Too Big To Fail fact of the day

Zero Hedge quotes the latest report from the US Office of the Currency Comptroller and writes about the extreme concentration of derivatives risk in the US financial markets,

"Of the $250 trillion in gross notional amount of derivative contracts outstanding (consisting of Interest Rate, FX, Equity Contracts, Commodity and CDS) among the Top 25 commercial banks (a number that swells to $333 trillion when looking at the Top 25 Bank Holding Companies), a mere 5 banks (and really 4) account for 95.9% of all derivative exposure... The top 4 banks: JPM with $78.1 trillion in exposure, Citi with $56 trillion, Bank of America with $53 trillion and Goldman with $48 trillion, account for 94.4% of total exposure."

And more worryingly, the TBTF problem keeps getting worse, posing even greater systemic risks,

"The biggest banks are not only getting bigger, but their risk exposure is now at a new all time high and up $5.3 trillion from Q1 as they have to risk ever more in the derivatives market to generate that incremental penny of return."

No lessons learnt - The UBS ETF scam

The $2 bn loss incurred by the rogue UBS trader Kweku Adoboli is surely another big blow to the confidence of the embattled European banking sector. It is also a reiteration of the fact that financial market regulators and governments have learnt little from the bitter lessons of the sub-prime mortgage meltdown.

Adoboli headed the Exchange Traded Funds (ETF) trading desk, which packaged ETF-based derivatives and transacted its trades for clients, and which are typically hedged to minimize risks. But Adoboli did not always hedge them, thereby exposing the bank to huge swings.

ETFs track financial indices and its value arises from either directly from an underlying index fund or a derivative with the index fund as the counterparty. It is the later which makes ETF's risky. If the counterparty suffers a huge loss, leaving it without the funds to service the derivative contract, then the ETF owner suffers huge losses.

Further, depending on the complexity of the packaging of the underlying index funds, the risk is dispersed far and widely across, making it difficult to accurately locate and price risk. In recent years, as ETFs have gained popularity, investment banks have even been packaging ETF derivatives to create "synthetic" ETFs (the counterparty is another set of derivatives). In this regard, it is similar to the complex and highly opaque Collateralized Debt Obligations (CDOs) and synthetic CDOs constructed by splicing and dicing and then packaging pools of mortgage loans.

The risks from activities of traders like Adoboli go beyond these. His 'Delta One' trading desk effectively conducted both client and proprietary trading. Investor clients were promised certain benchmark returns, with the excess returns going to the bank (and those in the trading desk), an incentive for the traders to take extra risk, often leveraging their employer's (bank's) balance sheet. Sometimes, even as banks sell ETF's to their clients, they themselves form the derivative counterparty (positions often taken with their proprietary capital), thereby creating the potential for deeply undesirable conflicts of interests.

Adoboli is only the latest in the long history of such rogue traders - Tomonori Tsurumaki of Sumitome, Nick Leeson of Barings, and Jérôme Kerviel of Société Générale - who caused huge losses to their employers and clients. Incidents such as these lend further weight to the argument that even the best monitoring cannot firewall a determined trader who tries to systematically mislead his employer, even over long periods of time. This naturally revives calls about separating commercial and investment banking operations in big financial institutions. An editorial in FT succinctly sums up the need of the hour,

"The narrow lesson is that derivatives can conceal risk as well as manage it. The broad lesson is that inherently risky investment banking must not be allowed to contaminate utility banking or the wider economy. It is a call to speed up efforts to increase investment banks’ capital buffers and the ease with which they can be resolved if the buffers are worn through. If this is done, the risks investment banks take on and the gains and losses that ensue are largely a matter between banks and their shareholders – provided that shareholders are not defrauded or misled."

The final report of the Independent Commission on Banking, appointed by the British Government to improve stability and competition in the British banking system, and headed by John Vickers, which was released a few days before, has much the same to say. It calls for ring-fencing investment and deposit taking retail banking and alos higher capital buffers for investment banks to limit systemic risks.

Ring-fencing will limit the taxpayer guarantees to individual and business depositers and will not cover the risks taken by traders within the investment bank. Today, the deposit insurance guarantee within the large universal banks (that combines all activities, not spearated from each other), acts as an effective public subsidy for their private investment banking activity. As Martin Wolf has argued, ring-fencing, and not outright separation (as was the case during the Glass-Steagall era in the US, which was replaced with the Gramm-Leach-Bliley Act in 1998), will retain the benefits of a single management - like an investment bank bailing out its failing retail banking division.

In this context, Matt Taibi raises an important point about inherently risk-taking investment banking traders and the apparent incompatibility of their activities with the need to protect the interests of retail depositers and tax payers. He argues that there is little distinction between rogue traders and most investment bankers, in so far as both have the freedom to take excessive risks with their client's money and bear limited direct and immediate responsibility to their clients' interests. He writes scathingly about the adverse consequences of the legal end to separation of retail and investment banking and the inherent risk-taking nature of investment bankers,

"the brains of investment bankers by nature are not wired for "client-based" thinking... it just defies common sense to have professional gamblers in charge of stewarding commercial bank accounts... Investment bankers do not see it as their jobs to tend to the dreary business of making sure Ma and Pa Main Street get their $8.03 in savings account interest every month... investment bankers by nature have huge appetites for risk...

The influx of i-banking types into the once-boring worlds of commercial bank accounts, home mortgages, and consumer credit has helped turn every part of the financial universe into a casino... They’re not "rogue" for the simple reason that making insanely irresponsible decisions with other peoples’ money is exactly the job description of a lot of people on Wall Street... they don’t call these guys "rogue traders" when they make a billion dollars gambling.

The only thing that differentiates a "rogue" trader like Barings villain Nick Leeson from a Lloyd Blankfein, Dick Fuld, John Thain, or someone like AIG’s Joe Cassano, is that those other guys are more senior and their lunatic, catastrophic decisions were authorized... if you're a well-groomed 60 year-old CEO who uses his authority to ignore quality control and internal audits in order to make disastrous trades that could sink the company, you get a bailout, a bonus, and heroic treatment in an Andrew Ross Sorkin book... rogue companies are protected at every level of the regulatory structure and continually empowered by dergulatory legislation giving them access to our bank accounts."

Felix Salmon's makes this excellent case for separating or atleast ring-fencing retail/commercial and investment banking activities,

"When you’re hiring people for the UBS trading floor, you’re hiring men who love to win, congenital risk-takers. And then you surround them with risk-management protocols designed to keep them under some semblance of control. There’s a natural tension there. And if you take the hundreds of thousands of risk-takers working on trading floors in London and Hong Kong and New York and Paris, it’s a statistical inevitability that one or two of them will go rogue every year or so.

Risk-managment protocols are important, but they can never be foolproof, because they’re run by humans. So we really shouldn’t let investment bankers — by which I mean risk-hungry traders with access to billions of dollars of balance sheet — anywhere near the systemically-important balance sheets of our largest commercial banks. Losses like the $2 billion at UBS are manageable. But they’re small beer compared to the entirely legitimate losses made by the likes of Morgan Stanley’s Howie Hubler during the financial crisis. He managed to lose $9 billion, and get paid millions for doing so."

The derivatives contract in slum housing!

Slumania is a squatter slum in the Urbania Municipality of Corruptionland. It houses nearly 500 families in 3 acres of government land. Like other such slums, it has all the features of un-planned growth - small and irregular lanes, no side drains and sewerage network, leaking water lines, unhygienic surroundings etc. The election promise of Aya Ram, the local MLA, was to get a multi-storied housing colony sanctioned with roads, water and sewerage lines.

Finally, thanks to the his efforts, as part of the National Urban Development Mission (NUDM), the Government have sanctioned multi-storied (G+3) housing units with all infrastructure facilities. The Urban Community Development wing of Urbania Municipality does the Socio-Economic Survey (SES) to document the list of beneficiaries. Possession Certificates (PCs) of all beneficiaries are prepared and kept ready for distribution.

Simultaneously, Aya Ram's cronies swing into action. They demand that Rs 10000 be paid by each household to ensure registration. This is despite their name already having been cleared in the SES conducted by the Municipal authorities. Now, Rs 10,000 is not a small amount for the beneficiaries. Most of them already face an uphill struggle to pay the Rs 10000-20000 beneficiary contribution required to get the house sanctioned. Despite this, they immediately pay Aya Ram's extortionary tribute.

Why do people pay the premium despite their name finding place in the SES list and the assurance of a formal government mandate, the PC? This requires an examination of the post-sanction risks faced by the PC holder. After the sanction, the processes of tender finalization and completion of work, would take atleast 12-18 months. Even the process of physical allotment has numerous uncertainties associated. This is a long enough window for several risks to surface - the local muscleman may arm-twist the beneficiary off his PC, Aya Ram's cronies may collude with officials to issue duplicate certificates on the same house (thereby robbing the beneficiary off his allotted house), and so on. So here is the economic rationale behind the exorbitant premium,

1. The premium is a hedge against these risks. It is the cost of buying protection against these uncertainties. The contract is a form of derivative - beneficiary being the protection buyer, Aya Ram the protection seller, and protection against dispossession is the risk being purchased! The payment made to Aya Ram's cronies is proportional to the perceived risks to obtaining final possession of the house. In many respects, it is the simplest of insurance contracts.

2. The willingness of the beneficiaries to pay an exorbitant premium, despite possessing a government issued and legally valid certificate (the PC), is a reflection of the credibility deficit of government contracts. In other words, the premium is a measure of the cost of the contract (even government ones) enforcement in such environments. Higher the premiums, greater the institutional credibility deficit or weaker the contract enforcement conditions.

Back to square one - financial market regulation?

The bitter lessons of the sub-prime crisis appears to be slowly receding away from memory and the unhealthy practices that inflated the sub-prime bubble era are returning back with vengeance. Now that the markets are back to normal, atleast in appearances, the urge to return to the boom days is proving irresistible.

The latest evidence comes from the US Federal Reserve’s recent decision to allow major banks to increase their dividends and to buy back shares. The decision comes in the aftermath of the Fed's Comprehensive Capital Analysis and Review (CCAR), a cross-institution study of the capital plans of the 19 largest US bank holding companies.

In an excellent post, Simon Johnson has strongly contested this decision and the validity of the CCAR to reliably assess the strength of banks

"The Fed’s decision on dividends effectively lets the banks pay out shareholder equity, making the banks more highly leveraged... Bank executives and other key personnel are paid on a "return on equity" basis, so this increases their upside — that is, what they will make as long as the economy and their sector does well... Any individual bank will want to keep its equity levels low, because its executives and owners are not worried about system-wide spillover costs, such as what happens to other banks when one bank fails."

The failure risk for big banks is mitigated by the blanket insurance provided by the too-big-to-fail problem - governments cannot allow such institutions to sink for fear of a financial market meltdown. The bank executives, creditors, and even shareholders, all suffer from the moral hazard problem arising from this.

In a letter to the Financial Times, Anat R Admati and her colleague financial academics, had this to say about dividend payouts and share buybacks,

"A dollar paid out to shareholders through either dividends or share repurchases is a dollar that would not be accessible to creditors in a situation of financial distress. For this reason, and to prevent the shifting of value from debt holders to equity holders, debt covenants typically restrict dividend payments when leverage is high... taxpayers should be concerned when banks pay dividends and remain thinly capitalized, because, as we have seen, taxpayers are the ones who are likely to end up covering the banks' liabilities in a crisis... retaining earnings is generally viewed as the least costly way to raise funds and build capital, as it avoids the transactions costs associated with new equity issuance."

This debate revolves around one of the most fundamental problems in modern financial markets - who will bear the cost of addressing the systemic risks (with its massive negative externalities) that are generated by certain actions of banks, what should be that cost, and in what form should it be levied?

The sub-prime crisis has drawn attention to the dangerous consequences of excessive risk-taking and leverage, and the systemic risk created by too-interconnected to fail big financial institutions (the TBTF problem). The tax payers had to bear the burden of the massive amounts required to bailout financial institutions in the aftermath of the bursting of the mortgage bubble. It is therefore universally accepted that these financial institutions have to internalize the cost of addressing the systemic risks generated by their actions.

It is widely acknowledged that adequate equity capital and reasonably high enough counter-cyclical risk weighted capital reserves are necessary to meaningfully resolve these problems. The global banking regulators recently announced the Basel 3 regulations in an effort to mitigate the systemic risks that arise in the financial markets. However, a large number of influential financial economists have argued that the capital reserves required to address such risks are much higher than what is proposed under the Basel 3.

In an excellent NYT article Gretchen Morgenson points to a few other instances of attempted regulatory dilution as the Dodd-Frank Law becomes operational. These measures are being pushed by taking the cover of getting the securitization, derivatives and the mortgage market moving again and to buoy falling home and other asset prices.

One of the biggest achievements of the new legislation was to route all derivative trades through clearing houses and exchanges. However, now bankers are calling for exempting currency swaps from Dodd-Frank citing a provision that permits the Treasury secretary to exempt foreign-exchange swaps from the regulation. Foreign exchange swap trades are in the range of about $4 trillion a day, and trading in foreign-exchange contracts generated revenue of $9 billion in 2010 in the top five US banks, more than was produced by any other type of derivative.

Critics say that the only the only reason this market did not seize up like others during the meltdown was that the Fed lent huge amounts — $5.4 trillion — to foreign central banks through so-called swap lines during the fall of 2008. However, the Treasury Secretary Tim Geithner looks inclined to providing the exemption.

There are details of interpretation of specific provisions in the Dodd Frank law that could determine whether the relevance or otherwise of the regulation. One concerns how regulators define a 'qualified residential mortgage'. Morgenson writes,

"Issuers of asset-backed securities that are made up of such loans needn’t keep any credit risk of those securities. But sellers of loan pools that don’t consist of qualified mortgages are required to retain some of the risk in them. This provision was meant to eliminate the perverse incentives of the mortgage boom, when packagers of loan pools were encouraged to fill said pools with toxic waste because they had little or no liability for the deals once they were sold.

What constitutes a qualified mortgage has become a battleground issue because of the risk-retention rules under Dodd-Frank. Qualified mortgages should be of higher quality, based upon a borrower’s income, ability to pay and other attributes to be decided by financial regulators... Among the questions to be considered is how much of a down payment should be required in a qualified loan, and whether mortgage insurance can be used to protect against the increased risks in loans that have smaller down payments.

The use of mortgage insurance during the boom effectively encouraged lax lending. Investors who bought securities containing loans with small or no down payments were lulled into believing that they would be protected from losses associated with defaults if the loans were insured. But when loans became delinquent or sank into default, many mortgage insurers rescinded the coverage, contending that losses were a result of lending fraud or misrepresentations. When they did so, the insurers returned the premiums they had received to the investors who owned the loans.Lengthy litigation between the parties is under way but has by no means concluded.

Clearly, for many mortgage securities investors, this insurance was something of a charade. So any argument that mortgage insurance can magically transform a risky loan into a qualified residential mortgage should be laughed off the stage. And yet, mortgage insurers are making those arguments vociferously in Washington."

She also points to the battle to re-open trade on covered bonds - pools of debt obligations that have been assembled by banks and sold to investors who receive the income generated by the assets, while the issuing bank retains the credit risk. The problem with this is that since the investors who bought the covered bonds would have first call on the banks' assets (over that of the FDIC), this would wind up bestowing a new form of government backing (FDIC's deposit insurance) to the major banks issuing the bonds.

And confirmation that things are indeed getting back to normal comes from the graphic below of financial sector (it accounts for less than 10% of the value added in the economy) profits, which have regained its pre-crisis share and is back to more than 30% of all domestic US profits



Felix Salmon should have the last word,

"Banks are still extracting enormous rents from the economy, and profits which should be flowing to productive industries are instead being captured by financial intermediaries. We’re back near boom-era levels of profitability now, and no one seems to worry that the flipside of higher returns is higher risk. Any dreams of seeing a smaller financial sector have now officially been dashed. And the big rebound in corporate profits since the crisis turns out to be largely a function of the one sector which we didn’t want to recover to its former size."

US Treasury to sell $142 bn worth of toxic assets

© AFP/File Karen Bleier

AFP

WASHINGTON (AFP) - The US Treasury Department on Monday said it would begin to sell-off toxic assets worth an estimated $142 billion, in an effort to close another chapter of the financial crisis.

"We will exit this investment at a gradual and orderly pace to maximize the recovery of taxpayer dollars and help protect the process of repair of the housing finance market," said Treasury official Mary Miller.

The department said it would offload up to $10 billion in mortgage-backed securities (MBS) -- assets which bundle together large numbers of often distressed mortgages -- each month.
The products, secured by state-backed mortgage giants Fannie Mae and Freddie Mac, were bought as part of the 2008-2009 financial sector bailout.

Their value plummeted after the housing bubble popped, prompting fears that a spat of asset write-downs could drag down individual banks and further plunge the financial system into panic.

The Treasury said the market for asset-backed derivatives is now much more robust, three years after the depths of the crisis.

"The market for agency-guaranteed MBS has notably improved since the time Treasury purchased these securities in 2008 and 2009," it said in a statement.

The Treasury hopes to net $15-20 billion profit from the sale, depending on market conditions.

The Treasury has also recently offloaded equity stakes in Citigroup, General Motors, Ally Financial and AIG it took to help them survive the crisis.

US insurer American International Group recently offered to buy back $15.7 billion in mortgage-backed securities from the Federal Reserve as part of its efforts to emerge from a government bailout.

© AFP -- Published at Activist Post with license

Related Articles:

US trade gap hits seven-month high

White House pushes Congress to avert shutdown

America's New Aristocracy

The Middle East and Then the World

Who Will Suffer in This Collpase? (Charlie McGrath Video)

LinkWithin

Enter your email address to subscribe to our newsletter:


Delivered by FeedBurner

Shareholder capitalism under threat?

Stock markets, one of the bedrocks of modern capitalism, are supposed to ensure efficient allocation of financial resources by both providing a platform for businesses to raise investible funds and an outlet for investors, big and small, to invest their savings. However, there is an increasingly evident trend that questions whether either objective is being met.

On the one hand, businesses, atleast the best-performing ones, are raising an increasing share of their financial needs privately. On the other hand, the sharp market volatility of recent years, coupled with pervasive regulatory failures, mean that equity markets are no longer as safe and attractive an investment option for the small retail investor as earlier.

In an excellent NYT op-ed, Felix Salmon brilliantly captures the "noisy sideshow" that stocks markets have become in the US. He writes about the equity market trends in the US,

"The stock market is becoming increasingly irrelevant — a trend that threatens the core principles of American capitalism. These days a healthy stock market doesn’t mean a healthy economy, as a glance at the high unemployment rate or the low labor-market participation rate will show... What’s good for Wall Street isn’t necessarily good for Main Street... the glory days of publicly traded companies dominating the American business landscape may be over. The number of companies listed on the major domestic exchanges peaked in 1997 at more than 7,000, and it has been falling ever since. It’s now down to about 4,000 companies, and given its steep downward trend will surely continue to shrink... Put another way, as the number of initial public offerings steadily declines, the stock market is becoming little more than a place for speculators and algorithms to compete over who can trade his way to the most money."

He writes that the shares of innovative listed companies like Google and Apple "are essentially speculative investments for people making a bet on how we’re going to live in the future". Further, attractive technology firms like Facebook and Twitter raise resources privately and are therefore out of bounds common investor public. The insulation from regulatory oversight, investor accountability, and the pressures to match market expectations, mean that companies prefer it that way. His conclusion raises serious concerns,

"Only the biggest and oldest companies are happy being listed on public markets today. As a result, the stock market as a whole increasingly fails to reflect the vibrancy and heterogeneity of the broader economy. To invest in younger, smaller companies, you increasingly need to be a member of the ultra-rich elite."

Stock markets continue to be important sources of raising business capital in countries like India. However, like in the US and other developed markets, derivative operations have assumed an increasing share of equity markets in India.

An examination of the records on capital raised by private firms through private placement and public market offerings throws up interesting results. As can be seen, private placement remains the overwhelmingly major route for private firms to raise fresh capital and the preference is increasing.




Even after deducting the share of private financial institutions share in the private placement market, the figures remain heavily skewed in favor of the private placement route.

Given all this, primary market remains a small investment channel for retail investors. Most retail investor activity is confined to the secondary markets, and as mentioned above, increasingly to the derivative markets.