EURO SOVEREIGN CRISIS - CURRENT POLICY ISSUES?

The Euro Area and the Euro System are in trouble as much from speculative attack by the money markets as from the natural difficulties of getting countries with very different growth stances of a mix of severe surpluses and deficits to share a common currency. It cannot expect all its legs to move at the same time together in the same way and in the same direction, not how any animal system walks or runs.
The EU needs a system of financial rebalancing that recognises the often extreme differences in each state's growth strategy and that accepts the inevitability of economic cycles. The Euro system rules are too simple and too rigid and offer the markets easy targets in the first recession testing of the Euro system.
The current system focuses on GDP only (not GNP) and fails to take account of payments external account and focuses on gross government debt (not net debt).
Greece and Italy are not the same problem except superficially. The EU and Euro Area are inevitably economies with opposing growth settings; export-led such as Germany (with banks focused 60% on lending to industry), deficit-led such as Greece and Spain (banks focused 70% on lending to property), or in rough external account balance such as France and Italy (where bank lending has been too conservative). Ireland is a unique mix of highest trade surplus and equally high payments deficit, which is bizarre? It has the highest trade surplus ratio to GDP and yet similarly high payments deficit. This shows it to be more a regional economy within the Uk than a truly national economy with its own domestic and national financial integrity.
Germany has a trade volume and export surplus equal to that of China. In the EU export surplus countries are equal to two times China. The rest of the bloc has to cope with this. Greece allowed itself to follow the examples of USA, UK, Ireland in growing GDP powerfully based on boom in mortgage lending. The banks were deaf to the entreaties of the Central Bank to stop that and lend more to industry.The central problem is not national debts and who these are owed to. Nor is it that the banks cannot be profitably financially helped by governments over time. It is certainly partly the banks' fault for the dysfunctional pattern within each country of their domestic lending bias. But the politicians are not aware how to address that or that they have the powers through EU laws based on Basel II to do so?
There are technical and definitional problems such as the simplistic Maastricht ratios. These should be termed funny money issues rather than levels of debt, which are well within the EU's financial resources to comfortably cope with over time.
The problem for all Euro Area governments is that when they provide financing loans to their commercial banks they have to do so on-budget and on-balance-sheet because their central banks no longer have treasury bill issuing rights. The USA and UK had no such problems and could insulate taxpayers from the refinancing of the banks.
When member states adopted the Euro it meant that T-bills (debt of 1 year or less maturity) that were previously issuable by central banks now gave up that power to the ECB. Today, countries in the Euro Area only issue T-bills from the Treasuries and debt management agencies and the debt therefore appears on budget (deficit) and on balance sheet (gross national debt). The UK and others can issue T-bills through their central banks where the debt is off-budget and off-balance sheet of the government. This provides immense flexibility to UK and others not in the Euro to provide financing to the banking system without directly embarrassing their budget deficits and national debt levels, a luxury denied to Euro Area governments.IS GERMANY AT FAULT? Merkel has in 2008 and in the years since including this year done and said no other than say Margaret Thatcher would have done and said in the same circumstances. One difference is the quality of Finance Minister and Schauble is not allowing himself to overstep a nationalist line. There is a concern to advertise Germany as safe, successful and superior so that German banks can continue to rely on getting cheapest funding, cheaper than other EU member states' banks. But those banks are heavily over-long on lending to exporting industry that is in severe pain to service its debts. Export surpluses, the principal source of Germany's GDP growth, are not won cheaply! There has come a point in time now when to ratchet down any further on the PIIGS ability to fly will rbound negatively, even catastrophically, on the German economy and the solvency of its banks. If Merkel and her team can see this danger they may start to give more credence publicly to reforms in the Euro system that permit less rigid adherence to simplistic fiscla rules. For the moment, however, the talk is of more rigidity not less and that means rich pickings for financial arbitrageurs and currency shorters, whose pay day is coming soon with the imminence of a full-blown Euro Area recession! Only when Germany has to loosen its own financial constraints it may agree for other member states to do the same? The present disparities will soon result in financial arterio-schlerosis spreading throughout the Euo Area system whereby many more states will find their wholesale finance cost rising and higher funding costs hitting all banks. A bout of recession will markedly worsen this and governments will then have to get together and realise that they have to act in concert and expand their spending and borrowing. Germany's economy appears to be externally strong (large export surplus as the main motor of GDP growth) but internally it is potentially weak. The banks are vulnerable by having loaned too much to industry (which is paying 10% of value added to service bank debt compared to only 10% of profit in case of UK industry, a nearly tenfold difference!).German banks are desperately in need of cheapest wholesale money (to support narrow margins and cash-flow based collateral) hence the hard attitude against deficit countries' fiscal problems - just a way of making Germany look good to wholesale finance providers relatively by comparison. If external trade shrinks and or becomes less profitable to exporters and if the Euro Area breaks up then Germany faces domestic economy meltdown (worst of all if it returns to a strong and soaring Deutschmark). The Euro Area is in any case now into its recession, a recession that follows as it usually always does 2 years after USA/UK recession. (EU/EA's brief recession in 2008 was not the real thing, only a shock from the financial bank crisis).EU politicians have to learn again to kiss their European frog and trust it will turn into a prince again. The USA (Tim Geithner etc.) has very right to criticise the Euro Area politicians for being too reluctant to act in the interest of the whole international community - but he may be foolish to do so publicly. The same may be said of the UK's David Cameron. The Fed, Bank of England and the ECB have a joint responsibility for world money markets and when these seize up they have to intervene jointly. Foreign politician's criticisms - brickbats flung across the Atlantic or across European borders - are usually for domestic political consumption. It is easy to make broad statements but they only make sense when there are concrete ideas to be shared of how best to resolve the problems practically.
It would be a reasonable accusation that the Euro Area fiscal rules are inflexible and simplistic. The Euro had its political supporters but technically was supposed to protect by sheer size against FX-money market speculators. The ECB was set up but placed in a constrained position and consequently fails to sufficiently compensate for the central bank powers that each Euro state gave up to the ECB.
Even the economists internally within the Euro planning teams in Brussels a decade ago foresaw this present disaster. But, back then, they hoped that after the first 5 years new more refined rules and better understanding of the technicalities would have evolved.
This didn't happen for various reasons most of which are political cowardice in face of global FX-money markets - mistakenly believed to be somehow most astute about economics and anyway ultimately all-powerful. The actual dysfunctional nature of information in these markets and their miserable irresponsible short term profit seeking etc. is all beyond the understanding of politicians and even of most political-economists, many of whom get little real-world model-building experience. The bankers also are afraid of economists and refuse to let them into the boardrooms where they fear that economists might take over - preferring instead to deal with the mathematical geeks whose understanding of risk cannot go further than market prices, rating agency ratings, and poorly cultured algorithms.Must a new Euro system be legislated? The default direction of travel here currently among EU politicians is to seek a tighter union and tighter rules with a fiscal policing agency. But, practical reality dictates that the EU and Euro Area need less rigidity not more. The Euro sovereign debt crisis is a product of rigid rules and crude definitions of national debt. It is the rigidity that makes it an easy target for shorting speculators.
The irony of the present situation is that the Euro was constructed to protect all members from money market speculators employing rumor-mongering of exaggerated insolvency scares. It is extremely damaging with incalculable repercussions worldwide in medium and long terms to undermine the credit-standing of OECD countries and to threaten the Euro system to generate investor panic for the sake of short term profits.
Any revised or new system must recognise if some EU members insist on maintaining large export surpluses then others must have sizeable external deficits. They cannot all aspire at the same time to export-led growth.
The Maastricht Rules should be elaborated to be made more intelligent, subtler and harder for the markets to analyse and play merry hell with! It does not follow that the answer is fiscal union or sameness within the Euro Area. And fiscal union should not mean aligning all tax and spending. It is not a sensible or workable basis for justifying cross-border financial guarantees. The proponents of more rigidity and fiscal alignment fail to see this course will require large fiscal transfers evey year between Euro Area member states. President Nicolas Sarkozy called up Hu Jintao recently to ask if China would care to invest in the European Financial Stability Facility (EFSF), the Eur750bn fund. Sarkozy and Kanzler Angela Merkel are imagining China's US$3+ trillion in foreign exhange reserves as a source of ready cash. Should China say yes?
Of course China should participate because it adds to its mystique as a most successful economic power that is impervious to the crisis elsewhere. This is however not the true case. China is extremely vulnerable. Its economy is considerably smaller than official figures suggest and its economy is starting to nosedive beginning with a property collapse. China's banks are teetering on insolvency caused by funding gap and growing poor and non-performing loans and are only sustained by massive deposits from China's foreign currency reserves. China's industry is massively over-borrowed and very vulnerable to fall in export volume and or profits, already accutely modest.
Europe should not seek China's involvement in contributing to Euro Area crisis funds, or from OPEC countries' dollar reserves either. Such a course would be giving foolish testimony to EU insolvency and internal failure, which is not at all the true state of EU or Euro Area financial resources, which exceed that of China plus OPEC many times over!
The reason China cannot loan a few $ trillion is because its reserves are mainly committed by over $4 trillions to supporting China's domestic banks' balance sheets. Chinese households cannot add much to current deposits and are only permitted to borrow a third back while two thirds of household deposits and all of corporate deposits are lent to industry. There is nearly $5 trillion in loans to China's industrial borrowers in support of which the government has deposited $2 trillion with China's commercial banks and loaned them $2.5 trillions Yes, China has extra pocket change (generated annually from the trade surplus) and could support its trade with Europe more assiduously and politically by directly buying Euro Area bonds including those of the EFSF and or IMF, but probably by no more than a % of its annual trade surplus with the EU totalling perhaps $40 billions in 2011. But, this is a trivial and unnecessary, and for Europe's self-confidence and global prestige hugely damaging - EU's politicians need a wake up call to understand the realities they are playing with.
For quite good succinct discussion on the background see:
http://en.wikipedia.org/wiki/European_sovereign_debt_crisis

Property lending and rules to save banks from themselves

Millions are frustrated because banks wll not lend them money to buy or develop property. Banks ascribe their lending restrictions to the new "Basel III" capital requirements (effective in 2012). This is not strictly a valid reason. Borrowers and others are given such simple reasons because the total picture is fraught with difficulties in striking the right balance between opposing demands, dogs and fire hydrants, rock and hard place etc. What is going on, or not?
Banks are shrinking their balance sheets and that inevitably means property lending (70% of UK and USA banks' customer loans - after exclusing loans to rest of finance sector which are also shrinking) and also hoping desperately to sell on bundles of property loans and foreclosed properties, if only they can find long term deep pockets to sell to without too steep a discount.
The retreat by banks from property is one reason why insurers and other institutional investors are getting into property lending, seeing an opportunity to do so without competition from banks and expecting higher returns than the banks can achieve.
The bankerspeak financial technicalities.
Basel III changes to higher capital reserves and more core capital of banks (higher amounts and higher loss-absorbing quality) are not genuine reasons for reducing the general loan exposure - it is really about narrowing the funding gap (between deposits & loans) that is filled by selling Medium Term Notes into the "wholesale interbank funding market" and banks are each fearful of when they next have to go to market to replace their MTNs on maturity (big amounts periodically every 3,6, 12, 18 months etc.).
"Internally generated capital" is recovery of monies loaned plus net interest income and other realised profits, and the banks are torn between using those gains to reduce their funding gaps or to increase their capital and liquidity reserves (as regulators under the name of "Basel III" require). They are also torn about how much they can allocate to bonuses rather than dividends. Hence, the banks blame Basel III for lower lending and want everyone to know that as part of their pressure on regulators and governments to soften or postpone Basel III and even on shareholders re. dividends and government and other pref bond holders to expect lower % coupons for longer - when actually it is really about narrowing their exposure to wholesale lenders i.e. to severely reduce their funding gaps, which UK banks have already halved from £1 trillion to £500bn, and falling, and that is a lot of balance sheet liquidated and internal capital generated.
The banks know the wholesale funders well and what is looked for an expected because they are also such funders in terms of their large loan exposures to other financial sector borrowers and have been liquidating cross-border interbank loans dramatically.
When (how soon) a bank has to next replace/refresh its "funding gap" finance will dictate its current openness to agreeing new loans; they are keen to say to their funders here is £5bn matured MTN repaid to you and we only want you to roll-over and buy £2.5bn of new MTNs back from us, which is supposed to sound good to the lenders and there should therefore be minimum fuss or embarassment (narrower spreads) that could leak out to market and damage the share price.
Property (development especially) is seen as riskier, and in addition UK banks are being warned by regulators to reduce the concentration of risk they hold in this one sector (property), especially while they are holding large amounts of receovered property collateral and seeking to sell on about 20% of their property loans (i.e. £260bn), probably with 15% haircuts = £40bn, some % of which could appear as paper loss relative to the outstanding loans, interest & charges that relate to the collateral recovered, perhaps £5-10bn (a wild guess).
The banks are in a bind partly of their own making insofar as the property market (asset prices) cannot recover until new property lending grows and yet until there is recovery they cannot sell their property exposures without risk of substantial loss, and without clearing out of a lot of property they cannot resume property lending.Therefore, if institutional investors (who are the major shareholders in bank other than governments) step in to make up the shortage in new property lending this, if on a large enough scale, could be important to breaking the logjam, and should be profitable to institutions in two ways (for themselves directly and via improved balance sheets of the banks), and given that property conditions are a major aspect of economic growth recovery.
But, when property lending is resumed by banks more assiduously the first port of call may be to refinance troubled loans rather than agree new loans to new borrowers, that is long term loans especially, while short term lending only looks relatively attractive to many banks. Medium to long term lending appears to have too many uncertainties i.e. the risks are very hard for them to compute.
The wider context includes policy that is torn between being seen to put in place measures that can be claimed to make sure the credit crunch recession never re-occurs, while also needing bank lending to stop shrinking and then to grow to generate more certainty of substantially higher economic growth. This facing in contradictory directions is why there is much fudging about the impoact of Basel III regulation including the Vickers Commmission recommendations that many outside UK as well as in UK hoped would provide a clear new line to follow and refresh the impetus of the G20 agenda of about 100 adjustments, policies and new institutions to protect the financial system from itself.
So-called "Basel III" rulings aim to increase banks’ tier 1 capital base from 2% to 4.5% (ratio to gross loans, or twice this to risk adjusted loans) to improve the resilience of banks. These discourage securitisation transactions, and there are four ways banks can increase their capital base to meet new ratios: raise more long term capital themselves (internally generated by cutting costs, bonuses, dividends and coupons), raise more in deposits, shrink loan balance sheets, commit less own capital to investment banking (market trading & derivatives), and reduce exposure (in economies where property dominates) to property and property loans.
There is the hope that interbank lending and funding gap finance and securitisation of loanbooks will sooner than later return as a reliable and substantial option, but only once the banks look safer bets i.e. the banks are strong enough to again dictate the loan spreads to those they borrow from. That is unlikely so long as the sovereign debt crisis reflects badly on banks and so long as Basel III looks hard for banks to comply with, even if these are very much parts of the banks own PR to shift the blame (playing up the sovereign debt crisis) and to soften new capital rules (foot-dragging on Basel III).
From the point of view of individual borrowers going to the banks with wonderful schemes of great quality all this bigger picture about future impacts reasons given for refusing loans is an immense frustration. It is actually the excat inverse of the pre-credit crunch past when banks ignored the bigger macro-economic and regulatory picture and approved any loans that passed merely microeconomic tests based on past high growth experience and not on forecasting future downturns. Yet, while the medium term future should be one of renewed growth and recovery, Basel III is ensuring future risks are assessed in terms of possible repeat of economic down turn (double-dip or another recession)!
In the case of seeking loans from banks that are underwritten or otherwise backed by government should ensure that banks can lend comfortably because the risk is low. But, low risk also means low net interest income when banks are anxious to raise their % net interest income, and given uncertainties about even government finance (subject to unexpected renewed cost-cutting at budget time) state-support may not of itself be sufficient to get the banks to lend. Institutional investors seeking to fill the gap also may not be attracted sufficiently by the low margins despite state guarantees. They are attracted by commercial property, not residential, and are not stepping into property lending because they are attracted by low margins of bank lending. Insurers are attracted by the higher interest income generated by commercial property loans compared with government bonds.
Over half a £/€trillion in commercial property loans are maturing in C.Europe over next 3 years and possibly a third of that additionally in the UK. Institutional investors will step in where banks fail to roll over what is of good quality and cannot be all repaid, and are already now financing about one quarter of comemrcial property lending.

Banks and Basel III: blackmail or chainmail?

Will the various new so-called “Basel III” rules make the world safer from financial crises? There should not be a short answer to such a complex question – but my answer is yes, and no, not much either way, and, looking back, taking the metaphor of New Orleans sea defences and levees, higher equity in banks core capital reserves means the same as adding only inches to the height of ‘sea defences’. Protecting the financial system is a systemic challenge; individual breaches in flood defenses may be contained or lead to general failure.
Erecting barriers, by setting global prudential standards, to prevent calamity is the job of the Basel Committee on Banking Supervision (BCBS), to mitigate, prevent or postpone, another Credit Crunch, its job is to agree techniques, laws, rules and guidelines to resist a 1/25 tidal surge or the 1/100 that some say defined the Credit Crunch.
But, what do we think of bankers’ response to new safety rules? They sound like road drivers opposing lower speed limits.
The banks publicly resent being told to increase reserve ratios. It is the same reaction if government asked the private sector to build and pay for sea defenses. The banks’ lobbyists such as the BBA and IIF warn gloomily of a probable £1 trillion less lending in the UK alone over the next decade - maybe €7 trillion less lending across the EU.
Our inglorious banks have, it seems, regained a bold-faced confidence sufficiently to complain loudly about new prudential rules, as if these ingrates* have superior information to warn us not to kill the Golden Goose**, and as if everyone else will trust that judgement and believe the banks?
But, is it realistic to suppose that excessive fear of another financial crisis and mistrust of banks by regulators and taxpayers could lead to borrowers and the economy paying a big penalty for higher equity-capital reserve ratios?
Alongside the new capital rules, the Basel Committee also published two papers on economic impact that media commentators and banks’ lobbyists, appear not to have read? These assessments are more sanguine and define it as a (very) “conservative” view to assume all the impact of Basel III will be borne by higher customer borrowing costs and reduced lending.
The Committee agreed higher equity capital ratios (announced 12th September) to oblige banks to hold more to absorb the inevitable losses of a recession. The changes are intended to mitigate and or postpone the next “financial crisis”. More equity means shareholders will bear the losses, as they have done so already in the Credit Crunch?
Reserves are ratios to loans and investments net of collateral after risk adjustments. New rules require twice as much equity reserve as before, but with years to get there, by when the USA and UK will probably be in recession again? Higher “capital buffers” are also imposed, but only in the proportions that national supervisory regulators are already demanding.
Bankers’ bleat that capital hikes mean higher customer costs, less lending, and will only jeopardize recovery. But, by the time the ratios kick in we’ll be past recovery and into the next boom. Bankers, it seems, don’t want us to see the many ways they can generate more “own capital”, including via higher profit-retention and paying smaller bonuses!
The BIS paper on macro-impacts finds that for each 1% increase in the capital ratio loan costs could maximally rise by 13bp, and for every 1% higher liquidity reserves loan margins rise 25bp, assuming RWA is unchanged. This falls to 14bp or less if RWA falls by shifting the risk diversity to less risky assets without any fall in gross assets. If banks adjust their expected return on equity from 15% to 10%, then each 1% increase in capital ratio is recovered by a 7bp rise in loan margin, well within what can also be achieved by cost-cutting or other relatively painless measures.
BIS is very clear: “Banks have various options to adjust to changes in required capital and liquidity requirements other than increasing loan rates, including by reducing ROE, reducing operating expenses and increasing non-interest sources of income. Each of them could cut the costs of meeting the requirements. For example, on average across countries, a 4% reduction in operating expenses, or a 2 % fall in ROE, is sufficient to absorb a 1% increase in the capital/RWA ratio. In practice, banks are likely to follow a combination of strategies.”
Cost of borrowing by banks should reflect the riskiness of banks. If banks are safer because of new rules then the risk spread banks pay to borrow should fall. But, if bankers don’t rediscover prudence, alongside a humbler piece of the pie, as governments anxious to balance their budgets exit from bank-aid measures, then the banks will have to pay more to borrow funding gap finance and to attract and retain deposits.
Let’s not forget that the Credit Crunch was caused by funding gap finance cost (risk spreads) becoming uneconomic, too high to ensure positive corporate lending margins. Why, because banks lost credibility and it is not at all clear that they can presume to have that back now, not while ratings agencies keep so many banks on the bottom-most rungs of unsecured credit grades.
The rates borrowers are charged should be dictated more in future by competition and demand than by banks seeking again the super profits of the years before 2008, and in Europe especially if cross-border lending is to recover and grow? Banks may accommodate higher reserve ratios by requiring more collateral and by exercising other risk mitigations including diversifying better across all economic sectors and by changed business models. Banks in trade-deficit countries are biased to property lending and in export-surplus countries to industrial trade.
In the years up to 2007, banks grew faster than underlying economies, earning dispro-portionately high profits, 25% - 50% of all profits of publicly quoted companies, which should be unsustainable. Shouldn’t they adjust to more realistic or reasonable profit targets?
The new rules are a cornerstone of the G20 response, a global effort to ensure stable international banking. The rules redefine “core tier one capital”, a measure of a bank’s solvency, plus sufficient liquidity to survive a short-run crisis with less dependence on short-term borrowing. The new ratios would not have saved the banks that crashed in the credit crunch but are a step in that direction to take some pressure off future government budgets.
Dame Angela Knight, chief executive and spokesperson of the BBA, was almost entirely negative about the announcements. She warned that banks have no choice except higher loan margins that will “suck money out of the economy” – by which she means the non-financial economy - as if banks’ profits, bonuses, and speculation can’t do that already. German banks made similar objections, and others too.
Three major UK banks have threatened to domicile themselves elsewhere if the UK government and its Banking Commission decide to split retail from investment banking - Paris and Frankfurt are offering lower tax to induce UK banks to move! Is this further evidence of a return to confident arrogance, of which resisting new capital ratios are shots across the bows of the regulators?
The threats are poor thanks for Government and Bank of England’s heroic roles as lenders of last resort in baling underwater banks. All banks were helped by state aid packages. Banks that did not require direct aid, or not as much as others, yet benefited massively from the help given to others. When Lehman Brothers collapsed, for example, among a host of emergency measures there was $2.5 trillion alone in temporary liquidity by the Fed, BoE and ECB to resolve failed money market trades.
Dame Angela (for the BBA) wants the new rules carefully handled to avoid “prolonging the downturn”. The banks got eight years, a long time in banking. She says, “The consequence is that inevitably the cost of credit – the price the borrower pays for money – will rise. The cheap money era is over.” Surely, a fun remark when the central bank rates continue negative in real terms. A lobbyist for bankers, the IIF used similarly dramatic language to persuade the Basel committee to dilute its reforms. Do bankers think we, politicians and taxpayers, learned nothing about how banks operate, or about how blinkered, self-serving, solipsic and short-termist their thinking can be?
The job of bank risk regulators can seem like herding cats!
The WSJ’s David Weidner wrote: “Judging by their hokey scare tactics, you'd think the act of raising capital requirements during an eight-year span was the final blow to capitalism. But it's not. Basel III is a compromise tilted toward an international banking community that's woefully undercapitalized and vulnerable to breakdowns.”
In truth, banks have far flexibility and head-room than their lobbyists want us to see. The public was not fond of banks before the crisis and now views them with mistrust, hatred, and derision. What other industry can prosper when so unpopular?
Banks do not have to make their customers pay; bankers can reduce their own bonus levels for a start, or perhaps regulators should do so – they now have that power! Banks’ pretence that certain people will only work for guaranteed bonuses, as for example for managers of ‘prime services’ to lend to hedge funds. Remarkably, it is so hard to lend them money this requires $5m guranteed bonuses?
Saving losses, what risk managers do, is never so generously incentivized, not remotely so? It is like paying football midfielders thirty times what the goalie gets, and strikers and team manager fifty times as much!
Privately, bankers, regulators, and most everyone else know that “incentivising” star players by handing them bonuses in excess of either group profit or loss damages credibility, solvency and shareholders. Fiduciary prudence is replaced by something else, poorly understood or defined except to call it ‘daylight bank robbery’ or ‘greed’. That is the dominant political and general voting public’s view. Are they wrong?
As someone who enjoys a spendthrift life on high-fees, I understand that heady culture that I am also part of, if better looking than Dick Fuld and freer than Bernie Madoff. Ah sure, wouldn’t we all be somewhat poorer for not having outrageously super-rich like us to gawk at, demonize and blame – but not if the consequence are distorted values that risk our whole economy! Martin Wolf in the FT wrote, “withdrawing incentives for reckless behaviour is not a cost to society; it is costly to the beneficiaries. The latter must not be confused with the former.”
Banks may reduce the capital they have committed to proprietary trading, to speculation, to profit from markets beyond lending to them. Banks may cash in realizable profits and sell non-core assets. Over the years banks can generate internal capital without upping borrowing costs of households and small firms. UK banks would do well to lend more to small firms who employ 40% of all jobs but only get 1.5% of non-financial loans – in the USA 10% and in Germany 19%. Banks can tap equity and bond markets for capital and retain more of net earnings before bonuses. When will they tell shareholders how much bonus is performance related or guaranteed?
The lobbying by IIF used the difficulties of Europe’s local savings banks such as in Germany and Spain, resulted in all banks getting a suspiciously long time to build new reserves, from 2013 to 2019. By then, all current top execs will have retired, rich, and we’ll be in the next recession when government again has to reflate the economy without help from banks!
Rather than scaremongering, bankers should grow up and recognise their priority is to rebuild moral authority and trust by customers, taxpayers and others, not least shareholders, show willingness to adapt their business models and pay themselves less. Scare-mongering fools no-one except the gullible of whom there are precious few left for banks to rely on for support today?
The banking lobbyists’ churlish failure to apologize or acknowledge that they must mend their ways and change how they do business and what is realistic and reasonable risk-based profit only does more damage to the recovery, not of the economy only, but that banks need to make to recover customer and taxpayer trust and loyalty, real self-belief and fiduciary responsibility, including in macro-prudential terms, i.e. real banking professionalism – or maybe I’m just old-fashioned, a grumpy old banker well past my sell-by-date?
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*Note: Ingrate, n. One who receives a benefit from another, or is otherwise an object of charity -Devil’s Dictionary.
**Note: Reminding us of, from “The madness of Crowds”, about the inventor of modern bonds, John Law, “he understood the monetary question better than any man of his day; and if his system fell with a crash so tremendous, it was not so much his fault as that of the people amongst whom he had erected it. He did not calculate upon the avaricious frenzy of a whole nation; he did not see that confidence, like mistrust, could be increased almost ad infinitum, and that hope was as extravagant as fear. How was he to foretell that the French people, like the man in the fable who killed in frantic eagerness the fine goose he bought to lay golden eggs?” (Charles Mackay writing in 1841)

MOODY'S BUGS CLEARED ON A TECHNICALITY

Moody’s has avoided prosecution by SEC and others on a technicality, announced some three years after the SEC investigation began!
Sam Jones, wrote in FT’s Alphaville over two years ago about bugs in Moody’s model for rating securitization issues that mistakenly gave top ratings for bonds.
When re-rated after June 2007 using a model in which the bugs had been fixed tens of $billions of CDOS, RMBS, ABS bonds dropped in value by up to 17 risk grades, sometimes from Aaa straight to 'Junk'! Moody's between 2005 and 2007 risk rated about 10,000 Residential Mortgage Backed Securities (RMBS).
http://ftalphaville.ft.com/blog/2008/05/21/13198/ft-alphaville-exclusive-moodys-error-gavetopratings-todebtproducts/
This was based on a fuller account that appeared in a few blogs including my own. Moody’s awarded incorrect triple A ratings to tens of billions of dollars worth of a type of asset covered bonds. The FT wrote, “Internal Moody’s documents seen by the FT show that some senior staff within the credit agency knew early in 2007 that products rated the previous year had received top-notch triple A ratings and that, after a computer coding error was corrected, their ratings should have been up to four notches lower…” In 2007 moody's downgraded about one third of all RMBS. This was the mild form of the story.
It was not just about ratings in 2006; between 2000 and 2007, Moody's rated $4.7 trillion in RMBS! For some model descriptions: Moody’s used its Moody's Individual Loans Analysis (MILAN) model for collateral analysis with a cash flow model such as Moody’s Analyser of Residential Cash Flows (MARCO) or ABSROM. Moody’s analysis was intended to provide RMBS investors with a consistent and transparent system of gradation by which relative credit quality is expressed.
The lack of transparency issue has however been the leading criticism by regulators. The Moody’s objective was laudable - to assign the same ratings to all debt instruments exposed to equivalent credit risks over time, irrespective of the country of origin, the industry sector or the structure of the security. This aim is however subject to differences in law regarding the underlying rights of mortgage borrowers and how the property collateral may be recovered.
Moody's aim was that over the same period of time, portfolios of structured finance securities with the same ratings should sustain similar credit losses. But, the problem remained of not just the history of defaults in the models (or not if they failed to be updated and when the models appeared indifferent to default rates) but also the forecasting of defaults under various economic scenarios?What happened was that Moody’s modelers noted a speech by Ben Bernanke in January 2007 where he reported that default rates were below 2%, which seemed both counter-intuitive and contrary to other earlier reported figures of 4% and rising. Bernanke had taken his data from Freddy Mac and Fanny Mae, data that was actually post-adjustment after many mortgage deals had been restructured. The modelers decided to put progressively higher default data into their models only to find that every time they cranked the numbers the result was always triple-A or otherwise unchanged from before i.e. the bugs in the model meant they were indifferent to default rates – seriously flawed fundamental errors! And, then they discovered that the models in any case had not been updated for default rates for some years!
When Moody's announced on June 5, 2007 that it was introducing changes to its model, it did not reveal how fundamental this was. It said "Moody's Expands Loan Characteristics in Subprime RMBS Ratings Analysis - New York, June 05, 2007 -- Moody's Investors Service announced today that its analysis of securities backed
by pools of sub-prime residential mortgages closing after July 1, 2007 will be expanded to include a systematic assessment of certain variables described in the Special Report, "Moody's Revised US Mortgage Loan-by-Loan Data Fields," published April 3, 2007. In addition, Moody's will be modifying the way it incorporates some other factors into its analysis. The refinement of its rating methodology is part of Moody's continuing effort to incorporate the expanding range of loan and borrower characteristics now being captured by many mortgage originators as well as the
performance data that has been accumulated during the past few years in the rapidly growing and evolving sub-prime mortgage market. Moody's expects to continue to refine its methodology in the future as it continues to analyze the increasing amount of performance information that becomes available."
This made the changes seem merely benign, when in fact they heralded the bottom falling out of the interbank credit market. To those who need to know a little of the technicalities, it may be of interest to note that given limited historical data, Moody’s used three parameters to determine the "lognormal loss distribution": − expected loss (base case losses) of the portfolio − adjusted MILAN Credit Enhancement, and − average life of the portfolio.
Moody’s assessed the expected loss using historical default and recovery data "provided by the Originator" or "based on comparable portfolios and benchmarking". All very well, but range of possible loss data is surely the main feature that the ratings agency model should be bringing to the analysis, not merely using the issuer's own data?Moody’s used MILAN to determine the MILAN Credit Enhancement (CE), and, in order to derive the ratings of the Notes, Moody’s used a cash flow model, MARCO, which included "key structural elements". MILAN was a risk scoring model, which is not ideal; each loan compared and scored against a country-specific benchmark loan, then, based on certain assumptions (mainly loan to value ratios that are especially relevant in the US, but much less so elsewhere). The credit enhancement necessary to agree with the benchmark loan can be determined, then tagged to a specific rating level (somewhat circular). No mention is made in the Moody's literature I have seen of credit cycle or economic cycle or macro-economics at all!
Overriding accuracy issues for the ratings agencies was also competitive ones of how to win ratings of big issues when the issuers could shop around for who would produce milder or harsher ratings! The question remains unanswered as to whether the ratings models of Fitch and S&P were a lot better than Moody’s or not?
Several internal emails have come to light that show this. For example, a July, 2004 S&P email: "We are meeting with your group this week to discuss adjusting criteria for rating CDOs of real estate assets this week because of the ongoing threat of losing deals. . . ." [emphasis in original] A March, 2005 S&P email chain shows that agency was slow to roll out ratings model changes because the updated model produced harsher results. Parts of the chain: "When we first reviewed [model] 6.0 results **a year ago** we saw the sub-prime and Alt-A numbers going up and that was a major point of contention which led to all the model tweaking we've done since. Version 6.0 could've been released months ago and resources assigned elsewhere if we didn't have to massage the sub-prime and Alt-A numbers to preserve market share."
Emails at Moody's include in May, 2007: "Thanks again for your help (and Mark's) in getting Morgan Stanley up-to-speed with your new methodology. As we discussed last Friday, please find below a list of transactions with which Morgan Stanley is significantly engaged already. . . . We appreciate your willingness to grandfather these transactions [with regards to] Moody's old methodology." And also in August, 2007 Moody's email: "[E]ach of our current deals is in crisis mode. This is compounded by the fact that we have introduced new criteria for ABS [asset-backed securities] CDOs. Our changes are a response to the fact that we are already putting deals closed in the spring on watch for downgrade. This is unacceptable and we cannot rate the new deals in the same away [sic] we have done before. . . . bankers are under enormous pressure to turn their warehouses into CDO notes."
Such emails show considerable overlap between quality of models and competition for the business to the extent that could be deemed evidence of compromising fiduciary duty to investors etc.
See DailyFinance: http://www.dailyfinance.com/story/investing/more-hot-emails-put-new-heat-on-the-credit-rating-agencies/19452156/?icid=sphere_copyright
Moody's had several points in its modeling where results could be massaged. There was comparison of the specific loan, property and borrower characteristics underlying each loan with those of the benchmark loan. This, if fully true, must have involved massive computing, which I sense may not have been fully deployed.
This then leads to adjustments to necessary credit enhancements of each loan, which are then compared to the minimum credit enhancement determined for a country. Again, we may wonder at the resilience of the benchmark concept?
Once each loan was scored, the portfolio was compared with the country benchmark RMBS in terms of regional, borrower and loan concentrations. This led to additional adjustments on the credit enhancement and ultimately produced the MILAN Credit Enhancement for the portfolio, relating to a specific rating level.
All steps are analysed and discussed by a rating committee. After, and if, further quantitative and qualitative adjustments to the MILAN CE by the rating committee (resulting in the adjusted MILAN CE), then, given a lognormal loss distribution, MARCO is used as a cash flow model for how different features in the transaction impact the final ratings of the Notes (each of the tranches of the securitised bond issued by the SIV).
The model calculates the loss and the average life of the Notes resulting from each portfolio loss scenario of the lognormal curve. The model will then weight each loss and average life on the Notes with the corresponding probability of the loss scenario.
The result is the expected loss and the weighted average life for each tranche in the capital structure. With these two inputs, the ratings can be derived from Moody’s Idealised Expected Loss Table.
That sounds simple actually, simply a way of getting the securities to comply with a standard ratings table. That is, until it is discovered in January 2007 that the models did not actually respond to different default or expected loss rates and that loss rates, presumably for the benchmark loans, had not been updated for several years before 2007!
Former Moody’s Executive Brian Clarkson described the approach as “you start with a rating and build a deal around a rating”.
While it certainly does exist, rating shopping appears to be a more significant issue in single-issuer debt ratings than in structured ratings. Given that single issuers exist prior to their rating and it is more difficult to change their existing businesses, balance sheets, income statements or structures in anticipation of review, rating shopping is a justified concern.
In structured securities, the SIV corporation (trust) does not exist prior to the rating, the structure to be achieved in order to garner a desired rating is defined by the rating agencies. As a result rating shopping is less a concern than is the pre-rating back and forth negotiations and substitution of underlying collateral which allows issuers to work with the rating agency until they create the structure that achieves the desired rating.
Working backwards and using feedback adjustments to get to a desired ratings is one thing, but operating models that are indifferent to default rates is another. Moody's modelers in January 2007 fixed these latter calamitously major bugs in the models and then found that the bonds or notes when reprocessed dropped by up to 17 risk grades! This they reported upstairs to a shocked board, who must have seen instantly that their company was now at major risk, and perhaps they might have also seen that the whole banking market was also at major risk.
The modelers were told to unfix the fixes and sit on this until it was decided how to handle this; how to tell the world? That thought-leadership process took 6 months, during which time other mind-focusing events occurred such as Bear Stearns securitisation collateral seized and sold at fire-sale prices by Citicorp's back office, triggering Bear's eventual collapse and US Treasury assisted fire-sale to JP Morgan Chase, and then UBS and Citicorp's own structured products exposures were subject to large writedown losses!
Yet, Moody's did not publicly mea culpa or publicly revamp its model until mid-year.
It made an announcement of a new model in June 2007. The news was not considered of fundamental importance to any but perhaps a few.
Then, from June 2007, using a newly fixed model. Moody's regraded securitization issues, mainly RMBS (of which Moody’s had graded more than half of all issues, or $4.7 trillions), that when cranked through the valuation model (a process like Chinese water torture on the interbank credit markets) with day after day, week after week, bank-issued (via SIVs) asset backed bonds and SIV notes (tranches) being severely downgraded that forced banks and eventually other investors to announce major writedown losses! For example on just one perhaps typical day, Moody's Credit Research Announcement 10 JUL 2007 "Moody's downgrades 399 subprime RMBS issued in 2006; 32 additional securities placed on review for possible downgrade". $ billions of RMBS were being downgraded every day.
Confidence in banks’ securities progressively collapsed and the Credit Crunch wreaked havoc on banks’ share values as well as on their ability to finance their funding gaps.
An SEC investigation followed the FT’s exclusive, EU authorities too, not least DG McCreevy when head of Ecofin, were extremely angry at the damage caused and considered suing the ratings agencies in court. Reforming credit ratings agencies became an important part of the G20 agenda. In various parts of the world including Europe various measures were considered and are being introduced to reduce reliance of the US credit ratings agencies. But, this is very difficult to do! It was obvious that when the ratings were re-run by Moody’s through new models in the second half of 2007, every week more downgrades, that coincided with full onset of the Credit Crunch.
It is reasonable to ask therefore if the securitization issues been properly, accurately, assessed, could the worst of the Credit crunch have been avoided? That is a big question, a big issue!
Similar criticisms of the ratings agencies followed in the wake of the Enron scandal but SEC legal action was not followed through with and was dropped. Enron's rating remained at investment grade until four days before the company collapsed. Similar failures were repeated in the cases of Bear Stearns and Lehman Brothers, and other firms. The ratings agencies failed in the case of Enron to notice that financial trusts linked to Enron made financial commitments largely based on Enron’s share price!
There were regulatory reforms in the US credit rating industry, the Credit Rating Agency Reform Act of 2006, and that put them in the context of the Sarbanes–Oxley Act of 2002. The SEC committed to improve the quality and integrity of the credit rating industry, but instead of focusing on detail resorted to broad reforms such as increasing competition between credit rating agencies including through new market entrants. That the SEC has in the case of Moody’s dropped further investigation on a technicality may have something to do with its own culpability. The SEC has been equipped with enforcement measures, which include the suspension and revocation of NRSRO status, and that may be used, for example, when a credit rating agency does not comply with procedures regarding the prevention of the misuse of material non-public information, conflicts of interest, and other abusive practices. Credit rating agencies are subject to (onsite) examination by SEC and extensive documentation retention and management programmes. It will be a long time before new competition can have a desired effect of improving the quality and integrity of the global US credit rating firms (the big three).
Arguably, the credit rating agencies are more powerful than the regulators in determining the creditworthiness of banks and their bonds. They also have a major responsibility and impact influence on sovereign ratings of governments. Given the influence of credit rating agencies in the capital markets and their regulatory responsibility as private-sector watchdogs, increased oversight of the credit rating industry is most laudable, but also most intimidating for regulators however backed by governments to undertake. Credit rating agencies currently remain prominently in the spotlight of national, federal, and international securities regulators, but appear let off the hook by the SEC, but only on a technicality. They remain subject to possible other agencies including private class actions slowly moving through the courts such as by CALPERS http://online.wsj.com/public/resources/documents/calpers.pdf
Three years on, on Tuesday, 31 August 2010, the SEC released this: “The Securities and Exchange Commission today issued a report cautioning credit rating agencies about deceptive ratings conduct and the importance of sufficient internal controls over the policies, procedures, and methodologies the firms use to determine credit ratings.”
The FT commented that the SEC’s Report of Investigation stems from an Enforcement Division inquiry into whether Moody’s Investors Service, Inc. (MIS) — the credit rating business segment of Moody’s Corporation — violated the registration provisions or the antifraud provisions of the federal securities laws. The Report says that “because of uncertainty regarding a jurisdictional nexus between the United States and the relevant ratings conduct, the Commission declined to pursue a fraud enforcement action in this matter…”
So, Moody’s has escaped prosecution for “fraud” because the relevant American legislation was defective – a shortcoming, the SEC notes has been expressly addressed in the newly-minted Dodd-Frank Wall Street Reform and Consumer Protection Act.
You can read the report at http://www.sec.gov/litigation/investreport/34-62802.htm
On May 20, 2008, the Financial Times published on its Web site an article that disclosed the coding error, citing internal Moody’s documents that showed the error had been discovered by MIS over a year earlier, and alleged that MIS had incorrectly awarded Aaa credit ratings to CPDO notes because of the error.
When Moody’s was contacted by reporters gathering information for the story, the company began an internal investigation into the coding error and the CPDO rating committee conduct. On July 1, 2008, a year and a half after the coding error had been discovered, and over a year after the European rating committee had declined to downgrade the credit ratings, Moody’s issued a press release discussing the investigation results and stating that “some committee members considered factors inappropriate to the rating process when reviewing CPDO ratings following the discovery of the model error.” Thereafter, MIS took personnel action with respect to management of the CPDO group and members of the committee, including termination of the Group Managing Director and two Team Managing Directors…
…Further, we conclude that, in early 2007, members of the European rating committee believed they could violate MIS’s procedures without detection, and in fact the conduct did not come to light until the Financial Times contacted MIS about the error in the CPDO model and an investigation ensued…
Note that today Moody's re-ratings actions based on improving or continued deterioration of subprime securitisations, or in conjunction with distressed or improving house price and rising or falling unemployment, will run each individual pool of mortgage loans through a number of stress scenarios to assess the rating implications of updated loss expectations. The scenarios include 96 different combinations within six loss levels, four timing curves and four prepayment curves.
For much more on all of this, I wrote about it in October 2008
http://bankingeconomics.blogspot.com/2008/10/risk-rating-smoking-gun.html
Also see:
http://newsroom-magazine.com/2010/governance/financial-crisis-governance/moodys-internal-corruption-detailed/
http://www.fcic.gov/reports/pdfs/2010-0602-Credit-Ratings.pdf

CEO Letter to my Rain-makers

Dear Rain-makers, friends & colleagues,
You have been asking how exactly our 2009 bonuses will be structured and paid? As some of you will know 2008 bonuses were the same as in 2004, and all paid in cash!
2004 (28 April) was also when the USA's SEC relaxed leverage ratios on investment banks; following which we all in the UK followed suit, mainly by upping our % bonus pool to profit ratio by a fifth.
FSA's Financial Stability Report in 2009 found that if Britain's troubled banks had retained 20% of remuneration bonuses & shareholder dividends (£75bn or $120bn) instead of paying these out based on short termism (so-called) that actually exceeded what was needed subsequently (in 2008 and 2009) in government and central bank supplied capital support (in preference share equity) to the same excessive bonus-paying banks. This I will show is a false correlation, what some culture experts might call a "post-modern relativism", usefully summed up by the following cartoon that I urge all non-bankers to take to heart as we bankers do.The years from 2004 on were also those when bonus pools exceeded profits, which only appears absurd at first sight, but not when we look at the matter more profoundly. This is for the excellent reason that our human capital is our most valuable asset, and what else is to be done when everyone else (other banks, especially US ones) do this, pay over the odds. All banks are in firm agreement about the deservedly high return necessarily payable to human capital compared to the return to passive shareholders or that old saw of "internally generated capital build-up", which we know would have just gone up in flames with nominal losses - far better to be retained by our staff and productively invested, I should think?The equation of bonus pool to government funding support is false, because we would have simply used the retained profit to narrow our funding gap by 8% or less (and depending on whether our share cap would have fallen further on lower dividends) and that £75bn (in the case of UK banks) is dwarfed by the £500bn in asset swaps to shrink our funding gaps by getting all that off balance sheet via SIVs in return for Bank of England treasuries and deposit balances. What choice did the SEC have (Paul Atkins, Cynthia Glassman, William H. Donaldson, Harvey J. Goldschmid and Roel C. Campos, SEC commissioners, pictured above, along with Christopher Cox, SEC Chairman, and Annette L. Nazareth, SEC dir. market regs.) when faced by a joint motion for relaxation of reserve ratio (leverage) requirements by Goldman Sachs, Lehman Brothers, Merrill-Lynch, Bear Stearns and Morgan-Stanley. SEC did not have models capable of predicting any outcomes of that decision; they therefore should not be blamed for the severe embarrassments that all of the above banks faced as a result of their over-leveraged trading books and unsustainable bonus pool growth.
The plain fact is that high bonuses are market-dictated with the weight of an immemorial tradition, socialised via top-dollar real estate prices. We are not "banksters"; we pay our taxes eventually. Furthermore, it is quite clear that leverage variance is simply what we need to do to maintain stable return on equity ratios and why bonuses are genuinely just that, bonuses! Who should begrudge anyone for legitimately striking it rich? There should be no limit to opportunity. What right has government to restrict incomes in any selected profession; that would be an attack on basic human rights or free market rights?Some bankers have sabre-rattled that severe cuts to bonuses will entice us to move our headquarters to Paris or Frankfurt or Hong Kong, who are offering us low tax inducements to move there. But, we don't go along with that shallow selfishness; where else will we find a central bank with the creative flexibility of the Bank of England, with the deep treasury pockets in money market operations to see us through stressful turbulent times?
US media comment has reported London bankers saying they would crash their own country’s economy by departing for foreign parts unknown if that's what it takes to defend bonuses. We have no part in that and know of no reputable British banks who think that is a realistic option.
Some calculations of government support to "bail out" us banks have supposed this to be a cost to all citizens. That is a false premiss. Governments have merely stepped in to fill a gap that opened up when the private sector failed to maintain inter-bank liquidity (funding gap financing). The bail-outs are not net costs but have valuable assets that will profitably reward taxpayers and the economies eventually. In my view therefore all of the supposed loss in wealth per citizen as shown in the graphic below will be restored and added to by at least half as much again over the medium term. Hence our bonuses need not be attacked, surely?It is altogether fair, however, that because of recent experience, shareholders and others ask why we pay bonuses in cash (out of profit or loss) and not as shares (or share options)? Apart from conflicts of fiduciary responsibility to alternative investment customers, and the net interest differentials between stock-shorting and interest bearing assets like cash (note that we never countenance any insider dealing type arbitrage or shareholder dilutions or trading to peddle our own share value upwards against a falling market), nein, n'immer, keineswegs, kommt nie im Frage, non, pas de tout, au contraire!
We paid bonuses as cash and not in shares or prefs for good prudential reasons, to safeguard against the temptation to create false markets in our stock, when annual bonuses can be 10-20% of capital or even 10-20% of capitalisation! When US investment banks' leverage restraints were loosened, US commercial banks and UK banks immediately ratcheted up their leverage ratios. These were years when risk management was considered anti-enterprise, anti-profit, anti-growth. We banks all used higher leverage to increase our own-portfolio trading rather than use the leverage to increase customer lending, which was facilitated by selling off parts of loan-books via securitised bonds. Kneejerk regulatory responses, so-called Basel III and CRD III, following the credit crunch experience, by making us increase our regulatory capital reserves and economic capital buffers to include liquidity risk and counter-party risk reserves - these are forcing us to shrink our own portfolio trading somewhat faster than we were doing anyway (to shrink our funding gaps and to focus better on only the most profitable net interest income sources).
Less capital for own trading when markets are volatile and there are rich pickings for clever arbitrageurs has hit our bonus pool. But I take comfort in the poor performance of hedge funds including macro-funds. Our fee income is up in part from stricter credit conditions, but mainly from restructuring customers' debts. This revenue stream is declining, but it looks like M&A and MBO activity is surging again. All in all, with net interest income stabilised, there is modest optimism about our return on human capital, our bonus pool growth, which we calculate based on a weighted peer-group algorithm that includes Goldman-Sachs and JP Morgan-Chase. What is now to change is how we are paid our bonuses and over what period of time. We are moving towards less cash and a medium term roll-over, what some of our sovereign debt traders are dubbing Euro-billions roll-over, an ugly expression I do not want to hear again!
Bankers are the elite of the business world. Our remuneration levels track the art market and have recently overtaken it. As someone with a collection of superior quality to that of Mr & Mrs Dick Fuld, I take this as a benchmark of our uniquely valuable creativity. Our bonuses are justified rewards for superior creative human capital and should not be relativised to the bottom line of mere profits or any other mundane comparator. I agree with Rene Magritte's comment on relativism.Talking of which, new European Union rules require that only part of bankers bonuses are paid in cash, provisional retention of another part, and some other part that may even need to be cancelled should risk performance outcomes warrant that?
We senior bankers know that our bonuses are a deserved return to 'human capital'. That return was depressed for decades. It directly correlates to the relative superiority of our education skill levels that only in recent years rebounded strongly to regain at last the same relative remuneration and skill in our human capital of the 1920s.Human capital is an asset, as we remind everyone, "the creativity of our staff is our most important, most valuable of all our asses!" Its market value is well attested by how the financial return on human capital investment (total remuneration divided by base salary) that has demonstrably held up well as all other asset classes fell (in mark-to-market terms).
Notwithstanding evidence we presented to demonstrate persistent skill-supply shortage, and using peer-group comparators to disprove the notion that experienced bankers are worth any less today than a few years ago, regulators insist on a more risk-diverse bonus calculation or less-cash only, structure, that offers some sensible tax efficiencies for all - effectively a system for lending by and borrowing from our remuneration bonus pools over time that will deliver yet higher return, what I call pleasure not lost, merely postponed. I wish to make it clear that while we took bonuses proportionate to profits as per our US competitors, it is not sensible to make sudden changes when profits become temporary losses; this is a longer term game.Following discussion with regulators, however, some adjustments are now required. Therefore, according to new guidance, the present value of the average bonus of $1 million per rain-maker in our bank (better than others and 20 times average wage) may be under $800,000, with 40-60% postponed payment payable over 3-5 years. Half of the bonus paid will not be in cash.
This means that you can only get at most 30% of due reward in immediate cash.
For those of us with bonuses of several $millions, deferred consideration is over 60%. A maximum of 20% ($200,000 from $ 1 million bonus) will be cash-credited to you immediately. You want to know how much you will get later, soon. Your deferred bonus of $600,000, half of which can be paid in cash, half in securities. This may be discounted for risk of poor performance and prudentially postponed. But, starting from a low point in credit cycle performance, actual payment has a tremendous upside potential. The superiority of human capital skills & education value among bankers in banks is fully proved by banks profitability and the speed of our recovery from the credit crunch recession, by how we skillfully helped government to help the wider economy by saving the banks painlessly through asset swaps and deposit guarantees for which help we are more than happy to buy government bond issues. We are over-subscribing to new issues and doing our best to squeeze out pension and insurance funds at the long end.
On the matter of deficits and national debts, far be it for me to point out to those who resent government deficits that they should note the obvious correlation of balancing budgets with imminent triggering the next recession, and double-dip will not help anyone, not even if the Euro Area appears to be gagging for one?Saving and rewarding the undoubted values of banks, including remuneration of bankers, is not for everyone, involves a steep learning curve and an inflexion point only after about ten years of hard graft at the front end of financial services i.e. our bankers take years before they earn their bonuses, often also after years of paying high college and MBA school fees, which they have to repay and earn a good financial return on, let's not forget that basic fact of financial life!Regardless of your initial background in say natural sciences, mathematics or some secular philosophy like MBA study, whether you have any formal qualifications in banking, you must have at least 5-10 years valid experience well-earned (keeping your job and getting promoted) before bonus hikes kick in, and that is both only prudential and fair. The Gordon Gekko banker image is Hollywood fiction.Compare this fiction with the very real Jamie Dimon, a great survivor, great leader, a pugilist and realist bar none among top bankers like myself.YOUR 2009 BONUS:
Assuming 5% risk of withdrawal of bonus each year and discount rate of 4% over the present value of money over five years, your bonus cash element falls in NPV from $300,000 to $213,000. That part ($200,000) paid in securities e.g. convertible bonds and in shares ($300,000) the risk of loss is outplayed by upside potential of say 0.75 of book value to 1.25 of book, which could and should be worth a conservatively forecast gain of $250,000, subject to say a % discount risk factor (net $140,000 upside or 28% return on your bonus investment over say 2-3 years, plus perhaps half of that again in annual bonus increases and a rolling additional 14% annual investment gain, say).
The risk factors of say two times 5% plus a hair-cut of 7% and the risk of claw-back given double-dip recession risk hitting our net interest income will modify and postpone tax payable, giving you more capital to play with in the interim than otherwise. Your $million bonuses could and should double every 5 years. That is great news! Other calculations and forecasts are possible, but it will be roughly on the above basis that our rain-makers can obtain personal loans at our lowest internal rate at up to 85% against bonus pool funds.
I for one have no fear of a possible return for a prolonged period such as in those post-WW2 decades when bankers and stockbrokers were considered boring bureaucratic desk-johnny, servile customer service-minded, paper-pushers. We will remain the kings of the global financial jungle - have no fear about that!It is only sensible given our enterprising capital and securities markets skills that we "my word is my bond" bankers are firmly to be counted among the net wealthy, prepared to put our money where our mouth is.
Some analysts quip that in recession and recovery periods our output (wages & profits) and unemployment estimates tend to be over-optimistic. This hypothesis I promise to disprove in the case of banks and bankers, our income, our jobs.In the past great artists and musicians, like today's football stars, were rewarded as a premium quality human capital. "Back in the day" as our American cousins like to say, the great days, uniquely talented individuals would coalesce into groups and teams, and from that tight economic unit create service product of high value for wide distribution. That is the quality and nature of today's creative bankers, a high-value, highly prized industry, however commoditised, reproducible, repackageable, rebrandable, along with the recycling capital that pump-primes it. Where other industries automate and replace human capital with synthetics, we computerise but never forget the human capital and its necessary rewards at the heart of banking.
Those Cassandras who call for a return to boring traditional fraction transaction banking do not appreciate the importance of human capital, or our humanitarian understanding of what is truly important, human capital, why we defend $20-30 billions in quarterly bonuses. Just look at the skills required to be a modern banker:"Our bank canvassed human resources professionals to bring you the following list of CV qualities when seeking or holding down a job at my bank. Qualities include:
1. Dealing experience (ability to grab capital allocations to leverage your bets) in both cash & derivatives markets. Some great skills were required in recent years of markets' undoubted liquidity shortage (double-default in insurance & near zero liquidity in the secondary markets for structured products) problems. Also, we needed skills to navigate how stock markets became shredded by alternative channels, but could hedge those problems as derivatives grew exponentially even if ultimately into a spaghetti mess and reinsurance "snake-eyes". Our rain-makers are syndicators, structured financiers, M&A, mezzanine and MBO specialists, an undoubted skill-set in recent years of MBO dearth and private equity competitive problems, but any booked deals will do for us that show double digit margins. It's experience that counts, especially if you look like understanding the basic intracies of structured products.
2. Be prepared, well groomed, for the interview process for our wealth and private equity divisions where the bar is loaded and set high. We test candidates on anything from financial modelling to verbal proficiency (dealing room and institutional sales jive talk), NPV reasoning and mental math, our smoke 'n mirrors hothouse personality that never forgets the bottom line of how to slice 'n dice the deal and the market. You must demonstrate business judgement of a shark (distressed debt hunting) and the vulture (finding hidden unrealised asset value), and able to think like a day-trade CFD investor.3. Speak one or more foreign (European or Asian) languages. In some cases recruiters say speaking Chinese, French, Japanese, German or Spanish is a prerequisite in primary credit markets, less so in asset management. Our candidates are frequently asked what their third, let alone second language is; first language: MBA English.
4. Show operational and IT experience. Be a team player capable of scoring individual goals. Restructuring or distressed debt experience is popular as we grapple with senior tranche triggers and other portfolio problems. The challenge is to marry deal-making with industry or operational process so that you know your cog and mechanism for how to take biggest bites our of the food chain and our internal 'deal carousel'. It is easy to find dealers, but few who combine that with operational experience to book most nominal profit.
We have moral values to define our bank by. :Our strapline "Money: if you'll take it, we'll make it!"
5. Have the right sector expertise - property and other collateral management, and fixed income (but forget small firms, retail distribution or trade manufacturing unless we post you to Germany or China). Strong sectors where we want hands-in-the-till experience are chemicals, pharma, oil, gas, institutional funds, and healthcare.
We reject Main Street's opprobrium of individual banker's success as unfair in the UK as anywhere:Other quality advice:
1. Don't embellish; cut to the chase, to the bone. A common pitfall is candidates listing deals in their CV they didn't control or had only cursory involvement in. We note when you umm and aah if asked to discuss deal-makers versus deal-breakers, or risk-accounted ins and outs of the deal, or when we ask you for an investor's perspective. If you're too into long term fundamentals you're not worth human capital investment by us.
2. If a trained accountant or actuary or economist, downplay that; classic capital & securities skills have ago changed. We used to look for corporate and treasury finance backgrounds - not any more; today we use deal-closers, salesmen who can talk upside and downside simultaneously polished on whatever side gets us the best upfront margins.
3. Referencing Goldman Sachs won't help - smells of failure in staff turnover stakes; no one leaves GS unless they're crackpots. We need candidates who were highly rated, notn simply having worked someplace unless with a financial regulator or central bank.
4. Don't assume working with large clients qualifies you. Private equity needs people with a broad portfolio of company board-level executive experiences at both large and small entrepreneurial outfits generating double digit returns i.e. an above average bonus history.5. Don't come across as young or naïve, or over 50 (early retirees). Candidates must demonstrate street-fighting skills in algorithmic analysis and monte-carlo research and more and more MBA maths mature. You may not be leading a presentation by a management team, but you will be a basket points or goal scorer."
You must talk the talk while instructing others how to walk the walk.The credit crunch and ensuing crisis exposed flaws in banks' business models to survive a whole credit cycle, but these were merely the flaws in our great society.
So, let's not hear more about the foolish risks of the financial sector or the devastation to the economy, or fiscal deficits. Too little has been appreciated about the wider societal moral deficit that is hardest to correct. We operate on a morality of profits, not deficits. We judge ourselves by peer review, to do better than our competitors have done in the last decade and the next and or last quarter and next quarter.One of the lessons of this crisis is a need for collective action, which is only the role for government. When markets blindly shape our economy and society, doing their level best, we rely on government to pick up dropped balls, run and pass back to us to cross the line. We take care to shape events to what we want going forward; questions of blinkered targets and purblindness we leave to others, to good and sensible government.
best regards to all my staff,
Your CEO
see note attached