What Is To Be Done? - A Prologue

A very good friend of mine, Pliny the Younger, wrote me after my last posting:

“This is all very good, entertaining reading. I enjoyed this last one particularly. I know no one would question your authority on the fact that things have been handled incorrectly. But, and there is a but, Can't you be more constructive?

I suggest this as your friend. I respect you too much and I know you have too many great solutions inside you to risk becoming labelled as someone who only sees the problems. What about proposing and lobbying for a particular solution to these issues? What should the FSA, Treasury, BoE, CEBS, European Commission, SEC, etc., actually do differently (rather than 'have done differently'?) After all, they seem to need some fresh ideas!

Someone once told me that the safest car to drive would be one with a large steel spike protruding from steering column towards the driver's chest. Not sure what the banking equivalent of that would be, but whilst it would be safe no one would want one.”

Pliny’s point was not only heart-felt (it was he who said, “It is difficult to retain what you have learned unless you practice it” *), it was also very timely. I received his note whilst I was in the midst of researching the next several postings in which I will lay out my suggestions as to how the banks, their depositors and borrowers, their regulators, the markets, etc., indeed all of us, can benefit from the crisis we are now experiencing.

Whilst I have made it a point, from the very first posting, of staking out the role of being a Socratic “gadfly,” I, too, had come to the conclusion that I needed to offer alternatives, not just point out deficiencies. Unlike Pliny, I am not so sure that my solutions are all that “fresh” or that they will fall any more kindly on the ears of some than has my criticism, but nonetheless I will give it a serious effort.

My first foray into the role of advocate follows.


Cassandra

______________________________________________
* Difficile est tenere quae acceperis nisi exerceas.

A Modern Modest Proposal

For Preventing UK Regulators from Being Burdens to the Nation & for Making Them of Use to the Public.

The late, great, American bank robber Willie Sutton, when asked, late in life, why he carried a Thompson submachine gun on his heists, observed, “You can't rob a bank on charm and personality.”* Well Mr. Sutton, you were wrong; you can rob a bank on charm and personality, but only if you are a banker.

Witness the charm and personality that has besotted the FSA supervisory staff who reviewed Northern Rock. Was it the gleaming, youthful smile of Adam Applegarth or the toothy grin of David Baker or just that they were mesmerised by the financial sleight of hand that Northern Rock exercised so well?

Actually, it matters little, as we have just discovered that the FSA could not have done anything even if they knew all and knew it well in advance.

Why? Because they have no power!

That’s right, the poor FSA has no power to intervene because the structure of the Tripartite Authorities prevents them. According to the Financial Times of 20 September,

“FSA executives privately say the regulatory regime does not give them the power to interfere in the running of a bank, as long as it meets the regulatory capital requirements. Northern Rock met regulatory capital requirements and satisfied all solvency requirements.

FSA insiders also point out that the regulator insists on regular stress tests. It also stepped up monitoring, recently asking Northern Rock whether it was prudent to fund itself on such a short-term basis.”

Hello? Have I been living in a parallel universe where an alternate FSA rules?

The last time, in fact, every time I have had dealings with the old boys and girls of Number 25 The North Colonnade they were not so hands-off or so constrained by the UK’s “regulatory regime.” In all of the High Street banks I have been involved with over the last 10 years (I have worked or advised at 4 of the top 6), I have had direct contact with senior FSA supervisors and their teams. I can tell you that none of them were shrinking violets that blanched at the thought of telling us brutal, barbaric, bankers to behave and not to loot and pillage. No, they “offered” advice just the way you were “volunteered” in the military, "You, you and you come here!" On numerous occasions we, the banks, have been told in no uncertain terms by the regulator to fix or change very particular structures, including business plans and products. It would be laughable, if it weren’t so poor a porky pie, to have “FSA executives” claim that “they were only following orders", pardon, "principles-based regulations." I doubt that there is a single senior banker on this island who has not had to choke back a chortle when they heard the FSA Executive's latest rendition of the Whiffenpoof song.**

We're poor supervisors who can’t have our way,
Baa, baa, baa!
Our Tripartite Agreement has led us astray,
Baa, baa, baa!

Regulators watch bankers off on a spree,
Doomed to stand by to eternity.
Lord have mercy on such as we,
Baa, baa, baa!

But what a convenient "out" the mandarins have in the Tripartite Authority – the BoE can point to the FSA who can point to the Chancellor who can point at the BoE, and round and round it goes, where it stops nobody knows - the perfect Catch 22.

I was going to write, “Please, don’t treat us as idiots; there are all too many of us who have had dealings with the FSA and BoE, and we know when you are engaged in a CYA exercise,” but I have thought better of it.

Why not just take the Tripartite's position at face value? Maybe they weren’t asleep at the wheel or thoroughly incompetent; maybe they are telling the truth and there was nothing they could do except sit on the sidelines and wait for such a disaster to occur. After all, the same-said “FSA executives” stated, “This is a one-in-a-million event; nobody expected interbank funding to dry up.” After all, other regulators across the globe, not just the FSA, had failed to predict a total drying up of liquidity in the money markets; none of them had prepared banks for such an eventuality.

Maybe, this is the best we can expect from them; to quote Jack Nicholson as Melvin Udall, "What if this is as good as it gets?"

Don't Quail in Fear, for Here's an Idea,
Let’s Buy a Bank in L'Angleterre!

Instead of looking at this as a negative, why not look on the bright side of life? This crisis reveals a structural weakness that is a godsend for those wanting to make a profit. The stuffy old banking world of Mervyn King's 12 September warning note is dead. With no more silly worries about moral hazard and fiduciary responsibility, with regulatory bodies with self-inflicted wounds having neatly tied their own hands behind their backs, the UK is now a perfect place to buy up a bank!

Just sit back, close your eyes and dream of this possibility. A band of brilliant bankers backed by intrepid international investors enter the UK market with the view of creating a new financial entity, let's call it ÜberBank, following this plan:

• Do a leveraged buyout of a small building society and de-mutualise it. Using the benevolent UK tax code’s treatment of leveraged buyouts, gain "taper relief" so that one need only hold investments for 2 years and are required to pay only 10% tax on dividends.

• Start buying mortgages from other building societies, many of which are looking for liquidity and new funding, at present discounted “market” prices. This will build up the balance sheet rapidly and provide critical mass.

• Use the increased mass to issue mortgage-backed "covered bonds" - Pfandbriefe look-a-likes *** - into the emerging markets of China and India which have already turned to these vehicles due to their perceived increased security and tradability. Given the lack of alternative available investment vehicles, prices on this class have fallen thus increasing ÜberBank's profits.

• Start a major campaign to draw in depositors by paying above-market rates on smaller deposits, between £2500 and £5000, locking them in for 12 to 24 months. (Any number of UK banks are already doing this in the £1000 to £2000 range.)
  

• The “covered bonds” and new deposits become the base for further acquisition of discounted mortgages. Continue to grow the balance sheet without the need for direct lending.

• Onward and upward -- until the bubble bursts - and then go knocking on the Tripartite Authorities door!
  

What a concept! No penny-ante operations! This will be a truly dynamic, no-holds-barred, rapidly growing entity that can generate large profits for its senior executives and shareholders, who, of course, will be one and the same. Thanks to HM Government ÜberBank will have no worry about niggling things like depositors clamouring for their money back in the event that it is caught out, ahem, pardon, in the event that there is a disruption in the markets. That will be the province of the Chancellor and the Treasury who will act as the backstop for the pence and pounds of the hoi poloi, with the insurance costs being borne by the taxpayer. After all, is it not a small price to pay to ensure that London remains the financial capital of the world? ÜberBank will not be bothered by these worries as it builds the next generation of risk-less products selling them far and wide to Chinese and Indian “dentists” and their ilk across the globe. If things go pear-shaped, they will simply apply for "rescue" from the BoE. Of course, The "Old Man" of Threadneedle Street will start by huffing and puffing and pontificating but, in the end, he will see the light - the one that shines from Number 10 - and suck it up and do as he is told. VOX GORBI, VOX DEI.

And this scheme does not forget our friends at the FSA, those poor little lambs who are powerless to help the banking public. Given their sad lot in life, they will be offered a new opportunity to be of service to the people of Great Britain, as the staff of ÜberBank branches. Who better to deal with the public, and explain why they cannot help them, than the very people who wrote the principles-based regulations and were trained to quote them in such ponderous voices?

Can you imagine a certain Knight Bachelor standing at the till and explaining to an angry, frightened and bewildered group of depositors to please remember that "the wider economic background remains benign" and that "as an industry" we "have capital ratios which remain significantly higher than regulation requires" and our "return on equity is at levels which many competitors envy" and while we "may be subject to liquidity pressures," we "have, with a single notable exception, coped well with these pressures to date."

For those of you who didn't have the pleasure of attending, these remarks are taken verbatim, with the exception of the change from they to we, from those given by Sir Callum McCarthy at Mansion House on Thursday, 20 September.

I am sure that one of two things would happen if this flight of the imagination where to transpire: either the depositors would be swayed by the Knight's dulcet tones or he would say good-night and hie off to some QUANGO or other where he is safe from public, as well as Parliamentary, gaze.

Granted, my prose does not have quite the elegance found in the original Modest Proposal of Dean Swift, but at least it has no cannibalism, or rather only that related to financial institutions.

Finally, I want to go on the record that it is not my intent to disparage any of our regulators, whether they be individuals or institutions; I know it may be thought of as a cliché, but it is true nonetheless -- I am honoured to number among my friends several of the senior supervisors and their team members, past and present; they are not just adept risk practitioners, they are good and wise men and women. Rather, mine is a call for a return to sanity and consistency; to responsibility and accountability; to truth and away from "spin." We are told that financial institutions and markets need to be more transparent; so too do our regulators.

To those who think this "over the top," I leave you with the words of Prospero:

If you were dismay'd: be cheerful:
Our revels now are ended. These our actors,
As I foretold you, were all spirits and
Are melted into air, into thin air:
And, like the baseless fabric of this vision,
The cloud-capp'd towers, the gorgeous palaces,
The solemn temples, the great globe itself,
Yea, all which it inherit, shall dissolve
And, like this insubstantial pageant faded,
Leave not a rock behind. We are such stuff
As dreams are made on, and our little life
Is rounded with a sleep.
-- I am vex'd:
Bear with my weakness;
my old brain is troubled.
Be not disturb'd with my infirmity.
If you be pleas'd, retire into my cell
And there repose:
a turn or two I'll walk,
To still my beating mind.

Cassandra

* It is an urban legend that Willie Sutton said, in answer to the question, "Why did you rob banks?' “Because that is where the money is.” However, the above quote is actually his own words, as recorded in an interview he gave to The Reader’s Digest in September 1980.

** The Yale University Whiffenpoofs are the oldest collegiate a cappella group in the US, established in 1909. Best known for "The Whiffenpoof Song," the group is comprised of senior men who compete in the spring of their junior year for 14 spots.

The ending of the Whiffenpoof Song is as follows:

We're poor little lambs who have lost our way,
Baa, baa, baa!
We're little black sheep who have gone astray,
Baa, baa, baa!

Gentleman songsters off on a spree
Doomed from here to eternity
Lord have mercy on such as we
Baa, baa, baa!


*** The key difference between Pfandbriefe and mortgage-backed or asset-backed securities is that banks that make loans and package them into Pfandbriefe keep such loans on their books. This means that when a company with mortgage assets on its books issues the covered bond, its balance sheet grows, which it wouldn't do if it issued an MBS, although it may still guarantee the securities payments. This action of maintaining the mortgages on one’s books provides investors, or so they believe, with a seemingly better position than if the mortgages had been sold off into the market. At the time of their introduction in the UK market they were deemed to be in accordance with UK contractual law and thus no new regulatory law needed to be passed. “The Treasury and the Bank of England were happy that we could do something without primary legislation,” said Bill Young, managing director at Goldman Sachs.

Key Players in the Northern Rock Crisis

As the old saying goes "You can't tell the players without a score card." So here are some brief biographical sketches on the main personalities involved in the bail-out of Northern Rock.

The Executives

ADAM APPLEGARTH - Young, shaven-headed, aggressive, the Northern Rock chief executive joined from university and moved, in only 18 years, from cashier to the youngest FTSE-100 chief at the age of 39 (salary £1.3m last year). Considered, until this week, to be the golden boy of UK retail banking; rumoured to have been tipped to be the new chief executive of the Abbey Santander group.

DAVID BAKER - meant to be a steady hand on the tiller. Rose from Management Trainee working in the post room (1974) to deputy chief executive (2005). Greatest quotes - When asked, "How has the company changed since you joined?" , answered, "We’ve changed from porridge, being thick and slow to stir, to rice crispies, full of snap, crackle and pop." When asked in late July about the prospects for Northern Rock, "We are very confident about the long term future of Northern Rock. We are punching well above our weight."

The Mandarins

SIR CALLUM MCCARTHY - Chairman of the Financial Services Authority, his job is to ensure that financial markets are orderly and that consumers receive fair treatment. A former civil servant (DTI) and international banker (Kleinworth Benson, BZW/ Barclays Capital), he was chairman of Ofgem, the energy regulator, before joining the FSA in 2003

ALISTAIR DARLING - As a minister under Tony Blair, he was voted Britain’s most boring politician. Since then, life has not been so dull. As chancellor since June, he has faced turmoil in financial and banking markets. Supporters claim that his calm is an asset; critics say he is “just a mouthpiece for Gordon Brown”.

MERVYN KING - The Bank of England governor is the man to whom British bankers turn when all else fails. A former Cambridge
and LSE don, he joined the Bank in 1991. After becoming governor in 2003 he took a tough line on inflation - and, until Thursday, was not keen to bail out banks for reckless lending.

Sources: Websites of The Bank of England, the FSA, 10 Downing Street, Northern Rock and 'The Times'.

Cassandra

Willem Buiter - (Northern) Rock - Paper (Tiger)

The following link is to a piece on Northern Rock by Dr. Willem Buiter, CBE, Professor of European Political Economy at the LSE. Professor Buiter insightful comments need to be read and circulated.

Maverecon - Willem Buiter's Blog: (Northern) Rock - Paper (Tiger)

SAY IT AIN'T SO, MERVYN!

Dear Governor King,
On Wednesday 12 September, YES, ONLY TWO DAYS AGO, you wrote to Parliament, quote:
“The provision of large liquidity facilities penalises those financial institutions that sat out the dance, encourages herd behaviour and increases the intensity of future crises.”

You went on to confirm that whilst the Bank would lend overnight at penal rates to needy banks, its interventions would not venture further down the yield curve for longer maturities. In addition, the Bank would only accept risk-free collateral (i.e. government securities) from borrowing banks.

Last night, you, Chancellor Darling and FSA Chairman Sir Callum McCarthy, turned 180 degrees and bailed out Northern Rock, one of the prime engines (and now self-inflected victim) in the UK of the CDO debacle, for an indefinite amount for an indefinite period and collateralised by mortgages!! And what was the basis for this u-turn, none other than the argument by the FSA that Northern Rock “is solvent, exceeds its regulatory capital requirement and has a good quality loan book.''

Let’s just take these points one by one, shall we?

IS SOLVENT
Rather than start off by tossing the words of your own regulations back in your teeth, let’s just use the definition of Solvency as given by the Reserve Bank of Australia:
“… it is the capacity of an entity to meet its financial obligations as they fall due. Solvency may be expressed as maintaining positive net-tangible assets ... in short, having sufficient cash and cash sources at times when long-term obligations and claims become due.”

But what does this mean in practice? Simply, that a bank’s solvency depends on its ability to retain the confidence of both its depositors and the financial markets or institutions on which it may rely for funding.

The fact that Northern Rock had to turn to the BofE to fund its liabilities, because it could not raise sufficient funds under its own power in the public markets either from depositors or other institutions, means that it is insolvent.

EXCEEDS ITS REGULATORY CAPITAL REQUIREMENT
According to the Lex Column of today’s Financial Times, “based on its current market capitalisation (Northern Rock) barely exceeds core tier one capital.”

For those of you who are wondering, tier one capital is a term used to describe the capital adequacy of a bank. Tier-one capital is core capital, this includes equity capital and disclosed reserves. Equity capital includes instruments that can't be redeemed at the option of the holder.

At present, until the full introduction of the Basel II capital reforms, the FSA requires a bank’s tier-one capital to be no less than 8% of the entities risk weighted assets. The combined ratio of tier-one capital and tier-two capital (Tier-two capital is secondary bank capital that includes items such as undisclosed reserves, general loss reserves, subordinated term debt.)

To fall below this level of gearing (equity to liabilities) while not desirable is usually not a major problem because of what makes up the normal liabilities of a UK bank’s balance sheet.

Major UK banks’ aggregate balance sheet at end-2006

Sources: Bank of England, FSA regulatory returns, published accounts & calculations.
(a) Includes borrowing from major UK banks.
(b) Includes (among other items) loans to UK-resident banks and other financial corporations and holdings of UK government debt.
(c) Includes Tier 2 capital, short positions, insurance liabilities and derivative contracts with negative marked-to-market value.
(d) These assets are not risk weighted. As a percentage of risk-weighted assets, Tier 1 capital is 8%.

At present, until the full introduction of the Basel II capital reforms, the FSA requires a bank’s tier-one capital to be no less than 8% of the entities risk weighted assets. The combined ratio of tier-one capital and tier-two capital (Tier-two capital is secondary bank capital that includes items such as undisclosed reserves, general loss reserves, subordinated term debt.) To fall below this level of gearing (equity to liabilities) while not desirable is usually not a major problem because of what makes up the normal liabilities of a UK bank’s balance sheet.

Northern Rock's Aggregate Balance Sheet at End-2006

Unfortunately, as you can see, Northern Rock looks nothing like the “average” UK Bank, with only 76 branches supporting its £100+ billion balance sheet. The “key” to their success, as well as their downfall, is their funding base – euphemistically described as “debt securities” - actually securtisations and covered bonds sold into CDOs. The problem is that the bottom has fallen out of the securitisation and CDO market. Thus Northern Rock has had to fall back on the inter-bank market for its funding, most importantly, the renewal of their short-term borrowings. A month ago, Northern Rock was offering flexible fixed-rate mortgages at an annual rate as low as 6.19 percent, according to a press release on its Web site. Since then, the rate financial institutions pay to borrow for three months has climbed to 6.82 percent from 6.28 percent. Add to this that Northern Rock net lending surged 43 percent in the first eight months of the year and you have the makings of today’s disaster.


HAS A GOOD QUALITY BOOK
In fairness, this remains to be seen but at the rate of growth that Northern Rock has sustained over the last several years there is a natural concern as to the quality of their existing book. One thing is for sure, the mortgages that they have put up as collateral to the Bank of England can scarcely be considered equal to UK gilts.

I think it fair to say that on all counts, the argument for rescue is spurious and goes against the very heart of the policy you, Mr. King, announced two days ago.


SO WHY AM I BEING SO HARD ON NORTHERN ROCK?
Because they have earned it! They have been the poster-child for the new and improved, risk-shedding, profit-making financial institution.

Starting from its origins as a modest Newcastle based building society, it has become a financial institution which borrows literally from the world and has thus been able to grow its mortgage book by 20% per annum over the last 3 years.

Last year alone they sold £17 billion in mortgage backed bonds and to date 47% of its mortgage business has been securitized, compared to the UK average of 7%. What makes this all the more ironic is that this scale of activity was made possible in part because the regulator – the FSA - reduce the reserves of cash that an institution needs to hold against loans that they securitise.

So successful was Northern Rock in the use of this “strategy” that were named in January as the "best financial borrower" for 2006 - meaning, most creative in raising funds. That’s right not some bulge-bracket Wall Street or City name but an erstwhile mortgage bank that figured out an end-run around risk.

Did I say an end-run around risk? Well, at least they thought so. After all, the logic is that they benefit because once mortgage-backed bonds are sold, somebody else is sharing the risk. Thus, in the event of a housing crash, a lot of the pain is suffered elsewhere. One wonders if the buyers of these mortgage-backs realize the danger that exists in the rapid lending and churning process. The sheer velocity of turnover calls into question how seriously or how well the original lender, who no longer bears all the burden of the risk for bad lending, takes the credit review process. There is a real risk that such lenders become less driven by concerns about the quality of the debt taken on and more driven by keeping the engine stoked.


SO, WHERE DOES THIS LEAVE US?
Regrettably, it leaves us being led by men like you, men with feet of clay. If the strength of conviction of The Great Troika - you Mervyn King, Alastair Darling and Callum McCarthy - could not last 48 hours, what hope is there that you will be believed again any time soon? You and your colleagues had the opportunity to walk the walk as well as to talk the talk and you failed. You allowed fear of market turmoil weaken your resolve; you let fear dull your wits as you failed to think through the problem carefully. Why did you not work on a plan that would have supported the depositors whilst taking the ball out of the hands of incompetent executives and place it in steady, firmer hands? Surely, if you had the presence of mind you could have pulled together a rescue within days rather than issue a carte blanche to the very people you upbraided only days before. When you said that quick bailouts would threaten “the efficient pricing of risk by providing ex-post insurance for risky behaviour. That encourages excessive risk-taking and sows the seeds of a future financial crisis” did you mean it? Were your words, just that, only words, empty promises to placate the masses and show yourself a "leader" until you were actually called on to be one?

Quo Usque Tandem Abutere, Mervyn, Patientia Nostra?

EPILOGUE
Some 230 years ago, with their backs against the wall, the future of their cause not just uncertain, but almost lost, the hearts and spirits of a ragged band of revolutionaries were lifted by these words:

These are the times that try men's souls.
The summer soldier and the sunshine patriot will, in this crisis, shrink from the service of their country; but he that stands now, deserves the love and thanks of man and woman. Tyranny, like hell, is not easily conquered; yet we have this consolation with us, that the harder the conflict, the more glorious the triumph.

These words galvanised that dwindling army; two days later it crossed the Delaware took Trenton & Princeton and set its feet on the road to victory.

Words do matter, but only when they are coupled with action.

Why, when we need a Churchill, are we given a Chamberlain?

O Tempora! O Mores!


Cassandra

...Cry “Havoc” And Let Slip The Dogs of War…

Over the last week, the cries,
indeed the demands, for further intervention in the present credit crisis have grown shriller and shriller.

At the annual Ambrosetti Forum at Villa d’Este on the shores of Lake Como, a conference of leading global regulators and policy makers, a group of private-sector financiers urged the Fed and the European Central Bank to do much more to reassure investors and thus stabilise the markets.

Jim O’Neill, chief economist at Goldman Sachs, said the credit squeeze confirmed his view that the US economy would grow at below 2 per cent, probably for the next six quarters. “The big issue is whether the Fed can keep it from tumbling over into being a lot weaker.” He suggested the Fed must prevent the US housing market sinking into a depression resembling the Japanese property crisis of the 1980s.

Ken Rogoff, former chief economist at the IMF, said the world was experiencing its “first new-age financial crisis” that was following an unpredictable path and posing new problems for the world’s monetary authorities.

“We are in a window of vulnerability,” he said. “We have reached the point where there is going to be fairly aggressive interest rate moves and if that proves not to be enough then we may see some dramatic regulatory intervention,” he said.

Mr Rogoff even suggested that a further twist in the financial crisis could help clarify issues. “Having a medium-sized bank go under would almost be a blessing at this point because it would give them [central banks] confidence to do something more dramatic.”

My answer to Mr. O’Neil, Mr. Rogoff, and the countless others calling for immediate and dramatic action, i.e., massive rate cuts, is this plea to the Fed, Bank of England, ECB and others – Do Nothing

That’s right – do nothing - let the chips fall where they may, they made their bed(s) let them lie in them, throw the cat among the pigeons, let slip the dogs of war, or use any other cliché you like – it is time that the perpetrators of this disaster be held to account.

We are told that something must be done to forestall a greater economic crisis. This a chant of those who do not want to be held responsible for the wrecks they have made of tens of thousands, if not hundred of thousands, of people's lives.

We have heard this “line” countless times - in the Thrift Savings debacle in the ‘80’s, the Asian crisis, the Russian crisis, the dot.com crisis. Each and every time the central banks and the regulators have spared the “perps” and penalised their nations and their citizens. Bastante! Ça suffit! Das ist Alles! Enough is enough!

Forget about letting a “medium size bank” fail – let Countrywide fail; let Bear Sterns go under. Stop intervening and start letting the “free market forces”, the ones that all these shining examples of unrestrained capitalism are so in favour of when they are crushing their opponents, take control. It will not be the first time – the Fed “allowed” Drexel Burnham Lambert to be liquidated in an orderly fashion as the Bank of England “rolled up” Barings Bank. These loses are sustainable and can be done in good order. This “doing” makes a point that no rescue can – no one is above the law, no one is sacrosanct, no one who plays these sorts of games will be supported at taxpayers' cost. If you take the risk risk you take the responsibility. Period. End of sentence.

You are probably thinking that I have lost my mind – I have not; I have finally found it.

What I, and others, have been trying to do over the last 35+ years is not simply survive the repeated cycles of boom and bust in the financial markets. We have sought actively for a remedy that would end this repeated blood letting. We have used the knowledge and experience we have gained to build the tools and structures that would break the cycle and bring in an era of stable growth in risk asset value and earnings. We have made it our goal to implement this vision of balanced yet quality growth of risk assets; i.e., garnering earnings commensurate with our risks.

The problem is our Lords & Masters, with some notable exceptions, have used our vision, our experience and the very tools we built to control volatility to create more. They are so hell-bent for leather to build bigger and “better” businesses with more profits and bigger bonuses that they have misused the gifts we have given them. They have replaced good risk practices and common sense with the one value that they truly believe in – Greed.

Yes, Gordon Gekko is alive and well. He is not the anti-hero or the antithesis of what they believe and practice; rather he is their patron saint, their guru, their hero, their demi-god. Listen to the words and tell me that this is not the motivation for this new killing field:

Greed -- for lack of a better word -- is good.
Greed is right. Greed works.

Greed clarifies, cuts through, and captures the essence of the evolutionary spirit.

Greed, in all of its forms -- greed for life, for money, for love, knowledge -- has marked the upward surge of mankind.

And greed -- you mark my words -- will … save … that other malfunctioning corporation called the USA.

I am not going to preach but I do wish to point out that the meaning of the word greed, as taken from the OED*, is not merely the desire to take things for oneself but it also involves the denial of the same things to others . Of course, the counterpoint to avarice, which is charity, is the selfless giving to others. I am no idealist to believe that the “markets” are or ever will be run on charity – profit is a real and basic motivator of building and sustaining markets and economies. However, a concern for others need not be banished, as it is all too often has, from the equation. Even if it is only for the selfish motivation to endure and keeping growing one’s business, concern for the “little guy” is essential.

Whilst I am no idealist, I am a pragmatist; I am convinced, more so than ever, that modern risk and reward management is essential to the viability of all institutions. It not only helps them weather the storms of volatility that exist in risk markets, but it actually contributes to their stability, their asset quality and their earnings. We need to take a step back, examine the mistakes that were made and the damage that has been done and set our feet once again on the right path. This will not be easy or painless but it is essential.

I have gone on record here in support of the efforts of the Bush Administration to help out sub-prime borrowers to stay in their homes and their effort, along with the BofE, ECB, BOJ and others, to feed additional liquidity in the market, and finally their call for an investigation by the Financial Stability Forum (FSF)** as to the causes of this present situation. However, I draw the line at the Fed, BofE, ECB, etc., cutting interest rates to create some short-term boom to clear away the blood. Like Marc Antony, I believe that Caesar’s corpse needs to be seen by all if reality is to have a permanent effect on our psyches. This mindless madness must be stopped, and stopped now.

None other than Mervyn King, the governor of The Bank of England, argued the same case in a letter today to Parliament. Mr King stated that the BofE was facing “a balancing act” between its duty to ensure the proper functioning of the the financial system - thereby limiting the effect on the wider economy - and its fear that providing wider liquidity support would “undermine the efficient pricing of risk.”

Mr King warned, “Interbank interest rates rising far above normal levels could put a brake on the economy if they persisted but this was no time to compensate banks that had accepted too many risks too cheaply. If a central bank provided implicit insurance to lenders the next period of turmoil will be on an even bigger scale.”

“The provision of large liquidity facilities penalises those financial institutions that sat out the dance, encourages herd behaviour and increases the intensity of future crises.”

Mr. King agreed that the question of pumping additional liquidity in the system “is the most difficult issue facing central banks at present”, but he also made it abundantly clear that this was the wrong course of action to take as this would believed this would destabilise the markets in the long-term as it would threaten “the efficient pricing of risk by providing ex-post insurance for risky behaviour. That encourages excessive risk-taking and sows the seeds of a future financial crisis.”

Bravo, Bravo, Bravissimo, Mr. King! Hold to your convictions and let them echo from London to Washington & New York, to Frankfurt, Paris & Brussels, to Tokyo & Beijing, and across the globe. Else-wise, the epitaph of this generation may well read the same as that of Louis XV, le Bien-Aimé, “Après moi, le déluge”

Cassandra

* Greed is the selfish desire for or pursuit of money, wealth, food, or other possessions, especially when this denies the same goods to others. Oxford English Dictionary

** The Financial Stability Forum (FSF) located at the Bank for International Settlement (BIS) is a body of finance ministries, central banks and regulatory bodies from leading financial centres created after the Asian financial crisis. It was convened in April 1999 to promote international financial stability through information exchange and international co-operation in financial supervision and surveillance. The Forum brings together on a regular basis national authorities responsible for financial stability in significant international financial centres, international financial institutions, sector-specific international groupings of regulators and supervisors, and committees of central bank experts. The FSF seeks to co-ordinate the efforts of these various bodies in order to promote international financial stability, improve the functioning of markets, and reduce systemic risk.

Investment Bankers March on The New York Fed

Chauffeur-Driven Protest Leads to Arrests

Demanding further intervention from the Federal Reserve to protect their endangered fortunes, tens of thousands of members of the Wall Street investment banking community marched on New York Federal Reserve Headquarters yesterday.


Hailed as “The Militant Mega-Millionaires March” the protest was said to be the largest chauffeur-driven demonstration in US history. Some of the protestors were exhausted and dehydrated after the grueling 3-block drive from the New York Stock Exchange and were revived with bottles of Krug, Clos du Mesnil (1995). Paramedics wafted burning stacks of 100 bills under the noses of many others who were about to go into shock

Limousines started jamming the streets at approximately ten in the morning as the irate I-bankers converged in front of the Federal Reserve building to demand stronger action to protect their imperiled riches.

Chanting “No Rate Cut, No Peace,” the furious moneymen were doused with water hoses by police as their protest took a violent turn with pictures of Ben Bernanke and Hank Paulson being burned in effigy. Others attempted to chain themselves to the Fed doors only to be freed by police with bolt cutters. Many were carried into paddywagons (black mariahs) while still chanting their slogan or singing "We Shall Overcome."

Roger Cashman, a major player in Private Equity, said that the fear and anger that has developed over the last month in the financial community was “a volcano waiting to erupt.”

“We have yet to see the full effects of this crisis ... When these guys have to cut their trophy wives’ pocket money, not to mention their "girlfriends", there’s going to be hell to pay.”

His words were eerily prophetic as, late in the day, mobs of angry trophy wives & wannabes roamed at will across large sections of the Upper East Side of Manhattan looting Bergdorf Goodman, Saks Fifth Avenue, Bloomingdales and Harry Winston’s, ending their rampage at Henri Bendel where they stripped the boutique of its entire winter collection.

The fear is that if the Fed fails to intervene on 18 September to lower rates this ugly situation will only get uglier.

“I you think these guys are mad now,” Cashman said “wait until they’re down to their last hundred million - they will be like wounded wolves; it will not be a pretty sight.”


Cassandra

"Sometimes A Cigar Is Just A Cigar."

*

An old and dear friend of mine, Aeneas, wrote to me last week and brought up several very trenchant points about the present “situation" in the risk markets which I would like to share with you:

“It is interesting that so much of the recent discussion in the media has been focused solely on the sub-prime side of things. While this is sizable and serious most seem to be ignoring the impact of the massive risk re-pricing is going to have on the lower regions of the high yield market.

As you point out in your first entry, all of those covenant “lite” etc. deals done have been predicated (as always in a an overheated lending market) on the Ponzi-like need to churn the re-financings to keep some of these deals/ companies afloat. The exposures there are also stashed in a thousand out of the way CDOs which will become painfully clear over time.

This whole episode reminds me somewhat of the Latin debt crisis of the 80's in that all those petro-dollars had to be put to work somewhere which lead to a wide range of over excited lenders doing stupid things on a large scale, the most obvious of which was in Latin America.

This time around, the dollar amount is larger and the diversity of the outlets wider. Adding in the CDOs and derivatives and Mr. Toads Wild Ride is just getting started!"

Aeneas echoes a growing sentiment amongst regulators and market makers - one that we have heard from the lips of Hank Paulson, Ben Bernanke, Bob Diamond and a host of others - the re-pricing of risk is an essential element of any lasting recovery. The problem is that this will be accompanied by enormous pain and, potentially, great disruptions in the market. To date, the media, the pundits, and the Pollyannas who hope to wish this all away, have not had the fortitude to tell the truth, as unpleasant as it may be, so I will. To paraphrase "Old Blue Eyes" - "It's a real good bet, the worst is yet to come!"

And why? Because, as Aeneas noted, we have spread the toxin, oh so cleverly, across the globe - rats in the 14th century have transmogrified into CDOs in the 21st. The time has come to recognise that, once again, we have blundered with our modelling. The rating agencies keep talking about how strong the statistical base is on which the models were built and do not take kindly to the suggestion that, just maybe, the models did not and, of course, could not, factor in the double whammy that has occurred - an incredible growth in CDO and CDS issuance combined with the failure of the tranching mechanisms to properly identify and price risk - because there were no statistics on which to base such a supposition; that is, until now. These models live and die by the probability that defaults will not exceed a certain number in each tranche. In the specific structures that have collapsed this supposition has been demolished by the reality of a massive number of defaults which have drained the structures of their value.**

As is an all too human trait, we are now seeking to place the blame and, of course, the rating agencies are in the cross-hairs. However, the errors should not be laid solely at their feet, as the drivers for this disaster are legion. As Aeneas pointed out there is the "wide range of over excited lenders doing stupid things on a large scale". In addition, there are the legal and tax regimes that have created the gaping maw - which must be fed - that we call "Private Equity". Had we but thought through the process more carefully, we could have foreseen this present state. Every lender/debt issuer/regulator, needs to ask themselves, these two questions:

How could we have thought that we could lend billions, at incredibly low rates, to finance the buying of firms from their shareholders, thus creating highly leveraged entities, and somehow, through the "magic" of new structures based upon new, untested models, make risk disappear?

How could we have assumed that millions of people, who did not meet realistic standards of financial stability, could buy homes, with little or no equity, and somehow not run into trouble when a downturn took place?

The answer, while painful, is simple, we closed our eyes to risk; we failed in our fiduciary responsibilities.

To quote, as I did in my first posting on this Blog, from another portion of Alan Greenspan’s speech to the OCC in October, 1999:

“As I have indicated on previous occasions, history tells us that sharp reversals in confidence occur abruptly, most often with little advance notice. These reversals can be self-reinforcing processes that can compress sizable adjustments into a very short period. Panic reactions in the market are characterized by dramatic shifts in behaviour that are intended to minimize short-term losses. Claims on far-distant future values are discounted to insignificance. What is so intriguing is that this type of behaviour has characterized human interaction with little appreciable change over the generations. Whether Dutch tulip bulbs or Russian equities, the market price patterns remain much the same.

We can readily describe this process, but, to date, economists have been unable to anticipate sharp reversals in confidence. …

Nevertheless, if episodic recurrences of ruptured confidence are integral to the way our economy and our financial markets work now and in the future, the implications for risk measurement and risk management are significant.

This market has enriched the private equity barons, the sub-prime "flim-flam" men and the legions of traders and speculators who have fanned the flames. Some have already paid the price, particularly the sub-prime inveiglers, certain of the CDO creators and salesmen, and even the heads of an i-bank and a rating agency; many more will pay the price in the weeks and months to come – high on the list those lured into debt hoping that the promises they heard were true, and then all of us who rely on the markets for our livelihoods and the funding of our retirements.

We need to find a way to handle the living whilst burying the dead. One important aspect of this is to constantly stress, at every level of our financial institutions, the need for good solid risk and reward skills that are not constrained because of arguments over “the growth of the bottom-line” or “strategic market forces” or "I have this great model that can help us make money and take no risk." We need to remember Freud’s warning applies, undoubtedly in a way he never intended, to risk as well - “Sometimes a risk is only a risk.”

At the danger of appearing to be self-serving, I will end this posting with the ending of Mr. Greenspan’s OCC speech:

“... Boards of directors, senior managers, and supervisory authorities need to balance emphasis on risk models that essentially have only dimly perceived sampling characteristics with emphasis on the skills, experience, and judgment of the people who have to apply those models. Being able to judge which structural model best describes the forces driving asset pricing in any particular period is itself priceless. To paraphrase my former colleague Jerry Corrigan, the advent of sophisticated risk models has not made people with grey hair, or none, wholly obsolete.”

My thanks to Aeneas for his thoughtful and thought-filled commentary; your contribution to the debate, as always, is appreciated greatly.

Now, who will be the next one to comment? Stop lurking and get working!


Cassandra

*This statement, famous but apparently unsubstantiated, was made purportedly by Sigmund Freud in response to a question during his famous Clark University lectures (September 1909). Freud had been describing the latent sexual meaning and significance of dream symbols, when someone asked, "You seem to smoke a lot of cigars, what does *that* symbolise?" and he answered "Sometimes a cigar is just a cigar." I have used this quote, even though no one can find an exact written reference, because it is consistent with Freud’s persistent refusal to analyse his own actions, and, besides, it’s a great bon mot.

** Tranching of credit risk is a conspicuous feature of many securitisations and credit derivatives. In “Credit tranching” one creates a multi-layered capital structure that includes senior and subordinated tranches (classes). For example, a securitisation of commercial mortgage loans might create 10 different tranches, each carrying successively lower ratings and supporting the tranches senior to it. Different tranches within a deal's capital structure present different degrees of risk and have differing performance characteristics. When the deal's underlying assets consist of credit exposures for which default probabilities, recovery rates, and correlations can be reasonably estimated, simulation techniques offer a convenient approach for pricing different tranches and analyzing their risk-return characteristics. (Quoted from "Tranching Credit Risk, Examples with CDOs", Nomura Fixed Income Research. 8 October 2004)

Cassandra's Note: Unfortunately, the modelling & simulation techniques that created and priced these tranches are exactly what have failed in this present sutuation.