Financial Services Authority: bird's eye view

We expect the FSA to be like a hawk, an owl, an eagle, a warning look-out, noting smallest signs of foolish risk-taking, a regulator bird of prey... if the FSA is bird-like, it's not a 'raptor' as per 'bird of prey', more a vulture, a Turkey Vulture Shaver probably? Raptors kill their prey. Vultures, also crows and ravens, eat carrion, Nature's and our road-kills. In the 1980's Charles Sibley, using DNA-DNA hybridization to check genetic taxonomy of avian species, found vultures especially perplexing. Tweny years on, no academic consensus has been reached. So it is with the FSA (set up in 1997 to amalgamate financial regulators, much as the G20 agenda hopes to do by creating a global IMF umbrella inter-linking bank regulators worldwide). The FSA started out well, but had so much to do, and then along came Basel II. It is by far Europe's biggest regulator. Half of Europe's financial assets are variously managed or operated in London and the UK. The FSA is smaller than the USA's SEC, but has twice the scale of work,. The SEC (set up in 1934 after the '29 crash) receives half a million statements from over 100,000 firms but actually supervises 16,000 securities firms and can only scrutinise about one in seven annually. The USA's FDIC and the regional Federal Reserves cover banks and other firms taking deposits and selling loans etc. The FSA has relatively more to do but much less resources. Its budget is charged to the firms it supervises. It covers all financial sectors and 28,000 firms. It approves over 170,000 persons. It regulates, monitors, supervises, licenses insurers, investment funds, brokers and banks (about 400 UK licensed banks and building societies including foreign-owned). The flow of new regulations, especially CRD (Basel II and Solvency II), and their complexity is enormous, on top of a great number of other laws and procedures, plus national and international coordination - hard for anyone at the top to fully comprehend. It is unimaginable how the jobs of the FSA or the SEC or other such large agencies today could be done, publications alone, without the internet. Compared to ministries of state, the FSA is a minnow, yet it has jobs to do as important, broader and deeper, and a lot more difficult technically. The sums involved in bailing out the banking system are such that now everyone can see just how serious all this is. This graphic shows only a fraction of the UK response. The FSA has a budget of about £350m and employs 2,700 spends two third of its budget on staff costs. The SEC has 900 more personel and twice the budget of the FSA, only half the number of firms to closely regulate, most on a rolling 3 year basis, and even it should be doing much more. The FSA staff and budget is slightly more than the Bank of England, but the FSA probably does several times more work, or it should be doing that much more if it was properly resourced. The FSA's work is as varied and complex or more so than any of our largest banking groups. It acts in theory like a non-executive oversight, to challenge executives like a massive audit committee. The UK has sought to have regulation cheap, not slightly cheap but at least 4 times too cheap (my guess)! Some people imagine regulation is like health-checks. Get the patient in, stick monitors on, go through some tests and scans, process the data, and then ask some searching questions like do you smoke, drink, suffer anxieties, take medications, but exercise enough? Then, if complaints persist, we expect the FSA to write a prescription? Unfortunately, there is a large element of that being how the FSA itself thinks, it is here to help the clients get well, to work with them, privately, collaboratively, non-threatening except in most exceptional circumstances, an emergency. Now its plague and the FSA hasn't got the manpower or the equipment for the job. It has to rely on risk teams in the banks and that's a curate's egg too. There are massive health-check manuals, but regulation is based on expecting the banks and others to read and comprehend it all and mostly self-medicate. In a mature stable world when all the new reulations are one day well imbedded and second nature for bankers, insurers and so on that might be possible, but it is very far from possible today. The FSA is certainly negligent and partly culpable for the credit crunch, but not nearly so much as he regulated firm themselves. And government with the FSA has some self-assessment to do as to whether the FSA has been at all adequately resourced? It has not been light-touch regulation though. That's a myth. The regulations are heavy-duty, comprehensive and even brilliantly conceived, elegant, legalistic, comprehensive, but presuming on a level of intelligence, priority-setting nd resource commitment by banks and others that is simply not happening more than half as much as should be. Where the FSA has fallen down is in the expertise of people and systems at both the FSA as well as the banks. The mass of guidance reports, firm rules, reporting requirements, processes advised, and scrutiny is enormous. The flow of publications exceeds that of any other of Europe's regulators. But, the FSA should have warned of the risks of being under-resourced! Risk experts are in very short-supply, high quality experts as rare as sea-eagles, and the FSA has a constant problem of staff being poached. Audit firms cannot take on the burden, not yet. They are not tasked to cover risk - while they have expertise not enough of that either. Will the full scale be fully addressed now, probably not! There will be 10% increase in FSA professionals to be trained up, when several times this are needed.
Hector Sants today, yet again, defended the FSA while at the same time accepting some blame. but not enough ruthless self-assessment. Echoing his boss, Lord Turner, Hector Sants blamed the credit crunch on world trade and payments imbalances and politically-driven credit-boom culture. (This is noteworthy: These causes are new, gaining recognition in the last few months - from economists and models that predicted the crisis - the Levy Institute models of my economist friends Wynne Godley, Alex Izurieta, Francis Cripps, Gennaro Zezza, Marc Lavoie and others now lauded as seers in the WSJ, FT, UN, Goldman Sachs, Cambridge Judge Institute and elsewhere by Paul Krugman, Martin Wolf and others.)
Sants said today (echoing his Chairman's view Lord Turner): "...the main drivers of the crisis as follows. ...a set of macroeconomic and macro-prudential issues... global imbalances caused by the response of the Asian countries to the last crisis... period of historically very low interest rates and in general globally, particularly in the US, a drive by the wider authorities – governments, finance ministries and central bankers - to encourage a significant credit boom particularly for the benefit of consumers who wished to purchase housing. In addition ...a set of cultural drivers ...that credit was good for votes and ...it would be possible for the authorities to avoid a boom/bust culture." This is well and good, but problems persist in that we don't have models that fully link the macroeconomic to the financial sector in enough detail to guide the micro-prudential or even to assess the impact of government bail-out measures. Clues will come out in the wash only when we see how the top US and European banks complete the scenario stress-tests they have been tasked with - something Basel II regulations have insisted upon for years but too few people in the world have known how to accomplish. The big question is can banks be saved from making the recession worse by withdrawing credit and will better regulation play a role in this now? Then in a mea culpa, not unlike David Cameron's today apologising for the Conservative Party's failure to warn about the credit-boom economy (as a challenge to Gordon Brown to do the same), Sants went on to say, "These wider social and economic drivers were ...facilitated by ...weaknesses in the regulatory framework, ...in respect of the rules, particularly in the way the prudential and accounting regime works in a procyclical way, but also ...fragmentation of the regulatory architecture both in many national locations and globally." This is the FSF, IMF and G20 agenda view.
In taking this to the FSA's role, sants said, "..in the UK... the principal gap in the regulatory architecture was in ...‘macro-prudential’, with the local supervisors of the FSA primarily focusing on individual companies and the central bank on interest rates. There was also, here in the UK, an inadequate depositor protection regime and bank resolution mechanism." No reference to Bank of England's role in Systemic Risk monitoring and its warnings in stability review reqports!
Sants said, "Other countries... had ...in their regulatory architecture ...massive fragmentation, such as in the US which led to a lack of oversight ... of which AIG is the best example... lack of oversight of ‘bank-like institutions’, otherwise known as 'shadow banks'. So... economic... social and cultural... regulatory... market participant drivers ...failure of market discipline: markets did not self-correct... underpinned by ...investors and ... those who sell products not to ...'buy things you don't understand'... facilitated by credit rating agencies. Investors and banks ...too willing to accept their analysis as relevant to a whole set of risks ...not actually addressed by the research of the agencies... structural failures ...magnified by ...governance failures and poor business judgements by the financial institutions themselves." The above provides blanket criticism but also get-out sub-clauses; blame fully-risk-dispersed!
Sants, "The key question then is where do we go from here and ...minimise ...this sequence of events ...happening again recognising... a belief we can fully abolish cycles' is an illusory goal? ..in seeking to learn lessons ...be very careful that we are not sowing the seeds for the next crisis. ...FSA's view ...will be laid out in our Discussion Paper ...18 March... responses that the authorities in aggregate can make... the FSA has already embarked on a programme of change ...greater supervisory resource of a higher quality... 280 extra specialist and supervisory staff ...30% increase in our supervisory capacity... new Training & Competence scheme ... right mix between professional regulators and market practitioners. ...working in partnership with the Bank of England and the Treasury ...it is as a supervisor that we should be primarily judged ...under two headings: 'our philosophy' and our ‘operating model’... FSA characterised its approach as evidence-based, risk-based and principles-based. We remain, and must remain, evidence- and risk-based but the phrase 'principles-based' has...been misunderstood... principles alone is illusory ...policy-making framework does not allow it. ...limitations of a pure principles-based regime ...does not work with individuals who have no principles. What principles-based regulation does mean ...is moving away from prescriptive rules to a higher level articulation ...emphasise that what really matters is not that any particular box has been ticked but rather that when making decisions, executives know they will be judged on the consequences - the results of those actions... FSA, when it supervises, needs to supervise to a philosophy that says 'It will judge firms on the outcomes and consequences of their actions not on the compliance with any given individual rule'... 'outcomes-focused regulation'. ... philosophy was that supervision was focused on ensuring that the appropriate systems and controls were in place and relied on management to make the right judgements. Regulatory interventions would thus only occur to force changes in systems and controls or to sanction transgressions based on observable facts. It was not seen as a function of the regulator to question the overall business strategy ...possibility of risk crystallising in the future." This is saying FSA was not responsible for criticising and stopping or changing the Northern Rock business model or similar models of excessive liquidity concentration risk. A look back to see that defaults could rise 3-400% higher than currently experienced in 2007. Funding risks were also not that hard to look back historically to see they could also suddenly spike sixfold.
Sants on the future: "...we will seek to make judgements on ...senior management and take actions ...to risks to our statutory objectives ...moving from regulation based only on observable facts to regulation based on judgements about the future. This will of course carry significant risk and our judgements will necessarily not always be correct with hindsight. Furthermore, too aggressive intervention will stifle innovation and arguably reduce risk to a level that inhibits economic prosperity. ... what society as a whole expects regulators to be doing... what they thought we were doing. This more 'intrusive' and 'direct' ...'the intensive Supervisory Model'. ...'our credible deterrence philosophy' ...use all our powers including criminal prosecutions to deliver our mandate ...not ducking that responsibility. This week the first of our insider dealing criminal prosecutions has come to trial ...more in the pipeline." In the USA, the FBI already has over 200 such prosecutions in their pipeline.
Sants: "There is a view that people are not frightened of the FSA. I can assure you that this is a view I am determined to correct. People should be very frightened of the FSA... focuses on delivering credible deterrence in respect of its Financial Services & Markets Act (FSMA) mandate... on market-related offences ...not seek to be the responsible agency for prosecuting financial fraud in its ‘conventional’ or wider sense. ...responsibility is shared elsewhere and ...was not taken seriously enough but we are clear about our responsibilities and are delivering on them. To split enforcement powers from supervision would in my view make both tasks immeasurably more difficult... A comprehensive understanding of risk requires both prudential and conduct oversight responsibilities. The idea that 'twin peaks' regulation would have helped mitigate the current crisis is, in my view, not supported by events at all. Events such as the failure of AIG clearly demonstrate the value of integrated risk assessment delivered through a single supervisory authority. As the FSA ...was an operational and managerial failure in our supervisory area which was responsible for large UK institutions but the response to that should be to address the operational failure not to change the operating philosophy and structure. The problem was not structural, it was cultural. Much has been made recently of the importance of understanding business models. The twin peaks approach creates structural barriers to a full risk assessment of an institution and would sow the seeds of the next crisis. My second point, however, is to emphasise that effective risk assessment of a firm requires industry knowledge and ...not done in the past, but will be done in the future...involve both central banks and supervisors. The process should be 'top down and bottom up'. It needs to be a balanced partnership. My third point ...greater emphasis on outcomes testing relative to ...systems & controls. In the past ...focus was ...adequate management information and controls ...relying on management to address the issues. ...we will switch resources to outcomes testing...e.g. 'mystery shopping' and 'branch visits' rather than detailed reviews of high-level management information. This switch to outcomes testing is also central to the delivery of 'credible deterrence'." This revives ARROW reviews approach, which did frighten the horses, while detailed assessments did not because the ultimate penalty was taking away a bank's banking license and no bank believed in that threat! Now the climate permits FSA to recommend change of management, penalties and reputational criticism in public, "name and shame". This will be backed by the Treasury Committee report.
Sants: "..this switch causes risks... due to finite resources, we cannot test all outcomes and failure will be missed... ‘with hindsight’ criticism....better if the systems limitations were recognised, upfront, by all. ...changes are required but ...not realistic that we could deliver to perfection. ... fourth and critical ...delivery of supervision has to be done in partnership with responsible firms, shareholders and auditors. The supervisors cannot operate alone. All ...must ensure ...strategies and behaviours ...greater engagement by all ...in particular by shareholders and the non-executive community... central to this ...non-executives responsibilities... need to commit more time and raise their technical skills to exercise rigorous oversight. ...more support and indeed compensation for these individuals... more willing to challenge executives. ... more like full-time 'Independent Directors'. Sir David Walker’s report ...addressing these issues in more detail ...we cannot ignore that the principal responsibility for managing firms responsibly lies with the management themselves. ...ultimate responsibility for what has happened rests with firms’ senior management. ...specific decisions and strategies can be seen to be at the root of those firms' demise. ...improve the quality of management decision making to minimise failure. Yes, regulators can intervene more decisively, ...management could have greater technical skills ...through changes to our authorisation process ...to judge competence as well as probity. ...issue is behavioural. Markets have shown not to be rational; excesses have not been corrected by market discipline. ...managers... must acknowledge and fight against the ‘herd mentality’; ‘the collective wisdom’. ...'Do not take risks you do not understand.' 'Ensure the focus is on the long run franchise and profitability of the institution not the short term. 'Ensure a healthy and ethical culture in your organisation!' 'Recognise the future is not predictable and ensure at all times you understand the circumstances under which your firm will fail and that you are happy with the degree of risk mitigation you have.' 'Ensure a healthy and thoughtful culture of challenge from the independent directors.' These rules ...regularly ignored.... financial markets are not rational but ...a behavioural system built around personal aspirations is critical ...changing this time round... this crisis the reaction of society ...a contributor to the severity of events. ...a negative feedback loop... between wider society and the financial sector has been a unique characteristic of this crisis. ...require further consideration by us all... FSA has been seared by recent events but it is tougher and better as a result. The FSA has grown up." The idea of principle-based stated as late as Dec.08: "Detailed rules clearly have limitations. They have not always delivered the outcomes they were supposed to achieve. Detailed rules cannot cover all circumstances and eventualities - we cannot hope to devise a set of detailed rules to cover all types of business and all types of firm; and we cannot expect detailed rules to be responsive to market innovations and structural changes. Detailed rules tend to address processes, not outcomes - this can encourage a narrow approach to compliance, and can inhibit innovation and competition. And regulators need to avoid tackling problems by writing yet more detailed rules to address yesterday's problems - shutting the stable door after the horse has bolted."
There is sophistry here. It is based on the FSA's limited resources. The banks in practise could only adequately implement the regulations when they had detailed guidance. Primnciples, though just as mandatory, they found hard to implement, hard to do anything when innovation and some creative judgement was required. What the shift to principled-based supervision really reflected was not just being under-resourced and having insufficient expertise, but also a view that Pillar I, the quantitative accounting of current financial risk positions was completed and banks had to next move on to Pillar II, which everyone said was really about qualitative assessments and supervisor challenge. This was a general mistake, mistaking the principle-based definitions of Pillar II for qualitative and failing to see the massive amount of quantitiative modeling in economic capital models and how to integrate liquidity and all other risks. This is only being discovered now with scenario stress-tests in the wake of the credit crunch being placed centre-stage in risk management.
Principle-based supervision sought to shift the burden onto the banks and for some reasons, like 'innovation' and 'competition' imagine this is better? Basel II regulation is principle-based where it becomes too complicated to explain everything in precise etail. Bankers should understand, and also that the requirements have the force of law, therefore must be implemented thoroughly. In the UK it seemed that the legal force of Basel II was under-estimated. Verena Ross in a Dec 08 speech explained the new FSA policy in terms also of the need to convince Europe to follow the UK lead saying,"Finally we are also conscious that regulation and legislation that is coming from Europe is not always yet written in a fully principles-based way and ...we need to take a more prescriptive approach than we would probably have decided ...working actively in Europe to ensure that the Commission and other member states move increasingly towards more principles as well... worth at this point just dealing with some of the myths ...FSA's regulatory approach...being described as "light-touch" or "soft-touch". We are emphatically saying that it is not... It is purely about how we best achieve that regulatory standard ...we continue to regulate the areas ...in the most effective and efficient way ...We strongly believe that the more flexible approach ...is the right way forward ...we have limited regulatory resources ...we need to allocate ...where the greatest risks are... risk-based and proportionate, certainly not "light-touch". ...recent events surrounding the credit crunch, more properly called liquidity crunch ...reinforces, rather than contradicts the need to focus on the outcomes ...than just on the compliance of the action with a set of detailed rules. We are not operating a zero failure regime. We recognise that a successful financial market place requires innovation and competition and... there will occasionally be failures. But ...a more principles-based regime provides the best chance of achieving the requisite balance between benefits and risks ... such as conflicts of interest management or stress-testing, ...very difficult to ever have very prescriptive rules in those areas... businesses and their circumstances ... difference needs ...a flexible approach ...of either managing conflicts or conducting proper stress-testing." Note where this ends up! All roads in regulation and bank bailouts now lead to stress-testing, to Pillar II of the three Pillar Basel II. Banks and others failed to understand that it is not the accounting in PIllar I that is the essential detail, but the economic capital modeling in Pillar II that holds up and makes sense of the risk regulations. Just like liquidity risk was bottom of most banks' risk agenda until he credit crunch crunched them, so too was stress-testing the treated as least important of all concerns among the banks about getting their numbers right and systems in for Basel II compliance.
Not many can says events have validated their models and predictions. But I and my colleagues can rightly claim that. Getting unwelcome messages through at various banks was almost always a political and bureaucratic thicket.

CITIBANK JITTERBUGS AND PANDIT'S MIDNIGHT CALL: A JAZZ METAPHOR

Assume you know (from the 200 blogs here and of course everywhere else) about market and credit risk, volatility, VaR, fair value accounting, sub-prime, junk-bonds, transparency, hedge funds, credit crunch, and how all of this is to do with liquidity, funding gaps and market confidence, well then you must know metaphorically about Jitterbug, the dance-craze after the roaring-twenties, prohibition, Wall Street Crash, and at the end of Depression 1930s, and, extending the metaphor, I commend bebop as the 1950s music we have to get to when recovery returns. This is about the Citi CEO's 'Midnight Letter'. First, consider the Jitterbug - a very agitating way of dancing round and round or on the spot, like ice skaters flailing about to stay upright. This month the markets were spooked by jitterbugging-fears that Citigroup would be nationalised and or that Government might force bondholders in hard-pressed banks to convert their stock into shares! Short-sellers drunk on their 2008 successes e.g. Paulson hedge-funds $billions of bear-profits, became nervous about timing their short positions and cranked the rumour-mill helped by the Senate throwing down the Federal Budget, and Geithner's as yet empty plan, exaggerated fears about national bankruptcy and whether some big banks, e.g. Citibank, should be allowed to collapse; if small banks why not big banks, anything to avoid future tax-bills, maybe US Auto too. Of course, the sub-prime covered bonds are a scandal, but they still pay good money and have downside protection built-in. The market prices fell to the floor (mark-to-market tough-love fair value accounting) But we have jittered and shuddered beyond that into the recession that was on its way anyway! Recent weeks also saw media shock-outrage at further AIG money (when this was just drawdown on previously authorised TARP funds) and let's let all those financial insurance derivatives just get lost; why save AIG or its counterparties? When Senate Legislators talk that tough you have to wonder what they're politically medicating with, not just what the discredited bankers were smoking. (for detailed answers see: http://www.mcdowellsobamanomics.blogspot.com/) The data is surely clear enough. But, politics takes no prisoners, and outraged anger (US term: to be mad), the catcalls and cabbages were heaped by legislators and pundits on the Federal administration; boos and fears that bailouts and fiscal recovery are all just money-wasting and won't save jobs etc. There was other bad news, including titbits such as Citigroup's MerriLl-Lynch 'bonus bounce' (early bonus awards, in December, resulted in early price down-ticks before 1 January to thereby maximise 2009 performance). Bank shares remained volatile and Citigroup's postage stamp share price fell under $1. The effect of all the above was to knock Europe sideways. The cost of borrowing in European corporate bond markets reached record highs on Tuesday, in a sudden downturn in sentiment that could curb the rush of issuance so far this year. The main index of European investment grade corporate bonds saw spreads hit the highest levels on Tuesday, reaching 478bp, due to investor aversion to financial companies. Financial sector credit default swaps also reached new highs, as did key indices of investment grade and junk-rated corporate debt derivatives. The anxiety spiked Credit Default Spreads as surely as the collapse of Lehman Brothers in September wih inevitable ripples across the pond. Governments had to act and intervene to protect all their 'postage stamp banks', and, in the UK Lloyds Banking Group and RBS basket-cases, political pressures threatened outright public ownership. Quantitative Easing was launched in the UK (first time ever they say, though I can recall oher times when government debt was retired early?) plus the seemingly massive Asset Protection Scheme (together worth £655bn of Bank of England deposit cheques swapped for bank assets and buying-in £75bn of Gilts by end of this month). Bank shares have been wiped over the past 8 months by $hundreds of billions, and wiped out a lot of small shareholders directly as well as via pension and insurance funds. (Note: there is a severe pension cisis that will be variously addressed politically by next year in time for the UK general election. Will there be signs of recovery by then?) We probably won't see that value return for another 5-6 years. But these banks are not insolvent as cash-flow income-earners. They lost confidence of relatively few private sector funding sources. But these are now replaced mainly by Governments that within a few years will be showing large profits for this support, and that will appear as tax-dollar savings to be brought on-budget of government income and spending on public services.
PANDIT'S MIDNIGHT MEMO
Then came the simplest of all confidence-boosts, Vikram Pandit's “midnight magic” of a staff memo, sent just before the clock struck 12 on Monday night. Equity and bond investors could read that Citi is profitable in January and February, in fact, by a whopping $19bn in top-line gross revenues in the first 2 months of 2009 - best period since 3Q 2007. Citi’s battered stock closed up 40c to $1.45, 38%, nice if you were 'long'. Markets have focused too much on writedowns which are adjustment hits that will pass and failed to focus on the underlying strength of banks at the 'transmission-mechanism' centre of the economy's money flows. Market and media-comment jitters have encouraged a loss of perspective (on the double-entry book-keeping of financial accounting), and worst of all, have severely doubted the accuracy or truthfulness of banks published accounts. This does not help. It causes one-sided market bias that plays into the hands of short-sellers (of all kinds including those in politics and the media) not just those in stock-markets? Property, share prices, and other asset price falls have been extreme, but the impact is much less in cash-flow terms, and will, given time, recover. All other cash-flow losses are someone else's profits, and insofar as they live in the same national or global economy, again given time, some countervailing rebalancing will emerge! More than 1.87bn Citi shares changed hands on Monday alone – shorts feeling shorted - 4th-largest volume in US history - heavy buying/selling? Shares in Goldman Sachs and Morgan Stanley spiked up too as investors calculated that they, too, must have gained massive net interest income - maybe too some of the AIG drawdown. But the main gain, the Amtrak for postage stamps, is traditional retail banking gains - borrowing at historically low rates and lending at much higher ones - up too were Wells Fargo and Bank of America. The money markets must be in better balance, less jitterbuggered, more liquid! Is the credit crunch uncrunching? On the face of it, Citi’s profit estimates are not out of the ordinary. Excluding its enormous credit-related losses and loan provisions, Citi’s businesses have generated internal capital gain of more than $20bn in revenues per quarter even during the worst of the credit crunch crisis. Citi’s problem has been that of mark-to-market write-downs on toxic assets (plus some rising defaults on credit cards and other consumer loans) drenching cash-flow earnings, leading to over $18bn p/l loss for 2008. The financial asset losses in the US may be over a third ratio to GDP (National Income) but not a third of national income; that's only falling maybe at worst 6% in 2009 before a 4.5% boost from the government's fiscal stance? Property values are down maybe a third ratio to GDP too, but far less in income impacts. 5 million jobs have gone, but Government expects to recover three-quarters of that and private sector should do the rest over the next 2 years. Jitters all round, but not time for panic, or not if those in charge of policy including the legislators hold their nerve. The main panic seems to be public confusion about what is or is not tax-dollars. Three-quarters, perhaps four-fifths, of government financial measures have nothing to do directly with tax-dollars. Taxpayers may not like it, but Government has its own financial resources that are financially asset-backed and separate from tax-dollars! Maybe that is the steepest political-learning curve right now? That's a $100bn off the $500bn+ assets-for-sale, or about 80% of the bank's capital - but, hey, to experts (like me) that's just power-for-the-course, so why worry? Maybe Citi is gearing up for an April net profit announcement for the first quarter, maybe other big banks too, wouldn't that just be a great gift for the G20 colloquium in London on April 2.
As importantly, big banks, like Citigroup which may be about to cede 36% stake to the US government in return for more rescue capital asset swap, must prove they can sustain underlying earnings (capital generation) consistently quarter after quarter.
This is also a vital message to non-bank lenders into big banks MTN programs. That puts a great floor under government' risk planning and under everyone's stress-tests. Pandit gave few details of where Citi’s earnings come from but people close to the company told the FT it is not just trad-banking but also the investment bank did well in credit and equity underwriting as well as M&A. Investment-grade corporates tapped investors for $billions and rediscovered their appetite for mergers e.g. the two big pharma M&A, but also GE, AT&T and, of course, the banks themselves. Citi advised Spain’s Acciona $14bn sale of a stake to Italy’s Enel. Costs in Citi also fell $8bn and there were gains on the rising costs on Citi’s debt, a perverse but permissible accounting that boosts the bottom line.
The financial gyrations of big banks and why big is also too big to fail, brings us smartly to the jitterbug metaphor for the credit crunch economic-cycle. Ken Clarke, QC MP, UK Chancellor of the Exchequor, 1992-97, and current Tory shadow-business minister (who was not afraid of deficit spending despite always talking fiscal prudence) hosted a programme on radio 4 with Soweto Kinch on Charlie Parker and bebop and praise too for Dizzie Gillespie - music for our times? Are the '50s ahead of us again soon after the present war-economy (1940s) days as Warren Buffet and Jamie Dimon (JP Morgan Chase) metaphorically describe them? The dissidence of Jazz and swing from the late 30s to the 50s, saw Jitterbug become Swing (various types: Lindy Hop, Jive, West Coast Swing, East Coast Swing, or anyone dancing to swing) e.g. top-notch jitterbugging, jumping around, cutting loose and going crazy. The G20 London conference has as its aim to pin some global order on all corners of the global credit crunch recession. We just need to do all we can, pulling together (including severely curtailing the irresponsible leveraging of short-sellers) not to languish much longer in the war-economy equivalent of the '40s - when Europe and elsewhere failed to heed the message of democracy and economic recovery and governments everywhere had to control the commanding heights of the economny.
Jitterbug comes from a slang term for alcoholics who suffer "the jitters" (delirium tremens) and then became associated with dancers who dance with abandon or without formal knowledge of dance, 'jitterbugging', which just about sums up the public view of our 21st century investment bankers. They made up their moves, structuring deals every which way, and just presumed that funding would always be available, that someone else would always pay for musicians to keep on playing the same music. Structured products such as CDOs and credit derivatives could not be better described than by the jitterbug recipe:
If you'd like to be a jitter bug,
First thing you must do is get a jug,
Put whiskey, wine and gin within,
And shake it all up and then begin.
Grab a cup and start to toss,
You are drinking jitter sauce!
Don't you worry, you just mug,
And then you'll be a jitter bug!
Don't imagine, however, that structured product finance is over. It's biggest issues have been iin the last 8 months. ABS (RMBS and CMBS etc.) while arguably part of the cause of the credit crunch, they are also a big part of its solution. The difference now is that the government is paying the jitterbug musicians and calling the tunes. The surburban middle class (structured product brokers) learned to dance jitterbug by going to the black sections (credit risk rating agencies) learning to dance smoothly (ABS cash-flow smoothing), without hopping and bouncing around - The hardest thing to learn is the pelvic motion... somehow obscene (AAA ratings for junk and fat fee bonuses). You have to sway, forwards and backwards, with a controlled hip movement (dodging the historical default data), while your shoulders stay level and your feet glide along the floor (traditional net interest margins). Your right hand is held low on the girl's back, and your left hand down at your side, enclosing her hand (tail-risk sales-patter)..
Next stop is bebop. Taking the above culture and making it more sophisticated, culturally intelligent and working to a shared rhythmic sense. Whatever dissidences are contained in the new products will be comforting, interesting and enjoyable, not panic-making or stock-market jitterbugging.
For more on the US banking and economics see: http://www.mcdowellsobamanomics.blogspot.com/
For the music listen also to:
http://www.bbc.co.uk/iplayer/episode/b00j0c2f/Ken_Clarkes_Jazz_Greats_Series_7_Charlie_Parker/

DIMON SAYS, "TIME FOR NEW IDEAS IS OVER"

Larry Roibal ballpoint on newsprint sketch of JAMES DIMON CEO JP MORGAN CHASE
If any banker has succeeded in remaining above the carnage, and to the extent of, marvel of marvels, beinmg considered a hero of the hour it is Jamie Dimon, CEO of JPMC ($2.2 trillion assets). I watched him today give a judicious rabble-rousing confidence-boosting speech about our prospects of getting out of the credit crunch and recession crisis. He message was refreshingly simple, "THE TIME FOR NEW IDEAS IS OVER" going on to say that the ideas currently being proceeded with a good enough, not perfect, but if the government, US Treasury and Federal Reserve work well together, and Congress and Senate pull together and stop being a 'House divided', we'll be out of the worst and winning this by the end of the year, 'one of few defining moments in American history' equivalent to an war economy emergency. He had a clear idea of the three-pronged assault: $5 trillions in liquidity measures, TALF of so far $1 trillion in toxic asset funded sales and work-out, plus TARP $0.75tn, $1 trillion in credit insurance guarantees = 55% ratio to US GDP. He could have added $1-2 trillion in fiscal deficit, and a few trillions more in asset protection swaps for bank funding (by my reckoning, $3-4 trillions)over 2 years = total of 82% ratio to GDP, but 70% of it off-budget. If the auhorities continue with their current plans, including managing mortgage defaults by a waterfall system that goes through various contractual adjustment options to get monthly payments down to at most 31% of borrowers' legally verified income. It helps that Jamie Dimon has a look and demeanour of a cross between funny but politically-savvy talk-show hosts, David Letterman and Jon Stewart. He can take technically complex issues and make them easy to think they are well enough understood to be televisual and readily commanded with gusto, which is not how most experts ever discuss fair value mark to market accounting! Dimon talks expansively about reform priorities that he sees including doing something about the fragmntation of regulation, also sticking with mark-to-market accounting, but only where it strictly belongs, within bounds of elsewhere sticking with traditional custom of not applying M2M were it doesn't belong i.e. long term investments, inventory and loan accounting, and investment funds shouldn't be adding to volatility by reporting M2M valuations constantly. Some things he clearly sees as problems for next year, not worth getting to grips with just now when the only show in town should be to win through out of the present recession and credit crunch. He acknowledges there is too much accounting flexibility in market risk trading books and this needs severe tightening up - the problem that wiped the share value of Bear Stearns. he believes strongly in the wake-up call of strtes-testing and acknowledges how challenging that is for the banks. He also clearly believes in forensic due diligence accounting. This follows from JP Morgan's culture, and that of Chemical Chase too. These firms were among the leaders in the late 80s in using high powered computing for risk correlation of volatility VaR analysis, across and between all tradable instruments and asset classes. Unfortunately it did not continue on that path long enough and led the charge into derivatives and ultimately also into structured products. JP Morgan has had risk culture as central to its brand immage for decades. Dimon says it is policy at the bank to be afraid. In recent year the bank has been engaged in integrating and networking all its accounting systems onto a high quality common platform. It remains to be seen how well that translates into holistic risk management and economic capital performance. The clues of success are not yet there in its Pillar III public risk statements, but it is noteworthy that despite acquisitions it has a high reserve capital ratio of over 12% to risk-weighted assets, and after taking $35 bn in writedowns and credit losses or 3% of its $1.2tn assets, but that is probably just about the funding support it received from Government. Its share price has largely fallen because its quartely profits have fallen by three-quarters, but any profit is good performance. It should be generating $4bn quarterly net income, over half of it net interest, but is running with about $3bn crystallizing in quarterly credit risk impairments - still very healthy in my view. Basel II he says needs major improvement by the addition of Liquidity Risk (something he may have missed in the regulations literature, or something he wants to see translated into systematic technical detail, not just principles, however prudential and mandatory?) Liquidity management must be a major focus right now in the bank, and if done properly in all and every part of it, monitored in real time every which way on a super-computing platform. He expects to see securitizations become more plain vanilla with originators and arrangers remaining at the table of the issues much as syndicated loan lead arrangers do - a point that goes straight to what brought down lehman Brothers. He and his bank have worked closely with the authorities and the administration, which is one reason for his bank's relative success. He emphasised that JPMC works "on the ground" in 60 countries, which implies of course the emerging markets and global reach that protected HSBC and Santander and Standard Chartered from the credit crunch in North America and Europe. He didn't say that, but it was a message. He said the US Treasury and The fed asked JPMC to take over Bear Stearns, a tough call, but like WaMu too, this is working out. This is important for JPMC's current share price that has slalomed since September when Lehman Brothers was allowed to collapse. I noticed he did not say that the work-out of unravelling the derivatives exposures of Lehmans was going well and causing far less embarassments than expected, as some people do. He also did not mention AIG, the other spider in the cobweb of CDOs and CDS that is thought to be heavily risk-networked to JPMC. But actually, just as the Federal support to JPMC for absorbing Bear Stearns has never been disclosed (somewhere north of $30bn) so too has the ripple through to JPMC of positive cash-flow from funding of AIG or how Lehmans residual exposures have been netted off. He had an interesting back-hand swipe at ABS investors for complaining overmuch about trivialities in their uncertain cash-flows "get over it!" The implication, which I fully agree with as with much else he said or implied, is that direct ABS investors are actually doing relatively well compared to the generality and still earning more than reasonable cash-flow returns when base-rates are at historical lows. Also, of course, foreign investors are doing especially well out of the high $ exchange rate on their ABS interest-income. He delivered a big paeon of praise for Hank Paulson and Ben Bernanke for not be standing back, for getting stuck and fighting the good fight! Jamie Dimon has long had a reputation for being one of the best numbers men around. Whatever he says of the bank's performance or of its acquisitions representing good long-term value, Wall Street listens. Lloyds Banking Group's Eric Daniels has a right to, the skill too, and could and should emulate Jamie Dimon more. jamies doesn't just step to the plate to swing for his bank but also for the American can do culture and for strongly endorsing government for doing exactly the right things with fortitude and intelligence. Gordon brown and Alistair Darling and mervyn King have proven themselves no less, and even been ahead of the curve, compared to their American counterpart colleagues. Those British bankers still standing should be playing the same stalwart innings as Dimon.
The 53-year-old, Noo Yoycker is second-generation Greek-American, has led JP Morgan for two years, steering the bank away from the reputational pitfalls of the credit crisis in a way that Thomas Lamont of JP Morgan would approve by keeping close to Government. In October 1929 in the midst of the collapse five of the country's most influential bankers hurried to the office of J. P. Morgan & Co., and after a brief conference gave out word that they believe the foundations of the market to be sound, that the market smash has been caused by technical rather than fundamental considerations, and that many sound stocks are selling too low. This caused a rally that lasted a day or two. This time round, Dimon is intelligently saying he dislikes making forecasts but if we all pull together and stop political bickering there will be recovery by next year, if not we face several years of severe problems i.e. the 1930s D-word. Dimon said of his own bank that how well it (and by implication all other banks) do is dependent on how long it takes for the economy to recover - and that much is of course exactly right. Today, JPMC and the other banks are crossing the 3% tail risk loss heading for over 5%, and thus we might expect to see JPM book another $30bn writedown and losses in 2009, but that will be easily absorbed within the bank's capital reserves. Dimon's career is the stuff of Wall Street legend. He began with a degree in biology and economics at Tufts, before MBA at Harvard. He befriended and worked with Sandy Weil for 16 years before parting of ways in dark circumstances; Dimon was sacked for holding to a point of moral principle. He became CEO of Bank One, becoming President of JP Morgan Chase when it bought the bank after the dot.com recession. He said today that half of all financial crises and recessions involve property collapses, and that is probably what hit Banc One. Despite taking home some tens of $millions in salary, Dimon is not vulgar with it. On bonus-culture he sayd JPM always rewarded on long term performance, not for "hitting a home run", and not just for financial performance either, which suggests a partnership waterfall trickle down system? It seems as if the government's proposals for reforming remuneration systems will take a leaf out of JPM's policy.
Dimon is pugnacious, direct dealing, who, according to The Times, "can punch the air to punctuate his shouts", and "he invests heavily in philanthropy, does not play golf and is known as a family man who likes nothing more than playing tennis with his three daughters". Those are skills they should teach more of at Harvard.
see also: http://www.bloomberg.com/apps/news?pid=20601087&sid=a3xPFlNxi7i4&refer=home

COMMANDING THE HEIGHTS OF THE ECONOMY - BANK NATIONALISATION - NATIONAL SAFETY OR SOVIET COUP, IDES OF MARCH OR FRANKENSTEIN'S MONSTER?

ONE REASON US, UK AND OTHER CAPITALIST DEMOCRACY GOVERNMENTS (AND NOT JUST SHAREHOLDERS, TAXPAYERS, AND BANK CUSTOMERS) FEAR THE NATIONALISATION OF BANKS IS THAT IT OPENS THEM TO POLITICAL ACCUSATIONS OF FAVOURING SOVIET STATE CONTROL, AND IN THE UK LIKE FRANKENSTEIN'S MONSTER THE LABOUR PARTY’S OLD CLAUSE IV HAS RISEN FROM THE GRAVE. Even Julius Caesar feared the same problem!
The UK Government now owns about half of UK banking (Northern Rock, Bradford & Bingley, RBS that includes NatWest, LBG that includes HBOS and Birmingham Midshires). New Labour remains very sensitive politically to accusations of outright Socialism. I have to wonder whether Peter Mandelson pushing through with large part privatization of the Royal Mail is politically necessary to remind everyone that this Government and Party are not socialistic nationalisers? But when nationalization happens, for whatever reasons, banking is clearly a most sensitive issue. Banking is not like any other sector. After government itself, banking is the ‘commanding height of the economy’. The same is happening in the USA, what some call ‘nationalisation in all but name’. No-one should under-estimate the political backlash that is possible out of liberal-democratic fear of big government and of socialistIC-STYLE state-control.
This is very like the 1930s and 1940s. The political centre favours nationalisation on grounds of clarity, fairness and honesty - if taxpayers effectively own the banks and governments control them then it is only a matter of formally recognizing reality to nationalize! I disagree, not for political reasons, but for financial reasons. Let’s first revisit a bit of history, Clause IV. The original Labour Party Clause IV was drafted by Sidney Webb in November 1917 and adopted by the party in 1918, the year after the Russian Revolution. It read, in part 4: “To secure for the workers by hand or by brain the full fruits of their industry and the most equitable distribution thereof that may be possible upon the basis of the common ownership of the means of production, distribution and exchange, and the best obtainable system of popular administration and control of each industry or service.” In 1918 nationalisation was seen by many as “modernisation” the very term that Tony Blair used repeatedly to replace Clause IV thinking almost a century later. The Labour Party was the main opposition party in the 1920s, and gained power in 1924, 1929-31, a junior partner in the wartime coalition 1940-1945, and in 1945-51, 1964-70, 1974-79, and 1997 until at least 2010, just under 40 of the last 90 years. In the early years we saw, and not always passionately opposed by other parties, national education, but then the US New Deal, the wartime controls, and after World War II, (in US and UK and variously elsewhere across Europe) strategically important institutions and businesses were nationalised in name or all but in name. Postal services and other monopolies inherited from Royalty were perforce government-owned, also water and sewage, and education became in many countries a largely nationalised service. In the UK, after the war, Labour nationalised health, coal mining, railways, canals, civil aviation, telecommunications, steel, power utilities, embarked on public housing, and the Bank of England. Modernisation and the need to invest taxpayers money were the main reasons, but not the only ones. The 1944 Labour Party policy was that of “public ownership” for curing the ‘evil giants of want, squalor, disease, ignorance and unemployment (idleness)’. Nationalisation was led by Peter Mandelson’s grandfather Herbert Morrison who had experience of uniting London’s buses and underground train system into a centralised system in the 1930s. He started with the Bank of England in 1946, whereupon stockholders received compensation and the governor and deputy governor were both re-appointed. Further industries swiftly followed, civil aviation in 1946, telecommunications in 1947 and creation of the National Coal Board (90% of UK’s energy) in 1947, and in 1948 the establishment of the National Health Service and nationalisation of railways, canals, road haulage (briefly), and electricity. By 1951 the iron, steel and gas industries were also in public ownership and de-colonisation was a kind of permission to nationalise e.g. British India and African dependencies. Britain however also fought wars and disputed nationalisations e.g. over Egypts’s Suez Canal. Most of the world after World War II witnessed nationalisations of major revenue-generating industries, especially oil and gas, and other strategically important utilities. The 1970s saw Labour nationalising some of its oil to create the BNOC. In the 1980s, the Conservative governments reversed much of this with the privatisation of BT (telecommunications), BA and BAe, and energy companies BNOC, CEBG, BG and in the 1990s BR (railways), LT lines and bus services. Public house building stopped and local government sold off most of its housing stock and lease-back financed various utilities and services, private health and education encourages, and collective bargaining powers of trade unions shredded. Semi-private or ‘independent’ agencies blossomed to take over executive responsibilities for public policy. Public Private Partnerships were begun for many public investment projects. Privatisation became an international phenomenon. In France alone nearly 70 state-owned enterprises were privatised.
The commanding rationale for all this was predicated on how tight and restricted government finances were said to be (nothing of the unlimited financing now available to banks) and the necessity to “roll back the frontiers of the state”, “smaller government is better government” and inveterate belief that the private sector’s profit mkotive delivers greater financial efficiency than the moral imperatives governing public services, something that seemed to have won the great ideological war with socialism when the Soviet system collapsed after the end of the 1980s. Labour since 1997, has rejected much of its past beliefs, and continued and expanded public-private partnerships (PPP), full and part-privatisations, such as Airports and some sea-ports, British Energy (nuclear), London Transport, not building social housing, toll roads, PPP schools and hospitals, GP services, land, buildings, military maintenance and support, military R&D, and now also part of Royal Mail. One exception was taking RailTrack back under public control. But all of this, in financial terms, is dwarfed by the nationalisation of half of UK domestic banking and some also substantial UK-bank owned foreign banks. Insofar as we can consider the UK banking sector as one, it is now also ‘nationalised’ in name and also all but name. My inimitable friend Gerald Warner writes in The Telegraph, with his usual uncompromising high Tory instinct that can make even George Osborne seem self-doubting and guarded by comparison, by characterising the nationalisation-bailout of banks, “…the biggest bank robbery in British history." He then goes on to say, "...This is the state seizure of a private enterprise such as Aneurin Bevan would never have dreamed of attempting. Just six months ago Lloyds TSB was a successful bank, untainted by the excesses of RBS, HBOS et al. Now it is a nationalised basket case. “ This theme was picked up in the Sundays, predictably enough, by our hungry for scandal-detail, circulation-falling, press, notably by Sunday Times, but others too.
This is, of course, precisely the red-baiting, ‘reds under the banks’, accusations that modern social-democratic governments fear, and find most egregious and irritating. Warner twists the knife he hopes he has stabbed Caesar with by aiding Osborne's line of attack, “This is Gordon's doing, pure and simple. This time MacCavity has been caught in flagrante. On September 15 last year, at a drinks party in the City, the Prime Minister buttonholed Sir Victor Blank, chairman of Lloyds TSB, and told him the Government would suspend the competition rules if Lloyds took over HBOS, in return for an understanding that the merged institution would lend to first-time buyers. Later that month, when the takeover momentarily stalled, Brown publicly declared: "We have changed the competition law." Actually, we don't know that for fact. Until now the balance of opinion was that Eric Daniels it was who instigated the 'no reference to the Competition Commission' as a make-or break-precondition he, not Gordon Brown, attached to the takeover bid.
Is this not just ya-boo politics, seeking to tar the Prime Minister with the same brush as the bankers as being responsible for the credit crunch and bank failures. When the US Treasury decided not to save Lehman Brothers by granting Barclays Bank guarantees in support of it taking over Lehaman Brothers, but that AIG had to be rescued, the markets were rumour-mongering that HBOS would be the next domino to fail. Everyone was shocked that a big bank that was very interconnected in the credit markets could be allowed to go bankrupt. In hindsight most agree that letting Lehman Brothers go bankrupt was a mistake. There was genuine fear HBOS could suddenly become another Northern Rock, and there were immediate early signs of a bank-run on HBOS. It was necessary for the government to act decisively, and be seen to do so to shore up confidence in UK banks and reassure the public. There was no time to wait. At that moment Daniels had the opportunity to fulfill a long-held ambition to take over HBOS, something Lloyds bank could not have done except in such circumstances where the bigger bank's share price had fallen to only half that of Lloyds (just like as a few years earlier when HBOS offered to buy Lloyds)! Gordon Brown was only doing what seemed sensible and had several US recent precedents, which by the way all seem to have now gone wrong too (at JPM, BoA and Citigroup).
To accuse the Prime Minister of wilfully engineering the destruction of Lloyds bank to be able to nationalise it is just crude party-political spin.
It would have taken a banking economics genius to anticipate how all banks would eventually succumb to the credit crunch, requiring a recession and credit market collapse of such severity. Warner is not an economics or banking expert, only a conservative pundit, and his view is biased. He is right so far as it goes, however to say, “A 75% state holding in any institution is nationalisation: to pretend otherwise is absurd. Lloyds TSB was a cautious bank, mocked for its conservatism by the banking buccaneers whose testosterone-charged aggression precipitated the downfall of the British financial sector." He may indeed be right also to say, "It was precisely the kind of healthy institution that, left alone, could have led the national recovery." But he is wrong to assume that Lloyds Banks, Victor Blank and Eric Dabiels, were reluctant predators, to claim that "...Gordon Brown, with the anti-Midas touch that characterises him, pushed it into a doomed union with HBOS, thus destroying a bank that gave capitalism credibility.” One reason for this precise attack is of course that it was by being seen to be decisive in September and October that Gordon Brown's popularity rating began to significantly recover. I doubt any of the big banks are sufficiently immmune to survive the credit crunch and recession without becoming crippled, whether Lloyds TSB if it has remained independent, or Barclays, or now HSBC having said it needs capital, as with JPM and BoA, all have their work cut out and none can remain immune. It is interesting to ask if a bank with limited exposure to credit markets that does not by another distressed bank may survive better, and here we will be looking at Standard Chartered and the major Canadian banks. But I suspect all big banks are too globalised and intertwined that eventually all will suffer big losses of capital.
Warner relishes re-staging older geopolitical drama, “Though this takeover was effected amid all the gilded trappings of City hospitality, it is as crude and counter-productive as any Marxist confiscation. What an irony that Labour, in its dying days, has effected through incompetence what Bevan, Cripps & Co. could not accomplish from ideological motives. This has been as atrocious a piece of state piracy as any scene in an Eisenstein film with Bolsheviks storming the Winter Palace. The terrifying moral is: there is no limit to the damage that Gordon Brown and his feral Labour Party will inflict on Britain in their death throes.”
Gosh, how insulting to Eisenstein never mind Gordon Brown and 'New Labour'. In Eisenstein’s fictionalization of the Winter Palace storming the white guards are shown to be as callous and reprehensible as the public views blame-worthy ex-bankers and any soon to be ex-bankers. The world capitalist system let’s not forget imploded on the 90th or 91st anniversary of the Russian Revolution, give or take a few weeks - or the 80th anniversay of the Wall Street Crash - but does that have any meaning, metaphorical or symbolically, no not at all. This is not marxist nationalisation, but, whether for only a few years or a few years longer than that, perhaps it is about 'modernisation' and about saving capitalism not abandoning it.

BANKING IN CREDIT CRUNCH RECESSION

Recessions are periodically inevitable, unavoidable like the equinox-tides. All recessions are different in their precise triggers and are variously severe depending on national and international responses, but they also all have common or comparable events and sequences of events. Looking for the aggregates and averages across all post WW2 recessions does give reliable guidance as to shape, depth and longevity e.g. peak to trough and trough to peak. Some of these are quite well-known and furnish the indicator values that the banking regulators advise the banks to test for in economic scenario stress-tests. In the years before the credit crunch and subsequent recession, such tests could be called forecast simulations for unexpected shock events at some indeterminate time in the future. The tests would therefore be limited in the number and quality of factors to be considered, usually logical and financial only, but still requiring very high quality expertise and relatively massive computational, financial and economic modeling skill. There is politics involved, but usually only internal to the bank i.e. is executive management prepared to accept higher economic capital reserve buffers when this means curtailing asset growth merely to be prepared for a theoretical downturn that cannot be given precise timing forecast?
When such tests are required in the middle of a downturn crisis, they are no longer theoretical, there is massively more information to be processed and judgements must extend to quantitatively less tangible values such as market confidence factors in all risks and much more about how risks are networked and systemic, and above all the cyclical dimension including modeling for government responses and what impacts are going to and coming from all banks in the general economy, mostly the national economies for the banking book and internationally via global markets in the trading book. One difference between banks and non-banks is the inherent greater susceptibility of banks towards loss of confidence - bank runs - other types of business can experience share collapses, but banks can also have runs on them by depositors, and strikes by funding sources, or angry bondholders, who like many of bank's major shareholders are also competitor firms in the same sectors of financial services industry! No bank can withstand "a run" (fatal loss of confidence from any source), which is why we have Central Banks and Treasuries as Lenders of Last resort.
A bank may trade on its own account, but its main business is to intermediate between savers, borrowers, other banks, and all kinds of investors. Investments take anything from less than a day to years to generate economic return, or a whole business and political cycle in the case of governments as borrowers and investors. The complexity of managing the risks in the wide variety of transmission mechanisms between funding and lending is immense, but generally is assumed to be safe if the diversification is across the whole of the economy. The profile of a bank is not capable of being shaped to match the whole of the economy, it is shaped by the demands of the economy on banks, and that is never exactly proportionate to, or symmetrical with the economy, no more than the terms to maturity of funding and lending can ever be exactly matched. If banks sell loans before investments mature, or cannot economically balance between all the countervailing factors that impact banks' balance sheets, then banks risk possibly serious losses. In years when all seem to be on a rising tide, mis-management of liquidity and other risks are cushioned. By foreclosing on account A, there may be higher returns from accounts B, C and D. In a downturn, foreclose on A and B, C and D can all suffer domino-effect losses. The downturn spiral is more severe than the upward spiral is benign. Most savers want the ability to retrieve all of their money instantly at any time and they fear the downside more than hope for the upside. Hence banks must bias conservatively in risk terms. there can never be a perfect equilibrium balance to all of this. Logic depends on confidence to work. Focus on logic only and confidence will be lost!
Most banks and large complex financial institutions rely on 'sticky retail customer deposits' and on 'short term wholesale debt' that rolls over. The credit crunch began with the roll-overs no longer being reliable. Good houses may retain long term value, but not if the tiles come off the roof. That's what happened to banks when they couldn't keep repairing their balance sheets in timely fashion. When sufficient number of liability funders do not roll over their debt, the bank either has to issue long term debt, or liquidate assets, and in 2007-2009, these responses threatened the continued viability of banks' business models. Instead of rolling with the hits to net interest income, the banks balked at changing their business models. The consequence was they lost many times more in shareholder value and their capital reserves got more heavily depleted than should have happened.
Thus the problem today is we have no idea what the net assets (book values) of banks are really worth, because the information provided by banks does not allow that calculation. It takes an experienced risk expert and an economist and an accountant to do the sums, and maybe a maths professor of financial risk too. Without this information all people can see is a growing disconnect between stock prices and income flow values. The assets cannot be priced by their net income. This happens on the slower way up and on the very much faster way down! The shock hits at the most fundamental idea that of intrinsic or fundamental value. If no-one turns up wanting to buy my house I don;t imagine it has suddenly gone from being worth mega-bucks to zero. But, according to day to day market values, if I want the equity in the house today it is either worth nothing (totally illiquid) or worth very much less than I want or need (one-way buyer's market).
The old argument of an asset being worth only what someone will pay for it is not to be forgotten or discounted. Hence I, or the banks, need bridging loans to buy time until market confidence returns (more balanced two-way markets) and is no-one else then that requires the lender of last resort Governments to invest in lending.
People make human extrapolations based on what they know from experience, such as where various types of assets can trade. But, anyone reliant on a big abstract market, anyone not a market insider, they have no reliable experience, and so they panic! Anxiety is a state of mind of not knowing what and from where to precisely fear the worst or where to run too for safety.
Confidence can be restored by mapping out the precise risks and solutions. When governments and bankers and others cannot be trusted to do this, or simply don't do it, then everyone is right to panic! HSBC was such a place of safety and a source of confidence. It was important thereby to the whole market alongside few others. When it reveals as today that it has a complex and not quite clear appetite for increased risk-taking combined with sowing doubts about its balance sheet, the systemic effect is incalcuable. HSBC has failed to understand its wider market position.
Lloyds has said that traded debt pricing as in CDS spreads is a reliable if conservative proxy for all their assets. This builds a wide margin in their books for improving the balance sheet, but in precise accounting audit terms this is arguable absurd. But, for now, this is a realistic place for the bank to site its base camp 1 before climbing up the mountain. Unfortunately, HSBC, has not recognised at this time the need to be similarly globally risk-sensitive. Lloyds has produced bad results, but it has established a basis for renewed confidence. HSBC had more confidence than it deserved, and decided to risk squandering some of it! Wrong chess move, bad gambit, wrong direction to go in!
The world's internet bloggers, financial analysts and economists have been suggesting that our banks are generally insolvent, meaning, the liquidated value of their assets is below the value of renewing their liabilities. Commentators need not, and do not, offer precise data to support their insolvency claims. Are they inferring merely from the stock market prices? They are definitely correct if funding sources refuse to roll over short term debt, and when observers claim that interbank and wholesale funding is dead, a desert, frozen, or merely too expensive and in too short supply. Many large banks are insolvent, but if banks are the main funders of banks, is this just a self- fulfilling prophesy, or even technically true at any time in banking just because of funding gaps between customer deposits and customer loans? See 2009 list of maturing bank debt. There are different ways of analysing the question to produce half a dozen different quality answers. It's a difficult problem, especially because simultaneous with governments' financial stabilization plans for the economy as well as for banking, and we have mostly vague political-economy scenario stress tests that wipe out banks's capital reserves 1-3 times over. Therefore, it is a matter of regulatory and official government discretion, to deem if any bank is insolvent! The markets are in such an anxiety attack that mark-to-market fair value accounting, applying market prices and or estimates based on proxy indicators, does mot imply cash-flow insolvency but could trigger loss of confidence effects, political or not, that could trigger cash-flow insolvencies.
We can rely on the norms of past recessions and proxy approaches using derivative market values and various triangulations to get at the best approximations - but however this is done the risks remain that we might unnecessarily destroy a great amount of value that is then irrecoverable in the near-future. Recognise that much first and then think about your bank's strategy in terms of each of the major risk factors (see list) for the next 1-4 years. That's my advice to HSBC.

HSBC, G & G, TIME TO GO, GO!

The singer Lulu says the sixties were not about "sex & drugs"; they were about "rock & roll"! What would be a comparable statement about the credit boom decade and the credit crunch disaster years? Maybe Lulu has already summed it all up.
The noughties, the years that gave us the Credit Crunch (are defined in the HSBC 2008 annual report out today - Chairman Stephen Green's Statement - who did so without any new insight to offer!) nothing new, that is not until Green, on BBC radio 4 today, called those years "the GO GO years"! Green is also a Church of England reverend and was saying that while banks had always had a moral obligation governing their behaviour, it had "not always been honoured in the observance".
"I think there is an important need to underscore the critical necessity of good ethical principles in banking and in the markets," adding that there will be a reversion to some older principles of banking, in terms of "a simpler sense of providing good customer service, good relationship management, and a sensible approach to liquidity". he mentioned St.Paul before using the expression GO-GO years - a gift to the headline writers when Green has personally just let 16% of his bank's share value go, or was it just bad luck to announce a rights issue on such a sensitive day hit by the huge write-down at AIG, which needs another $30bn. Or, despite the respect for Stephen Green and Michael Geoghegan (let's call them G&G) among analysts, can they any longer be the right traffic-light KRI for HSBC? Is calling for a rights issue and the reasons given for this a major error and unnecessary blow to shareholder value and to confidence in HSBC?
G&G were admired for having maintained market and shareholder confidence in the bank, for the bank's transparency about write-downs at Household, and improved risk management and sound strategy. But G & G were able to do that also by doing nothing that risked confidence such as seeking government funding or rights issues - until now?
Why should a bank making substantial $9bn profits now decide to dilute its shareholder capital at a deep discount to get $12bn at this highly stressed sensitive time? One reason is that just as short-sellers claim they don't drag down bank shares, rights-issuing banks don't believe they drag down the share price either. You've got to laugh - till it hurts! Even if the logic makes sense, has the business risk of a rights issue and possible reputational risk been fully considered? Did anyone suggest this could trigger a 20% share price fall?
[Note: next day Tuesday,after writing this blog on Monday, HSBC shares dropped to their lowest in nearly 10½ years, dragging down the Hang Seng index as Hong Kong investors had their first chance to react to the bank’s discounted share sale plan and dividend cut that hit the stock in London overnight. The bank's shares fell 18.8% in Hong Kong to close at HK$46.25 after being suspended from trading prior to the announcement. The fights issue represents 41.7% dilution of existing issued ordinary share capital.] Is the answer that HSBC's G & G do not believe their own bank's share value (clearly under-pricing the bank) and care less at this time about share movements when prices are so volatile (a favourite word of Green's)? Is it just a matter of getting the money in and hope for the best, trading on the confidence and respect that bank has already won for itself? But, when other truly great banks can be dragged so low, when markets are not behaving rationally, however the rights issue is computed it is a risk, and I suggest not one worth taking! This is not helped by having opposing reasons for the right issue - on the one hand to shore up capital reserves, on the other to build an acquisition pot. Banks that have grabbed the carpet-bagger opportunities to buy other banks at fire-sale prices have not prospered from this so, notably Citigroup, Bank of America, Lloyds Banking Group. Does HSBC full appreciate the confidence factors in various solvency definitions and measures? Has he strategy been fully scenario stress-tested? How do reputational and business risk stack up against the Basel II capital ratios (that Green does know about and yet oddly describes as also "volatile")? Does he understand the banks full working capital picture given how it is spread across so many business units and countries - of course he does? OK, so 2008 was back to 2006 profit performance, 20% worse than 2007, plus a third off the profits because of goodwill write-downs. That is a great result - so why blow it on a paltry rights issue?
If the bank can say it is generating capital well internally, and when distressed bank assets can be share purchases, why go for a rights issue? If the result of this is severe dilution and share price falling down to what i call 'postage stamp prices' maybe the bank should just go to Government now and ask for 20% nationalisation - why wait? This is obviously the risk of what could happen later this year, maybe by mid-summer - so get it over with now and spare shareholders further shameful abuse! How might the share price have behaved differently, positively, if the bank had not announced capital-raising measures? Here is the 2007 picture. For 2008 see numbers in the attached comment below or on www.asymptotix.eu where this essay is easier to read. G & G say the following directly self-contradictory things to characterise their strategy and excuse why they are diluting share-value at this extremely sensitive time for all and any banks:
1. generating capital internally remains strong
2. financials are highly stressed, but HSBC competitiveness is gaining
3. capacity of financial firms is constrained by capital funding
4. all are focusing more on domestic markets
5. more HSBC capital will absorb impacts of economy and unforeseen events?
6. giving HSBC options re. opportunities which present themselves to superior banks.
All the above are precisely reasons that absolutely do not justify a rights issue! Either a rights issue is a forced choice that the bank must resort to to get desperately needed capital to repair its reserves, or (as G & G are trying to say) this is a 'nice-to-have' sensible option to get a bit more fuel in the tank to take in more of the scenery on this rough ride - and do some carpet-bagging - some acquisitions to be paid for in cash! This is madness and if you want to know how I can say that, it's simple; Chairman's report reads like it was written by a Rumsfeldian -wordsmith. Read the HSBC report and compare it with RBS and LBG. HSBC's mindset of what and where banking is today is stuck in the past - you can tell that from the language, the hackneyed phrasing, outmoded cliches, complete failure to say one thing new or different, G & G write their reports like wind-up automatons, talking 'speak-your-weight' language of an era that is now past, over, gone, but they don't see that. They are living on the heights and really that's all they know. Why should a bank making half a billion declarable net profit a month and with only a 12% 'funding gap' need to take the second to last, least attractive, option for capital-raising? Can this $2-3 trillion assets bank not squeeze £12 billion out of its net of its net assets and apply them to capital reserves. Of course, it can. Despite $41bn write-downs, mainly in US, the confidence in HSBC and its share price remained stubbornly strong. HSBC did not know how lucky it was to only fall to 750p from 900p in the 3 months after Lehman collapsed. Then in the last two months the share price falls from 750p to 480p, and today to under 430p with 350p as the next support level, maybe? Rights issues by banks are like pouring blood into a piranha shoal.
G & G don't like volatility and here they are inviting all that directly onto themselves. Maybe they know they can't hold on any longer to their management positions and it's best to go now while there's still a chance of multi-million pension top-up and contract-severance deal.
So now the market rightly assumes the bank has hidden major problems, whether the bank knows that itself or not, who cares now, its figures are no longer to be trusted, the markets will see to that, and HSBC's hard-won, or very lucky, but extremely valuable, credibility is blown - 20% of its share value, all its intangible goodwill as reflected in net unsecured borrowing - all heading for the cliff! HSBC, led by a cash-flow man and a marathon runner, is now just another lemming running with the pack. HSBC was a bank apart and above nearly all others, but G & G did not seek to understand that properly and how to build the lessons of that into their strategy! Whoever are the business-planning boffins in the bank, can they compute external hurdle rate risks as well as internal hurdle rates across the group, in the context today of no bank being too big to fall over a capital hurdle. HSBC only needed to keep a firm grip on the tiller, head down, least said the better, stick the toxic Household US mortgage business into a bad bank for long term work-out, fix up the accounts and accounting system, further improve economic capital risk systems, remain conservative, and manage all other non-performing and under-performing loan-books better.
Green is right, yes, it was Go Go years, but now they are gone, is his bank still wanting to play GO, GO by buying other banks' assets because that is cheaper than expanding via new loans? This is high risk and if it fails and the share price hits the postage stamp level alongside many others who are there already, then (in a famous Irish reverend doctor's words) Green & Geoghegan must Go!" Shareholders may as well call for that now - why wait - get the embarrassment over with. The rights issue may be a corporate suicide note, and for G & G become a "sack or resign issue". Just unbelievably risk-taking, so disappointing - making shareholders nervous in one of the few banks where they were least anxious until now!