there is also the “too bad to regulate”.

Sir Peter Thal Larsen writing about financial regulations in “A lot to be straightened out” March 31 comments on the option to submit the “too large to fail” to have to pay a hefty fee for the support they enjoy.

As an Executive Director of the World Bank (2002-2004) at a Risk Management Workshop for Regulators held at the World Bank in May 2003 as I said the following.

“Some old agricultural traditions of burning a little each year, thereby getting rid of some of the combustible materials, seem much wiser than today’s no burning at all that only allows for the build-up of more incendiary materials, thereby guaranteeing disaster and scorched earth, when fire finally breaks out, as it does, sooner or later.Therefore a regulation that regulates less, but is more active and trigger-happy, and treats a bank failure as something normal, as it should be, could be a much more effective regulation. The avoidance of a crisis, by any means, might strangely lead us to the one and only bank, therefore setting us up for the mother of all moral hazards—just to proceed later to the mother of all bank crises.Knowing that “the larger they are the harder they fall,” if I were regulator, I would be thinking about a progressive tax on size.”

Sincerely do we really need regulators that have to wait for a catastrophe before coming to reason? Looking at the regulators utterly silly behaviour over the last decade or so it becomes clear that we also have a problem with regulators that are too bad to regulate.

FT should not give Alan Greenspan voice just so he can utter platitudes.

Sir you keep on giving voice, more than a third of your most important Comment page, second week in a row, to someone like Alan Greenspan who did nothing with all the voice he had to save us from this crisis, much the contrary. And then salting the wounds, he only uses it to utter platitudes.

In “Equities show us the way to a recovery” March 30, he says “Restoration of normal global lending could be as effective a stimulus as any fiscal programme of which I am aware” and that “restoring a viable degree of financial intermediation is the key to recovery. Failure to do so will significantly reduce any positive impact from a fiscal stimulus”. Do you believe there are some of your readers that are not fully aware of the above?

Do you believe there are some of your readers that are not fully aware of that a rising stock market could also be beneficial as the creation of capital gains augment spending and gross domestic product, whereas capital losses lower spending.

I do not wish to imply that Greenspan should be silenced forever, of course not, but the least we should be able to expect in order to give him additional voice is that he uses it for something really important.

Times are hard enough for the press but if the Financial Times does not do a better job of defending the quality of one of its most important pages then it will encounter even harder times.

A wanted safe haven is not the same as a wanted permanent home.

Sir Michael Mackenzie reports on “Concern at size of debt auctions” March 27, and of course they should be very concerned as so much of the current plans of helping the economy recover hinges on the possibilities of finding buyers for the US treasury bonds.

As I have often repeated the danger is that US confounds the eagerness of markets in finding a temporary safe-haven with a willingness of capitals finding a new permanent home in the US and that is as we all should know a totally different animal.

Also there is a clear and present danger in not being able to access the real market signals since the current rates out there have nothing to do with the rates required if the Fed was not doing so much buying. In some ways it is like a bank participating in buying some securities in order to make the harsh mark-to-market truth easier to digest. It only works over a short period of time.

That plus 20%

Sir when Adam Thomson reports that “Calderón challenges Obama on drugs war” he quotes the Mexican president saying in reference to the help the US should offer “The help should be equivalent to the flow of money that American consumers give to the criminal”. What a splendid logical and forceful reply. The only thing that could have been added is a “plus 20% since it is a just cause”.

Greenspan commanded an amazingly naïve and gullible generation of financial regulators.

Sir Alan Greenspan starts out his “We need a better cushion against risk” March 27 with his silly chorus that all this mess was because we trusted “the enlightened self-interest of owners and managers of financial institutions”. If that was true, why would the world have contracted the services of Mr Greenspan?

Thereafter he gets into more real explanations though, like accepting that “regulators cannot fully or accurately forecast whether, for example, sub-prime mortgages will turn toxic”. Of course not, when Greenspan and his buddies in Basel decided that a bank could leverage itself 62.5 times to 1 as long as it lend to corporations rated AAA by human fallible credit rating agencies they showed themselves to be amazingly naïve and gullible regulators

Greenspan also writes about the need for higher capital requirements for the banks but before this even more important is to get the financial regulators to stop meddling and imposing their own risks preferences on the banks and letting that to the market.

If only the AAA had applied

Sir Gideon Rachman in “Sensitive words” March 27 draws our attention to an extremely sensible institution, Companies House that has to approve the use of some sensitive words before they can institutionally be used “because they are thought to convey an impression of authority or trustworthiness”.

How sad that those using “credit ratings AAA” did not submit an application. It would have saved the world quite many trillions of dollars or what´s almost the same pounds sterling.

As a “global risk assessor” there is nothing like keeping the free press on its toes.

Sir Nicholas Stern is absolutely right in that “The world needs an unbiased global risk assessor” March 25, and his proposal on how to set up an independent institution for such purpose sounds absolutely right, yet I have to tell him to brave himself to the fact that it would probably not work. First because it is hard to see how the world would elect the right people to such place, instead of just the correct people. Second because it is hard to see how to guarantee that institution would just not turn into a club of mutual admirers. Lord Stern himself starts going down this last route of perdition when naming some possible candidates that he himself personally admires.

Let us look at the “unbiased global risk assessor” from our current perspective. Would it have been able to alert the world to what was happening? In such a way the world would have listened and acted upon the warning in a timely fashion? I believe not.

Also why use so many resources to try to identify the exact timing of when things go wrong instead of avoiding creating the conditions for things to go wrong. I myself even though I could never be sure of the exact timing of it knew that catastrophe was on its way when our financial regulators in Basel came up with such a silly idea that a bank should be able to leverage itself 62.5 time to 1 as long as it lent to corporations perceived as AAA or AA- by human fallible credit rating agencies.

No, much more important than creating this type of new oversight institution is to make certain that the old oversight institutions work. Like that the free press, like FT, are stimulated enough to pose the right questions, in time, and which for a starter requires their journalists not joining the establishment.

When I see a journalist in the audience frowning and frantically scribbling away on a block I know we got it right. When I see a journalist moderating a discussion as another one among the learned I know we got it all wrong.

Are we multiplying the systemic risk?

Sir I agree completely with Martin Wolf´s concluding reaction “If this is not frightening, I do not know what is” “Why a successful US bank rescue is still so far away” March 25.

Now, that said, one of the things that I find most frightening is the possibility that we could be concentrating too much our efforts on salvaging (or lynching) the Titanics instead of making sure that all other smaller vessels are doing fine. In other words, by insisting on helping all the “systemically significant financial institutions” are we not making these even more systemically significant?

What do we know about all the other regional and smaller community banks? Should we not care about these more?

Where have you been minister?

Sir Karl-Theodor zu Guttenberg is right reminding of us of the need to be very clear about what went wrong to cause this crisis in order not to unlearn the many good lessons we have indeed learned over time, “A new era of accountable capitalism”, March 25.

But, surprisingly then zu Guttenberg goes on mentioning as a principle that “risk supervision by rating agencies and financial authorities must be strengthened on a global level to prevent the build up of systemic risk”. Where has he been? Does he still not get it? It was the mingling on risk by the financial authorities that got this crisis started in the first place. Like when the financial regulators in Basel came up with the naive idea that a bank could leverage itself 62.5 times to 1 as long as it lent to corporations perceived as AAA or AA- by human fallible credit rating agencies.

It must hurt GE so much

Sir I have nothing whatsoever to do with GE but when Francesco Guerrera reports “Moody´s strips GE of triple A rating it has held for 42 years”, March 24, I truly commiserate with them. It must hurt so much being stripped of your AAA rating by one of those primarily responsible for your current problems.

In times like these more willingness to take risk is needed at the IMF and the World Bank.

Sir I entirely support Trevor Manuel´s “IMF needs reform to respond to changing mandates”, March 23, where he calls for much more diversity in the recruitment of staff so as to get more diversity of views. As a former Executive Director I would like that to extend to the World Bank too.

Having said that, there is tough little to be gained from more diversity of opinions if this is not welcomed and nurtured by the management. Currently, in the multilateral finance institutions, there is way too much risk-adverseness among their managers against anything that in the slightest way could upset their somewhat too comfy internal order. In times like these managers must also learn to scale up their willingness to take risk… on all fronts.

A regulatory bias that favours the big prevails

Sir Clive Crook recommends to “Strike faster on death-wish finance” March 23 and he is right though that would clearly require a dramatic reversal of the regulatory bias in favour of the big that now prevails.

In May 2003, at a workshop on risk management for some hundreds of financial regulators held at the World Bank, as an executive director, I said the following:

“A regulation that regulates less, but is more active and trigger-happy, and treats a bank failure as something normal, as it should be, could be a much more effective regulation. The avoidance of a crisis, by any means, might strangely lead us to the one and only bank, therefore setting us up for the mother of all moral hazards—just to proceed later to the mother of all bank crises. Knowing that “the larger they are, the harder they fall”, if I were regulator, I would be thinking about a progressive tax on size.”

And, as you might guess, that recommendation went unheeded and I would even dare say unwelcomed… unfortunately.

The real question is what does the market have to say in general about retroactive laws?

Forget about the AIG executives, the real question to be made is whether a country that has to hit the markets to the tune of a couple of trillions in public debt can afford to be tinkering with such dangerous-to-confidence issues like retroactive taxes.

The 160 million in cost of the bonuses could pale in comparison to the additional margins the markets could charge the US in risk premiums in order to compensate for such unsettling behaviour.

The world has a serious shortage of elites.

Sir at long last we might now be starting to debate what should have been debated all the time namely how to ensure true accountability and true good governance that ensures that our human endeavors lead us to a better tomorrow instead of having us all sign up as baby-boomers on a Après nous le déluge.

Jessica Einhorn in “Corporate governance without a hint of systemic surveillance” begins putting her finger on important pieces of said debate pointing out that “few corporate managers today are permitted the luxury of thinking about long-term returns for their ever changing cast of investors”, “that regulatory activist… have special interests and they do act to further them through initiatives in corporate governance” and “that we need to hold our public officials accountable for thinking through systemic issues”.

Could the glue that help us overcome the above mentioned challenges be found anywhere else than in an enlightened elite of families capable of including all humans as heirs? I do not think so!

Do not tax Gekko-style risk-taking.

Sir Gillian Tett writes about “That secret desire for burst of Gekko-style risk-taking” March 20 and that must lie very close to the heart of anyone looking for a speedy recovery.

May I suggest she reads the following table derived from the Minimum Capital Requirements for the Banks issued by the Basel Committee under the Standardized Approach in order to cover for Credit Risk:

Rating of the ......Required Bank...... Allowed
Corporation ......Equity $100 Loan ...Leverage

AAA to AA- ..........$ 1.60 ....................62.5/1
A+ to A- ...............$ 4.00 ....................25.0/1
BBB+ BB- .............$ 8.00 ....................12.5/1
Below BB- ............$14.00 ...................8.33/1

From it she should be able to conclude that the regulators have imposed, on the core of our financial system, the commercial banks, a de-facto tax based on a loosely defined “default risk” and as measured by the credit rating agencies.

When as now bank equity is scarce and very expensive this de-facto tax on risk, which is charged on top of whatever the market commands for assuming higher risks, is extremely high. So, if you want Gekko-style risk taking? Start by not imposing special taxes on it.

The Turner report is not even close to being a watershed.

Sir I have tried to figure the why of Martin Wolf´s “Why the Turner report is a watershed for finance” March 20, but I can´t. A regulatory watershed implies some fundamental change in the basic paradigms used, and this is definitely not it.

As an example the Turner Review holds that “Credit ratings have played a valuable role since (i) good investment practice should seek diversification across a wide spread of investments; and (ii) it is impossible for all but the very largest investing institutions to perform independent analysis of a large number of issuing institutions” which only makes us ask: Have they not seen enough of that what matters is not the diversification within one institution but within the whole system? Have they not seen enough of the how expensive the too-big-to-fail are so as to insist in giving the larger institutions special rights?

But perhaps Martin Wolf illustrates best the shortcomings of the report when he writes “if everybody believes in the same (faulty) risk models, the system will become far more dangerous than any individual player appreciates”. Did you notice that “(faulty)”? Well that means that Martin Wolf, like the report, still believes that the risk models can be right and that if we all follow them we will find financial Nirvana.

Wolf also stands firm and refuses to understand that a credit rating is simply the result of a model that analyzes one type of risk, and that these simple one dimensional published result created more havoc than all the other sophisticated financial models put together and that without the AAAs would have remained stacked away as unsellable nerdy creations.

Long live the diversifications of views that can only be present in a free market!... though that does not mean of course that we not do have to get rid of the regulatory naiveté that actually reigns and that allows a bank to leverage itself 62.5 to 1 times, as long as it lends to corporations rated AAA or AA- by some very few eyes.

PS. “A mixture of thousand solutions, many of them inadequate, may lead to a flexible world that can bend with the storms. A world obsessed with Best Practices may calcify its structure and break with any small wind."

Europe, hand over two chairs, immediately, no discussions

Sir Trevor Manuel in his commendable, timely and important “Let fairness triumph over corporate profit” March 17, asks several “Can we…?” and to these our only answer can be “yes, we have no choice”. That is if we want to live in a reasonably peaceful world that is if we want to have a chance to adjust to the environmental and energy related dangers that lurk around the corner.

This article, like last week’s Luiz Inácio Lula da Silva’s “The future of human beings is what matters”, evidences clearly why Europe needs to surrender to the rest of the world at least two of the chairs it occupies at the World Bank and the IMF. Immediately! No discussions!

That said I would have preferred to see Trevor Manuel’s article titled as “Let reason triumph over corporate greed” and I have an inkling that so would he.

Whistleblowers of the world unite!

“Managers need to listen before disaster strikes” writes Michael Skapinker March 17. Everyone agrees none argue against it and still it is almost impossible to achieve most often because what management and others would qualify as disaster varies dramatically. Sometimes the only real disaster is the pure possibility of a disaster being acknowledged.

But what can we do? Let me have a go at it. Since a corporate climate that is unreceptive to whistle blowers could hide a time bomb credit rating agencies should never be able to give more that a B- to any company that does not achieve some minimum results in a yearly secret internal ballot held on various governance issues.

That could help some managers to start listening.

There is exactly where the going forwards must begin

Sir Tony Jackson really shows he got his priorities right with his “Proper or improper, banks need society’s control” March 16. This is exactly the type of issues that should be exhaustedly discussed before you sit down and start to try to regulate the activities of the banks.

It is exactly the total lack of a reference to what the purpose of the banks should be that allowed the regulators to build up regulation systems almost exclusively based on the concept of minimum capital requirements based on perceived risks, as if that is all that risk is all about, as if avoiding defaults is the only objective for our banks.

Jackson’s article deserved an op-ed place and I sure hope he manages to start a discussion on the simple basics before hiding in the opacity of the sophistications.

FT, please don’t give up on the market.

Sir if you believe that a super-regulator is capable to control systemic risk without generating new and even worse systemic risk it is clear that you must have already given up on the market and also that you have not learned one iota from this crisis, “Why the US needs a super-regulator” March 12.

If you really think that such a regulatory could perform miracles in a market “with extreme complexity” would it then not be better for it to take over the regulatory functions in the UK, Europe or even the rest of the world?

Who do you think these regulatory authorities really are? How come you are so completely sure they’re angels?

Cheap money? Cheap credit? Humbug!

Sir, Chrystia Freeland in “The audacity for help” March 12, mentions “the era of cheap money” and “the end of cheap credit” May I suggest that the existence of an era of cheap money and cheap credit has just been a big bluff, promoted to make money on expensive credit, and that consumer credit is partially responsible for accentuating economic differences in the US and in most of the world.

When a consumer buys something at a rate that exceeds the rate of inflation and pays more than the risk free rate he is in fact impoverishing himself ,and would have been better off postponing any consumption and purchases he does not absolutely need.

Look just at the current reality. The US treasury pays about .01% on its short term debt and a US citizen has to pay at least 1,690 basis points more, at least 17% on his credit card. Who except a credit card salesman or credit card company shareholder, could even dream of calling that cheap money or cheap credit?

You want to see some of the wealth differentials reduced? Then teach the consumer about the worth of bargaining their purchases paying cash.

Doing a little sleeping with the enemy, aren’t we?

Though it is clear that the faulty ratings issued by the credit rating generated more real losses than what 50 Madoffs could have done it is amazing to see FT giving so much voice to the President of Standard & Poor’s to defend his business model “Re-evaluating and rebuilding a more useful rating system”, March 12, while silencing so much of the fundamental criticism against the creation of an oligopoly in the market of risk information, namely the systemic risks that this in itself generates. Doing a little sleeping with the enemy aren’t we?

You too FT

Sir in “The consequence of bad economics” you accuse our leaders of intellectual failure and blame their “unwillingness to see (or their wilful ignorance of) what markets need in order to produce good outcomes for society. I accuse FT of the same.

You say “People were not unaware of risks, but... The great mistake was to rely merely on self-interest in as imperfect and as important a market as the financial sector” and I have held for years, and in hundreds of letters to you, that it was exactly the reliance on self-interest that was missing in many of our regulations.

The minimum capital requirements for the banks which in the case of private corporations sometimes allowed for a 62 to 1 leverage, plus the official appointment of some external credit rating nannies, all in a globalized world slush away with funds, induced and facilitated some few reckless market participants to sell to the world a monstrously explosive systemic risk composed exclusively by perceived low risk AAA investments, and which all blew up. FT has mostly preferred to ignore these facts.

I agree though with your conclusions, “This was not a failure of markets... but the intellectual and moral failure of those who were in charge of it”... FT included, of course.

Complete truths are the best compasses

Sir as usual Gillian Tett has written a good article in “Lost through destructive creation” March 10. Having said that let me express two complaints. The first one is that when she writes “the banks were making such fat profits they had little incentives in questioning their models” one gets the impression that all or at least most of the banks were involved in the production of opaque assets and that is simply not true, the real culprits, they were few.

What also disappoints is the unwillingness of Tett to connect the dots between the opacity of the innovative financial instruments and their immense marketability. That is not merely explained by the fact that these instruments were awarded AAA ratings because for that to matter the credit rating agencies had to be invested with enormous amounts of credibility, and this is what the financial regulators erroneously supplied them with.

If we are more willing to bare all things as they really are and assign the responsibilities where they should really be then we might discover that we are in fact not that lost.

Muito obrigado!

Sir we should all give thanks to Luiz Inácio Lula da Silva reminding us that “The future of human beings is what matters” March 10. In days like these it is so easy to lose sight of the real priorities.

And the truths are the needed seeds for its reconstruction

Sir Martin Wolf gets to set the tone in the series on “The future of capitalism” and titles his opening article “Seeds of its own destruction” March 9. I object that for reasons I cannot explain he leaves out what some of us consider the fundamental causes for this crisis.

Wolf writes about “frenetic financial innovations”, “innovative financial systems” and of “how little banks understood of the risks they were supposed to manage” without even mentioning the fact that the Basel Committee ,with their minimum capital requirements for the banks, innovated to such an extent that banks were duly authorized to leverage their capital for instance in the case of corporations rated AAA and AA- to a never before heard astonishing level of 62 to 1; and that it was these capital requirements that gave way to the mother of all the regulatory arbitrage booms.

Also when Wolf writes on how “huge capital flows…largely ended up in a small number of high-income countries and particularly in the US” among other he suggests the US government programs but finds no place at all for the credit rating agencies. Wolf does simply not want to accept that the big explosion in the growth of the subprime mortgage market had very little to do with a FHA or a Fannie Mae and all to do with the excessively empowered credit rating agencies stamping their AAA sign on securities fabricated on Wall Street. Wolf simply refuses to ask himself why for instance Europe financed more subprime mortgages in the US than the US itself.

The current crisis is a remarkable fertile ground for all type of other-agenda-pushing and I have already heard arguments attributing it to Israel/Palestine, genetically modified seeds, increased narcotic production in Afghanistan, the military control of the political apparatus of the world and other similar mindless arguments. The only way we can avoid this crisis from degenerating into something even worse is to defend the truth and the whole truth about it.

Let’s be clear about the true origin of the financial “snake-oil”.

Sir Robert Shiller in “A failure to control the animal spirits” March 9,  completely ignores that the “snake oil” the financial world bought was produced almost exclusively by the financial regulators, those who held that banks could leverage their equity 62 to 1 when they gave credit to corporations determined to be AAA or AA- by their official default risk surveyors the credit rating agencies.

Shiller writes that “It was part of a story that all investments in securitized mortgages were safe because those smart people were buying them”. He is wrong! It was part of the story that those securitized mortgages were safe because they “are AAA and, if the credit rating agencies are good enough for Basel, they’re good enough for you”

AIG was only an addict and the Basel Committee its pusher

Sir, Henny Sender in “AIG saga shows how dangerous credit default swaps can be”, March 8, writes interestingly about the “regulatory capital forbearance” trades but without mentioning a word about the financial regulators who created such markets.

If she would take her time to read the current minimum capital requirements for banks she would find that if a bank lends to a sovereign country rated AAA it can have as much leverage it wants, there are no limits. If a bank lends to a corporation rated AAA or AA- it is authorized by the Basel regulations to have a 62 to 1 leverage. If it lends to a corporation that is not rated or one that has only received a BB- the banks are authorized to leverage their capital 12 or 8 times respectively.

Understanding this extraordinary range of authorized bank equity leverage, from limitless to 8 times, all of it depending on the criteria the credit rating agencies... where would AIG have been without the concept of an AAA? ... she could have but reached one conclusion, namely that AIG was an addict and that the Basel Committee was its pusher.

Yes, it has indeed a lot to do with the battle among generations.

Sir, John Authers is correct bringing in the baby boomers in the equation that explains the current crisis “Why baby boomers will put their faith in bonds”. March 7. 

I have in many letters to FT pointed out the problems with the generational transition between the baby boomers and those who will follow them. The latter have no incentives of buying their retirement roofs at the high prices houses have reached, nor to start investing for their retirement at a Dow at the 14.000 level.

Now the battle among the generations has started for real. The baby boomers are opening asking for stimulus spending to bail them out. It is very difficult to see the upcoming generation capitulating early, and pay the taxes that are needed to support that spending from transitioning into inflation.

A UK financed overnight?

Sir John Authers in “The Short View” March 6 writes about the Bank of England’s plan to buy long dated gilts…which will make money cheaper by reducing the rates on long bonds. That might be what happens with the marginal rate but not necessarily what happens with the average rate.

In fact what is being done is reducing the current interest rate cost of the public debt of the UK by reducing its average maturity and which could prove to be very costly tomorrow, like many Americans who entered into adjustable rate mortgages could attest.

It is indeed the Bank of England taking the short view. Let us see what happens when markets wake up and finds England financed overnight.

But Hank had company.

Sir John Gapper in “Too long in the spaceship, Hank” March 5, mentions that AIG´s “biggest money-spinner was regulatory arbitrage”. Exactly!

Before Basel banks and financial institutions always engaged in some regulatory arbitrage but it was mostly harmless. It was when the Basel Committee concocted a system of minimum capital requirements based on what they perceived as risk, and as measured by their risk sentries the credit rating agencies, that the real regulatory arbitrage business took off globally and turned into the extreme systemic danger it has proven itself to be.

And so if a Hank has been too long in a spaceship so has his fellow bank regulators.

I will gladly trade you one Basel Committee for a hundred of offshore financial centres.

Sir Avinash Persaud is absolutely right when he writes “Look for onshore, not offshore scapegoats”. The damage produced by the onshore enclave we know as the Basel Committee and all its regulatory derivatives, has caused hundredfold more misery than all offshore financial centres put together.

This does of course not imply that I would not like to trade away the financial centres too.

Revamp completely the minimum capital requirements for the banks

Sir (as you probably must gather from my hundreds of letters to you on the subject and that you decided to ignore for reasons of your own) I totally agree with John Stroughair in that “Rating agency system stifles innovation and competition” March 5. The fact though is that the reason that we even have to discuss the issue of the credit rating opining are minimum capital requirements for the banks issued by Basel which stifles something worse risk taking and promotes something really bad, the reliance on others.

Currently if a corporation is rated AAA to AA- a bank needs to hold only 1.60 dollars for each 100 of lending, which signifies an astonishing 62 to 1 of authorized leverage. But in the case of a corporation rated below BB- the banks need to hold 12 dollars for each 100 of lending, 7.5 times more than in the case of an AAA, notwithstanding the fact that the bank will most certainly be more careful when it comes to lending to a below BB- corporation than to a AAA.

The difference of 10.40 dollars of required equity, especially in times when bank equity is so scarce and expensive, is a de-facto regulatory tax on risk, levied on top of what the market requires for accepting risks and which stifles anything that smells innovation and which often implies more perceived risk.

In this respect it is not only the credit rating agencies we need to get rid of but also of the current malfunctioning system of minimum capital requirements based exclusively on the limited concept of default risks. Just as an example, is not the risk of the default of our planet because of climate change much worse?

A bit of navel-gazing, haven’t we?

Sir Paul Keating is absolutely right in saying that “Global financial confidence, once destroyed, requires myriad positive events and a heavy convergence of them to counter ambient pessimism and gloom”, “A chance to remake the global financial system”, March 5.

But then Keating lists issues, like better IMF governance, which is of course a very laudable thing to do, I support it completely, that in my opinion are almost irrelevant to the confidence of markets and perhaps even to most of the official actors.

For example when he mentions “the government of China has no intention of dealing with its surpluses by letting its real exchange rate redirect national resources, especially when such action risks putting it into the hand of the IMF” I would argue that the voting rights at the IMF, at this particular moment, is one of the very last real concerns of China.

Also whether the G20 structure “is truly dynamic” or the old Breton Woods arrangements are reformed sounds currently as some pure and unashamed navel-gazing.

Since it was the G10 that by means of endorsing the concoctions of the Basel Committee empowered the credit rating agencies so much that the whole world followed their AAA signs over the subprime precipice, I cannot honestly see how the markets would regain confidence in any sustainable way from a concentration of bureaucratic powers in a G20.

Does Keaton really believe a G20 success spells recovery? Is he long or short on G20 derivatives?

Pushing for a green recovery requires also reducing the conflicting market signals.

Sir Joseph Stiglitz and Nicholas Stern write “Providing a strong, stable carbon price is the single policy action that is likely to have the biggest effect in improving economic efficiency and tackling climate change”. Since it is always harder to bailout from a financial crisis than from a climate change crisis, although I come from an oil country I agree. “Obama’s chance to lead the green recovery”, March 3.

But these green market signals would be more effective were we capable of reducing some of the competing signals, for instance those present in one of the most important drivers of world capital namely the minimum capital requirements for the banks as defined by Basel.

Currently for a bank to make a 100 dollar loan to a corporation the banks currently need to have an equity that ranges from a minimum of 1.6 dollars to 12 dollars, a whooping 7.5 times the minimum, which depends on the risk assessments produced by the credit rating agencies.

Since bank equity is scarce, and expensive, especially now, this means that besides what the market would normally be charging for assuming a high perceived risk, the regulators have imposed an additional de-facto tax on risk. This would be great if “default risk of a corporation” was all that mattered. But what about the default risk of our planet? What if most investments in projects destined to fight the risk of climate change presented more risk than projects that increased the risk of climate change?

What if the securitized finance of car purchase financing gets an AAA rating while the project to install a solar panel only achieves a rate below BB-? Is it logical then that the financing of a solar panel needs 7.5 times more bank equity? I don’t think so!

The credit rating agencies were not just innocent bystanders

Sir, Vickie Tillman, Executive Vice-President of Standard & Poor Ratings Services, in “Rating firms do not capture risk in one measure”, March 2, writes, “credit ratings are opinions about future default risk and do not address the many other risks that have affected debt securities in recent months and accounted for the bulk of losses reported by financial institutions … policymakers should review regulations that may inadvertently encourage undue reliance on ratings. If rating opinions are used as benchmarks of creditworthiness – which, incidentally we have never encouraged – other benchmarks and factors should be considered as well.”

Does this mean that I have wrongfully been accusing these poor credit rating agencies, that they are only innocent bystanders and that they have nothing to do with this crisis that is going to result in so much misery for the world? Of course not!

Granted, the primary responsibility lies with the regulators who enabled the regulatory framework that incited this crisis and then with those investment bankers who took advantage of the system failures but in no way should we allow the credit rating agencies to go free of any historic guilt; as we should neither allow those financial newspapers that still have the gall calling the credit rating agencies “indispensable” something that even the credit rating agencies would not dare to do, to wash their hands.