Sporadic witering oN economiks

Son of Wallis

2010-12-13T06:39:00.000-08:00

In attempt to get those $1000 AUD I put together this missive on banking for the competition:

The end of toxic logic.

Individuals and companies have been incentivised perversely across the banking industry, and being led by a corrupt banking ideology, Australia has paid a price for this. It could should shape itself as a role model for banking leadership by implementing the following proposals, and creating incentives for small banks, and securitized bonuses. Until these factors are dealt with the banking industry will always claim more free market economic is a good thing. Unfortunately when it goes wrong, free market economics is the last thing they are prepared to confront. Their logic went something like this:

(I)we have assets on our books that are not what we thought they are, we are now undercapitalised.
(II) If people know this, they will remove their money from our bank, this will cause a bank run.

(III) If we collapse, banks X and Y will collapse as well because they have assets we sold to them.

(IV) If we all collapse, your banking system will collapse.

(V) If the banking system collapses, your country will collapse. Therefore, you must help us.

Any cohesive solution to preventing this occurring again must deal with preventing this logic to ever hold true.

(I)How did the banks end up with these “faulty” assets?

A big topic, but lets consider a simple process. A retail bank lends to customers to purchase a house. The securitizers at an investment bank then buy these loans and package them into an issue, create the securizitaion vehicle and sell tranches to other institutions. Based on a rating given by an “authorised” entity banks and other institutions then pay an appropriate risk premium for the bundle of coupons all the individual retail borrowers pay. The advantage of this is that pension funds and insurance companies can invest in these assets which claim to be as secure as corporate bonds. At every point in this process, an individual is basing his expected year-end bonus on these deals going through: the retail bank adviser, the securitiser. the ratings agency advisor,the fund manager. However the security is expected to last on average 20 years.

Hence there is a duration mismatch in the risk profile of the individual and the institution. Any solution to the current banking crisis must minimize this risk.

The retail bank and the securitising institution should be forced to take a substantial piece of any “synthetic” product (e.g. 20% each). These “mirco-issues” should contain a piece of each tranche, in effect replicating exactly the payoffs for each institution. Bonuses for their employees should be paid annually from the coupons of these micro-issues. If the bank wishes to pay them more, then let them take a bigger share of the coupon, however they should be very aware that their own personal wealth is intimately linked to the product that they are creating.

(II) How can a retail bank end up with assets of ambiguous quality on it's books?

Were a retail bank to package and hold it's own debt, the loan quality of the book should be clear. They verified and created the mortgages. Instead were third parties are used to sell mortgages the quality is likely to decrease: the downside incentives for third party individuals are massively outweighed by volume related pay incentives. Hence a loan book of false creditworthiness and overestimated earnings claims.

The other side of this is large retail banks wanting to play in the interbank markets, buying and selling securities in a hope to create “alpha”. This has been sanctioned by executives at the top level who see peers performances and bonuses and hope to create the same for themselves. Buy buying poor quality opaque products with artificially secure ratings and apparently high yields, these executives encouraged their own staff to take bigger risks.

All of this was implicitly made possible by banks trusting ratings that proved to be in the short term “cheap”, but in the long run very expensive.

The rating agency model is completely conflicted where an agency is authorized by the government to define the quality of a securitized product. As the rating individuals involved see their year end bonus defined by the quality of the ratings they give, clearly they will always be proposed to “do business”, rather than “do analysis”. As they are government sponsored, a competing independent agency is always considered a lesser value analysis. The author proposes an end to “certified ratings agencies”, and an open platform for securitisation vehicles to present the credit worthiness of their underlying mortgages. Hence independent analysis houses can access this information and provide independent reports to funds and banks who are interested in these products. The increased competition and reputational damage of poor analysis would likely cause margins to drop, and prosecutions for misratings are much more likely to happen in the free market. Suing the government is generally an exercise in futility, as each department displays no fault with bureaucratic aplomb.

(III) & (IV) Why are the banks so interconnected, and how can this be prevented?

The banking system is highly connected via the repo and swaps markets. The fall of one institution could mean the fall of all, as the asset book of a bank becomes less determinable as it's counter-parties default. As it becomes less determinable, the reserve ratio requirements and mark to market accounting become even more problematic. The bank is essentially bankrupt. For a small bank, this is a problem for counter-parties, but for a large bank, it is a system threating collapse.

The author proposes that banks be taxed not in proportion to their size, but in proportion to their connectedness to the market. Each trade entered into must be registered with a central institution, where the deal is valued in terms of risk and size. The total risk to the system of an institution should be composed of it's own outstanding debt, and a proportionate amount of it's nearest neighbours.

Hence as interconnectedness in terms of size and risk increase, the institutions forming this risk nexus should be taxed appropriately more.

A tax such as this on profits before wages that is relative to the proportion of risk that the institution poses to the system, not to itself. Given the current scale of the banks, this taxation would effectively be extremely punitive on bank earnings, however as executives realize a small institution is more profitable to them as an individual, they would be incentivised to start their own small banks.
The overall effect should be to force bankers into competition rather than into collaboration by preventing large institutions from making huge profits.

Trading with institutions in a jurisdiction which does not manage risk in the same way should be allowed, but have an extremely high risk profile to reflect the risk of the unknown.

Without uniformity in global systemic risk management, a crisis in one area can cause a crisis in another. It could be argued that America exported toxic debt and fetid banking. If a jurisdiction (aka fiscal area) is not prepared to impose risk curbs on its bank, local banks should be incentivised to avoid trading within the region.

(V)How can any country become so dependent on one industry?

Money has been the lifeblood of economies across the world for centuries. However if the control of money is centralized, the greater the risk a failure at this control point will effectively destroy the system. As discussed above the scale of large banks is now an implicit threat to any country that allows them to grow out of proportion to the economy that they exist in. And it must be asked how much do the executives know about their business? How can they continue to work in the financial services industry while overseeing a period that has effectively jeopardized the whole system? The claim is that who else can understand the complexities of modern finance? It's obvious that these people cant.

Bankers must face serious financial and personal losses in the face of failure.

The author proposes a stringent set of examinations similar to an actuary or a barrister for any person who wishes to become an executive of a bank. They should include banking history, economic theory and financial mathematics. Qualification should come at only serious personal cost (i.e. many years of personal study), and should be stripped away immediately in the event of failure. Top bankers should by law have undergone a training regime as rigorous as top surgeons or judges. As the recent crisis has shown, their role in society is in many was more powerful than other people in serious positions of responsibility.

To conclude:
Measure and tax systemic risk
Align incentives to financial products sold and created across their lifetime
Ensure that bankers know their business, and are barred from the industry on failure.

In any other business, most notably the current wave of environmentalism, taxation and responsibility are seen as good things. Why not banking?

The shackles of debt

2010-05-29T04:23:00.000-07:00

This is my repsonse to Edward Hughs insightful post on the future of Spain found here.

As a hegelian antithesis:

If an internal devaluation occurs, wont this massively decrease wages available for debt repayments, causing further defaults -> bank balance sheet issues -> bank runs -> bailouts?

Even demanding loan haircuts to domestic loans on a 1-1 basis with any wage devaluation would likely cause most Spanish banks to collapse (I base this on the recent mergers of smaller banks in Spain, and absolutely no fundamental anaylsis).

Also, I can only assume this would be seen as an aggressively protectionist move within and without the Eurozone, treachery in fact, by the coalition of the willing (Sarkozy, and er, Merkel?) for the Eurozone project. Is it politically tenable to have the recent “all for one” measures if everyone is attempting to effetively slash wages and gain comparative advantages?

Assuming it’s not, would this internal devaluation only realistically by solved by a devaluation of the Euro as a whole, massively unpalatable to Germans and their fear of money printing madness, and also everyone else in the export driven world?

Seems like a no win situation: Discuss :)

Marx, Soros and the Mega cycle

2009-02-02T00:50:00.000-08:00

After reading a book on Marx's Das Capital (not Das Capital itself), Marx states that when there is surplus capital some is returned to the capitalist employing labor and resources, some to the employees, and some invariably gets to middlemen (i.e. the service sector), thus reducing the amount of capital given to workers or reinvested as fixed capital.

And here's is prediction of banks and debt: "Owners of capital will stimulate the working class to buy more and more of expensive goods, houses and technology, pushing them to take more and more expensive credits, until their debt becomes unbearable. The unpaid debt will lead to bankruptcy of banks, which will have to be nationalized, and the State will have to take the road which will eventually lead to communism."

Soros talks about the world being in a 60 year mega cycle. Clearly he believes (whether he admits it or not) the same as Marx. In fact on Bloomberg recently he even goes to say that the financial system is collapsing under his own weight.

Clearly all of this is true about the US. With so little production of anything useful (they make a lot of cars apparently), there's nothing to skim, so it's been running on gas for a while. On the other hand we see China, the worlds factory, to lead the way out of the slump. Interesting times, especially to see Marxists winning versus Keynesians.

US to go Sharia

2008-11-19T23:51:00.000-08:00

Now that the FED is moving to 0% interest rtes, looks like it's time to bring in full Islamic banking under Barrack Hussein Obama. They'll probably even start talking to Iran!

Surely China will be a bit upst about this: many problems in CHina are to do with Muslim dissidents, and now they control their 1.5 trillion of dollar reserves. Smacks of pending war!

Bernanke: The Historian

2008-11-13T03:03:00.000-08:00

So Bernanke is now in charge of the FED. What's his claim to fame? An understanding of the Great Depression of the 1930's.

So imagine you actually wanted to create a depression. Would you pick someone who knew exactly how to make it all go wrong? :)

Let's face it: none of the moves he and Paulson have made have actually fixed anything.

Your tax

2008-10-28T07:43:00.000-07:00

Yep, that's your tax.

However, when you don't have a job, whose tax will it be?

Do you think Shell will be prepared to pay with their profits? Or will they leave this country?

Sobering indeed :\

naked capitalism: Steve Waldman on Good and Bad Financial Innovation

2008-10-19T02:55:00.000-07:00

naked capitalism: Steve Waldman on Good and Bad Financial Innovation. See the Buffet quote at the bottom

The final bit of irony in the MBS debacle

2008-10-15T10:39:00.000-07:00

Sigh :)

Just found Ron Paul's website

2008-10-14T15:50:00.001-07:00

Geezer

A link on Stefan Karlssons blog with Ron Paul and Jim Rogers warning you of the future

2008-10-14T14:51:00.000-07:00

Here

I'm becoming a big fan of Karlsson

Systemic crisis, or redefining class boundaries

2008-10-14T04:47:00.000-07:00

The bailout of the banks is considered a great success by governments and people in finance, that has saved we serfs from a financial cataclysm.

Of course it can also be viewed another way: we now have confirmation that if you are in relatively successful in finance, you are safe from penury, unlike those people who rely on finance, who are now at the whim of central banks (via interest rate control) and the directors of these invulnerable institutions.

Given they are now incentivised to pay off the government as quickly as possible, will they really want to loan more money out to you, their benefactors, and extend new and greater lines of credit?

The idea that we will *make a profit* is, for a lay person, ridiculous. Are you expecting to make an income stream from this money? Will you ever be able to appreciably see the improvement in your public services, or transport?

Realistically, for those people not in London, you will not see a penny of this. I can see spin in the future that the profits are going to the Olympics, or Cross-Rail in London.

So what's just happened? You, and this means the "middle" and "working" classes, are, and will always be, the backstop for these financiers. So perhaps the world has shifted.

Meritocracy in industry is dead. Be part of the club, and you are safe. Be a suitor to it's members and you are at their whim. Perhaps it's always been this way, but never so publicly announced by a Prime Minister.

Cool spending graph

2008-10-13T03:15:00.000-07:00

Taken from Angry Bears posting check out this cool graphic for consumer spending around the world.

Nationalisation will probably result in greater contraction

2008-10-13T02:48:00.000-07:00

Reading the FT this morning, a few articles suggest hedge funds are desperately trying to deleverage, this being on of the main reasons for the flight to cash in the commodities and stock markets.

Paul Mason suggests there will be a greater emphasis by the banks on small business and mortgage lending stability.

This is an assumption, but surely there must be several private equity deals financed by the recently nationalised banks, and hedge funds who are still geared on RBS (for example) loans.

So the pressure from the government / public to call this money from these gearing engines will almost certainly result in a greater move to cash, causing further falls in these markets as these institutions desperately look for businesses and stock to sell.

Interesting times ahead if this is the case. Then magnify this across the other regions of the world where banks are being nationalised. Is this the beginning of the end of the middle of the beginning of Monte-Carlo capitalism? (Excuse the highly geared time frame ;) )

Recapitalising RBS: a story of misadventure

2008-10-12T15:42:00.000-07:00

So the current plan by governments around the world is to *recapitalise* the banks. What does this mean? Essentially, taxing you for the next 6 months to pay for *ordinary shares* in banks who have clearly lent too much and want some help to keep them ticking over.

This strikes me as insane for 2 reasons:

1) If this works...

The market cap of RBS is around £12bn at time of writing, so the UK taxpayer (Taxy) for this money could own 100%, not (for examples sake) 50%, for it's £15bn. So in very basic terms, I'll pay more for half the company than I would for the whole one. Darling and Prduence need new calculators.

2) If this fails....

The UK tax payer has just bought 50% shares. At what price? Current market? The rest can still be sold, costing taxy a not inconsiderable amount. And they keep getting sold. So at what point does Darling step in to go to step no. 1. Lets say he doesn't. The shares tank completely (Taxy feeling the pain), then margin call after margin call producing a 50% owned bank. Taxy now owes £15bn to the central bank. Better crack that whip Prudence

Money Mechanics

2008-10-12T15:37:00.000-07:00

Here's the text book to get to the point that you need to start deleveraging

http://landru.i-link-2.net/monques/mmm2.html

Gold from cheese anyone?

Peston

2008-10-12T15:30:00.000-07:00

I read Pestons blog, but surely this man is a puppet (whether he knows it or not) of somebody near the top f our economic institutions.

He's clearly bright enough, and must have plenty of experience, but he keeps getting market defining stories for the Beeb, that no other media outlet seems to get a handle on.

Someone's feeding him, and someone powerful. As a peasant, I'll never know, but I figure we should be suspicious about the clarity and timing about the information he provides. Anybody else would be in serious trouble (although clearly in the world of *unregulated* world of Bloomberg chat, anything can be said) for manipulating the market

http://www.dailymail.co.uk/news/article-1058825/Share-sharks-190m-profits-HBOS-trading-minutes-BEFORE-BBC-announced-Lloyds-TSB-rescue.html

Boris

2008-10-12T15:13:00.000-07:00

Some humorous Boris debunking

http://www.fuckboris.co.uk/

At least he's more comedy than Ken...