Do Regulators Want To Run Their Supervised Banks?

A big story this week has been the Fed's current hobby horse, "Comprehensive Capital Analysis and Review ("CCAR") for the 18 largest Bank Holding Companies ("BHC") with assets of over $50 billion.  The Fed's March 2013 publication set the stage by redoing the stress tests done by each of the BHCs with an "interdisciplinary team" of Fed staffers who sound just like most corporate staffs, with the exception of not having bank auditors on the corporate teams.

In August, the Fed published "Capital Planning at Large Bank Holding Companies: Supervisory Expectations and Range of Current Practice."  The large bank holding companies, as we've said before, have become too complex to manage, especially if we are looking to eliminate any possibility of a failure like the system wide crises of confidence and then liquidity which brought the global system into paralysis.

This document reads like a rehash of many reports on risk management, internal control, and corporate governance.  Have a look at the Report of the Committee of Sponsoring Organizations of the Treadway Commission from 2009, and the reader will see language, themes and recommendations which are reprised in the Fed's August volume.

Basically, the agenda seems to come down to this: the Fed doesn't want banks to consider returning capital to shareholders through dividends and buybacks without redoing their stress tests and then changing their return of capital plans to add a second significant digit (after the decimal) improvement to some capital ratios.

Here's a stirring sentence from the report's conclusion,

"The fundamental insight governing the Federal Reserve’s
expectations about capital planning is the importance
of having a forward-looking perspective on the risks
to a BHC’s capital resources under severely stressful
conditions."

We also learn, "These elements represent substantial conceptual and operational improvements in capital planning that go well beyond simple consideration of current and expected future capital ratios."  It's never clear at all what lies at the end of having gone "beyond."  A new set of indicators?  A digital dashboard of minute-by-minute risk indicators for every business, financial product, trading desk, currency, and country?  What would it all mean anyway?

We've often made reference to Andy Haldane's speech at the Kansas City Fed's Jackson Hole Meeting, "The Dog and The Frisbee."  In it he notes,

"It is close to impossible to determine with complete precision the size of the parameter space for a large  international bank’s banking book. That, by itself, is revealing. But a rough guess would put it at thousands, perhaps tens of thousands, of estimated and calibrated parameters. That is three, perhaps four, orders of magnitude greater than Basel I.   

If that sounds large, the parameter set for the trading book is almost certainly larger still. To give some  sense of scale, consider model-based estimates of portfolio Value at Risk (VaR), a commonly-used  technique for measuring risk and regulatory capital in the trading book. A large firm would typically have  several thousand risk factors in its VaR model. Estimating the covariance matrix for all of the risk factors means estimating several million individual risk parameters. Multiple pricing models are then typically used to map from these risk factors to the valuation of individual instruments, each with several estimated pricing parameters."

We haven't yet implemented Basel III, and now we are layering Dodd-Frank's evolving regulatory creosote on top of other complex, costly and ineffective frameworks.

The stories about traders dealing with marks on their trading books should tell a dispassionate observer the reality about how global international banks work, as opposed to the bureaucratic schema envisioned in the schemes of European, American, and other regulators. There is no single, infallible, scientifically correct number for the marked to market value of a trading book full of instruments with few buyers and sellers that trade by appointment.

So, some traders walked away from the midpoint of a spread convention.  A regulator would have acted differently.  So what?

Let's also not forget about the boards of directors of the largest bank holding companies. With all due respect, the membership of these corporate boards would never be willing or able to, for example, challenge management on the specifics of their scenario designs or on their methodologies for estimating credit loan losses.  Yet, the Fed report talks about these issues in bureaucratic abstraction as if their schemes can be actually implemented. They can't and they won't.  And, even if it were possible, there would probably be no net marginal benefit to shareholders.

By quoting Haldane's example, I am certainly not advocating the continuing or exclusive use of VaR models, but at least everyone has had some experience with these, for good and ill.

People who are really fluent with complex financial modelling, like Emanuel Derman know their limitations too. He writes,

"Derman, a professor at Columbia University and former head quant for Goldman Sachs, is outspoken on the limitations of modeling and the need for risk managers, along with CEOs, CFOs, financial engineers and traders, to keep their enthusiasm for modeling in check. “There isn’t a short cut or mechanical formula that will help you figure out the right price for a financial product,” said Derman in an interview, adding that, “these financial models are only trying to capture human emotions and instinctual feelings that we use to help us determine prices in financial markets. They are not absolute things like the distance from here to there or here to the sun, where everyone agrees on the distance.”

The managements of many of the largest bank holding companies have failed to exercise a degree of care, diligence and commitment over their sprawling organizations, and JP Morgan has been one recent example, among many.  Their businesses, which each have distinct portfolios with different risk profiles, have been stitched together by acquisition and by evolution.  Trading desks have cowboy cultures that are polar opposite to consistently profitable, high net worth wealth management businesses. Their compensation metrics, conventions and attitudes towards regulation and oversight are polar opposites: yet, they exist under one corporate roof, as in JP Morgan, Bank of America and Wells Fargo, for example.

When things have gone wrong, they have gone wrong in trading businesses, often by the action of rogue individuals who are allowed to buck the oversight.  These are not complex, multidisciplinary, quant issues.  The heads of profit centers, their supervisors, everybody in the C-suites, the board, internal and external auditors, analysts, shareholders, creditors, rating agencies, bank regulators, securities regulators and the courts all have responsibility for making sure that the inevitable issues that arise in complex businesses don't become systemic issues.  We already have plenty of infrastructure aimed at the problems, and we don't need more regulatory complexity.

Which Economist Am I Most Like?

Greg Mankiw sent along a probing survey of over 100 questions, which was clearly well designed by academic economists.  Although I despise the usual corporate or non-profit surveys, I took the bait on this one.  The outcome of the survey determined which "famous economist" I was most like. Professor Mankiw's answers made him most similar to Yale's Professor Ray Fair, whose econometric forecasting model of the U.S. economy I used for as background for some corporate consulting projects.

My views are most like those of Professor Hyun Song Shin of Princeton University, who is also a member of Chicago Booth School of Business IGM Forum. I don't know Professor Shin's papers or views at all, which is interesting given how widely I read.

I am buoyed by having a highly regarded companion in economic thinking, and I look forward to reading his published work. Take the survey yourself, if you want to put your economic policy thinking cap on and get a little surprise at the end!

Redrafting Goldman's Business Principle #1

As we noted in a previous post, the first business principle of Goldman Sachs per its own disclosure is.

"Our clients’ interests always come first. 

Our experience shows that if we 

serve our clients well, our own 

success will follow."

I thought I would take a shot at redrafting this platitude into something meaningful: here goes.  

The interests of every client always come first.

Our clients want to acquire or dispose of assets in order to achieve their financial goals.  We stand ready to help them by acting as their agents in the marketplace for real and financial assets.  Where a suitable financial instrument doesn't exist to achieve their goals, we will work with our clients to create a unique financial structure which does achieve their goal, for which we will earn fees and commissions for our expertise and our market relationships. However, we will always be open and transparent about how we earn our money and about how our interests are aligned with those of our clients.  

In a global financial marketplace, conflicts of interest will inevitably arise between those of Goldman Sachs, Inc. and those of our clients.  We will explain and disclose these potential conflicts when we write a client's business. The culture of our firm does not countenance treating bigger clients differently.  It also does not countenance writing a piece of client business and then pro-actively betting against our client's interest for the benefit of our business.  

While this ethical principle may cost us some business in the short run, if our clients achieve their goals and sustain their relationships with us, experience shows us that our firm and its shareholders will be amply rewarded. 

It's longer, but it does go out on a limb and say something. You may have surmised that this kind of required corporate disclosure is probably meaningless for institutions like Goldman Sachs, Deutsche Bank, the old Lehman Brothers and others.  Hence, Goldman's attorneys crafted their initial formulation: it gets the job done by checking the box for disclosure, and it doesn't impact the business. 

Senator Carl Levin's sub-committee produced a 645 page report on "Wall Street and the Financial Crisis."  It's interesting how the Goldman narrative in this doorstop of a report fits the contours of the Tourre prosecution.  A long chapter is entitled, "How Goldman Created and Failed to Manage Conflicts of Interest in its Securitization Activities."

Goldman went out of its way to "assist a favored client (John A. Paulson) make a $1 billion gain, and profit at the direct expense of the clients that invested in the Goldman CDOs." 

As we noted in our earlier post, "Paulson had a very negative view of the mortgage market which was publicly known...." 

Despite this statement, the chapter goes on to say, "Laura Schwartz (of ACA) was "unaware of Paulson's economic interest in the CDO."  So, the entire multi-billion ABACUS CDO subterfuge rests at the feet of Fabrice Tourre.  Don't get a stitch in your side from laughing: I did. Thanks, Senator Levin. 

Tourre, Goldman Sachs and Corporate Ethics: Nothing Has Changed

So, the financial crisis has past, we've prosecuted the first and only face from the crisis in Farbrice Tourre, and lots more ink is wasted on corporate disclosures.

Have financial markets become more fair, efficient and transparent?  No.

Have additional financial disclosures spread the antiseptic of sunshine into dark corners of corporate behavior so that abuses of the past are precluded for the future?  No.

Have the bad guys been made to pay where it hurts, and are they pariahs in their own country clubs? No.

Fabrice Tourre has been successfully prosecuted for "for making materially misleading statements and omissions in connection with a synthetic collateralized debt obligation (“CDO”) GS&Co structured and marketed to investors." No C-suite executives from Goldman, Sachs and Company, which created and sold the product have been prosecuted.  So, who is Fabrice Tourre?

According to the complaint, "Tourre was principally responsible for ABACUS 2007-AC1. Tourre devised the transaction, prepared the marketing materials and communicated directly with investors."

This is absolutely inconceivable in any kind of factual reality.  Were it true, his bonus would have been multiples of the already excessive $1 million or so that he earned.  Goldman had done enough of these deals well before Mr. Tourre's joining so that there was nothing for him to "devise."  When John Paulson approached Goldman to structure the equity tranche of the ABACUS 2007-AC1 CDO for him and offered to pay Goldman $15 million in fees, you can bet that he never spoke to, or heard of, Fabrice Tourre.  So, this part of the accusation is pure prosecutorial fiction, setting up a fall guy.

So, if devising the transaction was a fiction, what did Mr. Tourre actually do?  The closes thing to a tangible accusation is ,"Tourre had primary responsibility for preparing the term sheet and flip book." Note that word, "primary," which is not "sole."  In other words, he constructed a term sheet based on the text and boilerplate provided to him by lawyers and sales traders. Mr. Tourre can read, and he can cut and paste text. Also, he employed the PowerPoint he learned in university to produced a slide presentation in a flip book format.  Since his were the only personal emails from Goldman presented during the trial, all we know is that Mr. Tourre became delusional enough to believe that he was a player rather than a cog in the powerful CDO machine.

Mr. Tourre's legal costs were paid for by his former employer, and his role will soon be forgotten, as were the roles of Howard Rubin, Joe Jett, Jerome Kerviel and other traders in past financial crises. He will rehabilitate himself as a PhD. economist from the University of Chicago; I would guess that his thesis title might be, "Adverse Selection: The Behavioral Economics of Constructing Equity Tranches of Synthetic CDOs."  All will be well.

What was the nature of the misleading statements that Mr. Tourre made about the ABACUS deal? ACA Capital, hired as a "Portfolio Selection Agent," was to select the reference securities for the equity tranche that would produce a security with the appropriate risk-reward profile that Goldman's client John Paulson hired the firm to produce and market. Through a lot of fog and innuendo, Ms. Schwartz thought that Paulson's firm was long the equity tranche and would not have rated the deal had they known that Paulson was short.  In the case of ABACUS, ACA and Laura Schwartz were apparently duped by the earnest neophyte Mr. Tourre who made representations that Paulson's money was long the equity tranche.  This is probably nothing more than Mr. Tourre overreaching, trying to ingratiate himself and revealing his total lack of understanding of the deal's players.

According to the complaint,

"Had ACA been aware that Paulson was taking a short position against the CDO, ACA would have been reluctant to allow Paulson to occupy an influential role in the selection of the reference portfolio because it would present serious reputational risk to ACA, which was in effect endorsing (very much akin to a rating agency) the reference portfolio. In fact, it is unlikely that ACA would have served as portfolio selection agent had it known that Paulson was taking a significant short position instead of a long equity stake in ABACUS 2007-AC1"

This is totally laughable.  Anyone who even scans the business section of a newspaper would know that Mr. Paulson was broadcasting to anyone who would cover his story, his pessimism about the housing market bubble and how it could only end badly.  A person with the experience of Ms. Schwartz and ACA would never accept the contrary thesis on the basis of an email from a minor league player like Mr. Tourre.  With so much money at stake, either Ms. Schwartz or a principal of ACA Capital would surely just have called Mr. Paulson himself.

In the end, the verdict on Mr. Tourre was, in the words of jurors interviewed by the New York Times about "Wall Street greed," which had gone unpunished because no CEOs had gone to jail.  So, Mr. Tourre takes the fall, with an air mattress underneath him.

With all the ballyhooed academic legal writing about improved corporate governance and disclosure, let's read from Goldman's own published principles for running its business.  Here is Principle No. 1,

Our clients’ interests always come first. 

Our experience shows that if we 

serve our clients well, our own 

success will follow.

This isn't a principle, but a platitude.  Let's try and apply this in the case of ABACUS.  John Paulson and his hedge fund must have been such a client, because he came specifically came to Goldman to design an equity CDO tranche in which he could place the kind of bet for he was widely known to anyone with a pulse. Goldman took a $15 million fee and presumably took a fiduciary interest in Paulson's project.

A deal isn't a deal unless it is sold in the market place, and ABACUS couldn't be sold unless it had the "brand equity" of ACA as Selection Agent for the reference securities in the equity tranche.  If ACA Capital took the other side from Paulson, then they shouldn't be bailed out for being stupid.  Being stupid is not a violation of the securities laws, but perhaps it should be.

Goldman itself took some losses from the selling of swaps to Paulson, which is a bit hard to understand, but it appears that the market froze up on them before they could net out their exposure. So, Goldman takes the other side of Paulson's transaction, which is a service and arguably consistent with their principle that the client's interest comes first. Goldman also takes a bath, net of fees paid upfront.

What about the other big suckers in the deal?   German bank IKB Deutsche and Dutch bank ING.  But, they bought into what they thought was a AAA tranche at a time when the housing market fissures were about to explode.  These are sophisticated investors: what additional protections do they need which they themselves cannot demand from the marketplace?

Goldman, which itself came to see the wisdom in the positions of their client John A. Paulson, soon began trading against the very CDO instruments coming out of the other side of the sausage factory. Does this represent putting "clients first?"  Or, is it just legitimate proprietary trading?   But, isn't it based on material non-public information and communications coming from contacts with Mr. Paulson, the client?

The complaint cites this communication from an employee of John Paulson's hedge fund,

“It is true that the market is not pricing the subprime RMBS wipeout scenario.
In my opinion this situation is due to the fact that rating agencies, CDO
managers and underwriters have all the incentives to keep the game going,
while ‘real money’ investors have neither the analytical tools nor the
institutional framework to take action before the losses that one could
anticipate based [on] the ‘news’ available everywhere are actually realized.” 

This about sums things up.  The second sentence reprises Charles Prince's statement that as long as the music is playing, you have to keep dancing.  Rating agencies (like Moody's and ACA in this case), CDO managers and underwriters (like Goldman and Lehman) have all the incentives to keep the music playing.  Investors like IKB Deutsche and ING are too lazy or not smart enough to tease out the market's truth from publicly available information.

So, Fabrice Tourre is guilty of making misleading statements.  His bosses, who are the managers and underwriters and who hire the rating agencies, escape any prosecution and pay fines with shareholders' money.  Disclosures give no guidance about present or future behavior.  Nothing has changed, save for some intra-system transfer of funds, and life goes on.

Government's Abuse of Eminent Domain: Richmond, California Grabs Current Residential Mortgages

When we wrote about this issue over a year ago, most observers dismissed governments using eminent domain to seize residential mortgages as a tempest in a teapot. Instead, the whole issue has come to the fore in the summer doldrums, just before the coming September Congressional confrontations about sequesters, the budget and debt limits which will really color the 2014 election cycles.  Naturally, the first front has been opened in California, home to one of the biggest pots of electoral and popular votes.

On August 7th, Bank of New York Mellon filed a motion for Declaratory and Injunctive Relief against the City of Richmond, California.  Here's a link to the complaint.

BNYM calls this "a case about the misuse of public power for private benefit," which in effect "rents out" the City's powers of eminent domain for the private profit of Mortgage Resolution Partners, a for-profit group masquerading as a community action group and funded by well heeled investment banks like Evercore Partners, which was founded by former Clinton administration staffer Roger Altman, who is also a major fundraiser for President Obama.

The "Seizure Program" will purchase mortgages, including current mortgages, at deep discounts to fair market value, refinance the mortgages for the existing homeowners, while generating fees for the City of Richmond and its financiers.  The financing investment banks will receive the Federal guarantees for the new mortgages, which will then be packaged and sold, the big paydays for the investment banks.

The trusts which now own the seized mortgages will take their hit, as will investors in pension plans and mutual funds which own MBS.  So in part, this is a government sponsored transfer of wealth from one set of investors, public and private, to a selected set of private investors.

As the complaint states, "...the Seizure Program actually targets performing loans and does nothing to help homes in foreclosure."  Yet, slide presentations attached as exhibits trumpet the community action nature of the program to save the City of Richmond money by forestalling expensive foreclosures while keeping people in their homes.  Well, if the homeowners are current, they were staying in their homes anyway.  The propaganda would make a Russian blush.

The document says the the city has offered to initially purchase 624 loans, 85% of which are not in any stage of foreclosure.  81% are current or have not received any notice of default.  90% of BNYM's 105 loans in this initial pool are not in any stage of foreclosure.

The relevant language of the Fifth Amendment reads, "...nor shall private property be taken for public use without just compensation."  As Professor Mary Ann Glendon of Harvard Law School points out, what began as a notion of the just compensation being solely for a public use became "silly putty" in the hands of the courts.  Glendon cites retired Supreme Court Justice Sandra Day O'Connor who wrote, "where the exercise of eminent domain power is rationally related to a conceivable public purpose, the Court has never held a compensated taking to be proscribed by the Public Use Clause."

"Keeping people in their homes," saving municipal funds and preserving jobs in the local community are all part of the propaganda for the Seizure Program, so MRP and its government enablers have thought this out well.  From as early as the 1790's however, jurists recognized that use of the eminent domain clause should never be used to generate "taking" schemes which merely transferred wealth from one group to another. Unfortunately, that is exactly what is coming down now as this scheme begins to be implemented.

Major fixed income investors like PIMCO and BlackRock have awakened out of their slumber, intoxicated and flush from the longest bond bull market in history, to protest the scam.

The stench has returned worse than before.



.

Met Life Reports And More Thoughts on SIFI

I had been thinking about the FSOC process for designating non-banks as Systemically Important Financial Institutions (SIFI) for some time, and Met Life's potential designation as a SIFI stood out to me, which led to the post.  Since they just happened to have reported their second quarter results, I thought I should go over them quickly to see how they tie to some of the points at issue.

The CEO noted that Met Life is in stage three of the process for being designated a SIFI.  He pointed out that AIG and GE Capital had spent about seven months in stage 3 before being designated as SIFI. Designation as such requires a two-thirds majority of the FSOC, including an affirmative vote from the Chair, who is the Secretary of the Treasury.  Met Life is in favor of prudential regulation of insurance companies, since they have lived under that kind of regime for their 140 year history; he does, however, want any additional layers of prudential or capital adequacy regulation to be suited to Met Life's insurance business model.

Non-GAAP operating income for the quarter was $1.624 billion, up 11%  over the prior-year period. The reported net income figure of $471 million was down dramatically compared to a reported net income of $2.264 billion in the prior-year period.  This was driven by a net derivatives loss in the current quarter of $1.69 billion ($1.1 billion after tax) compared to a net derivatives gain last year of $2.092 billion.

Met Life's derivatives portfolio exists to hedge the risks in their business lines and not as a profit center, as was the CIO at J.P. Morgan or at AIG.   About sixty percent of the derivative losses were attributable to the Americas portfolio, primarily the U.S.  The company's announced base case forecast, used for their stress tests in their 2012 10-K, showed the 10 yr Treasury rate at 2.58% at the second quarter of 2013, and it ended up at 2.6% compared to 1.69% at the end of 2012.   Average spreads on their product portfolio were projected to be 200-250 bp, and they ended the quarter at 244 bp.  Overall, there's nothing in their near-term performance versus outlook which suggests unanticipated risk in the next year or so.

Book value per share, excluding accumulated other comprehensive income and using actual shares outstanding, was $47.20 and $46.77 using the diluted share count. Overall the stock looks fairly valued on its outlook, and to their credit the management suggested that share buybacks were not a high priority in near-term plans for returning capital to shareholders. Most buyback programs, particularly in the tech sectors are sops to Wall Street and destructive of value.  Kudos to the CEO for stating his position clearly.

Overall, all of the business segments performed well, and as planned sales of variable annuity products dropped 40% over the prior-year period to $2.8 billion in the quarter, since this business is not a productive user of capital.

One small item, from the point of view of materiality, was a reference to a winding down of Met Life's business in Poland, as a result of changes in the previously privatized national pension system.  The CEO of AMEA noted changes coming in 2014, as a result of the government having to make emergency contributions to the plan assets.  Opponents of the 1999 privatization charge that the costs of the investment products and fees were exorbitant, where some of it surely has to do with plan design, benefit changes, and with economic trends.

GDP growth in Poland has been less than 1.1%, and the public deficit as a percent of GDP is at 4% versus the EU required target of 3%, which could trigger mandated EU austerity.  The system will likely be renationalized, according to local observers.  Met Life assets under management total around $7 billion, and all deferred acquisition expenses related to Met Life assets have been written off.

This company has been a quiet, perhaps sleepy performer which is in the midst of trying to unify and globalize its brand.  As such, some of their investor include value-oriented mutual fund operators like Dodge and Cox and Mass Financial Services.  From much of the conversation on the call, this process has a solid foundation, but is just beginning.

CIOs Don't Care About Dell's Proxy Battle

This piece from the Wall Street Journal's online publication "CIO Journal," says that corporate chief information officers just want a return to normalcy from Dell as a supplier, and reassurance that Dell will continue to innovate.  The piece concludes that going private won't give customers much reassurance.  What a surprise!