Do you remember this time last year? Banks were down 12-18% compared to all stocks and had been falling since February and by the Summer short-sellers were on message. The Sub-prime crisis was deemed to have started in July. By November, writedowns totaled a few tens of $billions with total loss forecasts of $2-400bn. The ratings agencies had downgraded only a $100bn or so,unyil following Moody's new models announced August 16, after which it became clear that the vast bulk if not all mortgage backed assets were to be severely downgraded. Bankers were scrambling to uncover what their own exposures were and guilty colleagues were no doubt hiding the figures. But then, when they could agree the totals, how to mark them to market? The illiquid ABX index covering maybe $1.3tn of ABS and CDOs circulating but not getting many deal prices was showing falls in 3-4 months of as much as 60% for AA when junk-rated was 80% off! That just seemed to reflect forced-selling, so clever guys said let's examine the fundamentals; where are they? Delinquency rates were up but 90-day overdues had not yet risen much, doubling or tripling from 0.3% or so for some banks did not seem like a whole lot, except steep compared to any earlier known recession shocks!
A Bank of England study said guys, the models pricing these bonds are extremely sensitive - if you tweak one tiny part hey presto the value is up 35% and maybe you've just gamed the rating! It was clear that to tinker on fundamental and values would just crash to the bottom. Ratings agencies could keep an eye on a load of SIVs but found that so far none were yet threatening collapse until Moody's new model (to reflect fast rising mortgage defaults) based downgrades from August onwards (causing a tsunami of asset values wiped out) and when one hedge Fund, not a bank, bravely said it was valuing all its basement tranches to zero. Maybe that was part of a short-selling strategy or let's torch it and claim on the insurance - but I doubt that. The big monolines had seen their shares crash, but not because of claims so much as their balance sheets don't make sense! Yes indeedy, the accounting for all this was shot. If you are using 30 year old accounting systems that have long exhausted their capacity for more details and definitions, then the real stuff is somewhere in the front or middle office accounts, or just in spreadsheets. Recall yesterday Barclsy going to court to get a bunch of contracts excluded from the spreadsheets (28,000 cells) that formed the basis of their purchase from the undertakers of Lehmans US.
Then through the Winter and into the Spring, banks were adjusting their reported exposures, re-vising massively the mark-to-toxic numbers just days or hours before Q407 and Q108 result releases. The Japanese had a strong right not to M2M and use fair value based on hold-to-maturity so US and European firms followed suit and found various ways of doing similar that continued to be argued back and forth with the regulators warning about taking all that's off balance sheet back on or formally moving the toxic from trading to banking books. Shareholders all the while got little of transparent detail in the published accounts covered over with confident assurances. But, all knew that the market was dead. Some said let's just bury the toxic and dig it up again in maybe a few years from now. Those banks like UBS who put their hands up when the value of ABS performance was publicly reported in its retail investment funds, and then Citigroup, whose collateral managers grabbed Bear Stearns ABS/CDO collateral and sold the stuff at fire-sale thereby busting their own bank's assets too, these got slaughtered in their equity capital. With all the uncertainty about true accounting and risk downgrades threatening no wonder interbank liquidity dried. But in the last quarter the quality of detail in banks reporting their toxic exposures has not improved and does not seem to be doing so even now! Is this not also at the heart of the problem?
Today, analysts and FT and others look at CDS spreads as indicators of likely revival of interbank lending. And good to hear the outgoing Chairman of RBS (slogan: "make it Happen")say it is very likely that existing shareholders will take up their first refusel of £15bn new 12% preference share issue (after £5bn goes to governemnt) because they represent a great opportunity for profitable investment (subject to general shareholder vote who have mixed feelings?). When the deal was struck between bank and government it took a bunch of Credit Suisse analysts hours to figure out on a little plastic table in a corridor of No.10 working into the night going through RBS's books on laptops with spreadsheets! We trust adequate and true detail is now in the prospectus. We also have to await the responses of the ratings agencies to see if government stakes in banks (subject to shareholder approval) will result in risk upgrades despite the onrush of recession and 30% falls in banking activity and capacity that is reducing bank profits considerably, if the most recent quarterly results can be thus aggregated. Some profits are only that thanks to tax credits and some losses only that because of further toxic asset writedowns.
Can shareholders confidently buy, or the ratings agencies up-grade, banks before knowing exactly what is happening to the toxic assets and what precise exposure types those 'assets' are? They may be CDO tranches or derivatives thereof. They may be actual securitization tranches or loans to SIVs, guarantees, underwriting, insurance, potential legal risks including over toxic assets that were transferred off the books into customers' accounts, investment funds, and of course whatever is in arm's length remote vehicles that banks originated or added to with bits and pieces of other firms' securitizable assets. Is US TARP still going ahead now that the funding for it is down $250bn for US SARP?
The light at the end of the tunnel will only be when banks' reserve capital gets reinflated with shareholders' equity in ordinary shares and that seems far off until the toxic assets are Tarp'd, buried, sold or quarantined and legal and reputational risks are clarified and quantified. Everywhere flexibilities are creeping in to how banks mitigate or dilute mark-to-market prices wih hold-to-maturity, not-for-trading, turbulence-adjusted, fair values. Apart from the light at the tunnel's end being an oncoming R-train, or merely another better lit tunnel, there are also, to stretch the analogy, tunnels within tunnels. This may be a good time to be a money-broker. Money-brokers sit in the innermost tunnel of the interbank markets broking at narrowest spreads between banks anonymously until settlement details are exchanged when done deals may get cancelled or not once the lender knows the risk grading identity and name of the borrower. And therefore the moneybrokers may know better than others if interbank liquidity is improving?
The not so plain fact is that all round the wholesale financial markets are shredded whereby we cannot really know what explains the directions of cash markets in terms of investors real views and requirements. Much of the blame for the present crisis had been laid at the door of liberalisation such as Bill Clinton's repeal of Glass-Steagel and of banks thereafter engaging in conflicts of interest between investment and traditional banking and shifting too far into consumer credit and mortgages and asset securitization because corporates borrowed less and also went off-piste when borrowing by doing so via bond issues rather than bank loans, and when deposits failed to grow as households and corporates savings rates fell with falls in government borrowing, and then came the vast growth of shadow-banking and banks' determination to get a share of that action and engage more aggressively in proprietary trading.
What then of classic rules for shareholder investment fundamentals when so much is going on out of the glare of regulatory transparancy or of economic assessments of the banking sector when so much is off-balance-sheet and in alternative investment funds of the shadow-banking community? Equities are least traded OTC unless one counts as OTC markets that are internal to large instutional investors, trading internally between portfolios. Regulators and stock exchnages at one time tried to ban this, along with institutions having direct access to broking markets, crossing networks, dark pools, and tried to ban algorithmic black box trading, now supported by low latency arbitrage networks. Shadow and dark and black box stuff are so-called by being unregulated, not volume measured or quality reported, but at least in traditional OTC markets like money markets and FX counterparties usually know each other in the back office settlement if not always on the deal tickets. They cannot know all the day and own-account private traders who have access to derivatives and short-selling instruments and who may be proxies for bigger fish gaming and arbitraging end of day and just after closing prices. There are so many modern 'dark pools', internal and external crossing networks and exclusive club high tier private exchanges for transacting large sizes away from the main regulated markets to minimise market impact and hide market signals. Market impacts are also reduced but may be signalled ex post to the rest of the market in regulated derivatives exchanges. A great deal of portfolio restructuring is by buying and selling contracts in derivatives exchanges to avoid resort to the underlying cash market. Then too we learn that short-sellers via puts, EFDs, and inverse ETFs are worth about 30% of stock market turnovers and that a few $trillion a year or 40% of hedge funds' $3tn are devoted to shorting and that double-figure percentages of bank stocks have been regularly loaned out to short-sellers in recent weeks by money market funds, custodians, and institutional investors, which is like renting apartments to people you know will trash the premises at a cost to you way above the rent and deposit.
Stock exchanges and Regulators have tried over the years to defend the quality of markets, but for the last two decades these quality issues have all been disregarded in the interest of greater competition in market infrastructure to encourage innovation and ever lower transaction costs. Exchanges, banks, broker-dealers, market-makers, the major well-establish OTC markets, all are disintermediated and shredded to the point that even when Bloomberg and Reuters and the biggest Exchanges can still report reliable market prices, the fact is that we can no longer know what the quality of markets are generating those prices. Brokers and analysts read the crib sheets and media newss and give interviews to the FT and WSJ and join the talking heads on the tv about what sentiments pushed or pulled prices but much of this is just circular and almost subjective with insufficient or timely post-trade clearing and settlement data to know what was really happening - was the buying or selling by institutional investors, or private investors or hedge funds, short-sellers and day-traders? Is the sell-off due to a few big guys or lots of little guys, or delayed fed-through from derivatives markets or banks' de-leveraging? Does it matter if we don't klnow precisely. We knew better when market-makers and other broker-dealers spoke to buyers and sellers by phone.
In principle the more reasons that investors and traders have for buying and selling and the more choices on offer and the more regulated news the better because it is less possible for one or a few alone to move the market. But we need to be able to check that market quality is within acceptable bounds and that has certainly moved beyond today's regulators to ensure. The SEC is very impressive, but when it tried last time out to get more hedge funds transparency it was defeated in Federal court.
All that may have changed now that the general public and politicians are angered by what they see as dysfunctional amrkets and irresponsible players in those markets. The scope for legal remedy is enormous, and the sums involved are huge. We may now be entering a period of a decade or so when regulators who have hitherto deployed guidance principles and been reluctent to fix rules or make civil or criminal laws will be led by what the courts decide and even try to pre-empt those decisions now that governments share the liability of the banks and others.
Against all this turgid background, it seems to me and I'm sure many others, that a bigger priority has to be urgently given to TARP solutions and others directly related such as money market and credit derivative exchanges. Payouts of Lehmans CDS liabilities may be currently estimated at $6bn only, but law suits on CDS and the underlying concerning Lehmans are estimated by some lawyers to be hundreds of $billions, in fact nearly $1trillion! Luckily when JPM took over Bear it could cancel a lot of the liabilities between them. Precedents for what happens when this is not done includes Japan in the '90s. The Japanese and SE Asian banks took years to work through loss provisions after their crises in the '90s. If the the litigation culture and legal system of Japan had been anything like the US, the motivation to do more and faster to salve the problems would have been immense. In Japan the economy continued to suffer because household mortgage borrowers remained saddled with enormous lifelong and even triple-generation debt.
We do not have a functioning TARP system anywhere yet, though in the US new clearing standards have been written for CDS and DTCC, Chicago exchanges and others are intending to clear CDS as is Euex in Europe, and others. Handling the underlying toxic waste that TARP was intended to do appears to be languishing. It may be revived given Paul Volker's strong support for it, given that he is one of Barack Obama's innermost circle, in a speech in Singapore on Tuesday, but just as a third of the TARP money was grabbed for SARP style bank bailouts. John McCain, if he wins on 4 Nov, will kill TARP. Meanwhile, various writedowns, settlement, fire-sale auction and accounting flexibilities are handling the toxic assets. In Switzerland,
UBS's $3.9bn Gov pref share money goes into a work-out vehicle for the bank's remaining $60bn toxic assets. In Belgium, Fortis's Eur43bn toxic assets were left behind when the bank was dismembered by 3 governments and given to the remaining rump of the bank's board. The Fortis bank's spreadsheeting risk team simply wrote senior tranches off by 75%, and mezzanine & basement tranches by 90% to a total of Eur10bn for the board to work-out on! But, in these and other such cases also no-one is yet looking publicly at the toxic assets in detail. Are they sub-prime ABS total return instruments such as UBS dumped into pensioners' and other retail investment funds! No details either are forthcoming from banks as to precise details of the various types of exposure they have to toxic assets. Banks' quarterly and annual accounts treat these as notes to the accounts in crude tables even though from a shareholder's point of view they remain the single biggest factor determining the banks' share prices. Here again is where the regulators, in this case the accounting standards bodies, should be insisting on more public detail - after all there has been plenty of time to get models and systems fixed and reporting sorted. After the carnage by now what more is to be gained by not fully explaining the toxic parts of the accounts and showing fair value model and stress test and over-the cycle and point-in-time revenues and forecasting fundamental valuations if held to maturity?