The Fourteenth Banker Blog

June 29, 2010

Fine Print Weakens Bill

Filed under: Running Commentary — thefourteenthbanker @ 1:35 AM

As the details emerge on the financial reform bill, it becomes apparent that it will do little to avert another financial crisis in the coming years. Huffpo notes the same regarding certain provisions of the Volcker Rule, intended to limit trading risks.

Specifically, there are varying implementation periods for the reduction in trading riskier asset classes. See Bloomberg article for details.

CNBC notes that the bill is likely to get weaker not stronger as delays mount and with the death of Senator Robert Byrd taking away a key support vote. The “bank tax”, may be eliminated to win Scott Brown’s support.

The bank tax could have been a small, but nice and clean way to penalize excessive risk taking. Instead it got muddled up with other provisions and now it is likely to be swept aside altogether. This is not that material in the scheme of things, but it would have been another nudge towards safety and soundness.

The biggest problem with the bill is that implementation delays and study periods followed by regulators discretion mean that the system will do little to strengthen itself even as global financial markets founder.

The Lincoln Derivatives amendment as now written allows the “bank” (deposit insured financial institution) to trade in interest rate swaps (like those sold the Greek government and Jefferson County). Foreign Exchange, Silver, Gold, hedging instruments, and investment grade Credit Default Swaps. That is a hole big enough to drive a truck through. Investment grade CDS become non investment grade in a crisis. I would like to see how regulators intend to monitor this.

Finally for today, the modified Merkley/Levin allows investments in Hedge and Private Equity Funds up to 3% of Tier 1 Capital. Given volatility, my guess is that this is a real 1% capital exposure at a minimum, and more if a liquidation cycle is triggered such as it was in 2008 with Lehman Brothers. So there should be other ways to increase bank capital or reduce the incentives for risk taking.

June 26, 2010

Regulation Takes Its Rightful Place, Second Place

Filed under: Running Commentary — thefourteenthbanker @ 6:29 PM

Regulation has its place and that place is and always will be of secondary importance to the character of the society it intends to govern. The past months have provided moments of despair and hope. At the end of the day, more than nothing was achieved. I’m not sure how else to put it. The post Conference Committee reports range again from hopeful to disgusted.

Even the most mainstream of media has declared the bill only a partial success even while the President declares it a home run.  I guess given his options, home run or strike out, he must call it a home run.

From Bloomberg:

The overhaul, which still requires approval from the full Congress, won’t shrink banks deemed “too big to fail,” leaving largely intact a U.S. financial industry dominated by six companies with a combined $9.4 trillion of assets. The changes also do little to solve the danger posed by leveraged companies reliant on fickle markets for funding, which can evaporate in a panic like the one that spread in late 2008.

From CNN:

Zombie banks, take comfort: The zombie regulatory system lives on.

The financial reform legislation hammered out Friday morning on Capitol Hill closes many of the loopholes that led to the last crisis. But it stops well short of breaking the bad habit that has fed outlandish risk-taking for almost three decades: too big to fail.

There are several excellent pieces providing more perspective.

Robert Johnson sums it up well.

The financial reform legislation is both disappointing and inspiring. The legislation is the product of a broken government process where dollars overwhelm voters. Lobbying in the gazillions predictably stopped the needed major structural reforms that were revealed by the scope and scale of the financial crisis. As a result we still have “too big to fail” firms with the perverse incentive (subsidy) that their default-free status confers upon them. We still have many practices that are not transparent and many off balance sheet problems that disguise the conditions of our financial firms. We are also still a society that tolerates usurious interest rates on credit cards and payday loans. That is deplorable.

What is heartening is to see how so many people and organizations — who had little knowledge of this arcane subject matter two years ago — have contributed the energy to learn and engage and push relentlessly for reforms against the monied odds. Notions such as consumer financial protection, the Lincoln attempts to separate OTC derivatives from the protective umbrella of the balance sheet of taxpayer protected banks, (and she did it in response to a primary challenge, please do not lose site of that fact), and efforts to remove risky activities from the guaranteed funding protections are a tribute to this energy.

It is also heartening to see people like Michael Greenberger, Elizabeth Warren, Damon Silvers, Dennis Kelleher, Matt Stoller, Jane Hamsher, the AFR team, Bob Kuttner and Senators Cantwell, Dorgan, Levin, Kaufman and Merkeley leading this formidable effort.

So after time to reflect, I would declare a partial victory.  More was accomplished that was originally hoped by all but the most ardent reformers.  Less was accomplished then might have been hoped at the high water mark of the negotiations.

Once the bill is passed and signed into law, the primary issue will return to what Simon Johnson and James Kwak pointed it out to be so early in this discussion, Regulatory Capture. Much has been turned over to regulators to study, implement, and oversee. Failure here will be failure of the potential of the bill, and let’s face it, the bill does not have that much potential. The epic battle financial firms have waged over this regulation will be continued, with much less fanfare, in hearings and in strategy sessions on how to circumvent the spirit of the legislation, invent now products that render it meaningless or assess new charges to pass costs right back on to consumers and businesses. The big banks will not easily relinquish their share of GDP or corporate profits.

To return to my original premise, regulation was not going to fully solve our problems no matter what was passed. Ultimately we must have a civilized free enterprise system based on integrity, justice, fairness, transparency and moderation in many forms. Otherwise, we risk the fall of capitalism as the ultimate consequence of exploitation. Do not disregard the fault lines in our system. Regulation if it is effective can facilitate some measure of these essentials. But sophisticates can often work in the nuances or vaguenesses of the regulatory system.

In fact, just this week arch villein CEO Jeff Skilling of Enron infamy drew some hope from a Supreme Court decision that might vacate a key part of his conviction. The timing could not have been more tragically ironic. Within 24 hours Christopher Dodd had in a legislative payoff removed a key provision of the Financial Regulation bill that would have provided some clarity to what is a financial crime.

Regarding the Supreme’s ruling, the vagueness of the applicable statute called into question whether it provided sufficient basis in law for most of his criminal convictions.

In an opinion written by Justice Ruth Bader Ginsburg, with varying support from other justices, the court found the honest services law used against Skilling covers only bribery and kickback schemes, and Skilling was accused of neither.

The court found that Skilling did not violate the honest service statute as the court interprets it.

“There is no doubt that Congress intended (the statute) to reach at least bribes and kickbacks,” Ginsburg wrote. “Reading the statute to proscribe a wider range of offensive conduct, we acknowledge, would raise the due process concerns underlying the vagueness doctrine.”

From Jim Cox, Duke Law Professor posting at TheParetoCommons:

Shame on you Christopher Dodd. You had a chance to address one of the serious weaknesses in financial reporting – the lack of individual accountability for fraud – any you deftly steered away from the problem and into the hands of those who have only their interests to be served.

The issue at hand is that there is white collar crimes, even those of great import, are very difficult to prosecute.  The most obvious fraudsters can often escape the administration of justice under a variety of legal shortcomings.  Here are some examples:

The Supreme Court’s narrow view of who can be a primary participant under the antifraud provision has prompted the lower courts to repeatedly reach results at odds with imposing just desserts on violators. For example, Pugh v. Tribune Co held the Supreme Court’s reasoning insulated from responsibility the senior executive who inflated his subsidiary’s revenues and income. In re Nature’s Sunshine Products Sec. Litig. holds that the CEO who falsely represents facts in a letter to the firm’s auditor so as to obtain an unqualified audit opinion is not liable under Rule 10b-5. And, most recently, in Provident Investment Management LLC v. Mayer Brown LLP, the Second Circuit absolved the attorney who fraudulent participated in his Refco’s financial gimmickry that fraudulently concealed the depth of Refco’s financial problems.

So it falls to our culture to not singularly focus on government as the solution. We must call upon the highest instincts or our own humanity and draw that out in others as well if we are to prevent future crisis and provide a measure of security to all our citizens. We are fortunate to have many able leaders who can help guide the way. Keep the conversation going.

June 24, 2010

BP and Systemic Financial Risk

Filed under: Running Commentary — thefourteenthbanker @ 10:02 AM

I have been waiting for this.

Energy is ine of the largest trades and therefore must be the basis for massive derivative activity aside from end user hedging.

These low probability-high risks are a reason this kind of activity should be limited and transparent. No investor today can know what exposures are out there.

June 22, 2010

Pay Cartels Rule Banks – Overpaid 2

Filed under: Running Commentary — thefourteenthbanker @ 7:16 AM

Adding to yesterday’s comments, banks are run by Pay Cartels.  They buy the myth of superhero financial status, despite the fact that they consistently destroy value at banks.  Any major bank ownership group consists of two classes of owners.  Those that were acquired and had shares of the new institution exchanged for shares of their purchased institution.  And new owners who trade the stock.  The legacy owners consistently get the shaft.  This is because of the pay cartels that rule decision making, taking excessive risk for excessive pay.  The Federal Reserve notes that pay practices have not changed enough.  I can tell you that from what I can tell, the pay philosophy has not changed at all.

The Federal Reserve has completed an initial review of compensation policies at 28 large banks it oversees and has been giving them confidential feedback on areas where they must change. On Monday, the Fed and other federal regulators issued final guidelines, stressing the need for policies that do not give executives, traders, and other bank employees incentives to make overly risky investments that might earn them huge bonuses in the short run while leaving the bank exposed to losses in the long term.

Good work there on the part of the Fed.   Real cutting edge stuff.

At least they are beginning to address the problem.

June 21, 2010


Filed under: Running Commentary — thefourteenthbanker @ 9:50 PM

The focus of compensation practices inevitably goes to executive compensation. After all, executive compensation is obscene. Then it goes to a discussion of million dollar and up bonuses paid to investment bankers and top corporate bankers. Here, Yves comments on a recent NYT piece by Robert Shiller.

Now some readers will argue that financial services industry pay is market determined and therefore virtuous. That’s a misconstruction. Compensation in the financial services is a classic example of market failure.

The big banks and broker dealers ALL went into the crisis badly undercapitalized. Why? Because the industry engaged in a variety of practices that allowed them to rely on what amounted to fictive capital. For instance, credit default swaps allowed them to hedge risk with undercapitalized counterparties like AIG and the monolines. When the hedges failed, the banks showed spectacular losses. Similarly, banks shifted assets into structured investment vehicles and other off balance sheet entities, but earned fees both for setting them up and providing services to them. When these entities started showing serious losses, the banks discovered they weren’t so “off balance sheet” and tool losses.

If the banks had accounted for these risks properly, they would have had to carry higher capital levels and would therefore have had to retain more in the way of earnings and pay less to employees. And the idea that escalating pay levels was needed to retain “talent” was dubious. The threat was that the best staffers would leave for hedge funds. But let’s face it, they did regardless, and hedge funds employ comparatively few people in comparison to the banks and broker dealers.

Now these points are all dead right. Pay is too high. Let’s say one firm brought down its level of pay. It would lose its mercenaries. So what! If the mercenaries are of value because of their connections, then pay is not in fact based on merit. The whole baloney about meritocracy is just that. If pay is based on talent, there is no shortage of talent. People will move up in the ranks and the talent is replaceable. If that is not the case, then why do banks allow such massive turnover in their retail divisions, caused by such massive pressure to produce daily? Have you seen the revolving door in retail banks?

What is actually needed on Wall Street is a purge of this so-called talent. It is a wealthy boys and girls club operating in an illusory universe. This talent is focused on the next deal, the next quarter, the next kill. Until there is a purge of this poisonous toxic talent, there is no real change in the system.

Pay at the top is not the only problem. The philosophy of the hunt has permeated these organizations. The customer becomes the next meal. There are two goals for the typical employee. One, make big money while the making is good. Two, survive in a culture that culls its bottom 10%. This is the Wall Street culture. It has infected organizations through and through. The shift from salary to incentive compensation exacerbates the problems just as much in the traditional banks as in the investment banks. The salary is sometimes just not enough to maintain middle class lifestyles. The incentive has become a “must”. Therefore, anything will be done to earn the incentive. So even the least corruptible employee is under enormous pressure to dissemble. That is how the upper class wants it. They want dependency. Dependency protects the upper class. Dependent people will not rock the boat, will look the other way, will be complicit.

All these mortgage originators that submitted bad loan apps, knowing all along that is what they were doing, did not start off as fraudsters. Senior management made fraudsters, even banksters, out of them.

So let’s not just focus on executive pay, let’s focus on corrupt pay practices.

No Ox Spared

Filed under: Running Commentary — thefourteenthbanker @ 1:20 AM

In this piece, Gonzalo Lira takes on corporations broadly defined to include governments, military, unions, GSEs and companies.  Repeatedly he illustrates how the corporations are shielding individuals from consequences for their actions. Meanwhile, unaffiliated individuals are easily and often prosecuted, even unjustly.  He starts with a case of individual injustice that you need to click on the article to read.  The main point though it that the protection of individuals from accountability is now all pervasive.

All of this underscores the same problems we are having throughout our society in the Industrialized West: Corporate entities, be they corporations, unions, the military, or the government, act lawlessly—anarchically—trampling the individual without hesitation, yet coming to accomodations between one corporate entity and another.

In other words, our society has become a neighborhood where street-gangs—corporate entitites—battle one another for position. Even the Government is just another street gang.

People allied with a particular corporate entity have rights and the full protection of the corporate entity to which they belong, much as street gangs are fiercely loyal to their individual members. The higher up in the corporate entities’ hierarchy—CEO, General, President—the more untouchable he or she is.

This is damningly true and with the reach of these enterprises it is little wonder that there is very little discussion of how the behavior and decisions of the “subjects” of these enterprises are created and supported by the enterprise itself.  The protection racket is both ways.  The enterprise protects the individual and so the individual is obligated to silently protect the enterprise.

June 19, 2010

On the Curious and Misguided Defenses of BP « naked capitalism

Filed under: Running Commentary — thefourteenthbanker @ 12:36 PM

On the Curious and Misguided Defenses of BP « naked capitalism.

Had BP demonstrated admirable intent earlier in the process, such as around May 17 when the 14th Banker called for suspension of the dividend as a statement that the owners of BP would take responsibility, they may not have had to be strong armed into the $20 Billion fund.  Doing the right thing is actually good business.

June 18, 2010

Joe Barton, BP’s Ho

Filed under: Running Commentary — thefourteenthbanker @ 6:30 AM

Texas fool and oil industry lackey Joe Barton is a sucker. Today he apologized to BP for the rough treatment they have received.  Then apologized for his apology after doing the political math. What do you want to bet he is in a safe seat?  As our own commenter Jerry P has pointed out, the $20B fund may not even cost BP that dearly when all the insurance, other party’s liability, and tax write-offs settle out.

But that is not the key mistake in judgment. To rely on the court system alone for recourse for victims is naive. There often is no recourse for victims in the courts. It is reported that Exxon tied up claims in the Valdez matter for decades and upwards of a thousand claimants died before their cases could be heard. The documentary movie CRUDE depicts the fight of Texaco/Chevron to avoid payment for environmental damages in the Amazon for close to two decades. The suit has been fought for 17 years and was filed well after the environmental contamination.

Consider this Saudi perspective just this week on a matter easily forgotten in the US, but still affecting Bhopal from a catastrophic 1984 accident with egregious negligence on the part of the firm..

Union Carbide should be gearing up now for a massive decontamination operation which would involve them paying whatever it takes to cleanse the Bhopal plant and the surrounding area, fix the poisonous water supply, provide proper medical treatment for the tens of thousands still affected, compensate them directly and, if necessary, relocate them somewhere where they can be safe from further exposure to deadly toxins. Or do 11 US lives matter more to Obama than 15,000 and more dead Indian citizens?

Just over a week ago seven Indian citizens were convicted for their roles, 26 long years later. Granted, Indian incompetence and graft played a role in these delays, but Union Carbide’s lawyers took advantage of that graft to settle a case without compensation to victims and without cleaning up of the still contaminated facility. The justice system let them off the hook. The US has shielded Union Carbide’s CEO from accountability in Indian courts.

US courts are better, but not that much better.

For BP to do the calculus and decide to offer some expedited claims process is not a shakedown, it is good business sense. For a President to expedite claims for affected citizens is fair and just. For Joe Barton, the largest recipient of big oil company contributions sitting in the Congress, to defend the offender in so consequential and obvious a case shows a tin ear, callousness to American citizens, and a blind faith that there is really nothing wrong with a system where huge corporations privatize profits and externalize or socialize the consequences of negligence, using protections offered Corporations under current law to evade accountability and shield employees.

June 17, 2010

Regulatory Swat Team Approach Needed

Filed under: Running Commentary — thefourteenthbanker @ 6:58 PM

Once the bill passes and is signed into law, then things move into the bureaucratic (not pejorative usage) realm. We know about regulatory capture.  (from excellent new blog theParetoCommons)

In my view there are many reasons why we have regulatory capture.  Fixing the problem is also very complicated, particularly in the American culture.  We simply don’t take regulation seriously enough as a society.  Indeed, because it seems counter to the “free market” philosophy we all share, becoming a regulator is sometimes portrayed as a sign of failure.  ”Real men” would be out there actually making the economy work.

Regulators are outgunned.  Moving the existing regulatory apparatus is going to take time. Typically regulators are running quarters, if not years behind the actual developments in the marketplace. That is the nature of working with historical information. There are delays in every step of the process. Data must be produced, compiled into reports, reviewed and scrubbed and then is given to regulators. Data is not volunteered. Only what is asked for is provided.

Here is a new suggested approach. Follow the money. The incentive money. Incentives are calculated and tracked at all times. They may be paid annually, or in the case of some business lines, quarterly or even monthly.  But staff knows where they stand at all times.  Incentives are the meter that coincides with business drivers.  That is how ingrained they have become in the corporate apparatus.

Regulators must be embedded into the Performance Measurement/ Compensation departments of all major firms as well as into their business lines. They should have access to any information they request at any time.  They should have robust field communication amongst themselves.  They must be given system access. They should take rabbit trails and discover what is going on, like detectives investigating a crime scene.  The detective controls the scene.  They should gather evidence.

As incentive results are generated, as close to real-time as possible, regulators should look at the transactions that are generating the largest incentives and should look at shifts in the incentive patterns. When they see data, they should be allowed to go direct to the bankers without any intermediary protocols and ask any questions they want. Then they look at the transactions themselves and make adjustments and deploy resources on the fly.

Where do you find and highly motivated regulators?  Form a Swat Team that is given a lot of operational latitude.  Recruit them from inside the industry and pay them well.

Finally, the institutions need to know that these embedded regulators will have broad powers including the power to refer to law enforcement for fraudulent activity.

Corporations will fight this tooth and nail.  But it is no time for Congress and the President to declare victory and go home. There has not been a victory from the standpoint of regulation.  Too Big to Fail is still there.  Many Fed Regional Bank heads do not believe the regulation has gone far enough.  Therefore, the implementation of the regulation must take up some slack. Put Elizabeth Warren or another like her in charge and form a Swat Team.  Increase the regulators budget like we did for Homeland Security after 9/11 and get people in there that are not “captured”.

June 16, 2010

Accountability and Freedom

Filed under: Running Commentary — thefourteenthbanker @ 6:00 AM

We live in a society where there is little accountability for individual decisions that are made in a group enterprise. This article is by an aggrieved victim who actually won compensation in a court of law.   However, the damages were paid by a famous upscale enterprise and there was no individual accountability for fraud.  Quote:

But over those same two decades I’ve grown disgusted by what corporate America has become. Several words come to mind: venal, corrupt, conniving, irresponsible, unaccountable, amoral. All are accurate, but none alone captures the extent of decay that has left us with a truly rotten system.

Corporations have mutated from organizations that once generated jobs, products and prosperity for the country into voracious, impenetrable monsters legally required to put their own selfish interests first. The result: Corporations now enjoy powers and privileges historically reserved for monarchs, and, like monarchs, the people who run them are largely insulated from the consequences of their actions.

Even in many of our psychological theories we discount the responsibility of individuals by saying that their brains tricked them.  Note this post by James Kwak in which he rebuts a NYT piece which lays primary blame for our crisis (plural) on irrationality in decision processes.  That irrationality is there and should be studied and mitigated, but it does not replace the moral dimensions or consequences of actions.

The problem isn’t that people have cognitive biases in assessing unlikely events. When you’re dealing with a big company like Citigroup or BP, you have many people applying lots of clever thinking to these problems. The problem is that there is a systematic bias within these companies against certain assessments and in favor of others. That is, the guy who shouts, “Danger! Danger!” will be ignored (or fired), and the guy who says, “Everything’s fine, the model says disaster can strike only happen once every hundred million years” will get the promotion — because the people in charge make more money listening to the latter guy. This is why banks don’t accidentally hold too much capital. It’s why oil companies don’t accidentally take too many safety precautions. The mistakes only go one way. You have executives assessing complex situations they don’t even begin to grasp and making the decisions that maximize their corporate and personal profits. (Is BP’s CEO going to give back years of bonuses now?)

So to the question of sin.  Religion has always dwelt on these topics the most and sometimes very well.  But one man’s sin is another man’s folly and another man’s license.   The elementary rule may be summed up in many faiths or no faith.  “First, do no harm.”   “Love your neighbor as yourself.”  ” Do unto others…”

So what we have today are systems that transgress against society by violating these most elementary and universally held values. And we allow no individual consequence of any proportionality to the transgression.  Should we be surprised with what transpires?


I believe that there are consequences to the individual and that part of the sin of management today is the promotion of unethical behavior with the mistaken belief that it is somehow harmless or that the individual actually benefits, say from higher compensation. They foster in individuals unrealistic thinking which is actually self-destructive. Such “sins” as avarice can have tragic externalities, as we have found.  But the bad thinking also serves to trap the individual in preoccupations with fear and fantasy.  Fantasy about the future, fear of losing it.  Fear of being found out.  Fantasy about successes, defined by metrics which may mean nothing, and are often falsified, which support false self concepts.  In these mental preoccupations we cannot truly be in harmony with ourselves or others. This is the shortest of all sermons.  But our corporate systems do harm in the most profound ways and there is no escaping it.

That is part of why I write.  I write to give voice to the suffering of employees everywhere who long to be free to do the right thing.  I support restoring consequences for actions as a way to help people “wake up” and ultimately claim their freedom.

June 15, 2010

BP Blowout End Game

Filed under: Running Commentary — thefourteenthbanker @ 8:34 AM
Tags: , , ,

This link provides more detail on the well situation than you will ever read in the press. I cannot vouch for its reliability but it seems to pass the smell test and is well documented.

Tonight the President will go on television to discuss damage control. Environmental damage control, political damage control, economic damage control. But beware the illusion of control. We are all oftimes captured by it. You cannot control all consequences. If this posted link is accurate, we may have met a catastrophe on a scale we have not seen in centuries.

It was preventable. The causes and conditions which led to this disaster must be struck from our society.

We will see tonight if the President dances around or blusters or puffs up. What I hope we see is wisdom and vision. Anything less is a failure.

June 14, 2010

Wall Street Trumps Main Street – Asymmetric Information in Derivatives

Filed under: Running Commentary — thefourteenthbanker @ 6:35 AM
Tags: , , , ,

There has been a vigorous debate on the portions of Financial Regulation concerning Derivatives.   This article by Jane D’Arista highlights why Derivative reform is an essential part of reducing systemic risk and bailout risk.  However, financial reform is not only about reducing these risks.  It is also about restoring balance, fairness and integrity to financial services, moderating corporate power and regulatory capture in Washington, and allocating resources in the economy in a way that provides more for job creating industries and less for the outsized financial sector.   To take one quote from the article which addresses my focus today:

Buying and selling OTC derivatives contracts is a zero sum game. Unlike portfolio lending that links the fortunes of borrowers and lenders, one party to a derivatives transaction wins while the counterparty loses.

So let me pull back the curtain on how derivatives work in one particular area on Main Street.  What is generally considered to be the most plain vanilla derivative product in the Interest Rate Swap.  In simplified terms, what an Interest Rate Swap does is allow one party (generally a borrower of funds) to pay interest to a bank at a variable rate but to “synthetically fix” the rate through a swap.  Another party takes the other side of the trade.  The borrower will generally assume that party is the bank, but if the bank wanted to take and be paid for the rate risk it could just have made a fixed rate loan in the first place at a higher interest rate. There is another party (counterparty) that takes the interest rate risk in return for being paid a monthly payment.

So as a simple example, the borrower may have a $3 million loan.  It might pay 3.5% per annum in variable rate interest to the bank.  It may pay a payment equal to another 2.0% on the interest rate swap for an “all in” rate of 5.5%.  The Counter Party gets the 2.0% (less the market maker’s fee), in order to assume the risk that rates will rise. The borrower is supposedly protected from a rise in interest rates.

On the surface, this seems pretty simple and a borrower might feel well prepared to make a good decision on the transaction.

Here are the problems as I see them:

  • The borrower has no way to know if the rate swap is a good deal.  In other words, they buy something that seems simple but is in fact quite complex.  Look at it this way, the borrower paid 5.5% instead of 3.5%.  That is a 57% increase in the cost of credit.  The borrower has paid a large sum of money and has few ways to ascertain if it is a good deal. You can rest assured that the counter party on the swap is much more sophisticated regarding the mathematics behind the transaction.They are financiers deliberately taking interest rate risk for a fee
  • The bank may have limited the borrower’s pricing options in order to induce him or her to enter into the interest rate swap.  The bank could have offered a fixed rate loan. Banks do this all the time, except when they don’t.  Often a bank will not offer a fixed rate loan at all and will present the swap as the only way for the borrower to hedge interest rate risk.
  • The borrower may not have any other place to go to get the interest rate swap. Generally the swap is cross collateralized with the actual loan.  Unless the borrower is shopping the loan and the swap at the same time, they have no competitive information available.  Since 90% of swaps are done by 5 banks, if the borrower is shopping a big bank against a local or regional bank, the best swap pricing is not going to be available to the smaller bank anyway.  So the big bank has a competitive advantage.
  • Swaps have risks to the borrower that are not necessarily apparent and may not be properly disclosed when the swap is sold.  These include the very real chance that the swap can actually be “underwater” if terminated early.  The amount it is “underwater” is based on complex mathematical formulas involving changes in interest rate curves from the time the swap was initiated until terminated.  Further, the rate that is “hedged” is the “index” rate, not necessarily the borrower’s loan rate.
  • The economic value of either side of a swap’s position is a function of several factors including the rate curve and discount rates.  It is not a function of the index rate.  The borrower will often not understand this.  Effectively this means that the net position on the swap may not be correlated well with changes in the “index”.  It is somewhat analogous to the problems with pricing on some ETFs that are based on futures contracts.  The ETF is intended to track a certain commodity price but since it actually owns futures contracts rather than the commodity itself, the value of the ETF does  not correlate well with the intended benchmark.
  • The borrower’s loan can be declared in default for a variety of reasons including failing to maintain certain financial ratios, credit ratings, etc., even if there is no payment default.  A loan default will generally trigger a default on the swap, which may become due and payable in full.  The borrower may find that in addition to whatever other difficulties it is encountering, now a large unexpected payment is due on the swap contract.  In this case, the contract failed to deliver the protection the borrower purchased.  The borrower would have to read and understand all the fine print to understand these risks.
  • Swaps are very profitable for banks and are generally sold by a commissioned sales force.  The individual incentives earned can be substantial enough to create a moral hazard at the individual banker level. Their personal interest may not align with the interest of the client. This is not disclosed.  The incentives differ at every bank
  • The front line bankers themselves rarely have a full understanding of an interest rate swap transaction.  The figures come from a wizard behind a curtain known as the “money desk” or “swap desk” or “derivatives platform”.  Even if the banker wanted to explain the exact economics to the client, they would generally not have the information or expertise to do so.

Please note that these comments relate to only the most simple form of derivative contracts.  I would expect all the shortcomings I’ve identified to be magnified in more complex transactions.

June 11, 2010

Criminal and Civil Fraud – BP Edition

Filed under: Running Commentary — thefourteenthbanker @ 12:26 PM

Would not misrepresenting the actual oil spill flow, on which massive fine calculations depend, be an act of fraud against the United States of America and all BP shareholders?

Reuters announces that the daily flow rate from the spill is actually double previous estimates: “News that the flow rate may be as high 40,000 barrels (1.68 million gallons/6.36 million liters) per day — twice as much as previously thought — came after the U.S. market closed on Thursday.” This is very bad news as it effectively doubles any accrued fines that the firm will ultimately have to pay: the new liability estimate now may be as high as $80 billion!

So the Justice department probes may not be just political posturing.

Additionally, from Naked Cap, is this discussion of whether full externalities recovery has a chance of going anywhere.  This opens up a whole new topic for discussion.  Limiting corporate liability as a general principle has something going for it.  It helps the profit motive and capital formation.  But, in the last several decades, capital has seemed to go disproportionately to large enterprise, which has a number of negative effects which I won’t attempt to enumerate.  I think much of the discourse out there, whether regarding Financial Services or any industry, is that industry has become too powerful.  If there was a general profit squeeze in big business, would capital seek out new entrepreneurial ventures or even local staple businesses more readily? Would this not be good for our communities even if the cost of goods was slightly higher.  After all, look what happens to all those cheap goods?  They break or are discarded.  If a more moderate, or as our government leaders put it, austere style of living is necessary, why not at least do it with more local businesses and fewer mega corporations?

Banking and BP on the Eve of Financial Regulation

Filed under: Running Commentary — thefourteenthbanker @ 10:58 AM

Reproduced from Huffington Post.

In upcoming posts I will comment on the specifics of the legislation, but first I need to make a point.

We have something in common, BP and I. It is a culture we share. I’m a banker for a large TARP bank. My bank’s culture seems sadly familiar as I read about BP.

On this eve of the Financial Regulation Conference Committee, the folly of BP has taken over the news cycle, highlighted daily for six weeks. Externalizing risks. Manslaughter. Fishslaughter. Greed. Lying.

Over four long years, the folly of the Financial Services industry has been highlighted in uncountable articles, studies, books, and anecdotes. So many that we have become numb, like at the end of a long war. The pronouns could fill pages. Some sound like they were a long time ago. Bear Stearns, GMAC, AIG, Lehman, Wamu, Indymac, Goldman, Auction Rate Securities, CDS, Derivatives, Financial WMD, Dick Fuld, Angelo Mozillo, Alan Greenspan, Robert Rubin, Ken Lewis, Bernie Madoff, TARP, TALF, Unlimited FDIC Insurance… it goes on, and on, and on.

BP and the Deepwater Horizon do us a favor by serving as a likeness of big finance. Big oil. Big finance. We have a lot in common. When I read this week about BP having fishermen sign a contract prohibiting them from speaking to the media, I was not surprised. The contract and other stipulations attempt to control BP employees and they work pretty well. Why did no BP employee leak about the magnitude of the leak? Perhaps if one had, the government would not have been faster to respond. Consequences?

scientists need to know is precisely how much oil and gas has leaked. Neither BP nor the Obama administration have been forthcoming on that front. Joye wrote:

It is virtually impossible to understand or quantify the ecological consequences of the BP blowout on the Gulf of Mexico ecosystem without knowing how much oil and gas has leaked from the wellhead. These numbers need to be estimated and corroborated independently based on available observational data. Unfortunately, the leak rate was not quantified robustly during the first month of the spill (at least that information has not been made publically available). Unless we know how much oil is leaking from the wellhead, we cannot gauge the full extent of the ecological consequences in deepwater or surface water environments. For example, how much deepwater water column oxygen consumption will be fueled by this influx of oil and gas? Which water column microbial communities will be stimulated by oil and gas? What is the time scale of this response? How will surface water microbial communities respond to surface oil and gas inputs? Potential fishery, marine mammal, and wildlife consequences of the BP blowout cannot be properly predicted until we know the magnitude of the disaster. To put it bluntly, the scientific community is hamstrung until we know precisely how much oil and gas has leaked and is leaking from the wellhead.

Like deep water drillers, banks are supposed to be good at risk management. Truth is a risk. As long as truth can be managed, leaked as it were, into a vast ocean at a steady trickle, maybe it won’t be noticed so much. Maybe banks can reduce the accountability. That little trickle can seem like disconnected events. Just look at the trickle from the last month or so.

Bank of America Settles

JP Morgan Fined

Goldman Subpoena

Morgan Stanley Under Criminal Investigation

Wells Fargo Investigated

Citibank Fined by Finra

This is a trickle of news, but it represents a flow, which represents a culture, which represents a problem. I have shown you one square mile of surface area. There is a lot more on the surface and deep underwater plumes that are not big or sensational enough to make the press. Regulation can fix a problem if it can fix an attitude.

So when Congress convenes the Conference Committee to deal with Financial Regulation, it should be under no illusions. All these items linked above have to do with regulations already in existence or enforcement actions pertaining to the same. While the goals of the regulation are directionally correct and helpful in a number of ways, let them not create an illusion of control. The technicalities of the regulation, while very important, are less important than the demonstration that the spirit of the law is more powerful than its letter. In other words, in the enacting of this legislation, the Congress must provide a powerful kick in the soft parts, as a down payment on another one should it become necessary.

Finally, changing an attitude may not be possible if you don’t change some people. To do that, Boards must be put on notice that if they do not clean up the industry over the resistance of their CEOs, they will also be accountable. Change requires governance in more than name.

June 9, 2010

What Happens to Economists Happens to Bankers

Filed under: Running Commentary — thefourteenthbanker @ 9:54 PM

James Kwak had a great observation today about students of Economics versus practitioners of Economics.  After some preamble, this is the crux:

This is something I’ve mentioned in passing often. I think that basic economics, the way it is taught today, tends to give people reflexive pro-free market, anti-government positions — positions that arenot held by people with a deeper exposure to economic thinking. When your understanding of government finances is based on reading the newspaper, it’s somewhat eye-opening to come to college and learn that free markets lead to maximum societal welfare and taxes impose a deadweight loss on society — the pictures are so simple and compelling. That’s why a little bit of economics makes you more likely to be a Republican.

But when you learn more about principal-agent problems, information asymmetries, and so on, you learn that those simple pictures are simplistic to the point of being misleading. That’s why Joseph Stiglitz argues in Freefall that understanding economics is crucial to understanding why free markets often lead to suboptimal outcomes. The problem isn’t knowledge per se; it’s a little bit of knowledge.

This reminds me of my journey.  Idealistic and naive to start with, I stayed that way awhile.  It was only on encountering reality without my blinders, that I began to understand. Those opinions that came from the left side of the spectrum, which I once dismissed ad hominem, are often true.  Things are not black and white.  I can also say, black is not black and white is not white.  There is more than meets the eye. Sometimes we think we are disagreeing about facts, when we are actually reflecting different priorities or perspectives. Experience counts.

June 8, 2010

Rich Banks Poor Banks

Filed under: Running Commentary — thefourteenthbanker @ 9:04 PM

This blog has been focused on big banks and related issues.  As this ZH post points out, there are also many other stories involving many other banks.  The author if this post knows the folks at Santa Barbara Bank and Trust and thinks a lot of them.  He/She is not being critical of the bank but is using this example to make a case in point about economics and how not to solve the banking crisis.  This viewpoint is primarily about boom and bust and the mistaken attempt to partially reflate the bubble as a way to prevent more profound crisis.  It is a point well taken.

However, in any enterprise of this sort, there will have been some who supported the strategy that led to the current situation, and some who opposed the strategy.  I would love to hear from those who opposed, who may have seen changes in the management and culture that lead to excessive risk taking and who can comment on the motivations of decision makers as well as those who “got on board”.  I would also love to hear what happened to voices of dissent.

Further, though this bank did receive TARP, I would be curious how they are impacted by subsidized competitors.

June 6, 2010

Ben Bernanke (Confused Economist) Lessons from the Gulf

Filed under: Running Commentary — thefourteenthbanker @ 12:11 PM

Ben Bernanke, economic oracle, hosted a forum on Small Business Financing in Michigan this week and had these eloquent words of wisdom from the throne of academic economic theorizing.

Unfortunately, lending to small businesses has been declining. Indeed, outstanding loans to small businesses dropped from almost $700 billion in the second quarter of 2008 to approximately $660 billion in the first quarter of 2010. An important but difficult-to-answer question is how much of this reduction has been driven by weaker demand for loans from small businesses and how much by restricted credit availability. To be sure, the distinction between demand and supply is not always easy to make. For example, some potential borrowers have been turned down because lending terms and conditions remain tighter than before the financial crisis, perhaps reflecting banks’ concerns about the effects of the recession on borrowers’ economic prospects and balance sheets. From the potential borrower’s point of view, particularly a borrower who has been able to obtain loans in the past, these changes may feel like a reduction in the supply of credit; from the lender’s point of view, the problem appears to be a lack of demand from creditworthy borrowers. Although lenders and borrowers may have different perspectives, our collective challenge is to help ensure that creditworthy borrowers have access to credit so that, should they choose, they can expand their businesses or increase payrolls, helping our economy to recover.

Ben, we give you this prestigious position and pay you to figure out complex problems.  Let’s take a look at your analytical approach, in your own words.

As we continue to examine the factors affecting small business lending, our thinking will be shaped by information from diverse sources. For example, our most recent Senior Loan Officer Opinion Survey on Bank Lending Practices suggests that, for the first time since the crisis began in 2007, most banks have stopped tightening credit standards.3 We also know, from the survey conducted by the National Federation of Independent Business that while only 8 percent of small businesses list access to credit as their principal immediate economic problem, just 40 percent of small businesses attempting to borrow in 2009 had all of their credit needs met.

If you were serious about understanding Small Business Lending you would go deeper than surveying the lenders, who of course are the experts and have no belief bias that might affect the survey results, and surveying the customers, who can tell you their experiences but are simply on the receiving end of a pipeline of money and have little real way of understanding why the pipeline is just trickling. So let’s just agree that your approach is a joke. You are speaking of Small Business Lending because politics requires you to do so. But it is not really where your interests lay. You would rather be working on funding the ECB through the IMF, buying toxic assets and carrying them at full value, buying hundreds of billions of treasury securities to supplement your trillions of mortgage-backed bonds, and maintaining a rate curve that starts at zero to recapitalize the players that created this mess. Either get serious or go back to Washington. The people of Michigan should run you out of the state.

Let me help you here. Your statistics are meaningless. Credit issued by banks to small business consists of term loans, lines of credit, and to a smaller extent business credit cards.  Business credit cards are mostly payable in full every month and are really a payment mechanism product and a way to drive interchange fee income back to the bank. So lets focus on term loans and lines of credit. In a recession, those struggling businesses with lines of credit will tend to draw them up. Their usage increases.  So imagine a water-glass that is half full and it fills up. That increases the total supply of outstanding credit. However, the water-glass was already there. The commitment was already outstanding. The rising of the level of water in the glass obscures the lack of issuance of new credit. It even implies more issuance of new credit if you are not aware of this dynamic (which you are, you just don’t want to let on)  New credit was not issued by the bank. Your constant focus on the outstanding amount of credit is a way to understate and misrepresent the more meaningful number, which is the flow of new credit to small business.

You have the power and ability to figure this out.  You need to get the information from the banks on what they do and how they do it.  You cannot rely on public information. Elizabeth Warren’s report already showed you that.

Now lets talk about an economic ecosystem.  Small businesses are like small schools of fish, plankton, whatever, in the Gulf of Mexico.  They exist in the millions, they do not get much individual attention, but they are an essential part of the economic ecosystem.  They do not wash up on the shore, they just disappear.

These undersea rivers of oil, though not nearly as concentrated as oil at the surface, are likely to affect the gulf through two mechanisms. The first is oxygen depletion, which has been estimated at 30 percent in the plumes. The other will be direct toxic effects of the oil and methane. says Harrould-Kolieb. Even small bits of crude, like those in the plumes, can suffocate fish by gunking up their gills.

Michigan is very close to the oil plumes. It is oxygen deprived. Figure it out, Ben. Figure out where the money for Small Business Lending comes from, which banks, which non-banks. Follow the money. Is there no money because of the toxic waste throughout the system?  Is there no money because the largest banks, those that represent something like 63% of national deposits, use their money elsewhere?  Make their profits elsewhere?.  What about their policies and operational systems?  Have you studied those?  What about the internal environments they create and what they incentivize?  How much have you studied that?  What about the skills they put out in the market?  How many business lenders are there and what is their credit experience?  What are they trying to sell?  Who are the managers and what are their motivations?  Are they masters at manipulating data and maximizing bonuses or are they masters at helping their Small Business operations take responsible risks?  If you wanted to you could figure this out. You might not be able to change much immediately, but at least you could identify the issues and shine light on the problems, and then maybe someone would work on getting them solved.

Hat tip Big Picture Blog for this chart.

Humans are more evolved than plankton or fish, or at least their brains are bigger.  When they go into an oxygen depleted zone they do figure out they can’t breathe, and they get back out.  They don’t go in again.  The absence of demand is not a static economic statistic.  It happens in an ecosystem.  Figure out the ecosystem.

Some time ago, there was no demand for Coke in China.  Did Coke simply shrug their shoulders and say, “Huh, no demand. Guess we’d better not supply that market.”??  A bank can create demand for credit cards for college students.  Why can’t it create demand for Small Business loans?  Because they are not as profitable.

Watch BP Closely Now

Filed under: Running Commentary — thefourteenthbanker @ 6:14 AM

From Naked Capitalism, this great summary of BP’s response to date and this ominous warning:

Despite BP’s brazenness, it could be simultaneously preparing itself for worst case options. Some in the financial media see a breakup, takeover, or bankruptcy filing as a real possibility. From the Globe and Mail:

A few weeks ago, when BP was relatively confident it could stem the flow, there was little sense that BP faced anything more than a very expensive cleanup bill. While some still think that’s the case, others say the company’s breakup, takeover by a rival energy heavyweight, or bankruptcy in whole or in part is probable, if not certain. “BP could be facing the death penalty in the U.S.,” said energy analyst John Kilduff, of New York hedge fund Round Earth Capital. “The viability of the company is definitely in question.”

Another high-profile analyst agrees. Dougie Youngson of London’s Arbuthnot Securities said investors who think BP’s selloff is overdone could be gravely mistaken. The company has “the real smell of death,” he said a few days ago.

The reports on the move to segregate the oil spill operations from a managerial standpoint (it’s conceivable that each major production operation is a separate legal entity) may be a precursor to a “good company/bad company” split. From the Guardian:

BP is to hive off its Gulf of Mexico oil spill operation to a separate in-house business to be run by an American in a bid to isolate the “toxic” side of the company and dilute some of the anti-British feeling aimed at chief executive Tony Hayward, the company said today.

Yves here. If the Guardian has this right, BP could be in the process of trying to maneuver to keep US claimants from getting access to the full resources of the company to pay reparations in the Gulf. This could get nasty indeed.

It may be time to turn the question back to the incentives of corporate senior decision makers. If BP stands good and pays out all claims, which cannot be predicted at this point in time, it may wipe out even more shareholder value, executive stock options, bonuses, and career longevity.  If BP management decides to stick it to the USA, externalize the costs with legal maneuvers, and keep the vast majority of BP assets and cash flow intact, the Executives and Board Members will personally have many millions more.  (I hope their bonuses are paid in euros).  So, how naive should President Obama be? Those calling for seizure or receivership may be on to something. My intuition tells me BP is going to cut and run.

BP will have much higher priced lawyers than the state or local governments. It may be time to pre-empt.

June 4, 2010

The Era of Behavior

Filed under: Running Commentary — thefourteenthbanker @ 12:08 PM

This HBR article is worth a read. It describes the increasing transparency of our media age as a catalyst in changing the conditions under which business must operate.  Adding the quality of behavior to the quality of product and marketing will be increasingly required as citizens become more discerning about whom they do business with.  To do that, tin ear managers cannot just put on a happy face as they have with diversity of gender and skin color, but not thought.  They must actually open up the talent evaluation process to include new kinds of managers.

What must companies change about themselves in a world where people judge them by how they do business as much as by what they produce or provide? The first priority is to promote managers with a mindset of sustainability, and assemble orchestras around them who share and amplify it. This mindset needs to inform environmental management, certainly, but it also needs to extend beyond green concerns to social issues that affect employees, customers, and other stakeholders — in other words, to guide the company’s conduct in all affairs and in all corners of the world.

I often speak to groups of business leaders, including CEOs, and I ask a simple question: “How many of you, in partnership with your head of HR, can quickly compile your list of top performers?” Most are sure in their response — hands fly up, showing how proud they are of systems and structures to identify that talent. Then I ask: “How many of you can do the same with regard to your top ethical leaders — the people who exemplify your organization’s values and standards for doing business?” The hands sink from the air.

As so many of the readers of this blog have commented, the current consensus is to do just the opposite.  Managers feel increasingly threatened by the new transparency and try to control messages with empty marketing campaigns, making up values to fill a vacuum. But the challenge to the system is arising from within. Upcoming generations are not “company men” with loyalty to the firm coming above all other loyalties. Quite the opposite. Managers that do not open up or step aside for new ethical leaders eventually find themselves on the defensive. That is a good thing.

The Biological Imperative for Prosocial Sanctions

Filed under: Running Commentary — thefourteenthbanker @ 7:45 AM

Dan Ariely in this post describes a the human desire for vengeance as illustrated in a research experiment known as the Trust Game.   The original experiment demonstrated that people will go to significant personal expense to exact revenge after they have been betrayed.  The really interesting thing though, is that now it has been proven that this is not just social conditioning.  It is wired into our brains, which means that it is evolutionary.

The experiment showed that many of the people who had the opportunity to exact revenge on their partners did so, and they punished severely. Yet this finding was not the most interesting part of the study. While making their decisions, the participants’ brains were being scanned by positron emission tomography (PET). This way, the experimenters could observe participants’ brain activity while they were making their decisions. The results showed increased activity in the striatum, which is a part of the brain associated with the way we experience reward. In other words, according to the PET scan, it looked as though the decision to punish others was related to a feeling of pleasure. What’s more, those who had a high level of striatum activation punished others to a greater degree.

All of this suggests that punishing betrayal, even when it costs us something, has biological underpinnings. And this behavior is, in fact, pleasurable (or at least elicits a reaction similar to pleasure).

So I am not endorsing revenge in general.  Too often it is violent and perpetuates a cycle of further vengeance, drawing innocents into its devastation. But, if biological and evolutionary, we must ask what is its purpose?  It is to prevent betrayal and protect the survival of the society.

Ariely speaks of the anger and desire for vengeance of the population against the banks.  The further question is whether society should levy sanctions against the banking system to safeguard the survival of the society rather than the survival of the system.  The Congress will be convening the FinReg Conference Committee soon and the policy questions have been debated endlessly.  Perhaps the Members should ask this question, “Is the intensity of the desire for vengeance evidence that society as a whole feels threatened by forces which can wreak havoc on and even destroy the livelihood and security of the citizens?”  If the answer to that question is yes, then revenge is a legitimate course of action and the break up of TBTF institutions is their democratic duty.

Is there even more to fear from such a course of action?  The Bank of International Settlements says no.

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