Category Archives: Risk and risk management

Guest Post: The 10 Most Systemically Risky Financial Firms in the US

Yves here. As we noted in January,

Treasury Secretary Timothy Geithner is trying to duck the assignment given the Financial Stability Oversight Council under the Dodd Frank legislation, namely, that of identifying “systemically important” financial institutions….The Treasury devised a list of banks it subjected to stress tests; conceptually, how is this process any different?

I’m pleased to see four professors from New York University’s Stern School take up this task. And they end their analysis with a rebuke:

This is the easy part for the Financial Security Oversight Council. The tough part is to then design efficient regulation that discourages the build up of excessive risk.

By Viral Acharya, Thomas F. Cooley, Robert Engle, and Matthew Richardson. Cross posted from VoxEU.

As part of the US policy response to the global crisis, the Dodd-Frank Financial Reform Act calls for regulators to identify systemically risky financial firms – the sort that took the US financial crisis global. But how to identify these firms remains unclear. Some claim the task is impossible. This column begs to differ and names the 10 most systemically risky financial firms in the US.

Gillian Tett on Losses at Central Banks

Is the old Gillian Tett back? The one-time Financial Times capital market editor has taken to writing less frequently (understandable now that she has head the US operation) and less intrepidly (much of her commentary was prescient, particularly on my pet topic, collateralized debt obligations).

But her latest piece sounds a wee warning, and it’s one we’ve commented on as well, namely, that central banks are vulnerable to losses, and just like the banks they mind, may need a rescue by taxpayers if the err badly enough.

Her object lesson is the Swiss National Bank. Unlike most central banks, the SNB is quite transparent, and publishes periodic statements of the value of its assets on a mark to market basis. The usually conservative SNB made a uncharacteristically aggressive move last year, intervening in currency markets in an effort to suppress the value of its levitating franc.

Even though the locals applauded the move, the central bank was outgunned by currency traders and threw in the towel mid year. As the swissie continued to rise, the bank showed losses at the end of 2010 of SFr 21 billion. The only saving grace was that the gains on the bank’s hefty gold positions exceeded the damage. But that does not reassure its shareholders, who have become accustomed to annual payments out of bank “profits”, and are concerned that the profits this year will be too meager for them to enjoy their customary level of income.

Haldane Unto the Breach

We remarked before that attempts to nobble Mervyn King would soon bring other UK bank reformers out of the woodwork, and we have a confirming sighting today, via a puzzled tweet from @EconOfContempt: Strange op-ed by Andrew Haldane in the FT. No one is really pushing the argument that he’s trying to shoot down EoC […]

King Dinged

Soon-to-be-unemployed sports team managers the world over know what it means when they receive an affirmation of full confidence from the club chairman. Accordingly, we know roughly what to make of this: ‘The Bank of England has credibility,’ said Osborne (pictured). ‘I have complete confidence in it.’ The chancellor will not alter the 2% inflation […]

“Project Merlin” keeps on giving

Well, it was obvious that this bullet point from the Merlin agreement: implementing and applying European and international rules to create a level playing field in both policy and practice whilst protecting and maintaining the particular strength of UK financial services, and without pre-judging the outcome of the Independent Commission on Banking (IBC). was a […]

Boeing’s Multi-Billion Outsourcing Fiasco

We’ve repeatedly said that offshoring and outsourcing are often not the big cost-savers that the industry promoting them, Wall Street, and the stenographers among the business press would have you believe.

Direct factory labor is typically just north of 10% of the cost of most manufactured goods; for cars, we are told it’s 13%. Even if you can extract meaningful savings there, you have significant offsets: the upfront cost of re-orgainzing production (which in the outsourcing scenario include hiring costly outsourcing “consultants” and paying attorneys to paper up the deals), higher ongoing managerial costs, higher shipping and related inventory financing costs. Yes, there are cases like Apple where outsourcing has been a big success, but there are also others where the benefits have been underwhelming and have come at considerable costs to US workers, communities, and the economy (see a very good long form discussion by Leo Hindery).

Moreover, these cost savings come with higher risk.

Our Response to the Center for American Progress Objection to Our Post on Its GSE Reform Proposal

Readers have hopefully had the opportunity to read “The Center for American Progress Objects to Our Critique of Its GSE Reform Plan”, which contained an e-mail by David Min of the Center for American Progress presenting its bones of contention.

While we appreciate that the CAP has gone to the trouble to communicate with us directly, we are not persuaded by its arguments.

We’ll recap the e-mail and then address the issues individually:

1. You need to have some form of government guarantee to have a mortgage product that is fair to middle class consumers (his writing is a bit confused, at one point he uses “no” when he means “yes”, but this is the drift of his gist).

2. We’ve mistated who would eat “catastrophic risk” under the CAP scheme, since the Catastrophic Risk Fund and the new mortgage insurer investors would take losses first

3. Not all “banks” are behind or support the CAP proposal

4. This plan is the best option for the public and less lucrative to the financial services industry than a “privatization” model

Let’s dispatch these arguments in order.

The Center for American Progress Objects to Our Critique of Its GSE Reform Plan

We received this e-mail from David Min on February 11 about our post titled, “Wall Street Co-Opting Nominally Liberal Think Tanks; Banks Lobbying to Become New GSEs.” That piece took a dim view of a GSE “reform” proposal from the Center for American Progress, which we pointed out is “THE mainstream Democratic think tank for Congress and the administration”.

We must note that this message mischaracterizes some aspects of our post (for instance, we discussed at length in the our post why we thought the catastrophic risk fund would come up short, and this e-mail does not address our argument). Nevertheless, we thought readers would be interested in his message. From Min:

Shoddy Anti Derivatives Reform “Study” From Firm That Falsely Claimed Top Academics as Advisor

t’s high time that reporters start lifting the veil to look at exactly who is behind the “research” put out by think tanks. Even drug company research, which many members of the public now know to view with some doubt, at least has an actual investigation of some sort underpinning it (the doubts about them usually involve study design and/or interpretation of results). Think tank end product should be taken with even more salt, since it too often is the intellectual equivalent of a CDO: taking junk ideas and dressing it up in a structure and a brand name so that most people will regard it as AAA-rated thinking.

A piece by Andrew Ross Sorkin at the New York Times is an all-too-rare and badly need hard look at the less than savory process of creating impressive-looking arguments in favor of special-interest serving policies.

Deep T: Australian Banking System on Unstoppable Path to Collapse or Government Bailout

Yves here. This long and informative post on the pending train wreck in the Australian financial system might seem to be too narrow a topic for most Naked Capitalism readers, but it makes for an important object lesson. Australia managed to come out of the global financial crisis largely unscathed because its banks did not swill down toxic assets from the US (chump quasi retail investors were another matter) and it benefitted from the commodities boom.

Nevertheless, one might think its bank regulators might see what happened abroad as a cautionary tale. Mortgage debt took center stage in the crisis, and Australia is in the throes of a serious housing bubble. Yet as this post describes, the regulators seem asleep at the switch as to one of its major drivers.

By Deep T., a senior banking insider who is fed up with his colleague’s reliance on public support. Cross posted from MacroBusiness.

Previously I have posted on how the major banks recycle capital in The Capital Rort. I want to extend that subject by showing how mortgage ‘rehypothecation’ in Australia has led to the massive expansion in liquidity available to Australian banks which is at the root of the mortgage affordability issues in Australia and has put Australia’s banking system on the unstoppable path to collapse or government bailout.

Exclusive: Harvard Economists Prove that Bankruptcy is Mythical

This document was leaked to Naked Capitalism by a university economics student who has asked to remain anonymous

Background

Mixed reactions have followed the recent brilliant demonstration by a pair of young Harvard economists that bankruptcy cannot occur. While the community of economists has generally affirmed the correctness of the reasoning at issue, various individuals already distinguished for their carping attitudes have willfully misunderstood the theorem; for example, the controversial blogger Yves Smith has publicly labeled the proof ‘yet another demonstration that economics is the ugly stepsister of astrology.’

This sort of obscurantism is hardly surprising – as Ludwig von Mises pointed out in 1956 in The Anti-Capitalistic Mentality, ‘economics is so different from the natural sciences and technology on the one hand, and history and jurisprudence on the other hand, that it seems strange and repulsive to the beginner.’ Ms. Smith is evidently one of the people who experienced as a student this natural but irrational feeling of aversion, and has since refused to make the effort to think with true economic rigor.

The insight incorporated in the recent theorem is not difficult to explain, although for a full understanding, knowledge of the relevant mathematical techniques is, of course, essential.

Questioning Goldman’s “Market Making” Defense

The notion underlying the Volcker rule is that too big to fail institutions have a government backstop and therefore their activities should be restricted to the types of intermediation that support the real economy. The taxpayer has no reason to fund “heads I win, tails you lose” wagers. Various firms, most notably “doing God’s work” Goldman, has tried to play up the social value of its role, whenever possible wrapping its conflict-of-interest ridden trading activities in the mantle of “market making”.

A big problem in taking about market making versus position trading is that, Goldman piety to the contrary, the two are closely linked. Even though all the major dealer banks created proprietary trading operations to allow top traders to speculate with the house’s capital, plenty of positioning also takes place on dealing desks. While dealers are obligated to make a price to customer (well, in theory, it’s amazing how many quit taking calls in turbulent markets), they are shading their prices in light of how they feel about holding more or less exposure at that time. And the dealing desks, just like the prop traders, are seeking to maximize the value of their inventories over time.

A Goldman discussion of risk management presented yesterday (hat tip reader Michael T) gives reason to question that much has changed on Wall Street regarding the role of position taking, now taxpayer supported, in firm profits.

Satyajit Das: Derivatives Regulation Dance

By Satyajit Das, the author of “Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives.” Cross posted from Wilmott

A question of values …

Derivative contracts are valued on a mark-to-market (“MtM”) basis. This requires valuation of the contracts based on the current market price.

OTC derivatives trade privately. Market prices for specific transactions are not directly available. This means current valuations rely on pricing models.

There are significant differences in the complexity of the models and the ability to verify and calibrate inputs. More complex products used sophisticated financial models, often derived from science or statistical methodology. There are frequently differences in choice, exact factorisation and even numerical implementation of the models. Different dealers may use different models.

Some required inputs for the models are available from markets sources. The nature of the OTC market and the limited trading in certain instruments mean that key input parameters must frequently be “estimated” or “bootstrapped” from available data. In certain products, the limited number of active dealers means that “market” prices are sometimes no more than the dealer’s own quote being fed back after being collated and “scrubbed” by an external data provider. This is referred to prosaically as “mark-to-myself”.