naked capitalism

As reporters keep digging into the “London Whale” story, the picture that emerges about the caliber of risk controls and management supervision at JP Morgan only look worse and worse.

The latest revelations comes via the Wall Street Journal. First, that there was no treasurer during the period when the CIO entered into the loss-making trades. The idea that a bank of any size, let alone one as big as JP Morgan, would go for months (five in this case) without a treasurer in place is stunning. JP Morgan contends this is not germane, since (allegedly) the CIO did not report to the treasurer. Then pray tell, why was it housed in the treasury at all? And the bank’s efforts to make this all sound normal are undermined by this part of the story:

Joseph Bonocore, who left the treasurer’s post last October before the trading losses ballooned, reviewed weekly the positions being taken by the office and had raised general concerns about risks being taken by the London office that placed many of the questionable trades, according to a person familiar with the situation. Mr. Bonocore knew the investment unit well; he previously was its chief financial officer for roughly 11 years.

So the former treasurer was looking over the positions, even if he was not part of the reporting line (or was he?).

But worse, the risk manager tasked to the oversight of the unit appears underqualified for the job, and that might not be unrelated to the fact that he is the brother-in-law of a JP Morgan executive. The Key extracts:

J.P. Morgan Chase JPM -4.31% & Co. didn’t have a treasurer in place during a five-month period when the bank’s Chief Investment Office placed trades that led to more than $2 billion in losses.

In addition, the executive put in charge of risk management for the Chief Investment Office in February, Irvin Goldman, was a former trader, not a risk manager. He is also the brother-in-law of another top J.P. Morgan executive, Barry Zubrow. JP Morgan argued that many risk professionals come from trading (true) but his background does not look logical for oversight of a business dealing in complex “hedges”:

Mr. Goldman had little risk-management experience before taking the chief risk officer post at the Chief Investment Office. He spent most of his career as a trader, starting at Salomon Brothers in the 1980s. He oversaw interest-rate product sales and trading at Credit Suisse First Boston and in 2003 joined Cantor Fitzgerald, where he was president of its debt capital markets and asset management divisions. Mr. Goldman ultimately left Cantor in October 2007 after his unit piled on trading losses during the previous summer.

Even though his role at Credit Suisse might sound relevant, he left that position nearly 10 years ago, and I would anticipate practice has changed quite a bit. Cantor is known primarily as an inter-dealer broker in Treasuries. Readers are welcome to correct me, but I am not aware of Cantor being a significant player in complex derivatives, and they would not seem to be positioned to play that role (you need a large balance sheet and good market share in the related cash products to be competitive).

An article at CNBC yesterday raised another troubling issue, that the CIO had a more permissive value at risk model than the rest of the bank. This is consistent with the idea raised by Michael Crimmins earlier today, that the “whoops we allowed that model to put on a lot of risk, didn’t we?” was not an accident, but a way to allow a unit that was expected to take risk to put it on, and/or put less capital against those positions. From CNBC:

The JPMorgan Chase unit that lost more than $2 billion through a failed hedging strategy had looser risk controls than the rest of the bank, according to people familiar with the situation.

The risk of losses is tallied by the bank using a so-called value at risk (VaR) calculation. However, the Chief Investment Office, the unit responsible for the high-profile loss that JPMorgan disclosed last Thursday, had a separate VaR system.

It used a less stringent calculation that gave a lower risk assessment of its trades, according to people who previously worked at the bank. The unit also reported directly to CEO Jamie Dimon, a factor which allowed it to maintain a separate risk monitoring set-up to other parts of the investment bank, these people said.

Despite repeated warnings from executives inside the firm as long ago as 2005, the CIO unit remained notably free from oversight. A source with knowledge of the situation said that these warnings included the size of the CIO, the fact that its risk reporting was not transparent and the scope for the unit to get “bigger and bigger” because it had a lower cost of funding than the rest of the investment bank.

Until April, the CIO unit’s unusual autonomy allowed it to build up risky positions without triggering alarms.

Sports fans, letting a unit run with lower VaR and is completely inconsistent with the JP Morgan party line, that the CIO was in the business of hedging. And this part is therefore no surprise:

Indeed, the unit was encouraged to be a profit center, as well as hedging against risk…

The facts in the public domain about this unit are damning. And if Jamie Dimon survives, as expected, it will serve as yet another bit of proof of how deeply the Obama Administration is in bed with major banks.

By Michael Crimmins, who has worked on risk management and Sarbanes Oxley compliance for major banks

The scandal surrounding JP Morgan’s losses in its Chief Investment Office is not going away, and for good reason. Its trading book continues to lose money at an astounding rate. The most recent report estimates that the losses have increased by at least 50% more than the bank’s original loss estimates. The total damage is anyone’s guess at this point.

This fiasco is beginning to look a lot like accounting control fraud. The Justice Department and the FBI have begun criminal probes. The SEC is also investigating. So far, the objectives of these investigations are under wraps, but if I were an SEC or DOJ enforcement official I’d be laser-focused on bringing a Sarbanes-Oxley case against Jamie Dimon.

Sarbanes-Oxley emerged out of the Enron frauds. This law requires the CEO to certify that internal controls are operating effectively to give comfort to readers of the financial statements that the disclosures contained in the reporting are reliable. There are civil penalties for filing a false certification and criminal penalties, including jail time, for false filings found to be fraudulent. So far none of the obvious candidates like Dick Fuld at Lehman or Jon Corzine at MF Global have been prosecuted under the law.

Jamie Dimon looks like a very attractive candidate to investigate for SOX violations.

For starters, Dimon’s description of what happened rings SOX alarm bells:

First of all, there was one warning signal — if you look back from today, there were other red flags. That particular red flag — you know, we made a mistake, we got very defensive and people started justifying everything we did. You know, the benefit in life is to say, ‘Maybe you made a mistake, let’s dig deep.’ And the mistake had been brewing for a while, so it wasn’t just any one thing.

- Meet the Press, May 13, 2012

Warning signs and red flags were ignored. And they’ve apparently been ignored since 2007. Once again, echoing what happened at MF Global, risk managers who raised alarms about the riskiness of the positions in 2009 were replaced with more cooperative risk managers:

Several bankers said that risk controls were not sufficiently strengthened by Doug Braunstein, who took over as chief financial officer in 2010, another reason the bolder trades continued.

This indicates the firm was aware of deficiencies in the controls if other executives knew Braunstein had a mandate to improve them. These concerns are probably documented in the meeting minutes of the management committees responsible for risk, financial reporting and SOX compliance. It shouldn’t be difficult for the SEC to review these sources to determine who knew what and when about the state of the internal control environment.

JPM has issued quite a few financial statements since 2007 and 2009. If the controls and riskiness of the trades were as alarming and deficient as the managers indicate, then the reliability of the financial statements for the last 5 years are questionable. For a portfolio of this size and importance it’s inconceivable that the controls and risk issues were not reported up the management chain.

More damning is Dimon’s tacit admission that the controls designed to protect the firm from these sorts of blowups were ineffective, due to lack of intervention. Ignoring internal controls, or red flags as Dimon characterizes them, is a failure in the control environment. The failure to disclose inoperative key controls in the CEO certification is a violation the law.

That’s the big picture case. Recent reporting about the trade itself point to other areas that should be investigated for Sox violations.

When is a Hedge not a Hedge?

It appears that the JPM portfolio ‘hedge’ isn’t a hedge at all, at least according to current accounting standards. As Dina Dublon, CFO of JP Morgan Chase from 1998 to 2004, explained:

Dublon also pointed out that JP Morgan’s $200 billion mistake was not an accounting loss. “There is a difference between accounting and economic valuations,” she said. “You have a mark-to-market hedge against an accrual exposure that is not being marked to market. So you can have a gain or loss on the hedge, but you will not recognize the change in value of the loan portfolio, which is on an accrual accounting basis.

Translating this into non accountant language, JPM had a portfolio of assets which are available for sale. The change in the value of those securities is tracked, but since they aren’t considered to be trading assets, the change in value doesn’t hit the bottom line until they are sold. By contrast, positions held in trading books are “marked to market,” meaning they are revalued as market prices change and the resulting gains or losses are reported on an ongoing basis.

JPM reported that this portfolio contains significant unrealized gains. Indeed, it realized some of those gains to offset the losses on the portfolio ‘hedge’.

To hedge this portfolio JPM bought and sold credit default swaps. This portfolio ‘hedge’ is accounted for on a mark to market basis. This is odd since a true hedge should get the same accounting treatment as the asset it’s hedging. This indicates that the ‘hedge’ failed the hedge effectiveness test required by the accounting rules that would qualify it for hedge accounting treatment. More precisely the correlation between the hedge and the underlying isn’t strong enough to qualify it as a hedge.

Further confirmation that the ‘hedge’ wasn’t technically a hedge comes from Jamie Dimon himself.

In hindsight, the new strategy was flawed, complex, poorly reviewed, poorly executed and poorly monitored. The portfolio has proven to be riskier, more volatile and less effective an economic hedge than we thought.

As Dublon explained above, “There is a difference between accounting and economic valuations.” Dimon takes care to refer to the ‘economic hedge’, which is a term of art. It has no significance for financial disclosure purposes. It means whatever the user wants it to mean. If Dimon has not been vigilant in using the phrase ‘economic hedge’ in his disclosures and public comments about this portfolio then he’s made some false disclosures.

An “economic hedge’ is not a ‘hedge’ for financial disclosure purposes. ‘Economic hedge’ is a meaningless phrase. The abbreviated term ‘hedge’ when used to describe the trading portfolio embedded in the CIO book is a false characterization of the portfolio. He should not be permitted to describe this as a hedge in any of his comments about this book. At a minimum, he should be called on it every time he utters the phrase.

If It’s Not a Hedge Then What is It?

To recap, JPM owns a portfolio of securities it is ‘economically hedging” with a portfolio of credit default swaps. The purpose of a hedge is to reduce the risk of adverse price moves on the underlying portfolio.
The CDS portfolio consists of CDS purchased and CDS sold.

CDS purchased for the portfolio may have been put on as a hedge against the “available for sale” portfolio. But the CDS sold as a hedge doesn’t seem to make any sense. Selling CDS is equivalent to increasing the exposure to the underlying credits. The CDS sold don’t seem to have a risk mitigating role as part of a hedge, but to date JPM hasn’t provided the information to evaluate the overall portfolio.

It’s possible JPM was funding the CDS purchases by selling longer dated CDS and justifying the inclusion of the CDS sales as funding of the hedging purchases, but that would seem to be pretty expansive definition of a hedge. Perhaps ‘economic hedging’ as JPM defines it includes the funding sources of the combined ‘economic hedge’. That seems ridiculous but the term is open to any interpretation.

Since the combined CDS portfolio is accounted for on a mark to market basis, the position may not have raised any red flags with readers of the financial statements as long as it was in the money. That appears to have been the case for an extended period, as evidenced by the enormous pay packages (over $100 million for the chief trader, the infamous Whale, if reports are to be believed) for the CIO desk. You don’t pay that kind of money to hedgers.

But the position has cratered this year and JPM was forced to disclose the losses on the CDS portfolio. To offset those losses JPM sold off some of its AFS portfolio. We’re still waiting for a precise definition of economic hedge from JPM.

This characterization raises additional alarms, since it appears that JPM effectively viewed the AFS/CDS portfolio combination as a net trading position. Normally, you wouldn’t sell your AFS portfolio (or enjoy the beneficial accounting treatment) unless there was an extraordinary exogenous event that caused you to liquidate the portfolio. Trading losses on a portfolio jointly managed as part of the AFS portfolio wouldn’t qualify.

This raises the question of whether JPM has correctly classified the available for sale assets since they acquired them. That’s a serious issue. If JPM misclassified a $200B position for years, it should be investigated for a host of regulatory violations and fraud.

For all intents and purposes the hedge portfolio is a separate trading book, and the financial reporting reflects that fact. There should be no way JPM should be able to spin this as a hedge of anything and deny the proprietary trading characterization the accounting treatment signifies.

What’s up With the Value at Risk?

Another area the SEC needs to investigate is the curious restatement of the VaR, which is a measure of risk used in disclosures to investors and regulatory reviews.

As discussed above, the risk exposure of the marked to market positions (the hedge porfolio) must be disclosed in the financial statements. JPM recently replaced the VaR model for this portfolio. It appears that the new model significantly understated the risk exposure and the bank has hastily reverted to an “older” model. One benefit of a reduced risk exposure is a reduction in capital held against the portfolio. Under the new model JPM would only have been required to hold half as much capital on the portfolio, than it did under the original model

It is extremely unusual that a risk model for such a critical portfolio isn’t exhaustively vetted both internally and by the regulators before it was permitted to be installed. There was clearly a breakdown in the controls around that model replacement. This breakdown resulted in a significant and material underreporting of risk in the initial 1Q 2012 SEC reporting. The restatement validates that a material breakdown in internal controls existed before the model was implemented.

It also raises other questions. Blaming models for management failures has become a fairly standard first response during the financial crisis. When HSBC took their first big hit on their securitization business in the 2007 (for fiscal year 2006), and shut down their US securitization business, they attributed the losses to the discovery that their credit risk models were flawed. I have no doubt this was true, but the discovery of the flawed model also coincided with the beginning of the collapse of the RMBS market.

The revelation by JPM in the days immediately following the reports of the Whale’s trade, that the new VAR model seriously underestimated the riskiness of the portfolio, is more significant to a SOX investigation around adequacy of controls than an investigation into the adequacy of the model itself for risk management purposes.

This sort of “whoops our models understated risk” is a convenient way to shift blame off management to “model error” for a decision to take on additional risk. Given that easy profits in banking are vanishing, which are we to believe: that JPM, heretofore seen as a leader in the CDS marker, suddenly became grossly incompetent? Or did they decide to take on more risk and implement models that would mask from regulators and the public the scale of the wagers they were taking?

It also raises concerns about other models use for these portfolios. Many of the underlying assets in the portfolio are illiquid and complex securities. The models used for pricing these instruments and reporting valuations deserve additional scrutiny at this point as well.

It doesn’t look like JP Morgan made a bunch of egregious mistakes. It looks like they broke the law, at least the Sarbanes-Oxley law.

By Abigail Caplovitz Field, a freelance writer and attorney. Cross posted from Reality Check

Jamie Dimon, John Stumpf, and to a lesser extent, Vikram Pandit and Bryan Moynihan, are running massive hedge funds. They’re placing enormous, incredibly risky bets. “Hot money” investors are giving them the cash to gamble because they all understand that you and me will make good on any losses, since we’ve started guarantying the banks-turned-hedge-funds as “Too big to fail.”

The money flowing to these gamblers-in-chief is growing by double digit percentages, and includes so much borrowed money the “leverage” may be six times what Lehman Brothers was doing when it flamed out. As long as this situation continues, a new financial crisis is inevitable, and the risks of it grow faster every day. There’s only one solution: cut these gamblers off from public support. The market will do the rest.

We cut them off by reinstating Glass-Steagall, a depression era law that kept the bankers in check for decades, until their Clinton-era lobbying prowess repealed it. Senate Candidate Elizabeth Warren has a petition going to do just that. Please sign it.

“Deposits”, the Word that’s Hiding the Hedge Funds

The information on the bailed out bankers’ hedge funds I just summarized comes from this incredibly important Bloomberg interview of Amar Bhide. (H/T to Yves Smith at Naked Capitalism.) Bhide is a professor at Tufts University who knows a lot about the financial services industry, as the excerpts I discuss below make clear. In a little more than four minutes, Bhide detailed how and why JPM “is a systemically important, structurally defective bank. As are all the other megabanks.”

Crucially, Bhide debunks the bailed-out-banker PR spin that his Bloomberg TV interviewers parrot, and he schools them in other ways too. If enough people are clued in to what is really going on, we will break up the banks and restore Glass-Steagall. But there’s no chance of that so long as major media embraces the bankers’ key word for their hedge fund money: “deposits”.

Hedge Fund Money is the “Surplus Deposits”

The media keep talking about the money JPMorgan lost as “surplus deposits” or “excess deposits“. You know what deposits are, right? It’s your money at the bank, and mine. And the business’s down the street; even big businesses. It’s the cash we all give the banks for safe keeping.

But that’s not what Ina Drew was “investing.” She playing hedge fund, speculating with hot international money.

Here’s Bhide’s first attempt to get Media Guy and Media Gal (his Bloomberg interviewers) to understand:

There’s this amazing narrative I keep hearing. The investment office exists to quote unquote “invest surplus deposits.” It isn’t the case that the surplus deposits walk in through the door. JP Morgan goes out and solicits these deposits in hot markets in order to invest them, in order to speculate with them.

Later in the interview, Bhide twice has to revisit the point because the interviewers have bought into the imagery of the bankers’ word “deposits.”

Media Guy:

But let’s explore a little bit what the bank does. We’re taking in deposits, we’re in a deleveraging economy, loan growth is anemic, what do you do with these deposits?…

See his subconscious bias in action? “Taking in deposits.” That’s “what the bank does” all right, the retail bank branch. The Chase that you and I might use. But the hedge fund branch, the “Chief Investment Office”, doesn’t “take in deposits.”

Bhide responds:

I think you have the chain possibly a little bit off. The deposits aren’t deposits put into the bank by individuals or even commercial deposits. These aren’t IBM’s deposits. These are deposits that JPM proactively goes out and solicits from hot money markets. If it didn’t solicit these deposits it would not have them to invest with.

But Media Guy isn’t ready to listen yet. Watch how he recites some data and then pronounces bank talking points, including the taking in deposits line.

Media Guy:

Well, I don’t know, the data suggest a couple of things. On the first hand, on a one-year basis JPM’s deposits on hand has grown by 13%. Wells Fargo’s have increased 11%. Citigroup 5%, Bank of America 2%. All of these banks are fighting for the same deposits. Either JPMorgan is doing something uniquely well, or, people think it’s a safer bank and Wells Fargo is a safer bank to put their money with. That’s a choice.

See how his words still evoke you and me? Notice too the “fortress balance sheet” meme in “safer bank”. Media Gal piles on that one: “Or they think Jamie Dimon’s is the risk manager.”

Bhide tries again:

Again, the word deposits is so misleading. This is hot international money. Hot international money going wherever it sees too big to fail institutions, so they’re ‘depositing’ this money, more or less, with the US Government.

To recap: Jamie Dimon and his bailed out counterparts are soliciting money, money that is looking for a hedge fund to gamble with. Dimon’s sales pitch has two parts: 1) I won’t lose your money, because I’m the greatest risk manager ever was (very Barnum of him) and 2) I can’t lose your money, because I can stick my hand into Uncle Sam’s pocket if I really need to, as deep into his pocket as I want.

The Bankers Are Going All In With Our Money

The hundreds of billions in play right now are real money. But the numbers are system threatening when you consider the “leverage.” Just like we shouldn’t call the solicited hot international money “deposits”, we should say “cash advance to gamble with” instead of “leverage.” Because that’s what “leverage” is in the hot money, hedge fund context.

Bhide:

Leverage upon leverage. The ‘deposits’ are leveraged 10 to 1. And the investor gets quote unquote “invested” by the investment office for possibly another 10 to 1. Possibly 20 to 1. So the activities of the investment office are a levered fund, probably levered 200 to 1. Levered on the backs of guarantees by you and me. And this is an enormous threat to the public good.

Let’s be clear why: enormous bets can lose and that’s bad enough when we taxpayers stand behind them. But hugely levered bets not can not only lose, they increase the losses by an order of magnitude or two, and can bring a daisy chain of other institutions into play–the money was borrowed from somebody, right? And don’t kid yourself about how big the risks are that these funds are taking. As Bhide says:

What scares me is not the $2 billion that JPMorgan lost. It’s the record $19 billion profits that JP Morgan made. How on earth do they make a $19 billion profit quote unquote “putting customers first” in an economy that’s supposedly slowing down and their customers are flat on their backs?

By placing really big, highly leveraged, very risky bets. That’s how.

The Mythology of Risk Management

Bhide makes one other extremely important point: the idea that these bailed out bankers are managing their hedge funds’ risks is complete b.s.; it’s fundamentally an impossibility.

Here’s his first try to get Media Guy and Gal to understand:

[Dimon’s] managing an organization of over 200,000 people scattered all over the world. In dozens and dozens of businesses. This is not a …Berkshire Hathaway who is on top of the specific trades that he’s doing. How could he possibly know?

Media Gal: “It’s his job to know.”

Bhide: “Well it’s a job that no human being can do.”

But the obviousness of what Bhide’s saying doesn’t sink in, so later on he tries again.

Media Gal: “Do you think the risk managers understand the type of products these traders are trafficking in?”

Bhide:

Well it’s one thing to understand the type of product generically, it’s another to know every single trade. The people running these very large organizations who are taking these very large audacious risks ought to be on top of every single trade. I know successful hedge fund managers, they make a fortune, it’s a well made fortune.

Media Guy:

So you’re saying if the CEO…cannot have enough visibility into these individual positions and understand the risks they present there’s no way that his or her institution should even be dabbling in this stuff.

Bhide: “Absolutely. I mean I have nothing against these individual instruments per se…”

Media Gal: “So you’re saying the derivatives products, it’s not them. It’s the way they’re being managed?”

Bhide: “I’m saying they don’t belong in JPMorgan, they do not belong in a large commercial bank, period.”

Media Gal: “Then where do they belong?”

Bhide: “In a specialized hedge fund!”

So there it is. Jamie Dimon and his peers are running massive hedge funds that are getting more massive (remember, Dimon’s grew by 13% last year alone), taking enormous, highly leveraged risks they cannot manage, secure in the knowledge that the American taxpayer is guaranteeing their bets.

We are accelerating toward our next, and larger, financial crisis. Time to bring back Glass-Steagall. Sign the petition, please. And watch the Bloomberg interview of Amar Bhide. And pass them both on.

Even with all the focus on JP Morgan’s loss bomb in the past few days, some critical elements of the story have not gotten the scrutiny they deserve. By way of background, Amar Bhide, who is currently a professor at Tufts, has run a prop trading operation (admittedly some time ago) and has written extensively both on the financial services industry and entrepreneurship.

Bhide takes issue with Dimon’s description of the funds that the Chief Investment Office (part of the bank’s treasury function) as “deposits” but rather as market funds. He also contends that no one can be running a major risk-taking trading operation along with a huge, sprawling international bank. A major trading operation requires that senior management be on top of position risks, and the organizational and operational demands of running a super big bank make that impossible. Finally, he argues that the risks JPM and other banks are taking are much greater than is commonly recognized, and JP Morgan’s profit level in the face of unfavorable conditions for financial firm is proof of unduly high risk levels.

By Michael Olenick, creator of FindtheFraud, a crowd sourced foreclosure document review system (still in alpha). You can follow him on Twitter at @michael_olenick or read his blog, Seeing Through Data

In an admittedly strange twist of timing JP Morgan, the same JP Morgan that just announced a surprise $2 billion loss caused by the “London Whale,” became the first and only of 26 banks disclosing subprime investor data to flip me the digital bird, refusing access to the public loan-level performance data for their Washington Mutual loans. WaMu, one of the most reckless subprime lenders, was swallowed whole by JPM and they’re having serious indigestion.

Nelson D. Schwartz and Jessica Silver-Greenberg of the New York Times verify that the purpose of the Chief Investment Office — the London Whale — is to offset risk caused by the Washington Mutual loans:

Under Mr. Dimon’s leadership, the chief investment office — which was responsible for the outsize credit bet — was retooled to make larger bets with the bank’s money, a former employee said. Bank executives said the chief investment office expanded after JPMorgan Chase’s 2008 acquisition of Washington Mutual, which added riskier securities to the company’s portfolio. The idea behind the strategy was to offset that risk.

It isn’t hard to figure out why JP Morgan doesn’t want anybody looking into and through their garbage. I have not been able to ascertain whether these reports are required under disclosure requirement Regulation AB (the law itself seems to say yes, but the experts I spoke to gave divergent readings). Whether they are or aren’t, JPM’s refusal — when everybody else cooperated speaks for itself.

As those loans sour, and they continue to rot like a dead skunk on a hot July day, the bets needed to offset the losses are increasing. It looks like the bank, peering into that portfolio they refuse to share, is becoming more than a little bit desperate. Like a compulsive gambler after a multi-day bender resulting in crippling losses they decided to double down rather than walk away, leading to their current whale of a surprise and likely a mirror-image follow-up for the WaMu losses this was supposed to offset.

For anybody who believes that JPM’s position is normal .. it isn’t. Twenty-six other banks quickly popped open the doors to their repositories, as they’re required to do. Perennial bad-boy Aurora Loan Services is the only other one that’s ignored my requests, though since it looks like they’ve sold their servicing operations the jury’s out whether their silence is purposeful or whether there’s nobody home on the other side of those requests.

Like I said, I’m not sure whether these disclosures are exempt. There are certainly many marked private, but they seem to be overwhelmingly CDOs and similar more exotic or clearly closely held instruments. I’ve never seen an entire series of MBS from an issuer that is exempt: even a few stray WaMu deals that ended up in other repositories are open to the public.

JP Morgan’s insistence that “[t]he site is maintained for JPMorgan Chase RMBS clients,” only, demanding that I include my JP Morgan Chase contact, may be legal but it is unprecedented. In context of their recent trading losses, the knowledge that those losses were to hedge against the WaMu losses, Dimon’s prior comments downplaying both losses, and strong analysis that the WaMu loans are some of the most impaired MBS it’s fair to conclude that JPM is hiding something in the basin of their loan outhouse.

I’ve spent the past couple months holed away downloading MBS data in bulk to enable investors, analysts, academics, government agencies, or whoever else wants to inspect performance information and project losses for every subprime loan trust. When finished, this week hopefully, I’ll have a veritable ABS MRI machine that can peer into the true health of the housing and housing finance market. It’s harder than it sounds: one of those projects where software engineers emerge from their digital caves after months, bleary eyed and long past due for a haircut but holding game-changing technology.

My database, which includes everything except WaMu loans thanks to Jamie, is finally almost finished. But even in preliminary form it is clear that the AAA-rated senior tranches — the ones that really were never supposed to take losses — are toast that’s burning worse by the day. Servicers, trustees, government officials have been doing anything to delay the inevitable losses but when people don’t pay their mortgages, and housing has declined by over 50% in many of their markets, there’s only so much accounting chicanery they can do: the money just isn’t there.

My suspicious are more grounded than tin-hat delusions we’ve been hearing from the housing is hot again crowd. R&R Consulting, a well-regarded structured valuation expert I work closely with conducted a portfolio-wide analysis of undisclosed (“limbo”) losses on RMBS. In a special in-depth report dated February 2012, long before JPM told me piss-off when asking for access to the more granular WaMu loan-level data, they reported that WAMU had the highest limbo loss level–about $810 million—in just one transaction. Repeat: experienced analysts dug this out even without loan level data. It sounds likely that it won’t be long until Dimon reports another ten-figure surprise that I’m sure he’ll apologetically pawn off on the US taxpayer.

For anybody asking “um — isn’t this over — didn’t all this fall apart back in 2008?” the answer is not really. That mega-meltdown was really a mini tremor caused by the lower and smaller tiers of these securities; last time junior visited to stir things up but this time papa’s walking down the street carrying a mean look and a big stick. That’s because the mezzanine level tranches of most bubble-era MBA are either gone or guaranteed to be gone — finally eaten up by current or pending losses — leaving the lower AAA tranches to take their place as the bearer of losses. This was never supposed to happen. Everybody knew that CDOs created from the lower tranches were risky, even if the ratings agencies said otherwise, but nobody thought the meltdown would last this long that the actual top tranches would be nicked. But the data couldn’t be clearer: those bottom level A-class tranches of yesterday are the new bottom level M-class tranches of yesterday.

All this is surprising because these same MBS tranches have been on fire lately. Hedge funds bought them for very little when nobody wanted them — setting their own price — and now they’re selling them back at steep gains because housing is peachy again, never mind the enormous amount of shadow inventory. Hopefully the buyers of these same securities aren’t being set up, again, because nobody would be stupid enough to fall for that same trick, again. Hopefully.

It is these lower tranches and other derivative products, which are by definition exponentially smaller than the more senior securities like the ones JPM is hiding (well, before the banks multiplied them several times over using credit default swaps) that blew up the world economy in 2008.

I’m guessing that it is the inevitable meltdown of what remains of the AAAs (the amount outstanding has been reduced considerably by refis) that has been at the impetus for the housing cheerleaders. By refusing to move their foreclosures forward, then refusing to take title, then refusing to REO those homes, the trusts don’t have to recognize the losses because, ya’ know, the abandoned and dilapidated properties will magically double in value as long as we hold our breath and wish.

My mountain of data that shows loss severity in excess of 100-percent is not uncommon. When we look at the loans, compare similar loans from those who report them more honestly, multiply the average severity by pending reported and, um, overlooked foreclosures, then it becomes clear that the lowest rated AAA’s are toast. This reaffirms the report by R&R Consulting report that $175 billion of loan level losses had not been allocated to the trusts. Whoops!

Jamie Dimon admitted his $2 billion loss “plays right into the hands of a bunch of pundits out there” on his conference call explaining his stinky. Dimon went on to call the losses “egregious” and “self-inflicted.” In light of the London Whale it is clear that when it comes to sky-high risk, like JPM’s WaMu exposure, the bank has adopted an advanced risk management strategy: telling researchers to piss off then hiding.

By Occupy the SEC

Jamie Dimon’s plan to enfeeble the Dodd-Frank reforms, specifically the Volcker rule, has blown up spectacularly. Apparently JPM was so confident that their interpretation of the hedging exemption would prevail, that they got ahead of themselves and operated as if this loophople were in effect. But then things went horribly wrong for them. And the losses are even more damaging since the blowup is the result of activity the law was meant to curtail. Double trouble now for JPM, since it’s inconceivable that the hedging exemption they designed will make it into the final rulemaking. If it does survive, then we’ve got bigger issues with our regulators than we imagined.

In today’s New York Times, James Wyatt provides an under the radar view of how laws are gutted when the regulators involved in rule-making are heavily lobbied by the regulated. One objective of Occupy the SEC was to inject a non industry perspective in this process as a counterweight to the overwhelming industry influence. By looking for loopholes we intended to shed light on the self-serving interests of the bankers and the vulnerability of the regulators to concerted industry pressure. Wyatt describes the lobbying efforts:

Several visits over months by the bank’s well-connected chief executive, Jamie Dimon, and his top aides were aimed at persuading regulators to create a loophole in the law, known as the Volcker Rule. The rule was designed by Congress to limit the very kind of proprietary trading that JPMorgan was seeking.

“JPMorgan was the one that made the strongest arguments to allow hedging, and specifically to allow this type of portfolio hedging,” said a former Treasury official who was present during the Dodd-Frank debates.

Portfolio hedging is at the heart of the London Whale debacle.

The loophole is known as portfolio hedging, a strategy that essentially allows banks to view an investment portfolio as a whole and take actions to offset the risks of the entire portfolio. That contrasts with the traditional definition of hedging, which matches an individual security or trading position with an inversely related investment — so when one goes up, the other goes down.

Portfolio hedging “is a license to do pretty much anything,” Mr. Levin said. He and Senator Jeff Merkley, an Oregon Democrat who worked on the law with Mr.Levin, sent a letter to regulators in February, making clear that hedging on that scale was not their intention.

“There is no statutory basis to support the proposed portfolio hedging language,” they wrote, “nor is there anything in the legislative history to suggest that it should be allowed.”

We were extremely concerned about this loophole and argued against it in our comment letter to the regulators.

We are alarmed by the focus on .“portfolio hedging.” throughout the risk-mitigating hedging exemption. We interpret the intent of this exemption as relating to Delta One or central execution desks that have become ubiquitous across banking entities in recent years. Certainly these central hedging operations pose significant risks, as famously exemplified in the rogue trading scandal that caused a $2.3 billion loss in 2011.84 While it is clear that such practices necessitate increased oversight and significantly improved risk-management procedures, there are other instances of aggregated hedging that will be inappropriately included within .“portfolio hedging.” that require consideration. Even outside of central execution desks, many risks a recurrently managed on an aggregated basis, due to the numerous, and often compounding, proprietary portfolios that exist on every market making desk of every covered banking entity. With so many independent strategies at play, it is not uncommon for large exposures across a variety of assets to result when they are combined in the view of a manager. Management will often make use of a .“back book.” or .“management book.” for the dual purposes of conducting broad-line hedges against lumpy trading-desk exposures, and taking proprietary positions that fall outside of the mandate or risk-limits of an individual trader. While it is expected that such obvious proprietary exposures will diminish with the implementation of this Rule, we fail to understand the continued relevance of most management hedging operations once individual trading books pare their component exposures. We are troubled by the potential for such .“back books.” to become havens of prohibited proprietary activity after the implementation of this Rule.

A specific requirement that each type of exposure be designated as one that is hedged exclusively on an Individual or an Aggregate basis is essential. Risks should never be hedged on both an individual and aggregate basis, and most risk types are appropriately mitigated in only one of the categories. For instance, counterparty risk should always be (and in practice, typically always is) mitigated on a portfolio basis, and individual traders should not be able to make use of the hedging exemption by claiming mitigation of such a risk. These risks can be managed by a level of organization that is out of touch with the day-to-day operations of a trading desk. We propose that the Agencies consider requiring banking entities to create central .“Risk Management.” groups to perform aggregated hedges, to the extent that such groups are not already in place.

The broad allowance for aggregated hedging is troubling and its exemption is inconsistent with the intentions of this Rule. This rule mandates strict risk mitigation at a micro level, and should remove all Implicit or explicit allowances for the dangerous practice of management hedging. More generally, a banking entity.’s need for substantive aggregated hedging is indicative of a failure to appropriately mitigate risks at lower levels within an entity, and is therefore in violation of the spirit of the Rule. We acknowledge that the statute allows for aggregated hedging in Section 619(d)(1)(C),85 and we hope that the Agencies are prepared to be diligent in monitoring this activity closely to discourage abuses, which we see as a serious risk.

It’s way past time for ordinary citizens to have there voices heard in this process. We were encouraged that over 15,000 letters in support of a strong Volcker Rule were submitted to the regulators during the comment period. That was a clear signal that ordinary citizens want some checks on the power of the banks. Additionally , its encouraging that another 1,800 people petitioned the regulators to do the same.

Thanks to Jamie Dimon, perhaps the regulators will finally lend and ear to the clear message the citizens of this country are trying to get them to hear.

By David Llewellyn-Smith, the founding publisher and former editor-in-chief of The Diplomat magazine, now the Asia Pacific’s leading geo-politics website. He is also the co-author of The Great Crash of 2008 with Ross Garnaut. Cross posted from MacroBusiness

The American academic Robert Shiller has taken another contrarian tack with his latest book Finance and the Good Society. His claim is that Western finance has lost the sense of virtue that it once had. It is interesting to trace where Shiller is wrong, or at least looking in the wrong direction. Because it tells us much about where finance has become post-capitalist and ever more dangerous.

Much of what Shiller says is right. For instance his observation that “financial institutions and financial variables are as much a source of direction and an ordering principle in our lives as the rising and setting sun, the seasons and the tides.” This is undoubtedly true. Indeed, finance IS rules, so it sets the rules of money, and therefore the rules of commerce.

He then goes on to argue that most bankers and financiers aren’t especially bad people, that greed is something of an aberration. He cites the virtuous stalwarts of the past from Goldman Sachs and ratings agencies to show that recklessness has not always characterised the sector. A return to that sense of virtuous service of commerce, he argues, will re-invigorate the strength of capitalism, surely the best economic and political system. Shiller cites Montesquieu’s argument that healthy commerce tends to produce societies less inclined to war and vicious politics (the Frenchman was obviously not writing at a time when some society’s commerce heavily depended on the production of instruments of war, as is the case now).

It is all fine stuff, and there is certainly considerable historical precedent to support what he is saying. Trouble is, it has very little to do with the problems that have emerged over the last decade or two. Here are some objections:

1. It is true that many bankers and financiers are not unusually bad people. They are probably like any other group of people; some good, some bad. And that is the point. It is a systemic problem. The financial behaviour that emerged is just what most would do, given the chance. Blaming individuals is not the way to solve it, deeply satisfying though that often is. Changes have to be made to the system.

2. Shiller makes an error that I think is almost ubiquitous. He assumes that regulation is somehow external to finance, acting on it as an outside constraint. That is not true, as we can see implied in his own quote. Money IS rules and governments set those rules. What has changed in the last two decades is that governments gave up that role, until they could no longer avoid it after the GFC, and traders instead established their own rules, derivatives mostly. We now have a system in which the financial players make up their own rules. Little wonder that the systemic problems are massive (see point 1).

3. Allowing traders to make up their own rules means that the subordinate role of finance, its function of serving commerce, has been altered, very much for the worse. Shiller argues that finance should support business, it should be humble. That is what will not happen in the current system, or at least not happen often enough. It has become a world unto itself, an exercise in gaming a system of rules in a potentially endless regress of making money out of the money made out of money.

4. We are now in that world of “meta-money”. Its most extreme iteration is high frequency trading, which, especially in stock markets, is a travesty of capitalism. The purpose of stock markets is to raise capital to fund public companies. The trading in nano seconds has nothing to do with that; the algorithms make no distinction between companies. It is just an exercise in gaming the rules of share trading. Same with currencies, which is also dominated by high frequency trading.

We would all love to go back to the world Shiller describes.Such virtuous men and women could grace the hallowed corridors of Yale, no doubt, making the odd financial donation. The problem is that it is not going to return. The computer driven monster of meta money has been unleashed. That is the world as it is, not as it once was.

One of the amusing bits of the hastily arranged JP Morgan conference call on its $2 billion and growing “hedge” losses and related first quarter earning release was the way the heretofore loud and proud bank was revealed to have feet of clay on the risk management front. Jamie Dimon said that the bank had determined that its value at risk model was “inadequate” and it would be using an older model. And no wonder. The Financial Times report contained this bombshell:

JPMorgan also restated its “value at risk”, a measure of maximum possible daily losses, of the CIO [the unit that executed the trading strategy that blew up] in the first quarter from $67m to $129m

“Restating” greatly underplays the significance of what happened. VaR is a prospective risk metric. From ECONNED:

…the objective was to come up with a single figure that captured all the risks in a simple statistical fashion: what was the risk that the bank would lose a certain amount of money, specified to a threshold level of probability, in, say, the next 24 hours? The model output would say something like: “We have 95% odds of losing no more than $300 million dollars in the next 24 hours.”

It took seven years of refinements to reach that goal, which should have been seen as a warning that it might not be such a good idea.

While firms look at VaR over a range of time frames, daily VaR (what is the most I can expect to lose in the next 24 hours) to a 99% threshold is widely used.

So get this: VaR’s real use is prospective. The VaR for a big risk taking unit was found to have been nearly double the level reported two weeks ago (hat tip Joe Costello). Remember, this was the risk incurred in the first quarter; this change has nothing to do with the losses incurred in the last six weeks. It means the risk originally reported by the folks in risk management (in real time, for use in management decisions) was grossly off.

The fact that VaR is a lousy metric should not come as a surprise. Anyone who has paid much attention to financial firm risk management should know that it is not what it is cracked up to be. There is a tremendous bias towards scientism, towards undue faith in quantification and statistics (see a longer form discussion in “Management’s Great Addiction“) which leads to overconfidence. And when people are paid bonuses annually, with no clawbacks for losses, and banks show profits a fair bit of the time, who is going to question bad metrics when the insiders come out big winners regardless?

But VaR is a particularly troubling example, more so because it is sufficiently, dangerously simple minded enough that regulators and managers a step or two removed from markets have become overly attached to its deceptive simplicity.

For newbies to this site, JP Morgan created the widely used risk management tool Value at Risk (note to Felix Salmon: JP Morgan did NOT invent risk management, investment banks were doin’ it in the stone ages of the 1970s and 1980s. And the pioneer among banks wasn’t JP Morgan, but Bankers Trust, with its RAROC, or Return on Risk Adjusted Capital model). VaR set out to create a single risk measure across an entire firm. As we wrote in ECONNED:

….the objective was to come up with a single figure that captured all the risks in a simple statistical fashion: what was the risk that the bank would lose a certain amount of money, specified to a threshold level of probability, in, say, the next 24 hours? The model output would say something like: “We have 95% odds of losing no more than $300 million dollars in the next 24 hours.”

It took seven years of refinements to reach that goal, which should have been seen as a warning that it might not be such a good idea….

Using a single metric to sum up the behavior of complex phenomena is a dangerously misleading proposition…

The output formulation was designed around statistical convention, that of probability distributions. But the part of the distribution that the analysis cut off is the very part that will kill a leveraged firm. It was almost as if the team that produced VaR had drawn a map that simply marked the edge of the world with the legend “Beyond here lie dragons,”when the treasure seekers will inevitably venture into those uncharted waters.

That discussion actually understates how misleading VaR is. As mathematician Benoit Mandelbrot discovered in the 1960s, and Nassim Nicholas Taleb popularized in his book Black Swan, risks in financial markets do not have normal (Gaussian) distributions. Taleb, in his article The Fourth Quadrant, pointed out there are many situations where statistics are at best questionable and at worst unreliable: where you have non-Gaussian risk distributions (as you have in financial markets) and complex payoffs. Even if you have comparatively simple businesses, aggregating risk across businesses creates complex payoffs. And the risks in these business aren’t simple. Taleb indicative list of “very complex payoffs” includes:

Calibration of nonlinear models

Leveraged portfolios (around the loss point)

Derivative payoffs

Dynamically hedged portfolios

Kurtosis-based positioning (“volatility trading”)

JP Morgan and every big dealer bank is stuffed to the gills with risks like that.

Now VaR isn’t the only risk model JP Morgan is using, but it has served to allow the inmates to run the asylum. The fact that Dimon dwelled on VaR was likely not just to assign blame; it’s guaranteed to be a major tool in communicating with senior management and the board.

The good news is the regulators seem to be a step ahead of Dimon in turning their backs on VaR. FT Alphaville last week reported on the latest missive from the Basel Committee on Banking Supervision on capital requirements for bank trading operations. They said they don’t like VaR and want to move to other metrics:

….the Committee has considered alternative risk metrics, in particular expected shortfall (ES). ES measures the riskiness of a position by considering both the size and the likelihood of losses above a certain confidence level. In other words, it is the expected value of those losses beyond a given confidence level. The Committee recognises that moving to ES could entail certain operational challenges; nonetheless it believes that these are outweighed by the benefits of replacing VaR with a measure that better captures tail risk.

Note that this change will not win with Taleb’s approval. He has also written about the difficulty of measuring tail risk. He has shown in many markets how tail risk estimates are often (statistically) based mainly on one or two data points, and how fraught that is. His main point still holds: the type of risks embodied in trading books aren’t suited to statistical measurements. The best approach is likely to be to use a variety of measures and models and (gasp) apply judgment. But the authorities, and Dimon along with them, have not given up their hunt for a philosopher’s stone to turn lead into gold.

One of the troubling ideas that seems to have gained traction is that nations should not care overmuch about the needs of their citizens and should accept market outcomes. This position is ultimately contradictory, since its proponents argue for the Reaganite “get government out of the way” position, when commerce depends on rights defined by and enforced by the state (thought experiment: would US companies have built factories in China, a Communist country which could expropriate assets, if the US were not a military superpower?)

This advocacy of “free trade” (when we in fact live in world of managed trade) runs two parallel arguments: the “free trade increases wealth and therefore we should all go along” and and the “more open trade is inevitable, you better be on this bus or you will be under the bus.” Too often, these arguments rest on the assumption that coming close to the economists’ fantasy of frictionless free trade is better. But that was debunked in 1953, in the Lipsey-Lancaster theorem, which demonstrated that trying to move to closer to an unattainable state was not only not assured to produce better outcomes, it could very well produce worse ones. You actually need to do the work of evaluating various “second best” alternatives, rather than assuming more is better.

And there are non-economic tradeoffs to consider as well. We’ve often cited this observation by development economist Dani Rodrik:

I have an “impossibility theorem” for the global economy that is like that. It says that democracy, national sovereignty and global economic integration are mutually incompatible: we can combine any two of the three, but never have all three simultaneously and in full.

Here is what the theorem looks like in a picture:

To see why this makes sense, note that deep economic integration requires that we eliminate all transaction costs traders and financiers face in their cross-border dealings. Nation-states are a fundamental source of such transaction costs. They generate sovereign risk, create regulatory discontinuities at the border, prevent global regulation and supervision of financial intermediaries, and render a global lender of last resort a hopeless dream….If we want more globalization, we must either give up some democracy or some national sovereignty. Pretending that we can have all three simultaneously leaves us in an unstable no-man’s land.

So what looks like a backlash may simple be these governments recognizing intuitively what Rodrik was able to make explicit: going further on economic integration would lead to tradeoffs they regarded as undesirable. And a big one is basic security needs of its citizens.

On the one hand, we have a new piece at VoxEU arguing that export restrictions have played an unrecognized role in food price increases, which is in line with neoclassical orthodoxy. Note that I find this paper, which has a much more robust model, far more persuasive, and it find the main culprits to be investor speculation and ethanol subsidies. Ethanol took enough corn out of food production to feed 330 million people for a year at average daily calorie levels. Think that wouldn’t have knock-on effects?

These radically contrasting conclusions not only demonstrate that analysts disagree over facts (what caused the price increases?) which makes it much harder to reach sound policy conclusions. The winners of this year’s Leontief Prize, Peter Timmer and Michael Lipton, lectured on the global food crisis and agricultural development (see Timmer’s and Lipton’s texts). To give you a taste of their talks, and the interviews below, here are some extracts from Timmer’s presentation:

Food price stability is a good thing, not a bad thing. The standard model of international trade can show “gains to trade” from highly unstable food prices, but these gains are illusory.

Do not mistake my point. I believe deeply in the role of markets in exchange and price discovery and as the foundation for economic specialization. Markets usually get these right, and governments usually get them wrong. But not always. And the exceptions are important, especially in matters of health, education and food security…

To my consternation (and secret delight), food price volatility is finally back on the intellectual and policy agenda…It is not easy to stabilize food prices, but it is not impossible either. We just need to stop arguing that stable food prices are a bad thing and get on with the tough analytical and empirical work to learn how to do it effectively, efficiently, and honestly.

Day-to-day prices in world commodity markets are a bad guide to long-run decisions on funding agricultural research and investments in rural infrastructure. “Do markets provide the right signals” to getting agriculture moving? Often not.

I hope you enjoy these conversations.

As readers may know, a recent post, “Frontline’s Astonishing Whitewash of the Crisis,”discussed the first half of the Frontline series, “Money, Power & Wall Street.” Producers Mike Wiser and Martin Smith sent a letter taking issue with this review, and I made an exception to my usual practice and posted their missive.

The major dispute is over whether their series lets the financial services industry off too lightly. The producers contend they attempted to provide “an accurate and informative telling of the crisis,” that they were indeed tough on financial firms, and that I “misunderstood” their program. The bulk of the letter then consists of extracts from the program meant to address specific criticisms.

I’ll deal with their particular claims in due course. But most important, their letter fails to engage the basic issue raised in the initial post: that of the overall message conveyed by this segment. Their assertion is that I misunderstood, when it it the obligation of Frontline to make sure its message is clear. And as we’ll also see, I am far from alone in “misunderstanding” their show.

Any form of storytelling, be it print or televised journalism, fiction, even scholarly work, involves choices as to what material present, how to guide the reader/viewer through the information, and what points to emphasize. Emphasis can take place in numerous ways, including by presenting information early (first impressions stick and are hard to dislodge), repetition, amount of time spent. One major choice is whether to provide a range of points of view and let viewer decide, or supplying a clear perspective. The use of a narrator (and this series had a narrator) signals that the producers intended to provide a perspective.

What happens if you fail to give non-expert viewers sufficient guidance through a complex fact set? The audience not only gets little in the way of illumination, but it also reionforces the idea that the situation is complicated and hard to grasp. That message is bank friendly. We’ve stressed repeatedly that complexity, opacity, and leverage serve the interests of financiers to the detriment of society at large. Treating this evolution as something that just happened is far too kind to the authorities and big banks. It represents a fundamental shift from the financial services industry providing mainly valuable services to becoming increasingly extractive. As we said in our original post:

So thus far, we have some populist decorating of a profoundly pro-Establishment account. Yes, the system got really out of control, but whocoulddanode? It just got SOOO complicated no one could understand it, not even those super well paid top Wall Street executives. There isn’t a single mention of ideas like looting, bogus accounting (remember the fictitious Lehman balance sheet, or Merrill’s CDO-hiding Pyxis, or the $40 billion of Citi CDOs that appeared out of nowhere?) or abuses in other areas (like swaps sold to municipalities all over the world, or rapacious privatizations, the auction rate securities blow up, or chain of title abuses). Nah, it’s just a bunch of fundamentally good ideas taken too far. And they really expect you to believe that.

In fairness, Part 2 does cover the swaps sold to municipalities in some detail, but even then, as we’ll discuss in a later post, this discussion also falls short.

But the most charitable conclusion you can reach is, in the words of a colleague who has taught at the Columbia School of Journalism for over ten years, is that this is “mediocre journalism,” that the producers didn’t recognize that the story they thought they were conveying was different than the one they actually presented.

Various viewers of the program also found that the overall message was favorable to Wall Street. I’m told there were many critical tweets on the first and second program. This assessment came via e-mail:

I happened to watch the two hours in one sitting yesterday as a film and I came away sharing most of Yves’ observations. The overall criticism that it was more a People Magazine expose (well done at that level with its bevy of interviews of key players!) that was heavy on characters and narrative and light on illumination is valid. While the narrative did have some great general quotes like the ‘infectious greed” described by Frank Partnoy, “the greed of Wall Street broke Main Street” by Roy Barnes and Reich’s “Wall Street got away with bank robbery” they were used more as attack lines on the “bad people” on Wall Street rather than the system.

Of course, the proof is simple: What conclusions is the viewer of the first two hours led to? Forget the throwaway lines here and there used for cover. I see three simple ones that were artfully laid out. Obama is smart and capable. The Republicans are stupid and incompetent. The bailout was flawed but necessary.

In other words the Frontline programs provided some great quotes, especially those of Alan Greenspan mumbling his bizarre bible that people in white shirts can be trusted to be more moral and aware than the 99%. The show did not deal with the inherent racist and classist attitude of our plutocrats that the 1% are less criminally inclined than the 99% and do not need the policing that the rabble do when, in fact, they need more because of the perverse economic “incentives” they face.)

And this e-mail reacted to the producers’ letter:

I find the response by Frontline is in denial regarding your criticism of the general tenor and overall effect, which really is what you were saying. In fact, the more I read of their apologia, the more annoyed I get. It’s a long set of excuses, with a few finger-pointings at you for writing overly fast.

Frontline response refused to acknowledge that it WAS bank friendly. It criticize you for pointing out that JP Morgan Chase was trying to solve its OWN problem.

You’re right. The Frontline show GENERALIZED the description, as if economists were trying to solve risk IN GENERAL, not shift their OWN risk somehow onto their own counterparties.

Your points are specific. Without concretizing what is happening, viewers are left with a lack of focus (“solving problems”) as to Cui bono?

Regarding the other “warnings” the Frontline show cites, these are like warning labels on a pack of cigarettes or liquor bottle (“Don’t drink to excess. Be responsible.”) They tend to get lost in the overall spirit of the show.

The Born comment simply got lost. Here was a real boxing match. They somehow glossed it over in a way that ONLY the people who actually had followed the story would know what was being said. It’s like a literal translation of Sumerian cuneiform — so brief that only someone who knows the context can understand what the tablet is all about.

What really is at issue is the importance of how to FRAME a point to highlight and explain it. They SAY that they explained that securitizing junk mortgages was what caused the problem. But this just wasn’t done effectively and straight-forwardly. Again, only the insiders who have been following things will get the message. It’s as astutely buried as cigarette companies bury the cancerous effects of their products. What Frontline did was “UNFRAME” the issue, to coin a verb, where this would really be confrontational with Wall Street. In a more popular word, it was simply wimpy.

I.e., “SOME of these mortgages MAY BE subprime.” “I wanna buy A LITTLE BIT of CDO” C’mon! They reduce it all to technocratic stuff — a problem to be solved, not a plan for a rip-off!

It’s like God drove a steamroller over the earth, flattening out the mountains, so that nothing stands out. Or like a composer of a symphony that had everything mezzoforte, no high points, no focal points. It was … blah.

You’re absolutely right. There didn’t HAVE to be a choice between bailout or “meltdown.” So the bondholders would have lost — the money they doubled as a proportion of US income and wealth 30 years ago. So what?

The Angelides quote implied that Obama DID have to “save the economy.” Not that it was NEEDLESS, as you say.

Bottom line: I’m “baffled” that Mr. Wiser is “baffled” at your comment. Perhaps Frontline needs someone who is NOT baffled!

Let’s now deal with their responses, many of which do not engage the issues raised, but instead seek to cast doubt about the accuracy of the post.

First is their objection to the idea that they “cribbed” from Gillian Tett’s account of the development of the credit default swaps market, Fool’s Gold. In fact, the series starts with the same narrative that Tett used, that of JP Morgan staffers first coming up with the idea of CDS at a corporate retreat, and even has the same hijinks. While people who read Fool’s Gold would see the inclusion of Tett in that part of the documentary as a way of acknowledging her influence, that does not obviate the fealty of Frontline to Tett’s storytelling. While “cribbed” may be deemed to be unduly strong, some readers saw this comment as “the lady doth protest too much.”

The much more important issue with starting with the genesis of credit default swaps is it launches the program on a pro-Wall Street footing (yes, there is the meant-to-rivet-your-attention, “we had a meltdown” juxtaposed with Occupy Wall Street protestors, but that is quickly undercut by various statements by apparent experts as to how complicated this all is, so the criticism is almost immediately diffused).

The producers chose to start with the genesis of the corporate credit default swaps market, which is a bizarre place to begin. Corporate credit default swaps had nothing to do with the crisis. The narrator describes their creation as “innocent” (!). CDS are depicted as an “innovation” repeatedly, with all of its positive overtones (and recall that no less than Paul Volcker begs to differ). They are also presented simply as a way to transfer risk, and that is presented as salutary, as opposed to a way to solve a big problem for JP Morgan and other banks (as the readers above noted, lack of agency is all too common in this broadcast).

The only reason to go that early might be to depict the missed opportunity to regulate them and prevent the creation of a standardized template for CDS on asset-backed securities, which as we described long form in ECONNED, is responsible for the toxic phase of subprime origination (third quarter 2005 to summer 2007). They try to have it both ways in their letter, saying they covered that ground in another Frontline documentary. Sorry, that doesn’t pass muster. A presentation needs to be self contained. And even with hard core Frontline viewers, this also demands that they recall content from an earlier program, when in our information-overloaded society, that is a lot to expect of those who do not follow the finance beat.

The letter continues to argue that the program did cover the notion that corporate credit default swaps were devised to transfer risk, which benefited banks. But this softpedals the motivation, which was set forth in our post: that JP Morgan was carrying more corporate credit risk than it was comfortable with (my recollection is that Fool’s Gold discussed specifically that JPM’s growth would be constrained). And recall in the viewer quotes above, that they also found that the issue of “cui bono” from the creation of CDS was skipped over. (I also have to note that one of the people they quoted in this section is Mark Brickell, identified in the program as a former JP Morgan employee. Most viewers would assume that that means he would give an unbiased take. In fact, Brickell is an uber financial services and even shows up twice in Frank Partnoy’s Infectious Greed as a bad guy of sorts).

Next, they shift to arguing that their discussion of CDS did cover the idea that they were tantamount to unregulated insurance. But merely citing text where CDS are referred to by various interviewees as insurance is inadequate for a generalist audience.

Contractually, a financial product cannot be both a “derivative” (price or payoff defined in terms of a readily priced underlying instrument) and “insurance” (payoff when an event of loss takes place). The JP Morgan misbranding of CDS as derivatives has been remarkably effective.

If you look at the transcript, the CDS are referred to a full 22 times as “derivatives” and there are three additional mentions of general concerns about derivatives that in context before you even hear the word “insurance”. These include seven separate comments by the narrator, some of which use the word “derivative” multiple times with reference to CDS, starting with this one:

NARRATOR: Credit default swaps, a kind of derivative that insures a loan against default.

This was a very new concept. Traditionally, derivatives were a way to bet on the future value of something. For hundreds of years, farmers have traded derivatives to protect themselves against fluctuating crop prices. It is this type of derivative that has been traded on the Commodities Exchange in Chicago, along with the futures of fuels, currencies and precious metals.

In Boca Raton, the JP Morgan team realized that they could use credit derivatives to trade their loan risks.

So get this: the narrator, the proxy for the producers, defines credit default swaps as a derivative, and presents them as being part of a proud history of derivatives. And how does the booming narrator first use the word “insurance” in the CDS discussion?

NARRATOR: Others wanted them to be regulated like insurance.

In other words, this is presented as a minority view, well after “CDS = derivatives” is well cemented in the viewer’s mind, and not adequately explained. Even before getting to the way CDS are described in the documentary, given the common lumping of CDS with true derivatives, it would take a clear statement that CDS are tantamount to insurance, likely with some factual support, to overcome the sloppy use of terms.

In context, the narrator comment presents “CDS are insurance” as a minority position. Yet the implications of it being economically equivalent to insurance are fundamental to understanding why the product blew all the major guarantors up. Insurers receive money up front. They may not take enough money (they underestimate the risk and price it too low) and/or they don’t husband it well (among other things, they pay too much in bonuses and dividends, leaving too little for policyholders). If that happens on a big enough scale, they go bust when the payments come due (or alternatively, engage in all sorts of fraud to escape payment on legitimate claims). Satyajit Das, who was interviewed for this program, and others have stressed that if you required protection-writers to post enough margin to allow for jump to default risk, CDS would be uneconomical. Pretty much no one would buy it. Underpriced insurance produces over time losses to insurers, and insurers who write enough are pretty certain to hit the wall, eventually. And that is pretty much what happened.

So we have the show coming out firmly behind industry PR, yet denying it when challenged.

The next new charge they turn to is our remark:

Similarly, the account hews to conventional lines in making Goldman out to be the poster villain in the CDO market, yet merely in passing, has Deutsche Bank CEO Joseph Ackermann admitting to being one of the banks that stuffed Landesbanken like IKB full of toxic debt. Crisis junkies know that Deutsche Bank trader Greg Lippmann was the most aggressive middleman in helping subprime shorts like John Paulson create and sell CDOs designed to fail (and they had their own program, Start, which was a synthetic CDO series just like Goldman’s better known Abacus trades).

They argue that they thought this oversight was OK because Goldman made “millions” while Deutsche lost “billions.”

That isn’t true. Goldman lost $1.2 billion on mortgage securities. It appears to have made boatloads of money on a net short position 2007, but the subprime short traders at Goldman were eating more than half the firm’s total risk exposure, and Blankfein and senior management told them to cover their short. They appear to have traded the February 2008 swoon and March rally in subprime well, but they went into the worst of the crisis net long and took losses that more than offset their earlier short gains (admittedly, they were behaving badly in 2008 in scrambling to offload risk, but they had lots of company in that exercise).

The producers next turn to this charge:

The segment provides anecdotes of the crazed subprime lending, but fails to explain how mortgage backed securities and CDOs were linked to lending (or most important, that CDOs came to drive demand for RMBS, which in turn drove demand to the worst loans).

They next quote a former Georgia governor stating that mortgage loans were securitized tranche and a “feeding frenzy” resulted. That is not an explanation.

The next bit they quote was one I had pointedly avoided addressing because it so embarrassingly wrong and hate criticizing Chris Whalen, who is very sound when it comes to traditional banking:

Chris Whalen (Tangent Capital Partners): Let’s say I have a pool of mortgages– I have a thousand mortgages from California and I want to package these up. But I decide, “Well some of these mortgages may be subprime and I wanna buy a little bit of credit default insurance.
Martin Smith: And by doing that, you improve the profile—
Chris Whalen: In theory, yes.
Martin Smith: –of your CDO—
Chris Whalen: That’s right.
Martin Smith: So you can sell it better.
Chris Whalen: And I can go get a rating for it, too. I could go to Moody’s and say, “Look. I have laid off 2% of the risk on this portfolio. Shouldn’t I get a better rating than if I just sold the pool as it was?”
Martin Smith: So you take a lot of crap—
Chris Whalen: That’s right.
Martin Smith:–a lot of mortgages that are—
Chris Whalen: Hi– hideous crap.
Martin Smith: But you insure it and the credit agency says, “Hey. That’s a good idea.”
Chris Whalen: Yes. Yes.

I’m sure Chris knows the difference between a mortgage-backed security and a CDO, but listening to this, you’d have no idea they were two different beasts. And he is completely wrong about CDS being used within any CDOs (and only an extremely limited basis in RMBS in the late 1990s) to lay off risk and get a better rating (there are such things as synthetic and hybrid CDOs, where all or most of the assets are credit default swaps, but that bears no resemblance to what Chris is discussing).

There’s no excuse for including this garbled bit of an interview. I know Frontline spoke at length to at least one serious CDO expert who could have prevented misinformation like this being conveyed.

They also quote Gillian Tett saying that “many investors” took more risk (RMBS risk? CDO risk?) because they thought they had laid most of it off with CDS. I beg to differ. “Investors” ex hedge funds rarely use CDS. The reason is that it typically requires the creation of a unit that can post collateral and that in turn requires regulatory approvals for most fiduciaries.

And the use of the term “investors” obscures which player were the biggest holders of CDOs and users of CDS to reduce the risk: the banks themselves. We described in ECONNED The “investors” that did that in a serious way weren’t what viewers would consider to be investors. It was Eurobanks who (remarkably) retained or in some cases even bought AAA tranches of CDOs, then hedged the risk with CDS, which their firms treated as “freeing up capital” which was tantamount to discounting all the future profit of the trade (interest from the CDO less hedge and funding cost) and booking it in the current period. This was system gaming on a massive scale, and was one of the big culprits in the crisis (US firms like Merrill and Cit wound up in similar positions through different mechanisms).

So let me repeat: the program never makes clear the relationship between RMBS and CDOs, and it fails to explain that CDOs kept the subprime party going well beyond its sell by date, and were directly responsible for driving demand to the very worst mortgages.

The discussion of the second hour contains a remarkable display of cognitive blindness. We pointed out, as did many readers, that the program set up the false dichotomy of “bailout versus disaster”. In any complex situation, there are always alternatives besides taking a specific course of action and doing nothing. There was robust debate before the crisis of various options for dealing with insolvent banks, including the approaches used by Nordic countries in the early 1990s and forced haircuts of bondholders (Nouriel Roubini was early to argue for this remedy).

Yet remarkably, in trying to defend that the show did not convey that message, Mike Wiser repeats a quote from Phil Angelides, which was particularly prominent by closing April 24 program (emphasis mine):

The real question is, how did it come to be that this nation found itself with two stark, painful choices, one of which was to wade in and commit trillions of dollars to save the financial system, where we still end up losing millions of jobs, millions of people lose their homes, trillions of dollars of wealth is wiped away, and the other choice is to face the risk of total collapse.

I’m gobsmacked that Wiser can’t see that the section he quotes supports my point perfectly. He provides more material from Angelides, Born, and Stiglitz which all talk about how regulators had become lax well before the crisis. And he also boldfaces this bit:

NARRATOR: For three decades, Washington had steadily moved to a hands-off attitude towards Wall Street. And with little oversight, inside these black boxes, Wall Street had created a host of complicated but lucrative financial products.

This is completely besides the “bailout or disaster” message. This accepts and reinforces the meme that by 2008, the authorities’ hands were tied, they had no choice other than rescue the now-terribly-important financiers they had allowed to run wild.

This is nonsense. I’ve said, for instance, that I’m not convinced that Bear was insolvent, as opposed to illiquid (remember how Jamie Dimon kept crowing what a great deal he had gotten, until he seemed to realize that if he kept saying that, any future rescues might not have such generous subsidies?). Bear was initially offered a 28 day loan by the Fed, which, with no explanation ever given, was turned into an overnight loan, enough to carry the beleaguered firm into the weekend. Why no 28 day loan? That would have given the Fed and Treasury a ton more time to look at Bear’s books and make a much better assessment of the impact of a firm failure on the markets, particularly CDS counterparties, and make other provisions for dealing with any fallout if the run on Bear was warranted.

And as we mentioned in our original post, the “we lacked authority” is also bollocks. Regulators have powerful tools. Frontline reported Paulson told Wells Fargo that it would be declared capital insolvent if it didn’t play ball. They could have threatened the investment banks with halting or curtailing their direct access to Fedwire (in simple terms, the Federal Reserve operated payment system used to settle net interbank balances at the end of day and for large payments during the day). The authorities didn’t just lack will. They had been part of the problem and were unable to recognize how disastrous their policies had been until the evidence was undeniable.

I recognize the Frontline producers strove to adopt a polite tone in their letter and they may take umbrage at this reply. But the stakes are too high to allow for courtesy to dilute a message they seem unwilling to hear. This disagreement isn’t a matter of mere aesthetic or reportorial choices. Most people in this country are not very well informed about the financial services industry. As you can tell from the comments on the Frontline website, many take this series to be gospel truth. For Frontline to let the banking industry off easy does the public and the cause of reform a great disservice.

Banking maven Chris Whalen has a must-read piece on the reckless real estate risk taking underway at Wells Fargo, the sanctimonious #4 bank. While I sometimes take issue with Chris on his readings on capital markets related businesses, he is solid on his knowledge of traditional banking and also has access to very good intelligence in that arena.

Thanks to the crisis just past, we tend to think of banks as creating danger to bystanders via their over-the-counter trading operations: securitizations, CDOs, derivatives, all that stuff that is now loosely termed as “shadow banking.” But the US crisis prior to that was the S&L and the less widely recognized LBO debt meltdown of the early 1990s, both traditional bank lending. Even though economists airily wave it away as damaging but not catastrophic, it didn’t look that way at the time. Citibank nearly failed and the entire banking sector was really wobbly. Greenspan engineered an extremely steep yield curve to help banks earn their way out of the hole faster.

Wells is in the awkward position of being a monster traditional bank, when its big retail bank competitors, Citi, Bank of America, JP Morgan Chase, also have substantial capital markets businesses. Citi has long had a leading foreign exchange and money markets business, and has a corporate cash management operation which in and of itself makes it too complicated to fail. Bank of America absorbed Merrill. JP Morgan, in addition to having a large investment banking business, also has a huge derivatives/tri party repo clearing business. That means they have more diversified sources of earnings.

Whalen points out how real estate dependent Wells is. In this way, it is not unlike Lehman and Bear, subscale players in investment banking who put their chips on real estate as a way to (hopefully) grow faster and catch up with the big boys. The difference between the now-dead investment banks is that they were at a competitive disadvantage by being smaller (in a crude simplification, you have to have pretty close to 100% of the infrastructure of the leaders, and since there are real returns to scale, for instance, big network effects in trading, the further you are away from 100% of their trading volume, the worse your economics are. That means competitors can poach not just individuals but entire teams, since they will produce more on a platform with bigger activity). Wells isn’t so much at a competitive disadvantage via not being as big, but is instead a prisoner of having been overweight real estate historically.

As Whalen makes clear, Wells is engaging in accounting games to make it look better than it is. The San Francisco bank is hardly alone it that, but Whalen depicts it as worse in this regard than its peers. It is only taking losses on its least bad real estate loans, and using those to value the rest of its portfolio. On top of that, as we pointed out, Wells has been releasing loss reserves aggressively since early 2009, something which we suspect will prove to have been ill advised (oh, except for the senior executives who collected bonuses between then and now). And lacking other high margin businesses to earn its way out of its hole, Wells is doubling down in real estate lending, and on top of that, engaging in yet more dodgy accounting. Per Whalen:

There is an old saying on Wall Street that when a company does not say anything to investors and the analyst community, then it is all bad. Since the start of the crisis, Wells has made an art form out of failure to disclose, particularly when it comes to the credit loss, doubtful and past-due experience on the bank’s retained loan portfolio and related loss reserves. While Wells’ peers among the largest banks have increased written and oral disclosure regarding loan losses and related data during the past three years, Wells consistently has stonewalled the investment and analyst communities. Most recently, Wells has even defied a subpoena from the SEC, failing to produce documents for a formal investigation regarding possible fraud in the creation of residential mortgage backed securities that the bank sees as “inappropriate.”…

Several participants at the HW conference told me that Wells is literally buying market share by writing loans which are not economic, but then enhance current earnings by booking the estimated value of the “customer relationship” up front in the quarter when the loan is closed. If this type of accounting gimmickry makes you recall the days of the dot.com bubble, then you are on the right page.

Whalen argues that Wells will take a hit when Basel III is implemented because banks will no longer be able to afford to retain mortgage servicing rights. This is his only worry that I discount, because Basel II was never adopted in the US and there are reasons to think Basel III will not be either.

The picture is just as troubling on the commercial real estate side:

Wells has become the leading lender to commercial property developers. One of the oldest and most respected players in the New York commercial real estate community tells HousingWire that Wells is writing business that is at least half a point lower in cost than loans available from other banks and with far easier terms.

Note that you can lose more than 100% of your money on development lending. You foreclose, losing the value of your loan, and you have to raze the partly completed project. Back to Whalen:

But to the point about Wells Fargo, the bank’s aggressive lending to both retail and commercial borrowers could come back to haunt the giant lender in years to come. Many of those commercial property financings that the largest U.S. mortgage lending is putting on its books in the New York market are premised on the idea of rising lease rates in the next few years, but nothing could be further from the case.

In fact, say most of the commercial real estate developers I know in New York, lease rates are likely to keep trending lower over the next few years as the oversupply of real estate starts to become a glut.

Some of the most prominent office buildings in the city are half empty, including the showcase structure at 9 West 57th St. where your humble commentator is writing this missive. The developers are pulling the space off the market rather than accept the $50-60 per square foot that is commonly paid for prime Manhattan office space today.

The private equity firms that are buying these Manhattan commercial deals funded with loans from Wells Fargo are assuming that the Silicon Valley world of media is somehow going to soak up all of the empty commercial space in New York City…

But the sad fact is that most of the large financial institutions I know are pushing back against rent increases in major New York properties – and moving offices to reduce expenses.

This has the smell of something that will end badly, but it may take a couple of years to play out. As Whalen said, stay tuned.

I’m late to write on a terrific and largely unnoticed paper presented at the Federal Reserve Board’s research conference on “Central Banking: Before, During and After the Crisis” in late March (hat tip Michael C). “A Proposal for the Resolution of Systemically Important Assets and Liabilities: The Case of the Repo Market” by Viral V. Acharya and T. Sabri Öncu could be more accurately titled, “What Financial Reform Missed.”

As Richard Bookstaber in his book The Demon of Our Own Design pointed out before the crisis, in a tightly coupled system like our modern financial markets, the most important step in reducing risk is reducing the tight coupling, meaning the ability of processes to move forward so quickly that they can’t be interrupted. The circuit breakers introduced in the wake of the 1987 crash are an example of a mechanism that reduces tight coupling. Bookstaber warned that in tightly coupled systems, measures implemented to reduce risk that failed to address the tight coupling typically wound up increasing risk (as indeed took place in the runup to the crisis).

Thus if you were to take a Bookstaber view of the world, you’d look first at reducing the interconnectedness of the financial system, and the biggest culprit is counterparty exposures. And it isn’t hard to make a case that the biggest source of counterparty exposures is repo financing. For newbies, Repo is short for “sale with agreement to repurchase.” In a repo, a party that owns a high-quality bond borrows against it in a pawn shop-like procedure, by selling it to another party with an agreement to buy it back it at a specified future date, including interest. Repos are typically overnight, and funds can thus
be readily redeemed if the repo lender decides not to renew the repo. (Operationally, it’s more complicated than that, since most repos are “tri-party repos” with banks like JP Morgan or Bank of New York acting as middlemen). Needless to say, the big global banks rely heavily on repo to finance their securities positions and collateralize their derivatives exposures.

The authors politely point out that the new Dodd Frank resolution powers would have done squat to prevent chaos in the wake of the Lehman implosion. Readers may recall that one disaster-in-the-making was the run on money market funds triggered when the Reserve Fund, a fund that invested heavily in Lehman commercial paper, broke the buck, leading investors to start to withdraw funds from other money market funds en masse. Money market funds are major providers of repo funding; the resulting run on repo would have been tantamount to a run on the major dealer banks. Not only would the Orderly Liquidation Authority under Dodd Frank have been unable to address the panicked withdrawals from money market funds, it is also unable to deal with other aspects of the Lehman failure (insolvency proceedings outside the US, some of which had systemic impact, the panic surrounding which hedge funds were caught with accounts frozen in the collapse of Lehman’s London broker-dealer).

And this is only the beginning of the critique of the OLA. The authors identify other shortcomings: the process may not move quickly enough, leading to anticipatory runs, not just on the firm at risk but also similar firms; counterparties of insolvent firms could lose money (what a concept!) and therefore contagion risk remains.

The paper argues that risk is better viewed as existing on the level of systemically important assets and liabilities rather than at the firm level. This is a fundamental repudiation of the current regulatory regime, which focuses on individual institutions and looks primarily to having higher levels of capital and liquidity as the way to insure systemic safety. But given the way prices of assets and liabilities can move adversely in a short time, even the increased risk buffers set forth in US and international regulation look to be inadequate. Stanford professor Anat Admati maintains that banks should hold 20% equity; Steve Waldman has argued for 30%.

Acharya and Öncu instead call for developing resolution mechanisms across a large range of markets:

Systemically important liabilities (SILs) can be defined broadly as those liabilities of highly-leveraged entities that are assets of other highly-leveraged entities and therefore when faced with haircuts in case of default would trigger runs on other entities. Examples of SILs include deposits, repos and over-the-counter (OTC) derivatives. Similarly, systemically important assets (SIAs) can be defined broadly as those assets that are either SILs of other highly-leveraged entities or potentially illiquid, high risk assets financed through SILs. Examples of SIAs include exposures to SIFIs [systemically important financial institiions], asset-backed commercial paper (ABCP) and risky repo collaterals such as mortgage-backed securities (MBSs). To the extent possible, the set of mechanisms should be expanded to cover as many classes of systemically important assets and liabilities as possible.

The authors argue for reducing risk in each of these areas via a variety of mechanisms: central clearing with adequate margining, deposit insurance, resolution mechanisms targeted to each asset type. The advantage is that by addressing only the systemically dangerous parts of financial firm balance sheets, the other pieces can be handled through existing legal/regulatory mechanisms.

They propose creating a repo resolution authority. Right now, effectively all repo is exempt from automatic stay in bankruptcy. In practical terms, that means repo lenders can grab the collateral when a firm fails. The authors would restrict that mechanism to only the very best collateral, namely Treasuries and agencies. The rest would be subject to the repo resolution authority, which would give a quick payout based on a conservative estimate of the collateral value. The authority would liquidate it in reasonably short order (target of six months) and would pay out more or claw funds back based on the actual amount realized).

Even if you don’t necessarily agree with the conclusions (the authors make a strong case as to why their proposal is less bad than alternatives), it’s worth reading for its history of the repo market and discussion of the role repo played in the crisis (I have a minor quibble in that it treats the fall in the value of repo collateral as driven by liquidity concerns, when in fact AAA CDOs were grossly overvalued prior to the crisis and correctly went to 95%+ haircuts when Lehman failed, which turned out to be a pretty good estimate of what they were ultimately worth).

It is nevertheless frustrating to see a useful paper like this appear so long after the reform horse has left the barn. Once again, complexity, opacity, and leverage have worked to the advantage of the banks. The authorities were caught flat-footed during the crisis, and reform proposals were wheeled into place when no real investigations had taken place. We are likely to bear the consequences of this rush to judgment sooner rather than later.

Regular NC readers have seen us repeatedly invoke the work of Andrew Haldane, the executive director of stability of the Bank of England. His thoughtful and original work on the risks and costs of our financial system have provided serious ammunition for reform advocates.

At the recent INET conference in Berlin, Haldane recapped some of his recent observations under the rubric of an arms race, in which efforts of individual players to improve their own position wind up leaving everyone worse off.

I have one quibble with his presentation. Haldane depicts the increase in returns to global banks post 1990 as due to leverage. That isn’t entirely true. The early 1990s saw the rise of the over-the-counter derivatives business, and big banks had an advantage over securities firms, since it took a big balance sheet and a decent position in the related cash market to be successful. The rise of derivatives gave the behemoth banks a new business they could enter on the ground floor. And while derivatives are leveraged, the real attraction to banks was the opacity, in that dealers could load a lot of margin into the various risk attributes without the customers being able to see what a bad deal they were getting. The exceptional profitability of OTC derivatives provide a big boost to bank bottom lines, and attributing all the increase to leverage misses an important shift in the mix of business at these players.

This is a bit of a sleeper of a presentation from the recent INET conference. It was from a session titled “What Can Economists Know?” which might cause willies among non-economists as being too much about epistemology and not enough about issues that might give insight, say, into why the overwhelming majority of economists in early 2007 thought a global financial crisis was impossible.

This talk by Gerd Gigerenzer is about heuristics, and why they are often superior to the more formal methods of analysis and decision-making fetishized by economists. He argues that one of the big things that economists miss is how to approach decision-making under conditions of risk (when probabilities of outcomes can be estimated with some accuracy) versus uncertainty (when you can’t estimate the odds of outcomes and/or may face unknown unknowns).

We normally limit our awards of the of Frederic Mishkin Iceland Prize for Intellectual Integrity to academic work, since the economics discipline seems increasingly to hew to the James Carville theory of motivation: “Drag a hundred-dollar bill through a trailer park, you never know what you’ll find.” However, we’ve been unduly narrow in considering who might be deserving of this recognition, so we are bestowing the award to Promontory Financial for its work on MF Global.

From our post inaugurating the prize:

The Academy Award winning documentary Inside Job depicted how the fish has rotted from the head in the economics academy, using former Harvard dean Larry Summers, former Fed vice chairman Frederic Mishkin and Columbia Business School dean Glenn Hubbard as object lessons.

Despite our publication of Academic Choice theory, which provides more formal support for the Inside Job observations, we’ve seen perilous little in the way of a change in attitudes from within the academy. So to make a wee additional contribution on this front, we are inaugurating the Frederic Mishkin Iceland Prize …

The reason for highlighting the intellectual integrity, or more accurately, the absence thereof, among many well paid academic economists it that they are paid well to say good things about dubious policies and organizations.

A direct analogy to the Mishkin paper praising Iceland’s financial system is reviews produced by private consultants acting as supposedly independent reviewers, or what amounts to an outsourced regulatory function. The glaring problem with this construct is that the reviewers are hired by the companies that need to get a clean bill of health in the end. Adam Levitin described how this works in the context of the OCC foreclosure reviews, which operates on this template:

By far the most interesting bit in the draft C&D [cease and desist] order is the bit requiring the banks to engage independent foreclosure review consultants to review “certain” foreclosures that took place in 2009-2010. There is no specification as to which foreclosures are to be reviewed or precisely what the standards for review are. But that’s all kind of irrelevant. Who do you think the banks are going to engage to do these reviews? Someone like me? Not a chance. They’re going to find firms that signal loud and clear that if they get the job, they won’t find anything wrong. It’s just recreating the auditor selection problem, but without even the possibility of liability for a crony audit.

Frankly, this sort of regulatory outsourcing is pretty astounding–the OCC has resident examiner teams at the major servicer banks. Shouldn’t they be the ones auditing the internal controls and performance, not a third-party compensated by the bank?

Now to the immediate example, Promontory Financial. The firm is deeply involved in the OCC foreclosure reviews and also the author of a glowing report on MF Global’s risk controls in May of 2011, a mere five months before the firm failed. Promontory has managed to establish itself as a blue chip provider of post scandal review processes (it’s often hired by boards to do forensics after rogue trader scandals). It was founded by former Comptroller of the Currency Gene Ludwig and has many former regulators on its staff. That’s a tad ironic, since one of its bread and butter businesses is based on regulatory arbitrage. Promontory is in the business of brokering deposits, which is taking deposits that exceed the FDIC limit of $250,000 per institution and spreading them around so as not to exceed the limit. It’s not clear why this should be allowed. Well off people can achieve the same results by buying bank certificates of deposit, or if they want liquidity at low risk, they can buy Treasury bills. The FDIC is not prone to pointed statements, but you can clearly see the agency’s polite unhappiness about this practice and Promontory’s role:

Despite the regulatory scrutiny that brokered deposits have received since the savings and loan crisis, the use of deposit brokers is recognized as a legitimate method of obtaining deposits. Although many brokers specialize in locating for their customers the highest rates of interest that are being paid on certificates of deposit, our discussion here concerns the subset of brokered funds that are used to expand deposit insurance coverage beyond the normal limits to much higher levels. The insurance-related risks associated with this form of brokerage are familiar. First, this form increases the exposure of the federal deposit insurance fund. Second, this form of brokerage does not subject banks to the market discipline that is ordinarily brought to bear by larger depositors when they are unable to obtain full insurance coverage….

Brokered deposits seemed to gain some respectability when the Promontory Financial Network (Promontory) launched the Certificate of Deposit Account Registry Service (CDARS) in January 2003. Promontory was founded by former Comptroller of the Currency and former FDIC board member Eugene Ludwig. Its board of directors includes a former vice chairman of the Federal Reserve Board, Alan S. Blinder, and a former FDIC chairman, L. William Seidman. Even though the principals of Promontory are quick to contrast their program with traditional brokered deposits,24 a skeptic could just as quickly disagree and argue that the system is nothing more than a well-connected brokered-deposit service. Nevertheless, the new service has met with approval from most observers.

Promontory was engaged by MF Global as part of a 2009 settlement agreement with the CFTC over alleged wheat futures trading abuses involving a former employee. The Financial Times obtained a copy of the May 2011 presentation via a Freedom of Information Act request (separately, I’m appalled that any regulator would consider a short Power Point presentation to be an acceptable end product. Consultants have done a great job of training client to accept deliverables that are less than complete). The document extols the leadership of Jon Corzine, who took charge in March 2010 (click to enlarge).

Promontory responded to the Financial Times by asserting that its assignment was narrowly focused and that its services were unrelated to sovereign debt trading or controls for segregated accounts. Yet Promontory said it only reviewed reports of risk committee and operational risk committee meetings in October, November, and December 2010, and also reviewed the meetings of the credit risk committee. That is inconsistent with its description of the scope of its work per the May document (click to enlarge):

The red flags raised by the fired chief risk officer, Michael Roseman, took place during that period. His February 2 Congressional testimony discussed how MF Global’s exposure to Italy, Spain, Portugal, Ireland, and Greece were $500 million total in March 2010, and he began receiving requests to raise the limits. He acceded to Corzine on a $1.0 billion total gross limit on exposure. By mid-September, the total positions had grown to between $1.5 and $2.0 billion, and the firm started to consider repo to maturity transactions as a way to boost earnings (the Italian government bond trade that played a key role in bringing down the firm was an RTM transaction). Roseman was now uneasy.

By late October, the positions ranged between $3.5 and $4.0 billion and Roseman was asked to increase the total limit to $4.75 billion. He was concerned about liquidity risk, but his risk scenarios were dismissed as implausible by Corzine and some board members. The Board
eventually approved the request to raise the limits. In January 2011, Roseman was fired and the role was redefined to make it less powerful.

It’s pretty hard to swallow that Promontory was not aware of the Roseman contretemps. The ouster of a chief risk officer is a major step and the downgrading of the role stands in direct contraction to Promontory’s claims that the “tone at the top” was supportive of tough risk management and controls. Firing Roseman over standing in the way of what was hoped to be beefing up a profitable trade and making sure his successor would not be able to make similar waves send a powerful message throughout the firm as to what really counted, and it wasn’t worrying about risk.

So the firm that gave an “all clear” review to MF Global is at the heart of the OCC foreclosure review process, and it isn’t hard to imagine it will give its bank cronies a pass too. That’s what you’d expect of a system that is run by the elites for the elites.