Basel III: Necessary, but not sufficient. Have you looked at Bank Analyzer? – Chapter 3.

In his speech http://www.bis.org/speeches/sp121106.pdf Mr. Wayne Byres, Secretary General of the Basel Committee on Banking Supervision, makes very interesting remarks about the responsibility of the “Trading book rules” and “Securitization activities” in 2008 Financial Crisis.

He also mentions the consultative paper issued by the Basel Committee on Banking Supervision in which Trading book rules are reviewed.
http://www.bis.org/publ/bcbs219.pdf

What’s the common responsibility of trading book rules and securitization activities with 2008 Financial Crisis?

During the happy years of the real estate bubble (before 2008 financial crisis), the securitization of subprime loans with mortgage-backed securities produced enormous profits for financial institutions. As we’ve discussed here in the past, financial bubbles are a great business while they’re inflated.

Unfortunately, history teaches us that the destiny of any bubble is to be burst, with the sad results that we all know.

As in many previous occasions, the key point for inflating a financial bubble is make the investors look at the short-term price of an asset (normally according to market demand and supply) and not to the sustainable, long-term value of the investment. If investors were able of valuating the intrinsic, long-term value of an inflated asset, nobody would invest in it.

Markets are not stupid, but they can have a blind spot…

The question is: how do we recognize this blind spot?

Making a market’s blind spot requires building a mechanism which hides the intrinsic value of the inflated asset.

The role of that mechanism was played by the securitization of subprime mortgages during the last financial crisis.

If I propose to any of you lending money to a Ninja (No Income, No Job, No Assets) you will refuse, but what happens if I asked you to invest in a profitable security?

Probably you will accept, at the end, investments are driven by greed.

But it’s important that you don’t know that your investment depends on the Ninja paying back his debt; this was the role of the securitization and the trading book rules.

Simplifying, the construction is more or less, as follows.

The bank lends money to the Ninja and sells the mortgage to the market inside of a security.

As the interest paid by the Ninja is higher than the interest paid by a high-rating borrower, the security can also pay higher dividends. With the money of the first investors, the bank borrows more money to other Ninjas, and subsequently it will issue new Mortgage-Backed-Securities.

By the way, maybe some of you already saw that this is not that different of a Ponzi scheme, http://en.wikipedia.org/wiki/Ponzi_scheme

On the other hand, those Mortgage Backed Securities are also traded by other banks and financial institutions. They are hold at the trading book and traded at market price.

While the price of the security goes up, the capital requirements determined by the value-at-risk of the portfolio are relatively small, letting the banks’ managers releasing more funds for inflating the bubble and increasing banks leverage.

This is not new, all the financial bubbles have required a hiding mechanism, more or less sophisticated, but at the end, with the same objective.

Preventing future financial bubbles requires preventing the implementation of hiding mechanisms; we need to provide investors with the intrinsic, long-term sustainable value of an investment.

Once again, disclosure is the word.

Looking forward to read your comments.

Ferran.

Basel III: Necessary, but not sufficient. Have you looked at Bank Analyzer? – Chapter 2.

Mr. Wayne Byres, Secretary General of the Basel Committee on Banking
Supervision, also mentioned in his speech that “a robust set of
international banking standards is critical for the future”.
http://www.bis.org/speeches/sp121106.pdf

In this sense, the International Financial Reporting Standards are a
very important step in the right direction of providing a homogenous
framework of accounting principles.

Nevertheless, as the 2008 Financial Crisis and Lehman Brothers
collapse sadly proved, in a globalized world the solvency of the
financial system relies on the solvency of its main agents, wherever
they operate.

In case of a serious solvency or liquidity issue in a systemic
financial agent, the malfunction of the liquidity channels would
spread to the global system in the very same day. The importance of
those systemic agents has been recognized by the regulatory
authorities, with higher capital and liquidity requirements and more
detailed supervision.

On the other hand as the quantitative easing cycles and rescue
packages have shown, sovereign monetary decisions generate currency
exchange rate fluctuations impacting the capital markets.

Those currency fluctuations have a negative impact in the solvency of
banks, as they increase their Market Risk capital consumption.

Simplifying, the volatility of the portfolio increases the Value at
Risk of the portfolio and consequently the capital requirements of the
bank.

This is a big issue, as in my opinion the world is facing a long
period of capital scarcity and wasting capital is not an option. If
currencies exchange rates fluctuations are a root cause for wasting
capital, mechanisms for minimizing those fluctuations will have to be
implemented.

But monetary policies, including implementing quantitative easing
measures, are sovereign decisions.

Coordinate monetary policies for reducing currency prices fluctuation
will require countries to give sovereignty to supranational entities
responsible of implementing and supervising the coordinated measures.
This will take time, one of the reasons why we are in a long systemic
crisis.

On the other hand, what’s the point for a global bank, to report its
financial statements only in a local currency, when the value of that
currency relies in a sovereign (local) decision?

Reporting the value of a portfolio in global capital markets requires
disclosing separately the effect of currency price fluctuations on the
value of the portfolio, and the intrinsic value of the banks
investments (many of them in foreign currencies). Both effects are
important and if one of them hides the other, very relevant
information will be lost.

SAP has understood the importance of this issue providing the release
8 of Bank Analyzer with strong Multi Currency Accounting
functionalities; also a very important step in the right direction.

Looking forward to read your opinions.

K. Regards and Merry Christmas.
Ferran.

Liquidity and Palliative Care.

Dear,

Just 7 months ago, the risk of collapse in the markets due to the Eurozone debt crisis was reminiscent of the uncertainty and panic of November 2008.

Seven months later the coordinated action of central banks, injecting liquidity to the financial system, has apparently eliminated the risk of collapse in the financial markets.

Unfortunately, this has never been a liquidity crisis but a solvency one. The real issue is not the stability of the Financial Markets; that’s just a symptom of a much more serious illness.

The real issue is the exhaustion of the economic model based on wasting capital, mainly represented by the scarcity of financial solvency and natural resources.

We’ve seen two approaches for dealing with this Economic and Financial crisis.

- Expansive approach described by injecting liquidity or what’s the same but in a different format, implementing stimulus packages. For some economists; this is the right answer for a fast economic recovery. According to them, if there are no inflation signs, a treatment based in injecting liquidity does not have contraindications. US Government and the FED have been the champions of this approach.

- Contractive approach described by implementing austerity programs which must increase the confidence of the markets. In this case the contraindication is deflation and pain. German government has been the main champion of this approach.

In my opinion both approaches are wrong. 

The US approach forgets that inflation is an average, and while some assets have not increased significantly its price (housing for instance) other critical assets, like Oil, have seen a dramatic rise in their prices. By the way, as commodities markets are traded in US$, the instability of US$ is affecting everybody, and it can have (and in my opinion it will have) a serious impact in the use of US$ as global trade currency in the middle term.

The contractive approach is also wrong, as combines the positive effect of reducing the size of the economy to more sustainable levels, with draining resources from some activities with real potential of sustainable growth generation. As a consequence, the countries affected by this approach are suffering a severe depression (southern European countries) or a slowing down of their economic growth (northern European countries, including Germany).

Again, the answer is efficient Capital Management. Capital allocation is becoming the most critical activity and it cannot be driven anymore by an economic model based in cheap Capital (represented by abundant natural resources and credit orgy). This is an old business model based in volume, when all the activities were profitable and it was not important if they were efficient and sustainable or not.

Now, the scenario is different. Capital scarcity is making us distinguish between efficient and long term sustainable activities, and inefficient and purely speculative investments; that’s the exit strategy of this crisis.

Current stability of the financial markets?

This is just the result of the palliative care represented by the liquidity injection of the last months, it’s temporarily alleviating the symptoms, but as the illness is very serious, they will return. 

Looking forward to read you comments.

K. Regards,
Ferran.

China and other concepts.

Dear,
Last week I had a very interesting conversation with a good friend, investment bank analyst in Hong Kong.

We discussed about two press comments, apparently not related, but with interesting implications with each other.

Two weeks ago, former Treasury Secretary of the US, Henry Paulson, warned that U.S. Government Faces 'Debt Bomb' that could be far more painful than the financial crisis in 2008 and 2009, and even more difficult to contain. 
http://english.capital.gr/dj/news.asp?details=1710189

Last week, rating agency Standard & Poor's warned that China is at Highest Risk of Downturn on Overinvestment.
http://www.bloomberg.com/news/2013-01-31/china-at-highest-risk-of-downturn-on-overinvestment-s-p-says.html

Those two warnings are just the symptom of a serious illness of our economic model in the last decade; the world has grown with China producing low value products that US consumers paid with debt. 
http://www.usdebtclock.org/

For years the construction has worked very well and as a consequence we lived the amazing growth of the years previous to 2008 Financial Crisis, but now the US Debt bubble is close to burst.

What those two comments reflect is that US can simply not pay their huge debt and China (main holder of a very important part of the US debt) faces a huge production overcapacity (plus a real estate bubble, and lack of solvency in their financial system, amongst many other problems).

What’s the long term value of your investments in manufacturing capacity, which will not generate future cash-flows, because your clients simply don’t have the money to pay the merchandise you produce?

While markets are happy to accept that some way you will pay your debt, no problem.

But when trust disappears, interest rates rise and then, problem.

What we see above is a huge waste of Capital, that when it becomes visible will generate huge financial tensions, which as Mr. Paulson pointed out, will be much worse than the 2008 Financial Crisis.

In my opinion making visible this problem will drive a deep transformation of the Financial System, from a model based in volume to a model based in efficient Capital Management (including very detailed Capital Allocation).

In a world of much more limited growth, Capital becomes a very scarce resource and managing efficiently the main priority.

On the other hand, the capacity of the US for financing its debt is supported by the position of the US Dollar as global trade currency. But if we look at the consequences of the breakdown of the Bretton Woods agreements in the 1970s, maybe we’ll understand that this privilege of the US economy can eventually disappear.

But we’ll talk about it another day.

Looking forward to read your comments.

K. Regards.
Ferran.