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Chris
The Institutional Risk Analyst
Time for Hank Paulson to Do the Right Thing and Nationalize the GSEs
July 14, 2008
On Friday and as was expected, IndyMac Bank, F.S.B., Pasadena, CA, was closed by the Office of Thrift Supervision, the FDIC was named conservator and a new bank was created. Of note, no buyer was announced at the FDIC press conference.
The $32 billion asset IndyMac has about $1 billion in uninsured deposits, according to the FDIC, which is reopening the bank today after a weekend hiatus. The estimated cost of the IndyMac resolution to the Deposit Insurance Fund is between $4 and $8 billion or nearly a quarter of total assets on the high end.
This morning Americans should be very grateful to the dedicated professionals at the FDIC and OTS who handled this difficult process. We should also heap steaming piles of radioactive scorn on Senator Charles Schummer (D-NY) for his bombastic statements prior to IndyMac's failure. Schummer's selfish actions deserve censure by the Senate.
Last week, while the short seller mob in hedge fund land and their co-conspirators in the financial media were focusing attention on the GSEs, Countrywide Financial (NYSE:CFC) filed its last 8-K with the SEC, detailing the movement of significant assets from the parent of Countrywide Bank FSB to other affiliates of the Bank of America (NYSE: BAC) group.
As we predicted, the huge CFC servicing portfolio was transferred immediately after the merger with BAC closed and at well above fair value, some $19 billion. This valuation, $2 billion over carrying cost, seemingly makes any possible claw-back efforts moot should CFC file bankruptcy.
As DC SC member Tom Day discussed last week, (A Discussion of Current Issues in Risk Management: PRMIA DC Chapter Meeting & Open Forum) this proposed guidance replaces the 2000 BIS paper on liquidity and should be the focus of attention for all banks affected.
I shall ask the BIS the two basic questions raised during the discussion by the DC chapter, namely:
1) Is risk management specific to aggregate liquidity even possible?
2) Is not the fact of a large, deliberately ineffecient OTC market structure the root of concerns regarding liquidity?
Says the BIS press release: "The principles underscore the importance of establishing a robust liquidity risk management framework that is well integrated into the bank-wide risk management process. The primary objective of this guidance is to raise banks’ resilience to liquidity stress. Among other things, the principles seek to raise standards in the following areas:
* Governance and the articulation of a firm-wide liquidity risk tolerance;
* Liquidity risk measurement, including the capture of off-balance sheet exposures, securitisation activities, and other contingent liquidity risks that were not well managed during the financial market turmoil;
* Aligning the risk-taking incentives of individual business units with the liquidity risk exposures their activities create for the bank;
* Stress tests that cover a variety of institution-specific and market-wide scenarios, with a link to the development of effective contingency funding plans;
* Strong management of intraday liquidity risks and collateral positions;
* Maintenance of a robust cushion of unencumbered, high quality liquid assets to be in a position to survive protracted periods of liquidity stress; and
* Regular public disclosures, both quantitative and qualitative, of a bank's liquidity risk profile and management.
The principles also strengthen expectations about the role of supervisors, including the need to intervene in a timely manner to address deficiencies and the importance of communication with other supervisors and public authorities, both within and across national borders."
These guidelines are among the most prescriptive and specific ever proposed by the BIS. PRMIA members employed by banks in the countries that participate in the BCBS process should be considering comments on this paper.
Chris
]]> Is "Financial Innovation" Good for Bank Profitability?
June 10, 2008
Watching the de-leveraging process on Wall Street continue, most recently with the torment of Lehman Brothers (NYSE:LEH), we are often reminded of the statement by author Martin Mayer that there are no economies of scale in banking. Mayer, who we feature in the next issue of The Institutional Risk Analyst, was talking mostly about commercial banking when he made that statement, but the investment banks fit into that shoe as well and seem to be doing an even worse job than commercial banks when it comes to achieving real profitability.
Go back and review the Sell Side research focused on financial names published over the past 18 months. Note the change in the tone of the opinions and, in particular, the volatility of earnings forecasts for the major universal banks, then and now. Almost seems like different industries. The growing visibility of the true risk profile of many financial institutions raises a fundamental question: Do banks and brokers really ever make money, especially in risk-adjusted terms? Or to put another way, is the combination of technology and deregulation -- aka "innovation" -- in the financial markets creating or destroying value for investors in financial institutions of all descriptions?
Earlier this year, a client asked us to extract the risk-adjusted return on capital or "RAROC" metrics for the top 100 US banks from The IRA Bank Monitor going back some twenty years and compare same with a range of financial statement and market indicators. One of the resulting charts from this effort suggests very strongly that the real, risk-adjusted profitability of the US banking industry has been declining since the mid-1990s, when securitization and other types of "innovation" really kicked into gear.
Notice that even during the period of "supra normal" asset and equity returns reported by US banks during 2004-2007, the average RAROC for the top-100 banks was trending lower. The Q1 2008 results only confirm this trend, especially for some of the largest US banks. The latest RAROCs and other Economic Capital components are available to users of The IRA Bank Monitor and the Compendium of Bank Risk.
Perhaps more puzzling, during this period the standard deviation among the 100 largest, financially sophisticated banks was also falling, suggesting that diversity among the group grew less and thus the risk profiles were likely converging. Notice the huge reduction in the SD for the group over the past decade.
At first we worried that the sharp decline in RAROCs displayed in the early 1990s was due to statistical anomalies, but The IRA asked Joseph Mason, Herman Moyse, Jr./Louisiana Bankers Association Professor of Finance, Louisiana State University, to review the results. His reply was that the falling RAROCs may be attributable to three factors -- deregulation, litigation and securitization.
The IRA: Joe, doesn't the sharp drop in RAROC in the early 1990s look like a data inconsistency? Dennis lined up the FDIC data labels perfectly, but still the change seems drastic. What do you think?
Mason: You are correct to be wary of the early vintage FDIC data, but that period also was one of great change for the banking industry. Your focus on the top 100 banks probably avoids some of the S&L crisis era capital distortions in the FDIC data that might affect RAROC, so on balance I think that the chart does tell that story.
The IRA: Do tell.
Mason: Starting in the early 1990s, you had a series of court decisions, legislative initiatives and an increase in OBS securitization activity, events which all contributed to changes in bank business models and risk profiles. From 1989 to 1994, we saw some baby steps in terms of bank securitization, senior subordinated structures and the like. By 1995 when I joined the OCC, the volumes were rising and we started to be concerned about all of the implicit recourse events. You see RAROCs fall until 1997 with the 120% LTV crisis. Then you get the turning point in 1999 when 120% LTV dies in the marketplace and you set the stage, as the chart suggests, for the run-up to the home equity loan crisis.
The IRA: And just by coincidence HELOCs are in the headlines again today. So you would agree with the chart that the real, risk-adjusted returns for the banking industry have been going down for the institutions most affected by "innovations" like securitization and OTC market structures? Is this a function of the economy or specific market developments like securitization?
Mason: Both. The economy is important, but I would say that the effects of securitization are probably going to drive your SD and RAROC.
The IRA: But despite the promise of "innovation," the results suggest that the industry is working for less and less real return, a trend which if true implies that banks are really poor investments, especially if regulatory demands for higher capital levels come to fruition.
Mason: The bottom line is competition. In the 1990s, we not only deregulated banks but also deregulated funds, for example, and allowed them to enter the low-risk areas of the banking business. Sometimes new players just entered the traditional banking market without need of deregulation like money market funds. So banks had increased competition and the result was lower profits.
The IRA: This reminds us of our discussion earlier this year with Bob Feinberg ("GSE Nation: Interview with Robert Feinberg," March 17, 2008), who argues that the banking industry model is broken. Indeed, you yourself have suggested that the banking industry never really recovered from the 1930s and was just carried along by the war mobilization. As Feinberg and Alex Pollock at AEI both would say, the banks all became GSEs after the Depression and WWII -- just competitive ones!
Mason: Correct. If we really do want a safe and sound banking sector, we must start to pay attention to issues like the effect of securitization on bank business model choices. The group you have chosen in this study emphasizes the securitization effect by excluding smaller banks, but it nevertheless tells the story.
The IRA: Thanks Joe.
]]>For additional information or to RSVP, please contact: rsvp@rgemonitor.com
Over the past several weeks, we have published a series of articles about the situation facing Countrywide Financial (NYSE:CFC) and Bank of America (NYSE:BAC). The former agreed to be acquired in January 2008 for $7 per share, but since then BAC has made several statements in filings with the SEC suggesting that it will not stand behind CFC's liabilities, even after closing an acquisition.
Simply stated, our view is that CFC cannot be acquired by BAC or any other bank w/o a restructuring of the company's current and contingent liabilities. CFC is facing hundreds of lawsuits, civil inquiries by the SEC, and criminal probes by the DOJ and state attorney's general. BAC rightly is reluctant to pull the trigger on this deal given the uncertainty regarding the valuation. Our view is that the stock is worth $0.
Click on the links below to read the items in The Institutional Risk Analyst, starting with our first comment back in January:
'Are Countrywide Financial Bonds Bankruptcy Remote?', January 22, 2008
'Update: Are Countrywide Financial Bond Holders Bankruptcy Remote?', May 1, 2008
'An Involuntary Transaction: Why BAC + CFC May Never Close', May 6, 2008
Comments? Questions?
The Subprime Three -- Rubin, Summers & Greenspan
The Institutional Risk Analyst
April 28, 2008
The events surrounding the financial difficulties of Long-Term Capital Management L.P. ("LTCM") raise a number of important issues relating to hedge funds and to the increasing use of OTC derivatives by those funds and other institutions in the world financial markets. The issues most directly posed by LTCM include lack of transparency, excessive leverage, insufficient prudential controls, and the need for coordination and cooperation among international regulators. I welcome the heightened awareness of these issues that the LTCM matter has engendered and believe it is critically important for all financial regulators to work together closely and cooperatively on them. Therefore, I applaud Secretary of the Treasury Robert Rubin's call for meaningful studies by the President's Working Group on Financial Markets on hedge funds and on OTC derivatives and look forward to working with him and the other members of the Working Group.
Brooksley Born
Chairperson
Commodity Futures Trading Commission
November 13, 1998
Kudos to Nelson Schwartz and Eric Dash of The New York Times for the Sunday business section cover-story on Robert Rubin. Their article puts into place another piece of the subprime puzzle. In addition to reporting on Rubin's seemingly conflicted behavior as a director of Citigroup (NYSE:C), the overview of Rubin's policy role in blocking federal oversight of the Over-the-Counter derivatives markets is a great contribution.
Schwartz & Dash describe how former Fed Chairman Alan Greenspan, former Treasury Secretary Larry Summers and Rubin coordinated to undermine efforts by CFTC Chairperson Brooksley Born to impose greater federal oversight of OTC derivatives markets. They report: "On at least one occasion, Mr. Rubin lined up with Mr. Summers as well as Mr. Greenspan to block a 1998 proposal by the Commodity Futures Trading Commission under Ms Born that would have effectively moved many derivatives out of the shadows and made them subject to regulation."
Click here to read the entire April 27, 2008 Times profile: "Where Was the Wise Man?"
Note that Born's comments of a decade ago regarding the LTCM collapse highlights those very same issues which led to the collapse of Bear, Stearns (NYSE:BSC) earlier this year, namely the systemically unstable nature of an OTC market structure. Note too that over the intervening decade nothing happened in Washington to effectively address these issues.
Greenspan, Summers and Rubin all acted -- or failed to act -- to enable Wall Street's quest for higher profits via the opaque OTC market structure model and did so at the expense of the public interest. Instead of a truly free and transparent securitization market where occasionally a player does fail, today's OTC jungle ensures the destruction of a significant portion of capital deployed by dealers and investors both. How does this serve the interest of investors or the marketplace?
The US Congress, the major regulators and industry groups such as the President's Working Group on Financial Markets, and two presidential administrations from different political parties, all collaborated to bring the financial crisis involving subprime debt and OTC securities to fruition. While talking about "innovation" and "competitiveness," the US political elite and their clients on Wall Street authored the subprime crisis from beginning to end, specifically by allowing the OTC marketplace to grow the point where it threatens the safety and soundness of large banks.
And the real irony of the past year or more is that the OTC market structure has been a catastrophe for many dealers, some of which laid out millions of dollars in lobbying fees to make the OTC markets a reality.
Perhaps even scarier than the Times account of the pro-Wall Street policies openly pursued by the Subprime Three is the peculiar position taken by Rubin regarding his role at C, namely that he was somehow not responsible for the financial performance and chaotic corporate governance of this bank over the past decade -- when he served as director and, in our view, shadow CEO. Read our previous comments, ("Should Alan Schwartz Be Citigroup's Next CEO?") for background on the House that Sandy Weill built.
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