This is a debate which needs to be aired in the widest possible way.

TO BE NOTED: From the FT:

"Insight: When it comes to global banks, size matters

By Gillian Tett

Published: June 18 2009 19:37 | Last updated: June 18 2009 19:37

Do the big global banks need to be cut down to size? That question has been hovering, half-stated, over the financial system ever since Bear Stearns blew up.

But until this week, most policymakers were reluctant to attack the big banks too publicly, in terms of size. After all, this has been the decade when global leaders – or the infamous “Davos man” – worshipped at the altar of free-market capitalism, globalisation and innovation.

Inside the Davos creed it was long assumed that private sector banks had the right to be as big as the market would bear, since scale was supposed to make finance efficient, and thus better able to promote innovation.

Now that creed has crumbled. The collapse of Lehman Brothers has shown the havoc that can ensue when large, interconnected banks implode.

Worse, in the aftermath of Lehmans, as governments have rushed to rescue the banks, the potential fiscal costs – and risks – have become clear. In the UK, for example, the balance sheet of the Royal Bank of Scotland at its peak was not far from the size of the British economy.

Thus, a new debate about “size” is finally starting. On Wednesday Mervyn King, Bank of England governor, warned that regulators might need to rethink the wisdom of letting some banks become “too big to fail”. In Washington, the Obama administration has voiced similar thoughts, albeit more diplomatically and obliquely.

On Thursday, though, an even more interesting and outspoken intervention emerged. Philipp Hildebrand, the next head of the Swiss National Bank, revealed that the central bank was considering introducing “direct and indirect measures to limit the size” of large international banks (which in the case of Switzerland means Credit Suisse and UBS).

“A size restriction would of course be a major intervention in an institution’s corporate strategy,” Hildebrand, the central bank’s current vice-chairman, observed with masterful understatement. “Naturally the SNB is aware that there are advantages to size. [But] in the case of the large international banks, the empirical evidence would seem to suggest that these institutions have long exceeded the size needed to make full use of these advantages.”

Now, to be fair to Hildebrand, I should stress that he only presented size controls as a policy of last resort. He is not, in other words, demanding the immediate break-up of UBS or Credit Suisse.

For what really worries the SNB is not any abstract issue about size, but the very practical problems that emerge when big banks collapse due to the absence of any international regime to wind down a large, cross-border bank smoothly – or restructure its operations.

What Hildebrand really wants to see is a credible international framework to handle big bank failures in a way that does not blow up the financial system. Call it, if you like, a call for a global Chapter 11 regime for banks.

Hildebrand is also a realist who spent the early years of his career working for a US hedge fund. He does not consider it a good trading bet to sit around waiting for global bureaucrats to actually produce a global insolvency regime any time soon. Hence his determination to start talking about plan B – and to stop banks from becoming too big if there is no global framework in place to deal with a collapse.

Whether Hildebrand’s idea will actually fly is unclear. Some Swiss politicians hate the idea of introducing measures that might leave their banks at a disadvantage relative to others. And Credit Suisse and UBS have powerful lobbying muscle, precisely because they are so ... er ... big.

Hildebrand is not the only western policy maker mulling these concepts. And he has successfully stuck his neck out before. Last year he was the first western central banker to call for the use of a leverage ratio to help monitor bank capital levels. The concept was loathed by Swiss banks, but is now being introduced into Switzerland and may yet be incorporated into a revamped Basle code.

So it will be worth watching closely to see how the SNB’s debate about size curbs develops. And I, for one, think the proposals deserve to be taken seriously. Quite apart from the fact that the world is littered with banks which are too big to fail (but too costly to keep saving), the world also has banks that are too big to manage. The sorry tale of UBS’s disastrous dealing with subprime securities is a case in point. So are the sagas of Citigroup and Merrill Lynch. Thus making banks smaller may not only be good for non-banking taxpayers, but it might yet bring some real benefits for bankers too – not just in small countries (such as Switzerland) but places which tend to worship size too (such as the US). This is a debate which needs to be aired in the widest possible way.

gillian.tett@ft.com"

it was perfectly valid to discuss money in abstract, mathematical, ultra-complex terms, without any reference to tangible human beings

TO BE NOTED:

1
Draft review essay for London Review of Books. Third draft
Safer than Safe
FOOL’S GOLD: HOW UNRESTRAINED GREED CORRUPTED A DREAM,
SHATTERED GLOBAL MARKETS AND UNLEASHED A CATASTROPHE by
Gillian Tett. Little, Brown, 338 pp., £12.99, 30 April, 978 1 4087 0167 6
Donald MacKenzie
Few people’s reputations have been improved by the credit crisis. One is the BBC’s
Robert Peston; another Vince Cable. A third is Gillian Tett, capital markets editor of
the Financial Times. Prior to the crisis, she and her team were the only mainstream
journalists who covered in any detail the then arcane, technical world of ‘credit
derivatives’ (of which more below). Tett saw – however imperfectly – the huge risks
that were accumulating unnoticed within that world, and spoke out about them.
Fool’s Gold begins in a conference room in Nice in spring 2005. Tett admits
that at that point she was baffled by the technical language – ‘Gaussian copula’,
‘attachment point’, ‘delta hedging’ – being spoken by the participants. However,
before joining the FT she had conducted fieldwork in Soviet Tajikistan for a PhD in
social anthropology, and the ethnographer in her re-awoke. The conference reminded
her of a Tajik wedding. Those attending it were forging and refreshing social links,
and celebrating a tacit worldview – in this case, one in which ‘it was perfectly valid to
2
discuss money in abstract, mathematical, ultra-complex terms, without any reference
to tangible human beings’.
Who were the key actors in the ceremony, those up on the conference hall’s
stage? She whispered the question to the man sitting beside her. ‘They used to all
work at J.P. Morgan. … It’s like this Morgan mafia thing. They sort of created the
credit derivatives market.’ The answer surprised her. J.P. Morgan was not Goldman
Sachs: it wasn’t an exciting bank. It bore the name of America’s most celebrated
financier, but it was ‘dull’: safe, boring, perhaps a little snobbish. (When its current
chief executive, the now well-respected Jamie Dimon, joined the bank from Bank
One, which was headquartered in Chicago, Tett reports one Morgan banker muttering
‘Not another retail banker from Hicksville, USA!’)
The core of Tett’s fine book, which is by far the most insightful of the first
wave of books on the crisis, is the story of J.P. Morgan’s credit derivatives team. For
all the bank’s traditionalism – the door staff at its London offices wear uniforms that
would not be out of place outside the Ritz – it was quietly innovative, and its blueblooded
heritage did not block all diversity. One of the team’s driving forces was a
young Englishwoman, Blythe Masters; another, Terri Duhon, makes no secret of her
upbringing in a trailer in Louisiana; central to its technical work was an Indian
mathematician, Krishna Varikooty. Boisterousness that would have horrified John
Pierpont Morgan was tolerated. Tett describes how at one off-site gathering in
Florida, one of the team’s managers broke his nose when he was being pushed into a
hotel swimming pool by drunken colleages.
3
The team’s pivotal innovation was a December 1997 deal they called ‘Bistro’
(Broad Index Secured Trust Offering). For a decade, banks had been experimenting
with credit derivatives, which are ways of separating out the ‘credit risk’ involved in
lending (the risk that borrowers will default on their obligations, failing to make the
required interest payments or not repaying their loans) and making that risk into a
product that can be bought and sold. Bistro helped turn this tentative activity into big
business.
Bistro transferred to external parties the credit risk of loans totalling $9.7
billion that J.P. Morgan had made to 307 companies. The scheme was an influential
version of the CDOs (collateralised debt obligations) that I described in LRB on 8
May 2008. Like other CDOs, Bistro was divided into ‘tranches’, of which originally
there were two. Investors in the lower or ‘junior’ tranche received a healthy rate of
return, 375 basis points over Libor (London interbank offered rate), which is the
average rate at which a panel of leading banks report they can borrow from other
banks. (A basis point is a hundredth of a percentage point.) This compensated the
junior investors for the fact that their investments would bear the initial losses,
beyond a small reserve built up during the deal’s first five years, should any of the
307 borrowers default.
Only if those losses were to exceed the entirety of the investments in the
junior tranche would the holders of Bistro’s senior tranche – which paid only 60 basis
points over Libor – suffer. The loans that made up Bistro were well-diversified across
industries, and predominantly to blue-chip companies, so losses to Bistro’s senior
tranche seemed unlikely enough to Moody’s, one of the three leading credit rating
4
agencies (the others are Standard & Poor’s and Fitch), that it awarded the tranche its
highest rating, Aaa.
Aaa was a rare distinction. Only a dozen corporations and less than two dozen
governments were judged worthy of it: neither Italy nor Japan, for example, has an
Aaa rating. (As readers will know, Standard & Poor’s has indicated that the UK is
now also in some danger of losing its top rating.) Blythe Masters had formidable
powers of persuasion, which helped when selling a deal that ‘look[ed] like a science
experiment, with all those arrows’, as one investor quoted by Tett described Bistro’s
documentation. Yet 60 basis points over Libor, for an investment judged safer than
the sovereign bonds of some of the world’s leading economies, was the most
powerful argument of all: an investor would normally struggle to find an Aaa
investment that yielded as much as Libor.
For J.P. Morgan, Bistro solved one problem and potentially addressed a
second. First, while the 307 corporations were low risks, even the most creditworthy
borrowers can default. So $9.7 billion in loans to the 307 corporations was a
significant constraint on the bank’s future lending. Bistro removed that constraint.
Second, the Basel Capital Accord, signed by the world’s leading banking regulators in
1988 and implemented by them in 1992, forced banks to carry reserves equal to 8
percent of their risk-weighted lending. While certain categories of lending – to other
OECD banks, for example – qualified for a reduced reserve requirement, loans to
even the safest industrial corporation incurred the full 8 percent, a figure that bankers
felt was far larger than justified by the risks involved. J.P. Morgan hoped that the
transfer of credit risk achieved by Bistro would persuade regulators to reduce that
5
requirement considerably, and Tett reports that Blythe Masters and her colleague Bill
Demchak pushed the Federal Reserve and the Office of the Comptroller of the
Currency to clarify what exactly would be needed to achieve that.
Bistro differed from earlier CDOs in that it did not, in fact, transfer to external
investors all the credit risk of the $9.7 billion of loans. The junior and senior tranches
amounted in total to only $700 million; the bank believed that the chances of losses
ever exceeding that figure were too tiny for it to be worth paying investors to shoulder
them. The regulators, however, demanded that the bank do something to remove that
residual ‘unfunded risk’ before they would relax the 8 percent capital requirement.
The residual risk was like a topmost tranche, sitting on top of the senior
tranche; it would come into play only if losses wiped out the latter in its entirety. The
senior tranche was Aaa, as safe as it gets; the residual ‘super-senior’ tranche (as the
J.P. Morgan team christened it) was thus safer than safe. To satisfy the regulators,
however, the team turned to the Financial Products division of the leading US insurer,
AIG. Sharing J.P. Morgan’s analysis that the super-senior tranche was ultrasafe, AIG
agreed to insure it against all remaining losses, charging an annual premium of only a
fiftieth of 1 percent of the sum insured. From the viewpoint of AIG Financial
Products, it was small-scale business but apparently highly profitable: by covering an
effectively non-existent risk, the firm earned $1.8 million a year.
In that little afterthought to Bistro – what to do with the super-senior tranche –
lay the germ of much of the credit crisis, especially of its disastrous effects on many
of the world’s leading banks. Bistro-like deals started in the world of corporate
6
borrowing, but from 1999 onwards began also to be implemented in the world of
consumer debt, especially mortgages. There was actually longer experience of
packaging mortgages into securities than of packaging corporate debt into CDOs, and
mortgage-backed securities had acquired an admirable reputation for safety.
Mortgage-backed securities have a structure like that of CDOs, with different tranches
carrying various levels of exposure to risk. The safest, Aaa, tranches of those
securities had impeccably default-free records, and even the riskier tranches had
performed well: indeed, on average generally better than corporate bonds with the
same ratings. It wasn’t that people never defaulted on their mortgages – they did –
but the securities were designed to take this into account, for example by building up
reserve funds (analogous to but usually proportionately larger than Bistro’s small
reserve) that would absorb the anticipated losses. For many years, such provisions
proved in general fully adequate.
What happened from 1999 on was that mortgage-backed securities, which
already represented one layer of packaging of debt, then started to be repackaged into
CDOs, thus creating a ‘Russian doll’ product: a tranched, packaged product each of
the components of which was itself a tranche of a packaged product. Given their
excellent reputation, putting mortgage-backed securities rather than corporate bonds
or loans inside CDOs might seem a small step. Yet when in 1999 Bayerische
Landesbank, which had become involved in the US mortgage market, approached J.P.
Morgan to package $14 billion of bundles of mortgages and other forms of
predominantly consumer debt into a Bistro structure, there were initially serious
doubts within the Morgan team.
7
The problematic issue was correlation( NB DON ), which is at the core of evaluating a
CDO. Low correlation means that defaults are essentially idiosyncratic events, with
the consequence that only the bottommost tranche of a typical CDO is at significant
risk. In contrast, high correlation means that if defaults happen they tend to cluster,
and the clustering of defaults puts investors in the higher, apparently safer, tranches at
risk of loss.
Participants in the emerging credit-derivatives market tended to be confident
that they had a fair grasp of the correlation( NB DON ) of corporate defaults. The rating agencies
had large databases of such defaults from which the extent of clustering could be
inferred at least roughly, and other market participants often took the easily measured
level of correlation between the moves of different corporations’ stock prices as a
guide to the correlation of their net asset values. (The link between the latter and
default is that the most important cause of corporate default is bankruptcy, which can
be though of as happening when a corporation’s net asset value falls below zero: that
is, when its liabilities exceed its assets.) Clearly, the correlation of the asset values of
two different corporations was unlikely to be zero, since general economic conditions
will affect both. Nor, however, were corporate asset correlations thought likely to be
1.0, the value that indicates perfect correlation. 0.3 was a commonly-used figure.
That, for example, was the standard level of correlation between the asset values of
firms in the same industry that Standard & Poor’s initially assumed in CDO
Evaluator, the software system it began using in 2001 in the rating of CDOs.
The credit crisis has inured us to gigantic numbers – losses measured in
billions or trillions of dollars – but we need to pay attention to its little numbers as
8
well as its big ones if we’re going to understand it properly. A correlation of 0.3 was
modest. If it was correct it would be highly unlikely that the senior tranche of a CDO
such as Bistro would suffer a loss – unlikely enough to warrant an Aaa rating – and
effectively inconceivable that the supersenior tranche would be hit.
However, the analysis that had initially produced the widely-used figure of
0.3 was of corporate debt. How could one estimate the equivalent correlation for
mortgage-backed securities? Paradoxically, their very safety was a disadvantage in
this respect: there was effectively no record of default that could be scrutinised for
traces of clustering. Nor did such securities trade often enough for the correlation of
their prices to be measured: most investors in them simply held them until they
matured. Intuitively, though, it seemed conceivable that defaults in bundles of
mortgages or other forms of consumer debt could be quite highly correlated, because
of the likely role played by matters such as the overall unemployment level, and that
could make a CDO based upon mortgage-backed securities an unduly risky product.
In an interview I conducted with her, Terri Duhon, who led the Bayerische
Landesbank mortgage-backed CDO, told me that this caused some of her J.P. Morgan
colleagues initially to doubt whether the deal should proceed: they argued that ‘there
is no way that we should be doing this because it’s way too correlated’. Tett reports
that Krishna Varikooty, for example, was concerned by a correlation risk that seemed
to him to be unquantifiable. Intensive discussion and analysis, and very conservative
structuring of the deal eventually led to agreement that it was safe to go ahead (it
helped that unlike in many more recent deals the ratings of the underlying assets were
high – around 95 percent had Aaa ratings – and it contained no securities based on
9
subprime mortgages). Yet the reservations remained, and J.P. Morgan was only ever
to construct one further large CDO, and a limited number of smaller ones, in which
the underlying assets were bundles of mortgages.
In consequence, the bank remained on the sidelines as the previously largely
distinct worlds of CDOs and of mortgage-backed securities became increasingly
linked from 2002 on. It was an encounter of two subtly different cultures, with for
example quite different mathematical approaches. (Understandably, Tett, the former
anthropologist, limits the more ethnographic aspect of her analysis to only on one of
those cultures, that surrounding CDOs.) The CDO world developed explicit and
increasingly elaborate models of correlation – the ‘Gaussian copula’ that initially
puzzled Tett is a correlation model – while the mortgage world handled the
phenomenon entirely implicitly. In most investment banks, and also – as far as I have
been able to discover – in the New York head offices of the rating agencies, separate
groups or departments handled mortgage-backed securities and CDOs based on
corporate debt. In the investment banks, for instance, those different departments
seem to have had surprisingly little to do with each other. The two cultures never
really merged; instead, the CDO, a structure invented by the corporate-debt world,
was applied to the products of the mortgage world.
Members of both cultures now see the encounter as corrupting. ‘They’ –
constructors of CDOs based on mortgage-backed securities – ‘took our tools’ and
misused them, one specialist in corporate credit derivatives told me a few weeks ago.
Those with a background in mortgage-backed securities blame CDOs (with some
justice) for being indiscriminate buyers of those securities, concerned only with their
10
ratings and the spreads (increments over Libor) they offered. Two experienced
industry observers, Mark Adelson and David Jacob,1 suggest that the fatal point was
when CDOs became the almost the only purchasers of the riskier tranches of
mortgage-backed securities. Previously, those tranches were either guaranteed
against default by specialist insurers, or bought by canny investors with their firms’
own money at risk, who would carefully assess the risks involved. These insurers and
investors acted as a brake on the riskiness of the lower tranches, and thus on the
overall riskiness of mortgage-backed securities, and they demanded a healthy rate of
return for taking on their risks. They were displaced by those buying tranches in
order to package them into CDOs, who were prepared to buy them at lesser rates of
return, and who cared a lot less about their riskiness, because those risks were going
to be passed on to the investors in the CDOs.
With the brake removed, the construction of CDOs based on mortgage-backed
securities became a fast-moving assembly line (participants frequently turn to
machinic metaphors when describing the process). Brokers sold mortgages knowing
that they could readily be sold on in the form of mortgage-backed securities. Instead
of having to worry whether the couples sitting on the other side of their desks really
had the wherewithal to keep up their payments, all that mattered was the dozen or so
quantitative characteristics – such as borrowers’ FICO (Fair Isaac Corporation)
creditworthiness scores – that influenced rating agencies’ mortgage models. The
constructors of mortgage-backed securities no longer had to satisfy specialist insurers
or experienced investors: CDOs had an apparently insatiable demand for those
securities.
1 Their papers can be found at http://www.adelsonandjacob.com/
11
Essential to the assembly line was that the higher tranches of its final products
– CDOs in which the underlying assets were mortgage-backed securities – be able to
gain Aaa ratings. A critical issue was the likely correlation of mortgage-backed
securities. Standard & Poor’s, for example, used the same system, CDO Evaluator,
that it employed for CDOs based on corporate debt, and it employed the same modest
baseline correlation assumption, 0.3, for mortgage-backed securities that it initially
used for corporations within the same industry. (S&P would later reduce this last
figure, while increasing its assumption about cross-industry correlation. These
baseline correlation figures could be increased by the analysts rating a specific CDO
if it was highly concentrated in a particular industry or consumer-debt sector.) I
haven’t been able to ascertain the equivalent figures used by the other agencies,
whose methods differed somewhat from Standard & Poor’s, but the similarity of their
ratings to S&P’s suggest similar judgements. My focus is on S&P here simply
because – commendably – it seems to have been more explicit than the other agencies
in laying out in CDO Evaluator’s publicly-available documentation these crucial
assumptions underpinning how the system worked.
The choice of 0.3, or a number close to it, as the baseline was critical: one
specialist has told me that even a moderate increase in the baseline correlation
assumption, for example to 0.5, would have made many CDOs based on mortgagebacked
securities much less attractive, perhaps even not economically viable.
However, as far as I can discover, analysing CDOs built out of mortgage-backed
securities using only modest correlation levels seems in general to have been
uncontroversial. Certainly, the performance of mortgage-backed securities – which,
12
as noted above, had in general been better than that of corporate bonds – offered little
reason to be more stringent when rating CDOs based on them. For example, S&P’s
statistical analyses suggested a correlation of mortgage-backed securities lower than
0.3; the latter figure was retained as a baseline because it was understood that the
correlation would rise when economic conditions became less benign.
Had the world remained as it was in 2002, the agencies’ assumptions and
ratings might well have turned out to be perfectly appropriate. The trouble with an
assembly line, though, is that it produces identical products. The only person outside
of J.P. Morgan I’ve so far found who thought, at the time, that the correlation
estimates being used to analyse CDOs of mortgage-backed securities were much too
low had discovered this by accident. In a previous job as an auditor, he was checking
the statistical tables that the sellers of mortgage-backed securities provide to
prospective buyers. These tables show the breakdown of the underlying loans by
state, FICO score, loan-to-value ratio, and so on. When checking the tables for one
security, he inadvertently used the loan tape (the underlying mortgage data) for
another, and found almost complete agreement. ‘These deals’ – apparently different
mortgage-backed securities – ‘were the same deal’, he told me. Even geographical
dispersion of the underlying mortgages across the US (a desirable feature when an
individual mortgage-backed security was considered in isolation, because it reduced
exposure to the vagaries of particular local housing market) had the paradoxical effect
of increasingly the homogeneity of different mortgage-backed securities. In a
situation of severe economic stress – falling house prices, rising unemployment – not
just some of those securities would perform badly: they all would. Instead of
correlation remaining modest, my interviewee came to fear that it would be nigh on
13
perfect.
Specialists in mortgage-backed securities in the US have not been entirely
surprised at the fraud and malpractice in mortgage lending that has come to light: it
was always present, and changed only in scale( NB DON ). (There had been an earlier US
subprime crisis in the late 1990s, which only specialists seem to remember.2 It was
much more limited in its scale, but it revealed extensive over-optimistic accounting by
lenders.) That mortgage defaults have risen, and the value of repossessed homes
fallen, is not in itself surprising to specialists, although the size of the changes
certainly is. At least some of them did begin to suspect that longstanding statistical
relationships – for example between individuals’ credit scores and the risk of them
defaulting on their mortgages – had ceased to be valid, but as far as I can tell that
suspicion arose only in 2006, by which time the processes that led to the credit crisis
were well underway. One problem, for instance, seems to have been that with
individuals’ scores increasingly determining their access to credit and the rates of
interest they had to pay, they found ways to manipulate those scores. A modest webbased
industry developed which arranged (in return for fees of around $1,000-$2,000
per person) for people – in some cases, apparently dozens of people – with low credit
scores to be added as ‘authorised users’ to the credit card account of someone with a
high score and an impeccable payment record. Within one to three months, the
benefits of the primary cardholder’s regular payments fed through into improvements
in the credit scores of the card’s ‘renters’.
If, however, CDOs backed by mortgages had worked as the J.P. Morgan team
2 It is discussed in the final chapter of an excellent book that, while more limited in scope and more
technical than Tett’s, deserves to be better known: Laurie S. Goodman et al., Subprime Mortgage
Credit Derivatives (Wiley 2008, $80.00, 978-0-470-24366-4).
14
had envisaged when designing Bistro, the losses to investors in those CDOs that the
US housing bubble and its collapse have caused, though very large, would have been
spread widely across the many institutions that bought the tranches of such CDOs. As
Tett notes, what has shocked the members of that team – many of whom now work
for other banks and hedge funds, but still stay in touch – is the concentration of such
losses, especially at apparently sophisticated global banks such as Bear Stearns,
Lehman Brothers, UBS, Citigroup, Merrill Lynch, Morgan Stanley and the Royal
Bank of Scotland.
The primary vehicle by which risk was concentrated was Bistro’s afterthought,
the super-senior tranches of CDOs. Even the riskiest mortgage-backed CDOs – those
that predominantly bought the ‘mezzanine’ (next-to-lowest) tranches of mortgagebacked
securities – have super-senior tranches that are bigger than all the other
tranches put together. These super-senior tranches were hard to sell to most outside
investors, because the need for attractive returns on lower tranches means a supersenior
tranche can offer only a slender increment over Libor. By 2005, Tett reports,
that spread was as low as 15 basis points.
So many banks did as J.P. Morgan did with Bistro: they kept the super-senior
tranches, sometimes insuring them via AIG or the specialist bond insurers. (Adelson
and Jacob point out the resultant irony. Risks that the mortgage experts in the
insurers would have charged heavily for or perhaps even declined were insured in
packaged form in huge amounts – and quite cheaply – by different departments of the
same firms.) If only a handful of deals had been insured in this way, it would have
made perfect sense. As Tett notes, however, AIG insured super-senior tranches
15
totalling $560 billion. Its bail-out by the US taxpayer dwarfs that of any bank, and as
John Lanchester wrote in the LRB on 28 May, it keeps rising (the current total is $173
billion), but AIG cannot be allowed to fail, because the loss of these crucial supersenior
insurance contracts could bring much of the banking system down with it.
Perhaps most surprising of all, top banks also bought super-senior tranches
originated by other banks. If you are a top bank, you can borrow at around Libor
(that, after all, is what Libor means); if you are particularly well regarded, it may be
possible to borrow at a rate a tiny bit lower than Libor. So you could borrow at Libor
or below, buy a tranche that seemed safer than safe, and from it earn a slender spread
over Libor. It looked like free money. It was especially tempting to traders whose
banks ‘charged’ them for their use of capital, in the systems by which traders’ P&L
(profit and loss) is measured, at around Libor, and credited them with the small
additional spread that super-senior tranches offered. The slenderness of the spread
meant that you had to do the trade on a very large scale to earn a really big bonus, so
traders did just that.
As I’ve already indicated, the vulnerability of super-senior is correlation.
Losses on uncorrelated assets are unlikely ever to impact on super-senior tranches.
When correlation approaches 1.0, however, a CDO’s asset pool starts to behave like a
single investment. It may suffer no defaults, or it may default effectively in its
entirety. If the latter happens, even the super-senior tranche, safer than safe, is
doomed.
As the US historian of economics Perry Mehrling points out, events in
16
financial markets cast their shadows ahead of them, not behind. What has haunted the
banking system for the last two years is above all the shadow of the gigantic, systemwide
default of the super-senior tranches of all the CDOs based on those US
mortgage-backed securities issued towards the end of the bubble( NB DON ). (Residential
mortgages have been the focus of most of the attention, but there are also lots of
problems with commercial mortgages.) Although, alas, the losses will not stop there,
most immediately at risk have been CDOs made up primarily of the mezzanine
tranches of subprime mortgage-backed securities issued from late 2005 on. Defaults
have risen enough, the value of repossessed homes has fallen enough, and the
structure and composition of these securities has been similar enough, that as far as I
can tell almost all such tranches have been or will be wiped out in their entirety. So if
a CDO contains little else but such tranches, even its super-senior portion faces closeto-
total losses. So far, only a limited part of those losses have actually been realised,
but the banking system is braced for the rest of them – and, with the massive aid of
taxpayers, it is hopefully now well enough capitalised to survive it and the other
losses that sharp recession will bring.
Unfortunately, this analysis – that the crux of the problem has been not in
CDOs per se but in the uncomfortable encounter between the world of CDOs and that
of mortgage-backed securities – remains only a hypothesis. The world of corporate
CDOs has itself manifested some of the phenomena of the mortgage CDO assembly
line: increasingly risky loans were made to private equity firms and to other highlyindebted
corporate borrowers because it was possible to package and sell on those
loans in the form of CDOs. I’ve just come back from New York, where I questioned
some of those I spoke to on the magnitude of the problems that may lurk below the
17
still comparatively quiet surface of this other sector of the CDO market, which, while
not as large as as the mortgage sector, is still huge. My interviewees seem convinced
that while the problems are real they do not approach the same scale: the amount of
truly irresponsible lending to corporations was much smaller. I hope they are right.
At its heart, the tale Tett tells is a moral one. She believes that the history of
the J.P. Morgan credit derivatives team shows that banking can be technically
innovative while remaining responsible( NB DON ). Her readers may fear that the anthropologist
has here simply gone native, but I don’t think so. I have met a good number of those
she is writing about, and have studied many of the events she has, and I largely share
her judgement. In particular, J.P. Morgan’s decision not to set up a mortgage CDO
assembly line (despite Dimon at one point wanting one) has meant that the bank has
not suffered the catastrophic losses that so many of its peers have; unlike theirs, its
solvency has never been in doubt. It is too easy right now to condemn all of those
who work at the heart of the financial system as either rogues or fools: for example,
Tett reveals that Blythe Masters, who stands out because even today female senior
bankers are relatively rare, gets hate mail. So Tett is right to emphasise that despite
all the pressures and all the temptations, prudent banking was still practised ( NB DON ) –
sometimes – even at the centre of history’s largest-ever credit bubble.
9 June"

a lot of unwinding to go. But it is improving. It started to improve in late March and into early April

TO BE NOTED: From the FT:

"Leverage creeps back on to the radar

By Gillian Tett

Published: June 1 2009 20:09 | Last updated: June 1 2009 20:09

Investors and policymakers have been scouring the financial landscape looking for green shoots.

One hint of these can be found in an elegant building in London’s Knightsbridge district, which houses the CQS funds.

A few months ago, hedge funds such as CQS, one of Europe’s largest credit funds, were finding it almost impossible to get leverage, or loans from banks to trade. The shock of the Lehman Brothers collapse left banks frantically hoarding any cash they had.

Now CQS says the climate is easing – a touch.

“At the peak of the euphoria you would get 20 times leverage. It was mad,” says Michael Hintze, a former Goldman Sachs trader who co-founded CQS a decade ago.

“Then it all disappeared. You could hardly get any leverage at all last autumn.

“[But] now we can get three times leverage on many assets. Not all – you cannot get leverage on most asset backed securities [such as mortgage bonds] or many Asian assets.

“There is still a lot of unwinding to go. But it is improving. It started to improve in late March and into early April.”

Mr Hintze is keen to stress that this modest shift is not remotely similar to patterns seen in the boom.

During the peak of the bubble, average leverage across the empire of funds that CQS runs was around five times.

These days it is nearer one-and-a-half times, echoing a dramatic shrinkage across the industry (see chart). That is forcing many credit funds to rethink their strategies.

Though CQS was one of the first credit funds to appear in London, in the first seven years of this decade a plethora of other funds sprouted up around the Knightsbridge area.

In the boom, many of these earned returns by applying high levels of leverage to highly rated assets. While asset prices were rising and leverage was cheap, the strategy produced results, not least because investors were generally willing to buy products on the basis of credit ratings alone.

But once asset prices plunged and the credibility of ratings was shattered, investor money deserted these funds.

Numerous credit funds have closed, leaving Mayfair “feeling like a bombsite”, one banker says.

CQS has not avoided pain. At the peak of the bubble, its assets under management reached $9.5bn.

Now they are about $6.3bn, due to falling asset values and redemptions.

Some of its stable of funds have performed badly. A vehicle that specialises in convertible bonds declined 32 per cent last year.

A fund that invests in oil rigs had to be restructured. That has been embarrassing for Mr Hintze, who has had a relatively high profile in London, partly because he is a big donor to the Conservative party.

“What has happened with the rig fund is very, very disappointing,” says Mr Hintze, who is a “significant stakeholder” in the rig fund himself. “It gives you the idea of the dangers of leverage. We thought we were being very prudent. There were some prime brokers offering in excess of 10 times leverage on these types of [rig] assets.

“But thank God the fund didn’t leverage up more.”

Yet the fact that CQS has retained an impressive $6bn of assets under management as other funds have closed is something of an achievement.

Mr Hintze says that some of the investors who filed redemption notices to CQS are starting to cancel them as the climate improves.

Away from the highly visible oil rig embarrassment, other parts of CQS are enjoying strong results.

A CQS fund that invests in ABS, such as mortgage bonds, posted returns of 73 per cent last year, and 12 per cent so far this year.

The convertible bond fund has returned 11 per cent this year and the main CQS multi-strategy fund is up 14 per cent.

There are signs that the carnage in the credit world is starting to produce benefits for the survivors.

For one thing, there is less competition to buy assets, since so many other investment groups have imploded.

“The [bank] prop desks are really just a shadow of their former selves. The fact that they are no longer so active, that they don’t have money, has really helped us,” Mr Hintze says.

He adds that “post Lehman, the prices of many asset classes have fallen to levels where little leverage is required to make attractive returns”, meaning profits can be earned even with low levels of debt. ( NB DON )

That is pulling new competitors into the credit world, such as long-only funds, which were absent during the boom.

But it is also prompting groups such as CQS to reposition themselves to cope with the lower leverage world.

Notably, instead of trying to earn returns by using cheap debt, the new mantra at CQS, as elsewhere, is to exploit traditional credit research skills.

“There are a lot of opportunities in the asset backed securities market now, in the credit world, particularly if you take a more granular, fundamentals-based approach,” says Mr Hintze.

He says that CQS has “invested in that fundamental credit research. You ask questions like ‘What is in that portfolio? What is happening to real estate prices in downtown LA?’”

He adds: “It’s really back to basics now.( NB DON )

“I am working harder than ever before.”

gillian.tett@ft.com

face both currency upheaval and more bank turmoil, as investors lost confidence that the state can keep propping up the banks

TO BE NOTED: From Alphaville:

"Gillian Tett: The shape of things to come… Posted by Gwen Robinson on May 29 08:50.

In the ongoing compulsion among commentators and analysts to use metaphors for economic trends and phenomena (a la “green shoots”, “black swans” etc), there’s also a continuing fascination with shapes - for example, the “hook-shaped” global economic scenario, the “square root-shaped recovery”, the “U”, the “W”, the “V” and even the Roubini-endorsed “L” shaped recession - and so on.

Now, the FT’s Gillian Tett has put a new concept on the table - the “bank-shaped recovery”, courtesy of Pitman, the shorthand regime so dreaded by journalists and secretaries of yesteryear.

The gnawing sense of unease in financial markets - compounded by rising bond yields - leaves all the “V”, “W” or “U” arguments in an uncertain place, she says:If you add the different elements of the picture together, my best bet is that the coming months will look like the first half of a “W”, but then flatten out into a straight-ish, horizontal line – meaning that after an initial, small rebound, there is likely to be a long, bumpy period of “flatlining”, as the forces for reflation and deflation pull in opposite ways.

But that scenario may be overoptimistic, in Tett’s view.

If government bond jitters turn more serious – say, if some auctions fail or there is serious political instability – it is entirely possible to imagine a far darker scenario, in which faith collapses in government finance. If that occurs, we would face both currency upheaval and more bank turmoil, as investors lost confidence that the state can keep propping up the banks.

However, if that government bond crisis does not materialise – which remains an “if” – then the resulting outlook looks rather similar to a symbol that is already plastered all over Tett’s notebook.

Many years ago, when I was a rookie reporter, I learnt the Pitman system of shorthand. And it just happens that the half-squashed, assymetrical “W” pattern that I am struggling to describe is almost identical to the shorthand sign for “bank” (see right).

So there you have it: as long as we avoid a government bond crisis, my best prognosis is for a “bank” shaped recovery-cum-stagnation, at least as depicted by shorthand. It is a fitting twist for a crisis that started with the shadow banks; perhaps the Gods of finance (and journalism) have a sense of humour after all.

Related links:
Presenting the hook-shaped global economic scenario - FT Alphaville
What shape the US economic recession and recovery? - FT Alphaville
The square-root-shaped recovery - FT Alphaville

This entry was posted by Gwen Robinson on Friday, May 29th, 2009 at 8:50 and is filed under Capital markets."

Me:

Don the libertarian Democrat May 29 16:12

How about the '?' shaped recovery?

the urgent pressure to sell assets is receding as banks raise capital

TO BE NOTED: From The FT:

"Why public private plan has bankers squirming

By Gillian Tett

Published: May 21 2009 20:04 | Last updated: May 21 2009 20:04

Cometh the hour, cometh the acronym. Thus might run the unspoken motto of American financial policy these days.

As the banking saga has unfolded in the past two years, a string of US initiatives have tumbled out, with titles so lengthy I will not attempt to list them in full. Remember the M-LEC programme that was launched to reorganise the shadow banks (but quickly died)? Then came Talf, TSLF and Tarp, which aim to provide liquidity, restart the securitisation machine and recapitalise the banks.

Now a new focus is emerging. This week Tim Geithner, US Treasury secretary, said that a PPIP – or public-private investment plan – would start in early July to use $75bn-$100bn of state funds to encourage the sale of up to $1,000bn of toxic assets by banks. Part of the programme will cover loan sales and be run by the Federal Deposit Insurance Corporation; the other half, relating to securities, will be organised by the Treasury. In both schemes, asset managers will be given state finance to encourage bids. So will this latest acronym-filled endeavour work? (Or, at least, avoid the fate of the ill-starred M-LEC?) If you listen to some senior US bankers, it is easy to feel pretty doubtful that the PPIP can really fly. The key sticking point is price. The PPIP plan will work if banks take part to sell assets. But right now, no banker wants to participate in an auction that produces asset prices lower than those on bank books. After all, if that were to happen, banks would face pressure to make more writedowns – which they can ill afford.

The Treasury and FDIC hope to avoid this scenario by encouraging asset managers to place high bids for the bank assets, by offering non-recourse leverage of up to five times (or far higher than non-recourse leverage available in the market). Some politicians hate that, since the details of the deals mooted so far appear to leave taxpayers with little embedded upside.

That political scrutiny, in turn, makes asset managers nervous. As a result, it is still unclear whether enough asset managers will produce bids that are high enough to make the banks happy with an auction price.

So some large banks are – unsurprisingly – adopting a policy of quiet footdragging. A senior official at one large bank observed this week that his group would participate in a pilot scheme, as a gesture of goodwill. But after that token gesture, this bank will probably stop.

And while the government wants to set a minimum lot size of $1bn, this bank is lobbying for a figure nearer $250m to limit the auction to a few choice (token) assets. Unsurprisingly, this banker – like others – concludes that he is “not optimistic” about PPIP, not least because the urgent pressure to sell assets is receding as banks raise capital.

That view may not be entirely representative: another bank tells me it is preparing to get properly involved (not least because it has the financial strength to have written many assets down). Government officials running the PPIP scheme insist there is strong overall interest from potential buyers and sellers. They also point out that it need not matter if the scheme ends up being limited in size. After all, what PPIP is trying to do (like Talf and much else) is reignite market activity, not replace it. Think of it as a chunk of firelighter on a pile of wet wood. Thus, the sheer act of talking about PPIP – and then staging a few sales – may be enough to kickstart a private sector trading toxic assets again. Or so the hope in Washington goes. “Success is what happens to the market overall,” says one.

They have a point, given that there is some evidence that schemes such as Talf are contributing to a market thaw. But, almost irrespective of whether PPIP “succeeds” in delivering many deals (and personally I have doubts that it will), there may be another reason to welcome it.

Most notably, irrespective of the complexities of arranging deals, the PPIP has already served one extremely valuable function by highlighting the sheer insanity that has bedevilled the financial world in relation to asset prices.

Most notably, if large American banks had previously marked their assets at a realistic market-based price, they would not be so scared of engaging in auctions with PPIP now. Better still, they might have spotted earlier the degree to which their assets were deteriorating – and taken action to address it.

But precisely because the supposedly “free market” western financial system has become stuffed with complex assets that were rarely traded – even during the credit boom – banks have been able to use fantasy prices for their assets for years. Hence their continued horror at the idea of open trading.

That is the real scandal that bedevils the PPIP idea. That in turn points to a wider lesson for the future: namely that to avoid a similar credit disaster, it is crucial that financiers are forced to place as much financial activity as possible on transparent trading arenas. Better still, they need to do that well before a bubble bursts – or there is any need to start fighting over whether a PPIP can truly fly.

gillian.tett@ft.com"

full 18-minute interview with Gillian Tett for Reuters TV, talking about Gillian’s new book

From Reuters:

"The full Gillian Tett interview

Post a comment (3)

Posted by: Felix Salmon

Tags: derivatives

My full 18-minute interview with Gillian Tett for Reuters TV, talking about Gillian’s new book, is now up:

I definitely make a better blogger than TV presenter, but there’s some good stuff in here all the same, I think."

Me:

I’m still puzzled by the logic. We use investment X because it falls outside the range of laws about capital requirements. No one forced us to do this, although we will someday claim that incentives are akin to uncontrollable urges. So, X has less collateral, etc.

Now, unless I’m mistaken, the capital requirements have to do with risk. In fact, even X has a capital requirement, so it must accepted that this requirement has something to do with risk. Lower capital requirements are riskier. The higher requirements lessen risk.

But wait, if X has a lower capital rate than the other regulated investments, that must mean it’s safer. Musn’t it? That seems to be the logic here. It’s like investing with Penn and Teller. Please explain to me how riskier investments become less risky. That’s all that I’m asking.

- Posted by Don the libertarian Democrat

Tett gave Brickell a few minutes to speak this morning, he confidently denied that there was any connection at all

From:

Tuesday, May 12, 2009 at 12:24 pm

Gillian Tett tells how JP Morgan made credit derivatives big, then backed off before they blew up

Posted by Justin Fox | Comments (2) | Permalink | Trackbacks (0) | Email This

The FT hosted a breakfast this morning where Gillian Tett promoted her new book about derivatives and the financial crisis, Fool's Gold. There was a great moment during the Q&A when NYT columnist Joe Nocera started off, "There's this character in your book, Mark Brickell ..."

"He's sitting behind you," Tett interrupted. At which point Joe and the rest of us turned around to look at the nattily attired man sitting on the windowsill.

Brickell is really the closest thing to a villain in Tett's book—a former J.P. Morgan derivatives guy who in the 1990s became the point man in the banking industry's effort to keep Congress from subjecting over-the-counter derivatives to regulation. Yet he showed up at Tett's book event, which tells you something about her style. She's a reporter (and a social anthropologist with expertise in Tajik wedding rituals) on a hunt not for villains but for explanations.

To me this is the great strength of her book, which tells the story of the team at J.P. Morgan that popularized credit derivatives in the 1990s (they didn't invent them; some people at Bankers Trust did that) and then pulled back during the great credit-derivatives-enabled housing insanity of the 2000s. I read it cover-to-cover on a flight out to L.A. a couple weeks ago, and while the J.P. Morgan focus keeps it from being anything like a definitive account of the credit crisis, this peculiar perspective delivers all sorts of insights that a more conventional account might not. Mainly it shows how hard it is to resist the demands and temptations of a financial market gone mad—JP Morgan Chase succeeded in doing so, Tett argues, only because of the lucky marriage of a time-honored-if-beleaguered culture of responsibility, risk-assessment, and long-term thinking inherited from the old J.P. Morgan with the similarly risk-aware approach of new CEO Jamie Dimon. But that turned out to be a rare combo: Citi, Merrill and UBS sure didn't have it.

The book also comes closer than anything I've read to nailing down the connection between the rise of credit default swaps and all the craziness in housing finance. It doesn't entirely nail it—when Tett gave Brickell a few minutes to speak this morning, he confidently denied that there was any connection at all. But Tett's account of the enabling role that CDSes played certainly makes me suspect that there was something there.

Finally, there's this point in my book (now less than a month from publication) where I'm discussing Robert Merton, Steve Ross and their 1970s options-pricing theories and I write:

The rise of these derivatives, as Ross called them, became one of the great financial stories of the next quarter century. Chronicling it adequately would require a book of its own.

Again, Tett's book doesn't entirely do that—it's not what she set out to do. But reading it I kept getting the sense that it was filling in big holes in my narrative (which I'd left because I didn't want to spend two more years expanding my book to 700 pages). So it's nice to see that on my book's Amazon page there's a recommendation to buy the two books together—for a mere $34.07."

Me:

1. donthelibertariandemocrat Says:
   Tuesday, May 12, 2009 at 5:51 pm

   "he confidently denied that there was any connection at all"

   I tend to agree with him, in the sense that I don't see these products as the cause of anything. I think that they enabled some poor and/or criminal investments, but that's simply because they fit the requirements that these leverage happy investors craved.

   Here's his basic view:

   http://www.forbes.com/2008/09/22/solutions-finance-regulation-oped-regsolutions08-cx_mb_0922brickell.html

   "Regulators should, in particular, consider the impact of government policies on housing finance, since no sector of U.S. financial markets has more state involvement. Investments in housing may have been stimulated by a series of policies--the "implicit guarantee" of Government-Sponsored Enterprises' liabilities, mandated investments in "affordable housing," lower bank capital requirements for mortgages than for corporate loans--that could reduce market discipline."

   I agree, except for the focus on GSEs. The entire system was under an implicit guarantee, of which GSEs are a small part. I like this better:

   http://blogs.wsj.com/economics/2009/05/11/feds-lacker-safety-net-could-be-more-limited/

   U.S. Federal Reserve Bank of Richmond President Jeffrey Lacker said late Sunday that a more limited financial safety net would help stabilize the financial system.
   lacker_A_20081016134646.jpg
   Lacker

   “I believe that a strong case can be made that the financial safety net, especially those parts that were more implicit and perceived than explicit and written into laws, played a significant role in the accumulation of risks that ultimately led to the turmoil we are still experiencing,” he said in prepared remarks to a banking conference in China.

   Lacker argued that the presence of a government safety net limits the incentive for too-big-to-fail institutions to prepare for liquidity disruptions, “thus increasing the likelihood of crises.”

   That was the underlying assumption that the big time investors and bankers were working under. Without these implicit guarantees, nothing on earth would have led them to try such risky investments. From my point of view, this system has been in place since the 1980s. What has happened has just confirmed my point of view, as did the S and L Crisis, way back when.

insatiable demand for safety in general, and triple-A risk in particular, which caused this financial crisis

From Reuters:

"Felix Salmon

preferred, not common

« Previous Post

Next Post »

May 12th, 2009

How we super-seniored the entire financial system

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Posted by: Felix Salmon

Tags: felix, multimedia, risk

Gillian Tett was just in the office to talk about her new book; I interviewed her for Reuters TV, and the results should be up soon. But we got to chatting afterwards, and she made a great point which we didn’t cover in the more formal interview and which she says she would have liked to have put in her book. But since it’s not there, I can at least put it on YouTube. She talks about the Bistro deal (see Jesse for background on that), and how it can be seen as a metaphor for the financial system more generally:

The point is similar to the one I made in my speech to the regional bond dealers: we were far too worried about risk, and not nearly worried enough about safety. And really it was the insatiable demand for safety in general, and triple-A risk in particular, which caused this financial crisis."

Me:

When I look at health care in the US, I agree with Milton Friedman, that we should either have much more govt or much less. Because I favor a guaranteed income with health insurance, and doubt that much less govt is a real option, I am in favor of much more govt. But our problem is that we want the best and most expansive health care for the cheapest price, or, at least, at a price that shifts our costs to somebody else. Hence, we have a tug of war between conflicting desires and possibilities, which leads us to an expensive and inefficient mess. It happens to play out through proxies like insurance companies, but they just ride the same wave as everyone else.

In your example, we have investors who want high returns without risk. That’s the only way that I can make sense of this desire for safety. I’ve just seen a Flight to Safety, but nobody was kidding themselves that they weren’t avoiding risk. I’m not even sure how you can want safety but not want to avoid risk, other than saying that you want high returns for low risk, which is hard for me to understand.

I can understand Japanese investors, unhappy with low interest on bonds, and a stagnant market, deciding to buy bonds in other countries and get a higher return. I can’t imagine them not understanding that it’s a lot riskier than just buying a Japanese bond.

I’m still not able to understand how investors can create investments with lower capital requirements, and not see them as riskier. The regulations were intended to lower risk by demanding more collateral. If you’re trying to get around those regulations,then how can you not know what they’re intended for?

Also, for the life of me, I can’t see what just occurred as anything but a desire for better returns during a time of low interest on govt bonds. Investors didn’t like the paltry yields.

Looking for safety in CDSs,CDOs, etc., anything that increased leverage, is like looking for virginity in a brothel. You’re not in the right place to find what you’re looking for.

- Posted by Don the libertarian Democrat

let banks themselves count their bad loans, not only are they apt to lie – but investors will disbelieve anything they say

TO BE NOTED: From the FT:

"US belatedly learns lesson from Japan

By Gillian Tett

Published: May 8 2009 18:47 | Last updated: May 8 2009 18:47

In recent months, Japan’s sorry banking history has provided the world with plenty of reasons to worry about America. Now, however, it might offer a crumb of comfort, too.

The reason? In part, it lies with those stress tests that Washington has just conducted on its largest 19 banks.

During most of the past two years, the American leadership has been in a state of procrastination and denial in relation to its banking woes: first it tried to pretend that the financial woes were not too serious, since they were “contained”. Then it insisted that free market pressures would be enough to force the banks to come clean about their mess – without the need for the government to act.

In reality, the Americans were not at all unusual in taking that stance: when Japan’s banks first became plagued with bad loans in the early 1990s, the government in Tokyo took an identical stance – and continued denying the scale of woes for almost a decade.

But precisely because the Japanese were such past masters of procrastination – and learnt the hard way what that can do – they have been quietly dubious about much of what Washington has said about the banking woes in the past two years.

As long ago as the autumn of 2007, for example, Daisuke Kotegawa, a canny former financial bureaucrat who was central to Japan’s own banking clean up, pointed out to me that what was missing from the American debate was any effort to conduct an audit of Western banks.

For Kotegawa is convinced that it was only when the Japanese government finally went into its banks and did a thorough, independent review of their operations – and then published the collective bad loan estimate and forced the banks to plug any capital gaps – that the Tokyo financial dramas started to heal.

The point is: if you let banks themselves count their bad loans, not only are they apt to lie – but investors will disbelieve anything they say, even if they do tell the truth. “What is needed [to solve the credit crisis] is not [just] cash but wiping out widespread mistrust,” Kotegawa observed back then.

Now, at last, it would seem that men such as Tim Geithner are finally – belatedly – learning that lesson too (and Mr Geithner is a man who knows this Japanese tale only too well since he worked there himself in the 1990s).

You can argue at length about whether the stress tests are completely “correct” or not. But what is undisputable is that they have taken place in a fairly thorough manner. In a world that has been marked by cognitive fog, in other words, investors now have something tangible to cling to. At last, there is a sense that someone is in charge – and a bottomless pit might not be so bottomless after all.

That is potentially very important for sentiment. Back in the 1990s, when Japan’s government was procrastinating and fudging, there seemed to be no limit to just how big the estimates of bad loan numbers could become: they started the decade at around $50bn, but then rose to over $1,000bn (and Goldman Sachs even slated in $2,000bn, which back then seemed unimaginably large).

But when the Japanese finally performed their own versions of a stress test, those ever-rising projections suddenly stopped growing, not least because confidence started to return – and the wider economy picked up. These days, economists now guess that Japanese credit losses were actually around $800bn – which is very large, but less frightening than $2,000bn.

There is, of course, no guarantee that America can repeat exactly that trick. One crucial difference is that men such as Kotegawa only had the Japanese banks to worry about. Mr Geithner does not share that luxury: irrespective of whether he has measured bad loans at American banks correctly, who knows what is sitting in European banks now?

Nor does America have the luxury of sitting in a world where there are other export markets that are booming – a sharp contrast to Japan, which started to enjoy an economic uplift when Chinese demand boomed soon after it reformed its banks.

Moreover, another reason for feeling cautious is that the slant of American policy still appears to be more focused on avoiding damaging bank collapses rather than trying to build truly vibrant institutions that could lend money again. Simply removing the patient from the critical list, in other words, does not make him truly healthy again – let alone ensure that the economy will properly heal. Recapitalisation is a necessary not sufficient condition for recovery, as the history of Japan shows.

Yet, even with those caveats, the fact that the stress tests have now taken place is certainly reason to cheer. The only crying shame is that it took such a ridiculously long time for the American administration to listen to that lesson from Japan – while many of Mr Geithner’s counterparts in Europe continue to ignore it, even today.

gillian.tett@ft.com"

But what has made the current crisis so disastrous is the behaviour of large, regulated banks

TO BE NOTED: From the FT:

"Insight: A harmful hedge-fund fixation

By Gillian Tett

Published: May 7 2009 20:00 | Last updated: May 7 2009 20:00

Almost exactly two years ago, at the craziest peak of the credit bubble, Western leaders gathered in a conference room at the World Bank in Washington to discuss what they should do about the financial world.

These days it is clear what those grandees ought to have discussed – notably the wild excesses afoot in subprime lending, structured credit, monoline insurance, credit ratings and bank leverage.

In practice, though, those issues were barely discussed. Instead, the hot topic for debate in that April 2007 meeting (as I describe in a book published this month) was how to clamp down on hedge funds – a topic dear to German leaders, who were chairing the G7 at that point.

“It was really hard to get anything apart from hedge funds on the agenda back then,” laments one international bank regulator, who tried – and failed – to divert the debate onto more pressing matters.

These days, there is an unnerving sense of déjà vu bubbling in some political quarters of Europe. Over in America the financial community is currently consumed with the matter of banking stress tests.

In London, however, there is another hot topic worrying financiers – what Brussels plans to do about hedge funds.

Last week the European Commission shocked the City of London by unveiling plans to impose potentially tough new controls on the hedge fund and private equity industry. The European parliament bayed for more.

Then, this week the French government warned that they might strengthen these measures, apparently because they, like many other Continental leaders, think that lax hedge fund controls have sparked the recent crisis.

In fairness, some of these calls for a clampdown are not ridiculous. Regulators need to get better information about what the hedge fund world is doing, and to prevent the abuse of off-balance sheet entities. There is also a strong case to reduce the scale of tax avoidance associated with the hedge fund sector.

But the real danger with the current debate – as two years ago – is that it risks missing the wider point. For sure, some unregulated hedge funds have taken crazy risks in recent years. And unregulated shadow banks have also messed up.

But what has made the current crisis so disastrous is the behaviour of large, regulated banks, which have spent the last decade operating with ridiculously high levels of leverage, and purchasing vast quantities of toxic assets.

And the only thing more remarkable than the scale of those bank follies is that they went unnoticed for so long, partly because many regulators spent the last decade so obsessed with hedge funds. Pace that Washington G7 meeting in the spring of 2007.

Given that, it seems self-evident that the real priority now in Europe is to ask hard questions about banks – and bank regulation. If I was a German voter, for example, I would want to know why nobody in Frankfurt tried to stop German banks from dashing into structured finance on such a spectacular scale – and why the only people who ever warned of those dangers before the summer of 2007 were investors who went short (ie, the hedge funds.)

I would also want to know why rumours remain widespread that German banks are still holding vast quantities of toxic assets which have been barely marked to market value. And why not ask what the German government will do if it turns out that the entire German system is insolvent (as the German press has recently suggested after leaked documents suggested German regulators privately fear that their banks hold over €800m of toxic and illiquid assets.)

Such questions, let me stress, do not entirely remove the need for some debate about hedge funds. But the issue is priority and scale. The global hedge funds sector is estimated to command about $1,500bn of assets on a global basis. The balance sheet of some individual European banks, by contrast, is not wildly different in scale – even today.

Of course, it is possible that European politicians have cannily spotted that logic and are simply focusing on hedge funds as a convenient, distracting scapegoat. It is also possible all the heat about hedge funds will disappear once the European parliamentary elections are over. That is what some senior UK government figures and bankers hope.

But even if that argument is right – and it remains a big “if” – the lesson from the spring of 2007 about the danger of policy distraction remains clear. If European politicians were squealing about the need to clean up big banks – say, by demanding that Europe hurry up and impose its own version of bank stress test – then they might have the right to worry about reforming hedge funds too.

Unfortunately, though, they are not. As a result, the likelihood is that Europe will remain plagued with doubts about the health of its financial system for the forseeable future. And that is a scenario which should worry everybody, hedge fund lovers and haters alike.

gillian.tett@ft.com"

what to make of the unusually low level of capital available to cover losses on the derivatives

TO BE NOTED: From the FT:

"Genesis of the debt disaster

By Gillian Tett

Published: May 1 2009 19:16 | Last updated: May 1 2009 19:16

In the 1990s, a young team at Wall Street investment bank JP Morgan pioneered a new way of making money – credit derivatives. Within a decade, the market for these exotic securities had exploded to more than $12,000bn – and some people later blamed them for fuelling the global financial fiasco. In the first of two extracts from her book, Fool’s Gold, the FT’s Gillian Tett reveals how the innovation genie was first let out of the bottle – and eventually devoured the system, to the horror of its creators. The first sign that there might be a structural problem with the innovative bundles of credit derivatives that bankers at JP Morgan had dreamed up emerged in the second half of 1998. In the preceding months, Blythe Masters and Bill Demchak – key members of JP Morgan’s credit derivatives team – had been pestering financial regulators. They believed that by using the new credit derivative products they had helped create, JP Morgan could better manage the risks in its portfolio of loans to companies, and thereby reduce the amount of capital it needed to put aside to cover possible defaults. The question was by how much. (Though these bundles of credit derivatives later went under other names, such as collateralised debt obligations [CDOs], at that time these pioneering structures were known as “Bistro” deals, short for Broad Index Secured Trust Offering). Masters and Demchak had done the first couple of Bistro deals on behalf of their own bank without knowing the answer to their question for sure. But when they were doing these deals for other banks, the question of reserve capital became more important – the others were mainly interested in cutting their reserve requirements.

The regulators weren’t sure. When officials at the Office of the Comptroller of the Currency and the Federal Reserve had first heard about credit derivatives and CDOs, they had warmed to the idea that banks were trying to manage their risk. But they were also uneasy because the new derivatives didn’t fit neatly under any existing regulations. And they were particularly uncertain over what to make of the unusually low level of capital available to cover losses on the derivatives.

When the team did their first Bistro deal, they pooled more than 300 of JP Morgan’s loans, worth a total of $9.7bn, and issued securities based on the income streams from these loans. The lure of the idea was clear: the team had calculated that they only needed to set aside $700m – a strikingly small sum – against the risk of defaults among the 300-plus loans. After much debate, the credit rating agencies had agreed with the team’s assessment of the risks, and the deal had gone ahead on the basis that if financial Armageddon wiped out the $700m funding cushion, JP Morgan would absorb the additional losses itself. To Masters and Demchak, the chance that losses would ever eat through $700m were minuscule.

That argument didn’t wash with European regulators, and some of their US counterparts were uneasy, too. Christine Cumming, a senior Fed official, indicated to Masters and Demchak that JP Morgan should look for a way to insure the rest of the risk – the “missing” $9bn in their original Bistro scheme – if the bank wanted to gain approval to cut its capital reserves. So Masters and her team set out to find a solution. They started by giving the bundle of “uninsured” risk a name. Masters liked to refer to it as “more than triple-A”, since it was deemed even safer than triple A-rated securities. But that was too clumsy to market, so they came up with “super-senior”. The next step was to explore who, if anyone, might want to buy or insure it.

The task did not look easy. As far as JP Morgan was concerned, this risk was not really risky at all, so there was no point paying anything other than a token amount to insure it. On top of that, whoever stepped up to acquire or insure the super-senior risk had to be brave enough to step into an unfamiliar world.

. . .

The seeds of AIG’s destruction

Masters eventually spotted one solution to the super-senior headache. In the past, one of JP Morgan’s longstanding blue-chip clients had been the mighty insurance company American International Group. Like JP Morgan, AIG was a pillar of the American financial establishment. It had risen to prominence by building a formidable franchise in the Asian markets during the early-20th century. That business was later extended to the US, making the company a powerful force in the American economy after the second world war. AIG was considered a weighty and utterly reliable market player, and like JP Morgan, it basked in the sun of a triple-A credit rating.

But within AIG, an upstart entrepreneurial subsidiary was booming. In the late 1980s the company hired a group of traders who had previously worked for Drexel Burnham Lambert, the infamous – and now defunct – champion of the junk-bond business under Michael Milken in the mid-1980s. These traders had developed a capital markets business, known as AIG Financial Products and based in London, where the regulatory regime was less restrictive. It was run by Joseph Cassano, a tough-talking trader from Brooklyn. Cassano was creative, bold and highly ambitious. More important, he knew that, as an insurance company, AIG was not subject to the same burdensome rules on capital reserves as banks. That meant it would not need to set aside anything but a tiny sliver of capital – at most – if it insured the super-senior risk. Nor was the insurer likely to face hard questions from its own regulators because AIG Financial Products had largely fallen through the cracks of oversight. It was regulated by the US Office for Thrift Supervision, whose officials had scant expertise in the field of cutting-edge financial products.

Masters pitched to Cassano that AIG take over JP Morgan’s super-senior risk, and Cassano happily agreed. It was a “watershed” event, or so Cassano later observed. “JP Morgan came to us, who were somebody we worked with a great deal, and asked us to participate in some of what they called Bistro trades [which] were the precursors to what [became] the CDO market,” he explained. It seemed good business for AIG.

AIG would earn a relatively paltry fee for providing this service – just 0.02 cents per dollar insured per year. But if 0.02 cents is multiplied a few billion times, it adds up to an appreciable income stream, particularly if no reserves are required to cover the risk. Once again, the magic of derivatives had produced a “win–win” solution. Only many years later did it become clear that Cassano’s trade had set AIG on the path to ruin.

With the AIG deal in hand, the JP Morgan team returned to the regulators and pointed out that a way had been found to remove the rest of the credit risk from their Bistro deals. They started plotting other sales of super-senior risk to other insurance and reinsurance companies, which snapped it up, not just from JP Morgan but from other banks too.

Then, ironically, just as this business was taking off, the US regulators weighed in again. Officials at the Office of the Comptroller of the Currency and the Fed indicated to JP Morgan that after due reflection they thought that banks did not need to remove super-senior risk from their books after all. The lobbying by Masters and others had seemingly paid off. The regulators were not willing to let the banks get off scot-free. If they held the super-senior risk on their books, they would need to post reserves one-fifth the size of the usual amount (20 per cent of 8 per cent, meaning $1.60 for every $100 that lay on the books). There were also some conditions. Banks could only cut their capital reserves in this way if they could prove that the risk of default on the super-senior portion of the deals was truly negligible, and if the securities being issued via a Bistro-style structure carried a triple A credit rating from a “nationally recognised credit rating agency”. Those were strict terms, but JP Morgan was meeting them.

The implications were huge. Banks had typically been forced to hold $800m reserves for every $10bn of corporate loans on their books. Now that sum could fall to just $160m. The Bistro concept had pulled off a dance around the international banking rules.( NB DON )

For a while, Demchak’s team stopped transferring super-senior risk from JP Morgan’s books. But then Demchak became uneasy. The super-senior risk was ballooning to a staggering figure, because when the bank arranged these credit derivatives transactions for clients, it typically put the super-senior risk in the deal on its own balance sheet. In theory, there was no reason to worry. But by 1999, the total pipeline of future deals had swelled towards $100bn. Something about that mountain of risk started to offend Demchak’s common sense. “If you have got $60bn, $100bn or however many billions of something on your balance sheet, that is a very big number,” he remarked to his team. “I don’t think you should ignore a big number, no matter what it is.”

. . .

The problem with correlation

Demchak was acutely aware that modelling the risks involved in credit derivatives deals had its limits. One of the trickiest problems revolved around the issue of “correlation”, or the degree to which defaults in any given pool of loans might be interconnected. Trying to predict correlation is a little like working out how many apples in a bag might go rotten. If you watch what happens to hundreds of different disconnected apples over several weeks, you might guess the chance that one apple might go rotten – or not. But what if they are sitting in a bag together? If one apple goes mouldy, will that make the others rot too? If so, how many and how fast?

Similar doubts dogged the corporate world. JP Morgan statisticians knew that company debt defaults are connected. If a car company goes into default, its suppliers may go bust, too. Conversely, if a big retailer collapses, other retail groups may benefit. Correlations could go both ways, and working out how they might develop among any basket of companies is fiendishly complex. So what the statisticians did, essentially, was to study past correlations in corporate default and equity prices and program their models to assume the same pattern in the present. This assumption wasn’t deemed particularly risky, as corporate defaults were rare, at least in the pool of companies that JP Morgan was dealing with. When Moody’s had done its own modelling of the basket of companies in the first Bistro deal, for example, it had predicted that just 0.82 per cent of the companies would default each year. If those defaults were uncorrelated, or just slightly correlated, then the chance of defaults occurring on 10 per cent of the pool – the amount that might eat up the $700m of capital raised to cover losses – was tiny. That was why JP Morgan could declare super-senior risk so safe, and why Moody’s had rated so many of these securities triple-A.

The fact was, however, that the assumption about correlation was just that: guesswork. And Demchak and his colleagues knew perfectly well that if the correlation rate ever turned out to be appreciably higher than the statisticians had assumed, serious losses might result. What if a situation transpired in which, when a few companies defaulted, numerous others followed? The number of defaults required to set off such a chain reaction was a vexing unknown. Demchak had never seen it happen, and the odds seemed extremely long, but even if there was just a minute chance of such a scenario, he didn’t want to find himself sitting on $100bn of assets that could conceivably go bust. So he decided to play it safe, and told his team to look for ways to cut their super-senior liabilities again, irrespective of what the regulators were saying.

That stance cost JP Morgan a fair amount of money, because it had to pay AIG and others to insure the super-senior risk, and those fees rose steadily as the decade wore on. In the first such deals with AIG, the fee had been just 0.02 cents for every dollar of risk insured each year. By 1999, the price was nearer 0.11 cents per dollar. But Demchak was determined that the team must be prudent.

. . .

The mortgage time bomb

Around the same time, the JP Morgan team stumbled on a second, potentially bigger problem. As the innovation cycle turned and earnings declined from the early Bistro deals based on pools of corporate loans, Demchak asked his team to explore new uses for Bistro-style deals, either by modifying the structure or by putting new kinds of loans or other assets into the mix. They decided to experiment with mortgages. Terri Duhon was at the heart of the endeavour. Only 10 years earlier, Duhon had been a high-school student in Louisiana. When she told her relatives she was going to work in a bank, they had assumed she was going to be a teller. Now she was managing tens of billions of dollars. She was trained as a mathematician, and she thrived on adrenaline, riding motorbikes in her spare time. Even so, she found the thought of being in charge of all those zeros awe-inspiring. “It was just an extraordinary, intense experience,” she later recalled.

A year after Duhon took on the post, she got word that Bayerische Landesbank, a large German bank, wanted to use the credit derivatives structure to remove the risk from $14bn of US mortgage loans it had extended. She debated with her team whether to accept the assignment; working with mortgage debt wasn’t a natural move for JP Morgan. But Duhon knew that some of the bank’s rivals were starting to conduct credit derivatives deals with mortgage risk, so the team decided to take it on.

As soon as Duhon talked to the quantitative analysts, she encountered a problem. When JP Morgan had offered the first Bistro deals in late 1997, it had access to extensive data about all the loans it had pooled together. So did the investors who bought the resulting credit derivatives, since the bank had deliberately named all of the 307 companies whose loans were included. In addition, many of these companies had been in business for decades, so extensive data were available on how they had performed over many business cycles. That gave JP Morgan’s statisticians, and investors, great confidence in predicting the likelihood of defaults. But the mortgage world was very different. For one thing, when banks sold bundles of mortgage loans to outside investors, they almost never revealed the names and credit histories of the individual borrowers. Worse, when Duhon went looking for data to track mortgage defaults over several business cycles, she discovered it was in short supply.

While America’s corporate world had suffered several booms and recessions in the later 20th century, the housing market had followed a steady path of growth. Some specific regions had suffered downturns: prices in Texas, for example, fell during the Savings and Loans debacle of the late 1980s. But since the second world war, there had never been a nationwide house-price slump. The last time house prices had fallen significantly en masse, in fact, was way back in the 1930s, during the Great Depression. The lack of data made Duhon nervous. When bankers assembled models to predict defaults, they wanted data on what normally happened in both booms and busts. Without that, it was impossible to know whether defaults tended to be correlated or not, in what circumstances they were isolated to particular urban centres or regions, and when they might go national. Duhon could see no way to obtain such information for mortgages. That meant she would either have to rely on data from just one region and extrapolate it across the US, or make even more assumptions than normal about how defaults were correlated. She discussed what to do with Krishna Varikooty and the other quantitative experts. Varikooty was renowned on the team for taking a sober approach to risk. He was a stickler for detail and that scrupulousness sometimes infuriated colleagues who were itching to make deals. But Demchak always defended Varikooty. His judgment on the mortgage debt was clear: he could not see a way to track the potential correlation of defaults with any confidence. Without that, he declared, no precise estimate could be made of the risks of default in a pool of mortgages. If defaults on mortgages were uncorrelated, then the Bistro structure should be safe for mortgage risk, but if they were highly correlated, it might be catastrophically dangerous. Nobody could know.

Duhon and her colleagues were reluctant simply to turn down Bayerische Landesbank’s request. The German bank was keen to go ahead, even after the uncertainty in the modelling was explained, and so Duhon came up with the best estimates she could to structure the deal. To cope with the uncertainties the team stipulated that a bigger-than-normal funding cushion be raised, which made the deal less lucrative for JP Morgan. The bank also hedged its risk. That was the only prudent thing to do, and Duhon couldn’t see herself doing many more such deals. Mortgage risk was just too uncharted. “We just could not get comfortable,” Masters later said.

In subsequent months, Duhon heard through the grapevine that other banks were starting to do credit derivatives deals with mortgage debt, and she wondered how they had coped with the lack of data that so worried her and Varikooty. Had they found a better way to track the correlation issue? Did they have more experience of dealing with mortgages? She had no way of finding out. Because the credit derivatives market was unregulated, details of the deals weren’t available.

The team at JP Morgan did only one more Bistro deal with mortgage debt, a few months later, worth $10bn. Then, as other banks ramped up their mortgage-backed business, JP Morgan largely dropped out. Eight years later, the unquantified mortgage risk that had frightened off Duhon, Varikooty and the JP Morgan team had reached vast proportions. And it was spread throughout the western world’s financial system.

Gillian Tett is an assistant editor at the FT. In March, she was named Journalist of the Year at the British Press Awards

This is an edited extract from ‘Fool’s Gold: How Unrestrained Greed Corrupted a Dream, Shattered Global Markets and Unleashed a Catastrophe’ by Gillian Tett. It is published this week by Little, Brown, £12.99, and in mid-May by Simon & Schuster in the US. To buy the book at 20 per cent discount, call the FT ordering service on 0870 429 5884 or go to www.ft.com/bookshop

Go to FT.com/tettinterview for a video interview of Gillian Tett by Andrew Davis, FT Weekend editor

Copyright The Financial Times Limited 2009"