Credit Derivatives: Ban speculative Buyers of 'Protection'

News that speculators are betting that municipalities and federal states in the USA may default highlights the urgent need for reform of the credit derivatives market. Not only does the ballooning of outstanding trades create a substantial risk of default by one of the participants in the market it also creates problems in the wider economy by accelerating and exaggerating real or perceived weakness in the credit ratings of various issuers. There is no reason why those without an insurable asset should be allowed to buy 'credit protection' - nothing is 'protected' and it is but a speculation on default. The argument that you need speculators to facilitate a liquid market so that  investors (banks, bond investors) with genuine reasons can protect themselves,  does not hold as you really need only SELLERS of credit protection to satisfy this requirement. So speculators are more than welcome to provide liquidity as sellers of credit protection. Adjusting legislation would mean that derivatives traded outside recognised exchanges would again be unenforceable if they are not hedging against a pre-existing risk.

How to control Commercial Property Lending

A report by the US Congressional Oversight Panel states that more than half of all outstanding commercial property loans are larger than the value of the underlying property highlight the need to reign in the banking system's freedom with respect to lending to commercial property. The report prompted us to submit the following comment to the Committee:

One often has to wonder how individual 'developers' can amass huge fortunes when most of them never had a shovel in their hand. A quick glance at the list of Billionaires in the Forbes list confirms that property development (and speculation) is an extremely profitable business for the few. A lot of this apparent success is due to the endless inflationary spiral during the post-war years, some is due to entrepreneurial spirit - but a lot is also due to lax lending practices (sometimes aided by dubious practices, the least pernicious being free tickets to sports events and meals in lavish restaurants provided to loan officers).
Reform should put strict limits on the loan value of any commercial property. At the same time 'interest only' loans should also be put under the spotlight. If they are deemed to be too risky for private homeowners they are even more risky in the hands of professional speculators and cannot be allowed to put the banking system under undue risk.

Risks - Higher rates and Creditor strike

All the financial and economic geniuses teaching Finance have forgotten that credit depends to a large extent on trust (lat. credere, to believe, trust in). Banks relying on buying in deposits, companies rolling over their commercial paper on a daily basis, countries buying off their voters with ever-increasing levels of borrowing all have to face the fact that when the music stops there might not be a chair left for them in the frantic scramble to replace maturing funds.
It is even more laughable to hear that Greece  claims (supported by many 'experts') that it cannot afford to pay interest rates of 6.5 or 7 per cent. I only can say, get real guys! Rates have been in double digits in the past few decades, and anyone thinking that this cannot happen again better wake up before it is too late. Interest rates do not have to reach extreme levels, but anything in the 5-7 per cent range, with a possible overshoot towards 8 or 9 per cent is in the realm of the possible. I used to say (well before the credit crunch!) that hardly anyone was prepared for a sudden shift in asset prices by 20 per cent. Little did I know that that was a conservative estimate in view what happened during 2007/09. Now I would warn all debtors to plan for higher rates.

Stability Fund no magic solution for Banking System

Germany seems to move closer to implementing some sort of stability fund for the banking sector. But its promoters already admit that the state (taxpayer) will still have to provide a backstop even in a situation when a fund is in existence. We would agree as the fund would have to be of enormous size if it ever would be able to provide for any crisis. Ironically a similar (simpler?) solution would be for banks to hold more capital reserves - which would effectively be an in-house contingency fund at every institution. Suggestions that other sectors (such as insurance) should also contribute to the fund are based on the argument that they have benefited from the bailout provided by the taxpayer. Now where does this argument end?

Causes of the global credit crunch

It is too early to fully understand how it could happen that the World's Financial System got close to a global meltdown during the past 12 months. Some blame greedy bankers, others lay the blame squarely at the foot of the (US) consumers. Institutional Investors also appear entangled as they allowed managements too much leeway and even egged them on to pursue ever-more risky expansion plans. However, we tend to think that regulators - and their paymasters the politicians - may have to take a large part of the blame.
Unfortunately they are the party that is the least likely to bear the full cost of their mistakes. Shareholders have to suffer from dramatically shrunken share prices, scores of bankers have lost their jobs, or are about to in the near future. Bureaucrats are happily engaged in the blame game and are joined by academics and media people who often are also less than objective in their judgement.

Michael Mayo Testimony - Financial Crisis Inquiry Commission January 2010

Nobody has the time to read everything of relevance - but occasionally we like to the highlight little gems such as Michael Mayo's testimony to the Financial Crisis Inquiry Commission.

Banking Reform - 2009 a year of lost chances

News that the former CEO of AIG, Hank Greenberg, is trying to have the regulators and politicians look into the circumstances of the bailout of AIG in the autumn of 2008 is just one symptom that the after-effects of the 2008 banking crisis will be with us for quite some time. Most of the ongoing problems can be traced back to the fact that bail-outs were executed in an arbitrary fashion devoid of any principle and in addition there was no democratic oversight. At least the citizens of Iceland have a say in the (non)payment of the bailout money they are asked to contribute to. In the past year there has been zero progress towards creating a banking system that does not explicitly or implicitly rely on future bailouts by the taxpayers. We are not confident that 2010 will bring more progress.

Mayor Boris still does not get it!

One nearly has to feel sorry for Goldman Sachs - though I would hazard a guess that the people there would not give a fig for our sympathy. But when even politicians such as London's mayor Boris Johnson who do not really have a say in banking regulation start taking aim at banker's bonuses we have to take a stand. Fact number one two and three in the sorry saga of the credit crunch is simply the total failure of banking supervision. And Boris and his fellow-travellers in the political class are barking up the wrong tree. All the politically-inspired interventions in the banking crisis poured oil on the fire and if anything made matters worse (apart from being arbitrary and discriminatory in their treatment of the various banks involved). And even more regrettable is the failure of the 'International Community' to agree on improved and effective rules and regulations.

Implicit government guarantee for banks

Niall Ferguson refers to the the implicit government guarantee for financial institutions deemed 'too big to fail' (Daily Telegraph, 6 October 2009) in a way that seems to imply that managements managed their business recklessly because they relied on being baled out if things did not work out well. We would dispute that managements were that devious and prefer the alternative explanation that - like most market participants - a lot of factors combined to overwhelm managements. A lot of mistakes were made and warnings were ignored but were few were really able to predict the extent of the panic that finally pulled markets to the brink of the abyss. What we are now really worried about is the fact that very little progress is being made in reforming the financial system in a coherent and speedy way.

Blueprint for Global Derivatives Market

Derivatives are in essence a bet on the price of the underlying asset. Economically they are a zero-sum game where the losing side funds the gains of the successful side. Like all bets the derivative markets serve to redistribute wealth minus the costs of running the market. As a consequence of the credit crisis reform of the derivative markets has moved to the top of the political agenda. This is not the place to discuss the role that derivatives have played in the financial crisis. But if more players are active in a market it can only be expected that moves above (and below) underlying value are exacerbated - despite the fact that derivative instruments are often claimed to help move prices back to their underlying trend. I do not agree that moving all derivative trading to exchanges is necessary to avoid bubbles and excessive risks associated with derivative positions as advocated by many commentators. For an new example see the paper just published by Deutsche Boerse. Instead, I think that higher capital requirements to support open positions will be sufficient to reduce the danger (real or imagined) attributed to derivative markets.

Less debt, more equity

Willem Buiter argues that the financial sector in most countries is too large partly because of the implicit government guarantee the sector, and in particular depositors, enjoy. This subsidy (in conjunction with the fact that interest expenses can be deducted for tax purposes) makes debt finance and saving in the form of deposits more attractive than investment and financing conducted in the equity markets. We think that a reduction of this subsidy would have the additional benefit of putting more companies on a more stable financial footing and stimulate the growth of business in general as start-ups and smaller companies in particular would benefit from the reduced attraction of parking money in supposedly safe investments.

Lehman - another eyewitness account

Larry McDonald has just finished and interesting book about Lehman. It just underlines that the all-purpose boards at best are an expensive form of consultant and at worst useless decoration. Would you like to have the ex-CEO of a brezel manufacturer discuss the details of your forthcoming brain surgery with your doctor? As we argue at another place we think that non-executive directors without any experience in the business a company is engaged can more cheaply and effectively be used in the form of consultants. That way it will be much more transparent if the can make a meaningful contribution to a company's progress.

Better Credit Research one of the lessons of the Credit Crunch

The Credit Crunch that we experienced during the past 2 years has produced – apart from financial pain the world over – an unprecedented amount of hot air. We are talking about the countless statements by politicians and self-appointed pundits in the media and academia who have proposed various measures of reform.
Rather than waiting on the outcome of the ‘Global Dialogue’ we suggest investors rely on common sense and focus on improving their own protection against the recurrence of a similar disaster.
Credit Research should be high on the priority list of every Chief Investment Officer or Senior Investment Professional.
We are not surprised to see strong demand for seasoned credit analysts and expect this to continue. Fortunately the convulsions in the financial markets have also resulted in a number of good quality analysts becoming available through no fault of their own.
Should you be looking to upgrade or expand your credit research effort we would be happy to discuss this with you or someone in your organisation.

100 percent mortgages - AGAIN!!

Do some Bank Managers never learn their lesson? One of the banks that was in the middle of the sub-prime crisis has reportedly started to offer 100 per cent mortgages again. The offer by HBOS - which is now part of Lloyds-TSB - may only be available to existing customers who have reached the end of their deal and find their equity wiped out. So HBOS may not have much choice but it still leaves a sour taste in the mouth.

Less Credit and more Equity is the way forward

Contrary to many commentators we do not think that the solution to the present economic crisis lies in restoring lending to unsustainable levels. If anything, business will have to de-leverage and the source of finance will have to be equity capital. In this context it would be useful to device a mechanism that prevents 'Private' Equity Capital from financing 'pass-the-parcel' transactions. Venture Capital should again be what it was originally designed for: a source of risk capital for new and growing enterprises.

Russian oligarchs and Western homeowners

BarCap's Rudloff calls for end to debt 'war' in Russia (FT, 21 April 2009). Many homeowners facing foreclosure would like to get veteran investment banker Hans-Joerg Rudloff on their side as well. Today he urges borrowers and creditors in Russia 'to forget about trying to enforce claims through legal action and focus on the effective restructuring of debts and assets'. We do not think that oligarchs merit a more charitable attitude than homeowners and if anything would have thought that the current crisis gives an opportunity to redistribute assets to more disserving owners.

Shall we 'modify' away Wilbur Ross' wealth?

Shall we 'modify' away Wilbur Ross' wealth?
During the past few weeks the chorus of experts in politics, academia and business has become noisier by the day. Everyone tries to peddle his own personal solution to the credit crisis. What is being lost more and more is any sense of personal responsibility and accountability. Each and Everyone seems to be entitled to be bailed out by 'society' or the 'community' (especially the 'international community').
Today the American 'Billionaire' investor Wilbur Ross contributed his 5-cents worth of wisdom on CNBC by suggesting that it should be made possible to 'modify' the terms of all residential mortgages in the USA. Effectively he is suggesting that either the taxpayer or - more likely - the mortgage creditors gift a cheque to the homeowner (more likely only those that the rulers consider worthy of public largesse).
One has to wonder what Mr. Ross would think if the legislators and other experts would hatch the idea that his wealth could be used to compensate the losers in the credit crunch? This idea may sound outlandish at first but there is no material difference to the idea of taking away agreed interest payments from those who lent through mortgages in good faith.

More on Mark-to-Market

See also: Former FDIC Chairman William Isaac on some historical perspective on mark-to-market accounting: Market Value Accounting Crippling Economy (American Spectator, 12 Nov 2008)

Failure of Accounting Reform

An interesting article supports our view about the problems associated with Mark-to-Market: Jesus Huerta de Soto: Financial Crisis, The Failure of Accounting Reform (Mises Blog)

Death Spiral in the Banking System out of Control?

After having watched the Banking System all our adult life (and some more) we are the first to admit that managements have committed serious errors of judgement. This just reinforces our view that hiring the right people is the most important job for all those working in positions of responsibility in any bank of other financial service business.
But this particular banking crisis is characterised by certain features that have a tendency to push institutions further down the path to ultimate destruction. For instance, hardly anyone seems to focus on what proportion of the loan books are actually delinquent. Instead, there is constant talk of 'toxic assets' most of which turn out to be mortgages that just happen to be under water to different degrees. Nothing new to that. That has happened before and will happen again.
Instead, the markets, commentators and the authorities are completely enthralled by what can only be described as a 'death spiral' of weakening economic data and falling asset prices which drive 'market prices' down. The main culprit is the 'mark-to-market' rule that has been designed to keep accountants, auditors and theoreticians in academia happy. Never mind that these 'prices' are created in thin markets and pushed around by speculation. They are accepted as gospel truth even though it is a well-established fact that all markets overshoot - on the way up and on the way down.
As a result prices for so-called 'toxic' assets are divorced from reality where assets may be somewhat impaired but are still in the major part serviced by debtors. The difference between these two levels of valuation is the difference between a banking system that is in trouble but able to work its way out of a hole and a banking system destined to hit the buffers sooner or later.
In addition, respected analysts such as Meredith Whitney (CNBC, 14 Jan 2009) paint a horror picture where banks are supposed to look at economic data such as employment or home price trends and mark down their books according to some spurious economic forecast. That assumes that economic forecasting is an accurate science - a heroic assumption if there ever was one!
The latest fashion among commentators is the reference to the 'Swedish Model' of bank rescue. As no one seems to realise what is driving the death spiral they jump to the conclusion that all bad assets should be written off against shareholder equity. Given the logic of 'mark-to-market' that would mean that ever-declining 'market prices' would set the benchmark for these write-offs. Naturally, the authorities - who must share a major part of the blame (banking was always heavily regulated and the authorities were if anything supposed to prevent bank runs) have to step in and nationalise the institutions.
Ironically this outcome would not even mean that lending can resume as usual. In our impatient age politicians, the media, academics and the world of business seem to have forgotten that credit cycles are a major - maybe the major - force behind economic cycles. After an extended period of excess credit creation it is inevitable that a period of credit contraction will follow. Banks have to rebuild balance sheets and the same applies to business and consumers.