The origin of the financial crisis: an iconoclastic view (3)

3. Regulation

Since the crisis flared up, we have heard in many corners of society about the need to regulate more. I disagree. Let's see the role of regulation in the financial crisis.

Beyond the expansionist monetary policy, upon which anybody will agree the private sector has no control, regulations imposed upon financial intermediaries in retail real estate financing (for example the Community Reinvestment Act and its successive amendments, in 1995 in particular) and the modification of Fannie Mae and Freddie Mac status, the SEC has a huge responsibility in the development of the crisis. The SEC authorized the naked short selling (where the short selling is perfectly legitimate). This led to a situation where, in some instances, the number of shares in circulation was higher that the authorized number: the SEC never enforced the obligation to deliver shares on settlement day. The SEC also failed in its supervision role, as exemplified by the Madoff affair. This failure is not bound to the US and can be extended globally.

I am also not convinced that FAS 157 accounting rule had the magnifying role : if the abscence (or quasi-abscence) market/liquidity led to a collapse in prices, hence losses to be accounted for, it is due to:

• The lack of buyer, nobody knowing where real estate prices would fall
• Investment banks had excessive debt (or lack of shareholders funds) particularly with respect to the imbalance of their balance sheets (short term financing on the interbank market and long term commitments). For example, class 3 assets (the most difficult to value) stood at 251% of shareholders funds Morgan Stanley, 185% for Goldman Sachs, 159% for Lehman Brothers and 105% for Citigroup.
• Being in the same situation, banks knew the difficulties of their counterparties and the unstoppable collapse of their assets (mark-to-market or not); this is what conducted to the interbank market standstill.

The crisis outlined the difficulty to value volatile assets when there is no market available, however.

Finally, Basle II rules require the use of complex mathematical models to fix the level of capital required for banks. When banks have a low level of losses (as it had been the case since the mid-90s), low level of capital are required which encourages the expansion of balance sheets. Conversely, when the period witnesses huge losses, like today, these models require a substantial increase in the capital base when it is not available, which led to the steep downsizing of banks' balance sheets (and we have not seen the end of it as yet). For example (and for illustration only), if the capital ratio is 1/10, any decrease of 1 billion of the capital base must translate into a 10 billion reduction in assets to comply with Basle II rules.

Derivatives are very useful tools for the real economy, particularly for hedging purposes (but not limited to), it is the excessive confidence in mathematical models that is damaging: remember the collapse of LTCM in September 1998 despite its two Nobel prizes; yet the FED saved it (in fact the banks counterparts) considering LTCM to big to fail...

We do not need more regulation and control but better regulation and control and make sure that useful existing rules are applied and useless/inefficient ones dropped. Policy makers see this crisis as one in a lifetime way to gain more control on the economy, on our life whilst in may cases they either created rules that magnified (or even sow the seed of) the crisis and did not do anything since the bubble started to implode in August 2007 until September/October 2008.

The origin of the financial crisis: an iconoclastic view (2)

2. Competence, governance and ethics

On this favorable background, the lack of competence, governance and ethics have exacerbated this dangerous policy.

• Competence
  

I do not feel sorry for all the institutions and investors who bought all these ABS, CDOs and others derivative's acronyms without analysing these products, understanding the risk, relying purely on credit rating agencies and interest rates received.

I however feel sorry for the investors that entrusted their savings in fixed income and money market investment funds that were invested in these toxic-non-performing-whatever-name-you-give: they did not know and could not know; they were ripped off by at best incompetent professionals / organisations and at worst dishonest (they are always good clients of law firms to make sure they do not have to indemnify clients!).

This was coupled to a remuneration system that encouraged short termism vis a dual asymmetry:

• Timewise: the bonus paid is never withdrew if after X years profits turn out to be losses
• Riskwise: the risk is entirely supported by the organisation
  

Regarding investments via feeders (either institutions or independent advisors), the Madoff affair just exemplified what happens when professionalism and ethics disappear to the benefit of quick profits and easy money: a huge scandal and tremendous losses for investors. In this case, both regulators (the SEC, but frankly other regulators did not do better) and feeders share the responsibility for the lack of supervision and due diligence respectively.

Derivatives were pointed out as being the origin of the crisis: I disagree! Derivatives magnified the crisis but did not originate it. Incompetence and greed are the culprits.

• Governance
  

Governance is a word that has been very fashionable with politicians and CEOs of large organisations for the past 10 years or so. Talking is not acting.

Most of the time, boards of directors are not independent and just there to agree to whatever the Chairman/CEO decides (golden parachutes, remuneration out of reality, platinum pensions, no takeover but if there is a fat check attached to it - remember Mannesmann/Vodafone Air Touch in 1999/2000-, etc.) : no questioning please! But why should questions arise when these boards work like a club of friends that distribute directorships regardless of the competence and of course independence whilst getting juicy indemnities...

Shareholders rigths are rarely exercised by individual investors that either do not fill in the proxy forms, or when they are filled, leave it to the board to vote. True, institutional investors are becoming more vocal as well as small groups of militant shareholders; they however are the tree before the forest.

And could carry on discussing about conflicts of interest lying with rating agencies or auditing firms.

To change this culture, it has to come from the top of organisations. What we witnessed is a problem of ethic at the highest level.

Boards of directors have largely failed in their role of control. The independence, accountability and competence of boards is THE prerequisite for governance, ethics and competence again take command of corporations and spread within.

The third part will discuss Regulation and control.

Cartoon of the day

The origin of the financial crisis: an iconoclastic view (1)

In a previous post, I commented on Goldman Sachs Q2 2009 profits and bonuses. I heard and read almost everything about the origin of the crisis and how to resolve it. I am not going back to silly comments like the one of Nicolas Sarkozy who, in October last year, identified tax havens as one of the two causes of the financial crisis, relayed soon afterward by many politicians, particularly in over indebted countries (curious isn't it?); unfortunately a wrong analysis of the causes of the crisis will lead to the wrong solutions. Let's reviex the origin of the crisis as I perceives it (this is largely extracted from a paper I wrote in French in December 2008).

1. Monetary expansion and indebtedness

Since Alan Greenspan took over the helm of the FED from Paul Volcker, and in particular since October 20, 1987, money has been flowing at will (with some restraints from time to time). The FED has pursued a cyclical monetary policy whilst policy makers did not engaged into structural reforms. Interest rates remained abnormally low thanks to the transfer of large chunks of the industry into low cost producing countries in the 1990's, phenomenon that accelerated in the 2000s, whilst developed world companies became so-called platform companies. This in turn had a deflationary effect, allowing developed countries to display low inflation rate (whether I believe official statistics is an other matter - have a look at Shadow Government Statistics - but the phenomenon was there anyway).

This lax monetary policy had three consequences:

• Government around the world could borrow cheaply and continue to see their sovereign debt grow
• Corporate had no problem to access borrowing to pay for a-never-seen-before flurry of takeover bids, as well as hedge funds and other that could easily leverage (over-leverage)
  
• Consumers could buy on credit many consumer goods (even at prohibitive interest rates) and not the least real estate, and think they were wealthy
  

This coupled with the blind belief in the modern portfolio theory and all the statistical/probabilist based models led people to ignore the reality of the human factor (I recommend everybody to read books written by Nassim Nicholas Taleb "Fooled by the randomness - the hidden role of chance" and "The black swan").

Everybody was happy and... shortsighted. The rare voices that expressed their concerns were rapidly silenced (consumers/electors prefer to listen to the free lunch story). Politicians continued in numerous countries to encourage people (with may incentives) to become owners of their home and banks to lend with total disrespect to the reality of life and credit risk.

This had a two side-effects:

• Enriching some developing countries (China in particular) whilst impoverishing the Western world (like for any corporation, to know your real wealth at any time, you have to substract net debt).
  
• A rapid change in the world balance of power from the West to the East, from democracy to authoritarian regimes. This will have tremendous consequences in term of imposing an agenda (environment, etc.) and access to commodities and energy (Chinese don't care about human rights, hence their successes in ensuring long term supply of natural resources in many underdeveloped countries).
  

So, all economic and policy makers took advantage of a situation that led to over indebtedness without Governments undertaking any fundamental/structural reform aiming at reducing this debt and preparing the future for our children and grand children (among world leaders, Thatcher is probably one of the few exceptions). Look at the state of the social security and retirement benefits in all developed countries: dismay!

The financial crisis is the brutal adjustment to this situation.

The second part of this paper will review Competence, Governance and Ethics.

Goldman Sachs quarterly profits bonuses and politics

1. The facts

Goldman Sachs, the world leading Investment Bank (forget about the universal bank status they took amid the financial crisis late last year, and that they will surely abandon as soon as politically feasible) posted this week record profits for its second quarter ending June 30, at $3.44 billion. Its share price has appreciated more than 70% this year and is now around the pre-Lehman Brothers bankruptcy filing in September 2008. The return on equity (ROE) is standing at 20.3%.

Trading and principal investments were $10.78 billion, 93% higher than Q4 2008 and 51% higher than Q1 2009. Trading in fixed income, currency, commodities and equities generated over half the bank’s record net revenues, almost tripling from last year’s second quarter. The rest of the business remained weak.

Accordingly record compensation will be paid on trading floors: bis repetitas.

2. Comment

Goldman is a private company and conducts its business in the best interest of its stakeholders; it has been very successful in doing so (do you remember that they were amongst the first to sell the real estate and financial sectors pre-crisis in 2008?).

Politicians are certainly going to cry foul whilst they should cheer the success of a private entity that will pay handsomely the Treasury directly via corporate taxes and indirectly via employees' income tax. True it will be a drop in the ocean of debt accumulated not only recently but over the years via relentless public spending and no forward looking policy (consumers are electors first), but it is still better than the current and future state of public finances (stripping off the aid brought to the financial and automotive sectors - by the way Goldman paid $426 million on the preferred stocks it received under the TARP programme). The methodology on which bonuses are paid and the risk asymmetry between the earners and the organisations can be disputed, but the freedom of any company to run its business as it wishes within the limits of the Law should not be disputed in a free society, whether we like it or not.

When one witnesses the attendance of politicians at Parliaments across the democratic world and the jitters between the Governor of California and the Assembly whilst the situation is more than critical for this State, having to issue IOU bills that have been refused by major banks from July 10, I wonder whether they should not get a pay cut for irresponsible behavior, incompetence and absenteeism.

What is at the center of the polemic since the financial crisis started (by the way in August 2007 and not in September 2008), is a power struggle between politicians trying to regain as much control on everything and free market enterprise, or a struggle between unaccountability and accountability. History demonstrates that the former is inefficient, costly, shortsighted and long term leads to a lower standard of living either in relative terms or in absolute terms in some circumstances.

Since the end of the Volcker era (a man of no compromise and Chairman of the FED pre-Greespan), the Western world economy has grown on debt steroids which has accelerated crisis after crisis with always more money thrown (Internet stock collapse, LTCM, 2001 etc.).

I will soon discuss the origin of the crisis from a totally independent standpoint having often been critical about the way investment banking was functioning during my 20 years in the City.

The magnificent 7 and equity markets - Review 2

After the low of March 9 and the recent high of June 11, we have entered a phase of market consolidation. Let's review what the magnificent 7 are telling us (I recommend the reader to go to the GTI web site for their monthly newsletter, one of the best available).

S&P 500 Banks index: after recovering from the early March lows and reaching a peak early May, the sector is consolidating. There are still uncertainties regarding the public/private plan to buy toxic assets from banks. Let's see whether the 100 mark will hold. Whilst consolidating, still positive.


Global 1200 financial index: Like in the US, the world financial sector is posing and closing on its 200 days moving average. Still positive.


TED spread (LIBOR USD 3 mth - US 3 mth T-bills): The spread continues to contract and is now well below the pre-panic level. Positive.


USD bank BBB 10 yr - US 10 yr yield: Still much too high and not fully convincing; no break of the 7% level as yet. Slightly positive.


OEX volatility: OEX volatility has recently increased reflecting new doubts about the pace of the recovery and uncertainties about a possible second stimulus package in the US. The rise is however not substantial. Still positive.


S&P Case Shiller house price index (source: S&P): The latest data published in June (151.27 for the Composite 10 and 140.10 for the composite 20) still going down whilst at a slower pace (Composite 20 down 18.1% yoy vs 18.7% for March 19% in January). Existing home price went up in May (172.9vs. 166 in April) and housing supply is also edging down in May (9.6 months vs 10.1 months in April). A few signs are pointing towards an improvement but not bottomed yet hence still negative.

Oil price: Oil prices reached $70/b in June before retreating sharply over the past few days. It will not last but positive.


Conclusion: In our last review (May 18), we advise to take profits off the table. Fundamentals in the interbanking market have much improved but many uncertainties still remain in the Western world banking sector. Several economic indicators point towards an improvement but nothing to get really excited about it. Many clouds are still around, even if hurricanes have disappeared despite the favourable period in the Gulf of Mexico and the East coast. Relax, enjoy the summer, take time for the next action: no need to be in a hurry.

Chart of the Day

Yesterday, US nonfarm payrolls (jobs) decreased by 467,000 in June. The headline came in at -467k compared with -350k consensus and the back revisions were negligible(+8k). The diffusion index fell to 28.6 from 31, which means that nearly three-quarters of the corporate sector is still in the process of shedding jobs. The 4 weeks average is continues it downward slope however. The stock market as well as commodities and energy declined sharply on the news.

Today's chart puts that decline into perspective by comparing job losses during the current economic recession (solid red line) to that of the last recession (dashed gold line) and the average recession from 1954-2006 (dashed blue line). The US have lost a record 9 million full-time jobs this cycle, more than triple the average in the context of a post-WWII recession, with over 2 million pushed onto part-time work. In fact, if this were an average recession/job loss cycle, the number of jobs would have begun to increase three months ago. This confirms the severity of the recession, but do not forget that employment data is a lagging indicator.
Source:

Bloomberg: July 03, 2009
http://www.bloomberg.com/apps/news?pid=20601110&sid=aNWsvYFLUCjA

Gluskin Sheff: July 02, 2009
Market and data musings - David A. Rosenberg
http://www.gluskinsheff.com/us-intl/musings/

From green shoot to brown shoot?

Tuesday's numbers in the US were nothing to rejoice:

The biggest downward surprise was the slide in the Conference Board consumer confidence measure to 49.3 in June from 54.9 in May and well short of the 55.3 consensus. The decline was spread out between both "expectations" (to 65.5 from 71.5), which does a decent job in predicting the near-term trend in consumer spending, and the "present situation" (to 24.8 from 29.7). Confidence is still well above the historic 25.3 low posted in February but is still very much consistent with an economy knee-deep in recession. For example, when the economy was moving out of recession in November 2001, the index was 84.9; at the end of the 1991 recession it was 81.1; when the 1982 recession came to a halt, the confidence survey was sitting at 57.4. Never before has a recession ended with confidence as low as it is today.

Inflation expectations jumped 3 tenths in the month to 5.9 percent fed by a roughly 5 percent rise in pump prices during the month. There's no indication that concern over monetary inflation is at play in inflation expectations.

The gap between this survey and the University of Michigan sentiment index, which ticked up to 70.8 from 68.7, is that the former has more of an "employment" orientation to it — and the labour market still looks very soft. The "jobs hard to get" series went from 43.9 to 44.8; and the "jobs are plentiful" component slumped to 4.5 from 5.8. The labour market gap (the spread between these two series) rose to 40.3 from 38.1 in May, which portends yet another month of rising unemployment when Thursday's data roll out.

In terms of spending intentions, housing is still getting very little traction as home buying plans edged down to 2.7% from 2.8%; plans to buy a major appliance slipped to 26.5% from 29.2%; and even with all the excitement over 'cash for clunkers', auto purchase intentions rolled over big-time to 4.6% from 5.7% in May in what was the second lowest print of the year (and suggests that the expected 10 million unit auto sales for June is a blip in an otherwise fundamental downtrend in consumer discretionary spending).

Case-Shiller's 20-index fell 0.6 percent in April, down from a long run of minus 2 percent readings, while the year-on-year rate improved to minus 18.1 percent, thus moving in the right direction. Whilst the second derivative is improving, don't forget that there is still at least 10 months supply of unsold inventory in both the new and existing residential market. Let's see what data the 2-3 forthcoming months will produce.

Next data on the housing front will be Wednesday's MBA report. Also the important ISM manufacturing report will also be released Wednesday to see whether it confirms Tuesday's data.

Source:

Bloomberg: June 30, 2009
http://www.bloomberg.com/markets/ecalendar/index.html

Gluskin Sheff: June 30, 2009
Market and data musings - David A. Rosenberg
https://ems.gluskinsheff.net/Articles/Lunch_with_Dave_063009.pdf

New regulation in the financial sector: US and Europe

I reproduce in extenso RGE Monitor's Newsletter regarding new proposed financial sector's regulation in the US and Europe:

"As decided at the latest G20 meeting, authorities around the world are devising micro- and macro-prudential reforms in order to strengthen the resilience not only of single financial institutions but of the entire financial system by extending oversight to all important financial institutions, products, and activities.

The United States

In the U.S., the Obama administration introduced its widely anticipated regulatory reform proposal on June 17. Its five main components include:

1. The establishment of the Fed as systemic risk regulator and supervisor of “too-big-to-fail” institutions in return for Treasury permission requirement for extraordinary liquidity programs. The plan proposes creation of a “Council of Regulators” (formerly the President’s Working Group) chaired by Treasury but with advisory powers only;
2. The creation for the first time of a regulatory regime for all financial derivatives, as well as a requirement that the originator, sponsor or broker of a securitized vehicle retain “skin in the game” – i.e., a financial interest of at least 5% in its performance;
3. The creation of a new Consumer Financial Protection Agency with rules against predatory lending and transparency standards at the retail level;
4. A new resolution mechanism that allows for the orderly divestiture of any non-bank financial holding company whose failure might threaten the stability of the financial system, including investment banks, large hedge funds and major insurers such as AIG;
5. Adopting a leadership role in the effort to improve and coordinate global regulation and supervision.

The main points of contention in Congress are likely to include the scope of the new regulatory powers conveyed to the Federal Reserve in view of the arguably minimal use it made of its already existing regulatory powers in the run-up to the crisis. Equally controversial are the need and the powers of the new Consumer Financial Protection Agency. Furthermore, some policymakers and market participants are equally worried about the potentially stifling effect of too much regulation on financial innovation.

The European Union and Switzerland

Two days after the Obama plan’s introduction, on June 19, EU leaders reached agreement on a new framework for coordinated (rather than unified at EU-level) macro- and micro-prudential supervision along the lines proposed by Jacques de Larosiere and endorsed by the European Commission on June 9. Regarding the macro-prudential authority, the new European Systematic Risk Council (ESRC) will comprise EU central bank governors and will most likely be chaired by the ECB president. The Council will issue financial stability risk warnings and macro-prudential recommendations for action to supervisors and monitor their implementation. In contrast to the U.S. Federal Reserve, however, EU central bankers will not oversee and regulate systemic cross-border institutions directly. ECB vice president Lorenzo Bini Smaghi, in a June 19 speech, deplored this discrepancy.

The EU agreement also establishes a new micro-prudential authority at EU-level. In particular, the European System of Financial Supervisors, comprising three new European Supervisory Authorities, will help ensure consistency of national supervision and strengthen oversight of cross border entities. This will be accomplished by setting up supervisory colleges and establishing “a European single rule book applicable to all financial institutions in the Single Market.”

Importantly, the new EU-level supervisory authority will have binding decision powers in the case of disagreement between the home and host state supervisors, including within colleges of supervisors. EurActiv cites the following example: “If Italian and Polish supervisory authorities disagree regarding recapitalization of an Italian bank operating in Poland, for example, it would be the new EU-level authority that would settle the issue with binding decisions.” However, EU leaders are clear in their agreement that “decisions taken by the European Supervisory Authorities should not impinge in any way on the fiscal responsibilities of Member States.” This precludes any ex ante burden-sharing provision, a very controversial issue. As EurActiv explains: “Should a major financial institution fail, there will be no European competence to establish which countries will have to foot the bill and by what means. National interests are likely to prevail again on this issue.”

Up until now, then, an EU-wide resolution regime for cross-border banks remains unaddressed. While this is welcome news for Britain, which worked hard to confine any EU interference to a minimum, smaller EU countries as well as non-EU countries with large banking sectors have a problem.

Not by coincidence, Philipp Hildebrand, vice president of the Swiss National Bank, noted on a June 18 speech: "The lack of any clearly defined and internationally coordinated wind-down procedure contributes to a de facto obligation on the part of the state to provide assistance to these institutions." Small countries, in particular, will need to develop wind-down rules for crisis situations. One possible consideration, according to Hildebrand is to "split off those units of a bank that are important for the functioning of the economy and wind down the rest."

‘The rest,’ of course, might include foreign EU operations in need of domestic backing. In terms of pro-active regulatory interventions, the Swiss have been at the forefront with an overall leverage cap for their large institutions, an innovative ring-fencing framework for bad assets at UBS, and a risk-adjusted remuneration scheme at Credit Suisse (i.e., to pay top bankers based on the performance of the toxic waste they originated or acquired on behalf of the bank).

The UK established new resolution powers for national institutions in the Banking Act 2009 in the aftermath of Northern Rock. Large and complex financial institutions, however, still await a comprehensive solution, a fact noted in Mervyn King’s June 17 speech. He noted that “one important practical step would be to require any regulated bank itself to produce a plan for an orderly wind down of its activities,” i.e. akin to making a will. That kind of information would also be a valuable input for the new EU cross-border regulators.

Alternative Investment and Derivatives Regulation

In the U.S., the President’s plan requires all advisers to hedge funds and other private pools of capital, including private equity funds and venture capital funds whose assets under management exceed some modest threshold, to register with the SEC under the Investment Advisers Act and provide sufficient information for effective systemic risk supervision. Similarly, under the EU Commission draft regulation, managers of hedge funds and similar ‘alternative investment funds’ that handle at least €500m (€100m for those using borrowed money) would have to be registered in trade repositories and provide information about leverage. For now, the draft law applies only to managers, rather than funds, because many funds are based offshore. After three years, the rules will get tougher for funds based outside the EU. Although the EU plan was under heavy attack by the industry, the latest U.S. backing should put any hope of a reversal to self-regulation to rest.

New rules in major financial centers also require all financial derivatives to be brought under the regulatory umbrella. As part of the U.S. plan, standardized credit default swaps (CDS) and other over-the-counter (OTC) derivatives will be required to clear through a central counterparty and trade on exchanges and other transparent trading venues. More customized products will be required to register with a central registry that makes aggregate data available to the public and detailed positions for regulators. In the European framework, the UK secured that the new EU supervision will not cover clearing houses for derivatives – an important objective for the City of London who is global leader in terms of trading volumes of derivatives."

I will have only one comment (besides the fact that I do believe that State regulation will sow the seeds of further and even more damaging crises - just look at the increasing indebtedness of States in the West for the past 40 years): the emerging markets' banking system is in much better shape and does not need to increase regulation. Interesting...

Source:

RGE Monitor's Newsletter: June 24, 2009
http://www.rgemonitor.com/

Chart of the Day

For some long-term perspective, today's chart illustrates the Dow adjusted for inflation since 1925.

When adjusted for inflation, the bear market that concluded in the early 1980s was almost as severe as the one that concluded in the early 1930s. Also, the inflation-adjusted Dow is now less than double where it was at its 1929 peak and trades a mere 30% above its 1966 peak – not that spectacular of a performance considering the time frames involved.

It is also interesting to note that the Dow is up 30.7% from its March 9, 2009 low which is actually slightly more than what the inflation-adjusted Dow gained from its 1966 peak to today.

Despite globally better news on the economic and financial front (well... let's see that will happen to commercial real estate), I believe that we have entered a period of market correction after a superb performance: look beyond the Western world tropism, emerging (leading?) markets (MSCI index) have increased by +/- 80% from through (28 October) to recent peak (2 June)! Since, they decreased by 8%.