The Financial Services Club's Blog

Bears, banks and bail-outs ...

Interesting to see that Bear Stearns are suffering the same issue as NCR, seeing this report on 28th March:

"A senior Bear Stearns executive with 20 years' experience has been accused of defecting to rival Morgan Stanley with so many print-outs of confidential client information that the troubled bank's Boston office ran out of paper."

Should have used a USB Memory Stick ... far easier.

Equally, I was researching a project over the weekend on Basel II - yes, I am that boring - and found this fascinating discussion in the Hindu Business Line from November 2006.

James Nicholas Haigh, Managing Director and Deputy Chief Credit Officer of Private Wealth Management at Deutsche Bank, and Hans Rudolf Schutter, Executive Director for Asia and Middle East at Risk Business International Ltd, responded to the idea that the Indian government funded the Indian banking industry with the following statement:

"The government backing a bank was not a good approach as it meant that taxpayers' money was being used to pay for mistakes of bank managements."

I have heard this statement a thousand times in the past. 

I wonder what they would say now, after the Fed bailed out Bear Stearns, the Treasury bailed out Northern Rock, and the ECB bailed out Spain's mortgage book, and, and, and ...

MiFID starts to bite as US ECN BATS launches in Europe

BATS Trading has announced plans to launch in Europe, putting further pressure on traditional exchanges. Their aim is to capitalise on the opening of the European markets to new execution and trading venues, such as Chi-x, Smartpool, Turquoise, Virt-x, MarkitBOAT, Rainbow and more.  Something that has been actively promoted by the implementation of Europe's Markets in Financial Instruments Directive, MiFID, in November 2007.

BATS announcement should strike a little bit of fear into some of the traditional and new players.

By way of example, some traditional US players dismissed BATS as a 'few servers in a trailer park' and yet they are now competing head-to-head with NASDAQ and the NYSE.

According to BATS, they now claim that they trade 8% to 10% of all US equities, which is phenomenal considering that they only launched two years ago.  Maybe their success is due to the fact that their trailer park servers are designed to handle high-speed, high-volume and anonymous algorithmic trading, and that's what everyone wants these days isn't it?

Equally, being backed by Deutsche Bank, JPMorgan Chase, Credit Suisse, Lehman Brothers, Merrill Lynch and Morgan Stanley should stand them in good stead. Maybe this is why they are likley to be granted full exchange status from the SEC.If they do the same in Europe, then whoever thought MiFID was a damp squib will have to think again.

'Immunity from prosecution' a major FSA weapon

It almost passed under the radar but, in light of the HBOS share drop of the other day, Alastair Darling - the UK Chancellor - announced on Thursday that anyone who snitches on their mates to the FSA about colleagues who try to manipulate share prices, will be immune from prosecution themselves.   This is seen as a powerful weapon for the FSA, as investment bankers have been reticent to say anything about such practices in the fear of getting caught out themselves. 

Now then, that Jeremy in the banking equities desk has been stopping me from getting a seven-figure bonus this year ... maybe I'll mention that to my new FSA mates down at Canary Wharf?

American Financial Regulatory Reform Announced

The New York Times published the detailed proposals for Regulatory Reform for all American financial markets, from the Treasury on Saturday.  The aim is to:

• consolidate all the regulations and authorities for everything from banking to hedge funds and private equity into three powerful overseers: a new Prudential Financial Regulator, the Federal Reserve and the SEC (currently there are five);
• merge the SEC with the Commodity Futures Trading Commission, and reduce the powers of the SEC by giving the Federal Reserve overall authority for the financial markets;
• eliminate the difference between 'banks' and 'thrifts', and close down the Office of Thrift Supervision;
• create a national regulator for insurance firms, eliminating the powers of state authorities over insurers;
• avoid any new regulations being introduced, but ensure regulatory authorities exert and implement their authority; and
• give the Federal Reserve the power to swoop into any part of the industry at any time to perform spot checks, including detailed examination of internal bookkeeping for any institution that they consider could pose a risk to the overall financial system.

The last bit is quite radical, as the Fed had no power to do this before, and there is expected to be a long and protracted debate between Democrats and Republicans, Congress and the Senate, before this passes into law in 2009.

The full text of the Executive Summary is available here.   

Reuters also reports that the US and UK have agreed a joint banking watchdog, comprising senior treasury and regulatory figures from London and Washington, to develop proposals to monitor and regulate the banking system.

Shine on you crazy Dimon

I really like Paul Kedrosky's Infectious Greed blog and, in a blaze of creative psychedelic, 1970s Floydism, he came up with this ode to Jamie:

 

Remember when you came from Banc One, you shone like the sun.
Shine on  you crazy Dimon.

Now there's a look in your eyes, like black holes in the sky.
Shine on  you crazy Dimon.

You were caught in the crossfire of Joe Lewis and lockup,
blown on the  legalese.

Come on you target for Hank's laughter,
come on you raider, you legend,  you banker, and shine!

You reached for Bear's jugular too soon, you tried for the moon.
Shine on  you crazy Dimon.

Threatened by shareholders at night, and exposed in the light.
Shine on  you crazy Dimon.

Well you wore out your welcome with fairness opinions,
rode on the  legalese.

Come on you trader, you slayer of brokers,
come on you bully, you banker,  you piker, and shine!

 

Goes with Subprime Rhapsody and all those other great banking songs.

 

Watch out for the thought police

According to the Byron review of social networking in the UK, Facebook, Bebo, MySpace and others sites are to be censored, and Google, Yahoo, MSN and others must show SAFE SEARCH in clear options from the home page.  This is because some parents do not supervise their children's use of the Internet.

Next, we intend to bring riot police into any home that accesses any undesirable websites, whether there are children in the home or not.  Sorry, that was my joke ... or was it?

Microsoft: Throw Vista Away

Following on from my comments on Vista, this one is not my comment ... but Infoworld's.  This was followed by this blog and it's worth reading the over 100 comments that follow that. 

Funnily enough, I'm now seeing 2-3 articles a day with similar sentiments.

Yep, you guessed it.  We're all going to get rolled back to XP!

LSE's 86 percent rise in SETS trading raises questions

Further to the mention of Iraq’s electronic trading exchange going live this week, the LSE has been running electronic trading since 1986, when the Big Bang moved the Exchange from open outcry to electronic trading.

This led to the introduction of SEAQ, the Stock Exchange Automated Quotation System, in October 1987.  SEAQ was supplanted in October 1997 with SETS, Stock Exchange Electronic Trading, for highly liquid share trading.   

Yesterday, the LSE announced their latest trading results, which showed an 86% rise in average daily trading on SETS for the last eleven months.  This is down to a mixture of market volatility, combined with algo trading and heavy discounting for volume trading. 

The average number of trades per day is now 629,000, compared with 338,000 a year ago, with the average daily value traded up 43% to £9 billion per day.      

Interestingly, with MarkitBOAT, Turquoise and Chi-x all breathing down their necks, the fact that LSE is still growing the number of professional terminals receiving LSE real time data (up 15,000 since February 2007 and 4,000 since December 2007 to 111,000 terminals) must be of particular cheer for them.

On the downside though, is the fact that the amount of money they earn for each trade, based upon trading fees, is falling fast.  The figures are now 89 pence earned per trade, compared to £1.34 last year.  This demonstrates how the LSE are being forced to offer bulk discounts to keep up with these new execution venues. 

Such discounting will, of course, increase volumes as it gets cheaper the more you do.  However, long-term, bulk volume could just as easily shift as it gets into a rate war and if volume shifts, in light of this charging policy, it will be high volume movement.

This discount for bulk policy could place LSE's future profitability in serious jeopardy therefore; or it could actually make them supercompetitive to beat off these alternative platforms.  It's all about volume, speed and value in our search for liquidity with best execution.

Hey ho, the merry-o ... or is that hey-ho the MiFID-oh!

Meanwhile, securitised derivatives trading reduced slightly to 4 million trades from 4.3 million ... I wonder why that would be?  Oh yes, a credit crisis!

 

FT says Terri Dial leaving Lloyds TSB

Today's Financial Times reckons that Terri Dial is leaving Lloyds TSB after a three-year stint to head up global consumer banking at Citi.  This proves interesting as Terri has really made a mark at Lloyds TSB and would be a big loss.  Nevertheless, the fact that Citi’s new chief executive, Vikram Pandit, wants to overhaul the group’s structure is worth noting, especially if he can attract heavy-hitting executive team members such as Ms Dial.

Visa's IPO strips to the core

Now that Visa have IPO'd and the execs and banks are profiting from the rocketing share price, the firm has decided to push the limits further by stripping their products down to the basics for their latest TV campaign.

Iraq starts Electronic Trading

This week, Iraq has moved from a trading floor with a whiteboard and magic marker pen to full electronic trading in their Stock Exchange. 

This is good news for the country and a sign of a return to stability.

Now what equities and commodities are we going to trade in ... oil?

Numbers, Part Eleven: Mobile and Cellphones

More numbers, and I was fascinated to see a presentation from O2, the UK mobile service, the other day where they held up a few numbers that are fairly staggering.  In the UK:

• 15% of people are dumped by a girl or boyfriend via an SMS text message;
• O2 sold their first iPhone at 6:02 on 6th November 2007 and the first iPhone call was made at ... 6:06!
• O2 sold 200,000 iPhones in the first two months of retailing in the UK compared to four million iPhones sold worldwide in the six months from launch on 29 June 2007;
• 65 million SMS text messages were sent on New Years Eve 2007 by the O2 network alone; and
• the average person's mobile telephone has 30 unique numbers stored on it (of which one is probably the bank!).

This was followed by a few other amazing stats, courtesy of my friend Roy Vella: 

• there are three billion mobile telephone subscribers worldwide, 1.1 billion PC users and 1.8 billion credit card holders;
• 1,000 new mobile telephone connections are added every minute;
• 60% of subscribers are in developing countries, and 80% of new mobile  telephone subscribers are from developing countries; 
• there has been a 10% increase in mobile usage in the last year, resulting in a 1.2% rise in GDP;
• a 2.5% reduction in the cost of remittances results in a 60% rise in volume; and
• mobile payments users average 26% more transactions than card users (according to NTT DoCoMo's Edy studies in Japan).

There's loads more numbers in this area, with many banking estimates and discussions on Finextra.  For example:

• Celent estimates that 35% of Americans will use mobile banking by 2010;
• US mobile banking users will rise from 1.1 million in 2007 to more than 40 million by 2012, according to  TowerGroup;
• mobile banking users will rise from 7% of users in 2007 to 25% by the end of 2009, with US users rising from 1.6 million in 2007 to 35 million by end of 2010, according to Aite Group;
• the number of users of mobile banking users in the US will reach 21.27  million by 2010, according to Frost &  Sullivan;
• the mobile payments market will rise from $77.6 million in 2007 to $11.5 billion in 2011, according  to a report from Juniper Research; whilst
• 53% of Americans have no interest in using mobile banking or commerce,  according to Harris Interactive.

Whatever.

I guess this quote demonstrates why the mobile is important to all of us financial services: "In 2007, there are 2 billion mobile phone users who do not have a bank account, or regular internet access, or both. Their primary banking service will be their mobile phone.”  The GSM Association

NCR at loggerheads with HP over Banks

Oohhhhh-errrrr.   Like any good blogger I love a bit of gossip and nothing better than my old firm, NCR, getting into a spot of hot-under-the-collar bother with HP.

Apparently, lots of NCR-ers have been toddling out of Dayton, Ohio across to sunny Palo Alto, California with little USB sticks full of sensitive materials.  Now, the weenies at Dayton have gotten so angry, they could crush a grape ... or even several.

So they've filed a lawsuit to stop the latest leaver from sharing her account secrets.  The particular lady who left the Dayton lake is a senior sales person, Diane Warner, who brought in $19 million in sales from Wachovia in 2006, "including 80% of Wachovia's total ATM spend for the year."

NCR contends she was "even more involved in NCR's business strategies and analyses, such as NCR's perceived strengths and weaknesses in various business segments. This involvement focused not just on the financial solutions division, but on other market segments as well. For example, she was involved in NCR's sales and marketing efforts directed toward the U.S. Postal Service (on which NCR directly competed with HP) and from gaming industry components, such as MGM Grand Casino."

In particular, NCR contends that:
"On December 26, 2007, Warner, for the first time, attached a Maxtor external hard drive to her NCR computer and copied more than 3,000 NCR files from her computer to the external hard drive. Many of these files contained NCR's proprietary information, including files related to Wachovia, NCR's financial services division, and NCR's business practices and strategies. For example, more than 100 of these files contained sensitive Wachovia-related information. Specifically, the filed entitled 'wachoviacallplantjonwittermay' detailed NCR's busines strategies for its Wachovia account strategies and other sensitive information. she also downloaded many files related to other customers. For example, the file entitled 'HSBbidreview2007' like the other bid review files she copied, contained NCR's discount rate, net rate, and other sensitive pricing information."

Oh, you naughty, naughty little tinker Diane, you.

To be honest, reading through the lines of all of this, it could just be that NCR is still miffed over HP nicking their CEO, Mark Hurd, after the Carly show left town.   

All of this goss courtesy of the blog, the Bellwether Daily. Thank you to Bill Sloat.

 

Credit Crash: final thoughts

Ah well, I can't leave the credit crash discussion alone without a final mention of poor Mr. Jack and Mrs. Jill, the taxpaying citizens who are now left carrying the can of the debt-fuelled crash. 

With the banks being bailed out by the central banks, Mr. Jack and Mrs. Jill are suffering.  Many of these poor folks purchased properties based upon easy access to a loan, and are now being squeezed by the credit institutions who want their money paid back, as the housing market falls even faster than Colin Farrell's and Paris Hilton's underwear combined.

Take poor Mrs. Ortiz for example.  Her story was exposed in the Washington Post over the weekend.  In summary, it goes like this:

Mrs. Ortiz works for a Best Western as a cook and lived in a cramped apartment, so she decides to get into the housing market boom in 2005 by buying a run-down duplex house for $430,000.  The mortgage will cost them $3,000 a month but, what the hey, as her husband and her bring in $4,200 a month they'll get by (?).

Now the home is in foreclosure, the mortgage company and person who sold her the mortgage have gone out of business and she's on her way to court.  What a shame.

Mind you, on the downside for Mrs. Ortiz, she:

• only looks at one house;
• doesn't look around the market and compare things;
• pays three times the price the house sold for only one year earlier;
• pays $5,000 more than the asking price at the time;
• doesn't speak English, but signs papers written in English that claim she is married to a man she doesn't know;
• didn't get any advice from anyone who would know what she was getting into; and
• was sold the policy by the woman next door who used to sell cosmetics and jewellery door-to-door.

According to the Center for Responsible Lending, 40% of loans to Latin-Americans fall into the subprime zone and they believe one in five will fall into foreclosure, probably for the reasons above.

A similar issue was highlighted by the BBC's Panorama programme last year.  Mind you, this has been going on for years.  For example, take this report from 1999 on the BBC which states: "Lenders have been criticised for imposing charges without having made clear to borrowers in advance exactly what they would owe under conditions such as lock-in clauses.  They have also come under fire for selling inappropriate mortgages."

There's actually very little that's new in any of this.  It's just basic human motivations. 

Q: Why did Mrs. Ortiz buy the house?
A: Because she wanted a nice house (and possibly thought she could make a killing but got dumped on instead).

Q: Why did the cosmetics salewoman sell the house to someone she knew couldn't afford it?
A: Because she thought she could make a killing (and did).

Q: Why did the mortgage firm provide a mortgage to a woman who couldn't afford one?
A: Because they thought they could make a killing (and could offset the risk).

Q: Why did the credit markets provide a vehicle to enable mortgage firms to sell mortgages through rogue agents to people who couldn't afford them?
A: Because they thought they could make a killing (and did for many years until liquidity dried up).

 

Who's at fault here really?
All of them.

 

Roll up, roll up, get your Bear Stearns memorabilia here

Popped onto eBay today and found all this wonderful stuff being sold by Bear Stearns employees to try and top up the coffers lost in the JPM bargain basement sale (although it's slightly more expensive after JPM upped the ante to $10 a share).

There was the award to the development team of a Bear Stearns building model in pewter, and T-shirts and stuff.  But the most expensive and desirable item has to be the 50th anniversary panel signed by Alan "Ace" Greenberg, who started as a clerk at Bear Stearns in 1949 and by 1978 was the CEO.

33 bids and $355, this one is going up and up ... a bit like the share price!

Meanwhile, it's a shame you can't change the whole internet to reflect real-time events, as the student advisory website wetfeet.com gives the following advice for Bear Stearns:

Q: Who are Bear Stearns' competitors, and how is your  firm different?   

A: Our competitors are other major financial institutions. We believe that the services we provide our clients and the opportunities we offer our employees distinguish us from our competitors. The firm has 75 uninterrupted years of profitability and stability. We have managed significant growth in many new businesses in an effective and profitable manner.

Oh yep ...

... by the way, if you miss out on Bear Stearns' stuff on eBay you can always get a bona fide Northern Rock shirt anytime.

Xobni for your inbox

I've been trying to get into Xobni's (inbox backwards) plugin for Outlook for a few weeks, but they're blocking me out as they've been overloaded with demand even though the product is only in Beta test mode.  This is because Bill Gates referred to them as the “the next generation of social networking” and touted them as a great plugin for Microsoft Outlook.

Checkout the video on YouTube and you'll be desperate for it too ... Xobni that is.

Causes of the Credit Crash, Part Three: the Governors

Having had a nice Easter break, this was going to be a short entry about the regulators role in the credit crash ... but it's really, really long.  Sorry.  But it does start to get to the heart of the matter.

So, what’s the real problem here?

Is it the machines, the humans?  The banks, the citizens?  Or the regulators?

Well, the regulators do have a lot to answer for, as they create the conditions in which the market operates. 

As Jeff Jacoby points out in the Boston Globe, the Community Reinvestment Act (CRA) of 1977 created the credit focus amongst the US banks, as it prohibited banks from only targeting wealthier areas.  This targeting was a practice known as ‘redlining’ and, under the CRA, banks were graded on their attentiveness to the ‘credit needs’ of poorer areas.  As a result, banks were viewed as being more community oriented, and graded higher accordingly, if they focused upon offering riskier loans to poorer folks.

This maybe one reason for the time bomb of mortgage debt, as Jeff concludes with the line: "And all of it thanks to the government, which was sure it understood the credit industry better than the free market did, and confidently created the conditions that made disaster unavoidable."

Equally, we could say the same in the UK, as the situation that created today’s issues could be viewed as being sown through the seeds of deregulation back in the 1980’s.

In 1986, the UK government deregulated the Building Societies.  In 2007, the firms being viewed as most at risk – Northern Rock, HBOS (Halifax), Alliance & Leicester and Bradford & Bingley – are all converted building societies.  These firms also all have leveraged mortgage books.  For example, when Northern Rock hit rock bottom last September, here were the loans to deposits ratios of each bank:

                                   Deposits      Loans         Deposit to Loan
                                     (£ bns)       (£bns)              Ratio
Northern Rock                   26.7             86.7          £1 - £3.25
HBOS                             211.9          376.8          £1 - £1.78
Bradford & Bingley             22.2            36.1           £1 - £1.63
Alliance & Leicester          29.6             46.4          £1 - £1.57
Lloyds TSB                      139.3          188.3          £1 - £1.35
RBOS                             384.2           446.9          £1 - £1.16
Barclays                          256.7           282.3          £1 - £1.10
HSBC                             442.4           428.2          £1 - £0.97

As can be seen, the banks with the greatest exposure were the ones that were originally buildings societies who converted. 

Before the Building Societies Act (BSA) of 1986, these societies focused upon mortgages based upon coverage by deposits. Now, as proprietary banks, they were seeking to increase returns to shareholders and lower cost-income ratio by doing the opposite: as in promoting mortgages based upon a leveraged loan book.  The fact they could leverage that loan book using cheap access to credit in the interbank markets was also part of the bubble that burst in 2007, some might say. 

Both Acts – the CRA and the BSA – could account for some of the seeds of this crisis therefore and, whatever your view, the fact is that we sit here today with market conditions that allowed banks to create a loans crisis of over $1.5 trillion and that is now being bailed out by the Central Banks and taxpayers.

The governors must take some blame here therefore, as they are meant to govern the markets.

The Governors are all those in power who are meant to manage the markets: the politicians, the lawmakers, the law enforcers, the regulators, the policymakers and so on.  A disparate bunch with little consistency.  And yet, critically, this disparate bunch of governors are meant to protect the hard-earned savings, pensions and investments of Mr. Jack and Mrs. Jill, the citizens.  And they do not seem to be doing very well at it.

After all, you would think that where you see an economy 'fuelled by consumer demand' based upon 'rapidly rising debt' and supported by 'house price inflation' that someone would say, hold on a minute.  It's the emperor's new clothes.

For example, the Economist's main story this week is about the Wall Street crisis, and quotes research from Canadian firm BCA Research. This research identified that America’s financial services industry grew from 10% of all of America’s corporate profits in 1980 to 40% last year.  Its stock market value grew from 6% of all American equity to 19% during the same period.  Yet, financial services only accounted for 5% of jobs in the private sector, and only 15% of corporate gross value-added.

What should have stopped such growth was the dotcom bubble bursting, which meant that consequent American corporate growth slowed.  Instead, financial markets carried on careering over the hill, happily making billions whilst everything else stagnated.

This was because the continued, unabated profiteering in the financial markets was being secured by debt, with financial sector debt rising from a tenth of the size of non-financial debt in 1980 to half of all debt today.  In other words, financial markets were bubbling over with wealth fuelled by debt.  Goldman Sachs’ $40 billion of equity allowed them to leverage $1.1 trillion of assets, whilst Merrill Lynch’s $30 billion of equity pumped $1 trillion of assets around the markets.  This leveraged gearing is like a magic carpet during good times but, someone pulls the rug away, then the drop is sudden. 

The emperor’s new clothes: look we’re all making money!  But look, it’s all based upon borrowing, so there’s no real money there.

Suddenly, the tide turns, the borrowing isn’t there and everything drops faster than Colin Farrell’s underwear.  And the fact that no-one kept this in check means that the governors must take some, or even most, of the blame.

Part of this is because of the fragmentation and lack of coordination of the governors; and part of this is that regulators no longer understand what they are regulating.  This was admitted by the Bank of England in light of the Northern Rock collapse, and appears to be admitted by the Federal Reserve in light of the Bear Stearns debacle. 

First, the UK demonstrated a critical regulatory faux pas with Northern Rock. 

This was a situation created by a triumvirate of buck passing between the Bank of England, the Treasury and Financial Services Authority (FSA), where each could hand-off and blame the other for missing things between the cracks of their authority. 

The Northern Rock example is an interesting one because they lent on the basis of the risk model being one where the UK housing market might collapse.  As a result of looking at this risk, they estimated they had to cover only 40% of their total borrowings: the amount of a correction in the UK housing market in worst case scenario, forecasted by their risk analytic models.  The fact that they never took into account the tightening of the lending markets, particularly short-term lending, was their fundamental flaw.  This is why, when they went belly-up, Northern Rock had lent £3.25 for every £1 on deposit whilst only having £1.5 billion of ‘liquidity insurance’ against their £90 billion mortgage portfolio.  A recipe for disaster as it turned out.

Yet Northern Rock was applauded as a great UK bank with the best cost-income ratio for years.  How come no-one spotted this risk? Because no-one thought credit would dry up? 

Well, the FSA and Bank of England showed some concern in early 2007, but the fact that no-one foresaw a squeeze on interbank lending just shows a basically mistaken hypothesis.   

The fact that the FSA, Bank of England and Treasury all acted independently meant that, when Northern Rock entered into crisis mode, no-one acted in a coordinated manner.  The FSA tried to broker a deal for the bank to be acquired with Lloyds TSB, but the Bank of England felt they could not allow this.  They then went public with their need to be lender of last resort for Northern Rock which meant the bank’s security became questionable.  The Bank of England blamed this on EU disclosure rules, which was incorrect, and the Treasury were made to look like idiots as it resulted in the first UK bank run for decades.

The Bank of England blamed this on EU disclosure rules, which was incorrect, and the Treasury were made to look like idiots.

The real issue, as disclosed later by the Bank of England, is that they didn't understand the markets.  CDOs, SIVs, Credit Default Swaps, Hedge Funds and all this leveraged, global debt and risk was beyond the ability of their little grey cells to understand.  Equally, the FSA seems culpable of the same basic views of the markets, with little real knowledge of the depths underneath, as demonstrated by their reaction to the most recent rogue trader scandal.

So this is the crux of the regulator’s issue: how to keep up with markets that are changing rapidly, are linked globally, and have products that are so complex only rocket scientists can understand them?

Which brings us to the governors of Bear Stearns.

For a long time, everyone thought the SEC had cleaned up Wall Street, thanks to their lightning rod leader: the New York State Attorney, Eliot Spitzer.  Rod being the operative word as it turns out.  Nevertheless, under Spitzer, everyone thought Wall Street had been cleaned up. Not really.

Now, in a post-Bear Stearns market, you have people like Barney Frank, who chairs the Senate's financial services committee, saying: “To the extent that anybody is creating credit, they ought to be subject to the same type of prudential supervision that now applies only to banks”, with the Federal Reserve empowered to act as the regulator.

Some might wonder why credit firms aren't subject to the same prudential supervision as the banks, which brings us to the same point as the Northern Rock issue. The USA has a regulatory market split between the Treasury, the Federal Reserve and the SEC, just like the UK was split between the Treasury, the Bank of England and the FSA.  Again, many are now saying that this is a recipe for regulatory disaster.

This is why the U.S. Treasury is saying that there will be broad changes to the regulatory structure in the near and short term, in light of the subprime credit crisis and, particularly, in light of Bear Stearns.

What happened to Bear Stearns is a similar case in point to Northern Rock.  Again, Bear Stearns were exposed because of their huge exposure to the Structured Investment Vehicles (SIVs) and mortgage books of the subprime American markets, and now Merrill Lynch and others have also been challenged. 

Investors lost confidence, removed funds in droves and started another bank meltdown that was averted from total explosion by the bailout by JP Morgan at the last minute ... thanks to the Fed’s $30 billion line of credit providing a step in to support JPM’s bid.  It was this last piece that changed things fundamentally in the US, as governments do not prop up the banks and have not done so since the Great Depression of 1929 which resulted in the Glass-Steagall Act ... funnily enough, an Act that was meant to separate brokers, dealers and investment houses from insurance and general banking.

Now, it appears that the Federal Reserve have determined that the SEC cannot manage the investment markets, as investment markets are so intertwined with retail and insurance.  After all:

Your mortgage bones are connected to your derivatives bones,
Your derivatives bones are connected to your investment bank bones,
Your investment bank bones are connected to your monoline insurer bones,
Oh, hear the word of the Fed.

The bottom-line is that regulators are too fragmented, uncoordinated, with little or no real knowledge of the markets they are meant to be regulating.  This is why they have made a strong contribution to the issues arising in the markets today, especially as many think they can control the markets ... often only in hindsight however.   

The overall view therefore, is that regulators are fragmented, uncoordinated and have no knowledge of the markets they are meant to be regulating.  This is a recipe for disaster, and a strong contribution to why we have seen the issues arising in the markets.  

The result is that we shall see a swathe of new regulations coming downstream in light of the market crisis of 2007-08 (note: good news for all tech firms – new regs always means new systems sales!).

Already, the Federal Reserve and Treasury are working closely with Wall Street, around the SEC.  This new regime will probably not come in until the current administration moves out, but when George W hands over to whoever then there will be change in 2009.

The UK has also proposed major structural changes to the banking regulatory environment in January, with the British Banker’s Association responding in March, and draft legislation likely to be released during the next Quarter.

Equally, Europe has agreed to improve the regulatory structures beyond today's multitude of Directives through four principles which will:

• improve transparency with respect to banks' exposures relating to securitisation and off-balance sheet items;
• upgrade valuation standards to respond to any problems arising from the valuation of illiquid assets;
• strengthen the prudential framework for the banking sector, including the treatment of large exposures, banks' capital requirements for securitisation, and liquidity risk management; and
• investigate structural market issues, such as the role played by credit rating agencies and the 'originate and distribute' model.

Therefore, the regulators will change regulatory regimes as a result of the credit crisis, but will never solve the issues.  Why?  Because:

(a) they will create risks in the market that will only come to light much later on in hindsight, such as the issues of today that date back to the 1970’s and 1980’s regulatory structures;

(b) there are too many gaps between regulatory offices and not enough integration or ‘joined up’ thinking;

(c) regulators do not understand what they are regulating anymore anyway, as CDOs, SIVs and Credit Default Swaps were way beyond them ... who knows what they would make of algorithmic quant analytics; and

(d) the most fundamental issue: they are domestic.

Domestic regulators cannot regulate global markets.  Global markets need global regulation and, today, there is no ability to globally regulate.  In fact, we cannot even regulate effectively across Europe.

When we live in global markets, with risks being moved between firms, across geographies, instantaneously and in real-time, to have regulators who cannot even regulate effectively domestically means that we have to rely on market self-regulation.  And the issue with self-regulation is that, when times are good and markets are running away with profiteering, who the hell cares about giving up their millions just to keep the governors happy? 

 

Causes of the Credit Crash, Part Two: The Humans

In Part One, the fact that the markets are technologically turbo-charged was discussed.  Today, it's the humans fault as technology is only doing what the humans tell the systems to do. 

I could talk about SIVs, CDOs, Credit Default Swaps, Hedge Funds and all sorts of other stuff, but I've done that before (see "Department of the Bleedin' Obvious" and "The Less so Obvious" from last September).

But there's another dimension to add to this.  It's an idea that occured to me a while ago which I dismissed as being completely wild, but there may be some mileage in it, so let's see.  And, if true, bearing in mind yesterday's comment about the machines multiplying any human error ten-, a hundred-, a thousand-fold, we really do have a problem.

I was looking at this BBC website, and noticed how regular are the booms, busts, crises and crashes in the investment markets :

2008         Societe Generale Kerviel Crisis
2007-08     Credit Crunch
2007          USA Housing Crisis
2002          Enron, Worldcom, Parmalat and Split Cap Investment Trusts Crisis
2000          Dotcom Crash
1998          Long-Term Capital Management (LTCM)
1998          Latin American Financial Crisis
1997          Asian Financial Crisis
1995          Barings Bank Leeson Crash
1994          Japanese Banking Crisis
1990          UK Housing Crisis
1987          Stock Market Crash
1985          US Savings and Loans Crisis

It just goes on and on and on.

And many of these have related and similar patterns, e.g. Nick Leeson - Jerome Kerviel, LTCM - Credit Crisis, UK Housing Crisis - USA Housing Crisis ...

Between each crisis there's about ten or so years.

Every time the markets have a big sneeze and billions in capital are lost, the markets and the regulators all buzz around saying it must never happen again.  Then the markets bounce back and we all start making money again.

Much of this is well documented in the classic book, "Extraordinary Popular Delusions & the Madness of Crowds", published in 1841.

So here's my theory, to add a modern perspective to this book.

Every decade or so, a new wave of traders and dealers come into the markets. Fresh-faced pups, who are ready and raring to go and sell, bet, deal and make millions. 

They all run around creating new ideas, new pitches, new product wraps, new technology plays.  They then start pushing the boundaries of risk, technology, products, markets and ethics. 

They should be held in check by their management, but their management see too many of the rewards whilst the risks are hidden from their prying eyes by these eager, over-achieving, over-zealous young bucks.

Then it goes wrong. 

A market does the opposite of what's expected.

A product play is not hedged, because the confidence was soaring and so none of the inexperienced youngsters expected that to happen.  Risk has been created, but is not visible due to the technology, product and service that the pups have built to fuel it, and these pups have not been exposed to these risks before.

Therefore, we suddenly see the same thing happening again.  Something that happened 7-10 years before.  Markets collapse, front and back office blur, booms go bust, billions are lost and firms collapse.

So we weedle out the culprits and fire them, whilst demoting and side-lining the managers responsible for the mess.

The market learns its lessons and says that it will never allow XYZ product and ABC risk to occur ever again.  The regulators are satisfied that self-regulation can work and the markets stabilise.

Then a new group of young pups come in.

They're eager and hungry. 

They hear about XYZ products and ABC risks, but there's no issue as they're not doing XYZ and ABC.  They're doing UVW and DEF.  It's actually the same product with the same risk, but it's in a different market sector and is dressed differently, so it doesn't look the same.

The young pups create a market that fires itself into orbit with turbo-charged investing and stellar returns.  It's making billions so management are happy, the young pups are making millions and the markets have liquidity and alpha unbounded.

No-one listens to the ex-trader who says: "watch out"; the side-lined manager who says: "this looks familiar"; or the demoted disillusioned whinger who says: "you don't want to do that".

They're just dogmeat from the XYZ and ABC debacle.  They don't understand UVW and DEF.  They're just jealous of the billions being generated for the bank, the bonuses being made by the young pups and the millions being made by their managers.

High-five.

Then the markets repeat the mistakes of yesteryear.  DEF risk was the same as ABC; it was just rolling around in disguise.  UVW product was the same as XYZ; just under a different name.

So the pack of dogs who created DEF and UVW are kicked out.  Their managers are demoted, deposed or departed. A few firms collapse and a few billions are lost.

The market learns its lessons and says that it will never allow UVW or XYZ product and ABC and DEF risks to occur ever again.  The regulators are satisfied that self-regulation can work and the markets stabilise.

Then a new group of young pups come in.

They're eager and hungry.  They hear about UVW, XYZ, ABC and DEF, but there's no issue there.  They're doing RST product and GHI risk ...

The Wall Street Dance

A friend pointed out this video  in French to me. 

I've no idea why, except that there's a new dance craze sweeping the world.  The idea is to hold one leg off the floor whilst swinging your arms around. 

Not a bad idea. 

Apparently, it takes its inspiration from the old English song, the Hokey-Cokey, which goes:

You put your left leg in,
You put your left leg out,
In, out, in, out and shake it all about.
You do the hokey cokey and you turn around.
That's what's it's all about.

However, the true story is that the dance craze began in Wall Street dealing rooms, as traders realised they could do nothing to stop their losses and so they started doing this instead as it's far more constructive.

Happy Easter!

Here is the City does it again

It's been a long time since there's been a good banking song (the last one I put out there was way back in May last year), Here is the City has come up with another new one.  Bohemian Rhapsody's subprime blues:   Is this the real price ? Is this just fantasy ? Financial landslide No escape from reality Open your eyes And look at your buys and see. I'm now a poor boy High yielding casualty Because I bought it high, watched it blow Rating high, value low Any way the Fed goes, Doesn't really matter to me, to me. Mama - just killed my fund Quoted CDOs instead Pulled the trigger, now it's dead Mama - I had just begun These CDOs have blown it all away Mama - oooh I still wanna buy I sometimes wish I'd never left Goldman at all.  I see a little silhouette of a Fed Bernanke! Benanke ! Can you save the whole market ? Monolines and munis - very very frightening ! Super senior, super senior Super senior CDO - magnifico I'm long on subprime, nobody loves me He's long on subprime, CDO fantasy Spare the margin call, don't blame me for all ! Easy come easy go, Will you let me go ?  Peloton ! No, we will not let you go ! Let him go Peloton! We will not let you go ! Let him go, Peloton ! We will not let you go ! Let me go ! Will not let you go Let me go (never) Never let you got Let me go Never let me go - ooo No, no, no, no, no, no, no Oh mama mia, mama mia, mama mia, let me go ! S&P had the devil put aside for me for me, for me, for me............. So you think you can fund me and spit in my eye? And then margin call me and leave me to die?  Oh  - can't do this to me Just gotta get out, just gotta get right outta here Ooh yeah, ooh yeah No price really matters No liquidity Nothing really matters No price really matters to me Anyway the Fed goes...