Saturday, February 20, 2010

When the banks stopped dancing

A couple of days ago "Voter" linked to a blog he had written commenting on a piece I wrote here about my fears that the public sector in the UK is creating a client state that is undermining British global competitiveness. He -I assume he, and I am sure I will be corrected if not- made the point that breaking up the banks might not be the answer, since " Far from different banks behaving in completely different ways, there was some convergence. If banks converge, they are really just equivalent to one larger bank".

When it comes to understanding the failure of risk control that led to the credit crunch, I like to quote Chuck Prince, the then head of Citibank who famously said in June 2007: “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you've got to get up and dance. We're still dancing,”

Well, as we now know, the creation of various innovative instruments like CDOs did not reduced risk by sharing it out, it actually concentrated it into one space: liquidity risk. To explain what happened in 2008, let me use an analogy of owning a building. The building has let us say ten tenants. Of these you know that eight will always pay their rent no matter what. Then, suddenly, the two that you think are a bit doubtful do indeed stop paying rent. You have borrowed money to buy the building, but the reduced income you now have is still sufficient to pay back the loans. However, no one now wants to buy the building off you, and the result is that even though you are still receiving rent, the building is essentially worthless - the bank decides that it is not suitable collateral and withdraws its loans. Unless you can find other income, or post more collateral, then you are bankrupt- even though the building is still earning money. In essence this is what happened to the pooled products market, which brought down the banking system, even though by all reasonable measures before the crash, the failure of borrowers to pay should not have caused a meltdown. It should still have been possible to refinance the shortfall. However, what actually happened was that although the instruments were novel, what they had done was to increase the level of credit beyond the level of liquidity. When everyone tried to sell, the securities became worthless.

The next question is why then did a meltdown in the CDO market cause the collapse of the banking system? The problem was that the meltdown in the US property market rendered the mortgage backed component of CDOs worthless, so in order to raise money, the other underlying securities- AAA sovereign bonds for example- were sold at fire sale prices. The whole bond market went into meltdown. So even though the trading firms believed that they had pools of valuable assets they could not sell them, and so the short term margin calls began to overwhelm them. Bear Stearns was the first house that needed to be rescued. However the rescue of Lehman Brothers could not be arranged in time, and they went broke. This caused immediate panic. It became clear that the company that insured the value of these securities- AIG- could not meet its obligations. Huge quantities of all securities were dumped as every house sought to find liquidity. trading lines were cut and the system would have failed completely unless the global central banks, led by the Fed, had not stepped in.

Liquidity risk- the ability to freely market securities for some price- had been taken for granted. In fact no bank had created a stress test based on total market failure- which was why Chuck Prince though he could keep dancing, even though he knew that liquidity could be a problem, he did not understand that it was already at a critical point, and that he would end up not just writing down the value of his securities, but writing them off altogether.

Now, Voter asks, how can we stop this kind of group think destroying the market in the future? Firstly, both regulators and the banks themselves have learned that the multi-business bank model: originating loans and then selling them on in packaged securities has much greater systemic risk than was previously understood. There are much more extensive stress tests based on liquidity than there were before. Secondly it is important to recognise that in fact not all banks actually did respond in the same way and nor were they equally affected. Both Goldman Sachs and JP Morgan had drastically lower levels of exposure to the MBS and CDO markets than their competitors. Although the market was focusing on the efficiency of capital allocation, which is what these innovative products were supposed to improve, in fact many bankers made a strategic decision to reduce their risk exposure to the CDO market well ahead of the crash. That these banks also needed some TARP money was because they were caught up in the general market rout, not because of their specific risk.

Nevertheless the risk profile in loan origination versus loan ownership is completely different- and shareholders are waking up to the idea that the need much higher returns to justify their investment in higher risk businesses. It is that which will help to discipline the business in the future. One can certainly understand why regulators suggested that many bank shareholders behaved "like absentee landlords" - failing to police the value of their assets, but those shareholders were punished by either the drastic fall in the value of their shares or indeed their total loss. Frankly, since in many cases it is the government that owns the largest banks, the various finance ministries should now start to focus on maximising their investment: and giving employees a blank cheque to be paid more than the owners is the first thing that should now stop.

The strange thing about the banking crisis is that bank shareholders did not actually hold their employees to account. The whole point of the capitalist system is that it works when people act in their own self interest. The banks did not- most of them kept on "dancing" long after it was becoming clear that the orchestra was playing bum notes. If it is the case that shareholders were not able to understand the assets that they owned, then why did they bid up the prices, both of the assets and indeed the banks themselves so much?

In the end the markets, where some of the best minds hunted for profits so avidly, turned out to be turkeys. That in itself will discipline future investors to ask more searching questions. Secondly the propagation of risk across the system turned out to to be so extensive that not just individual banks needed to be rescued, but the whole system. In the future regulators will understand that better, and proposals such as the Tobin tax will reduce the profitability and therefore the attractiveness of such business while also in theory allowing regulators to amass fire power before a crisis actually happens. Thirdly, owners of lower risk businesses will seek to make sure that their business is not undermined as the result of an allied higher risk business. Branch banks were separated from market banks in the US, and although I see no formal return to Glass Steagall, I do see greater understanding of this risk problem.

The fear I have now is not that the banking system will make the same mistakes, but rather that the new environment of more intrusive regulation will warp the market in different ways and lead to governments becoming more involved and much more exposed to businesses that should not be the preserve of the state. Once the system is re privatised, I want to see clear and simple regulation, with clear boundaries about where the responsibilities of the regulator stop, and those of the shareholder begin. With the banks in the UK at least now largely state owned, I fear that the position could be blurred and that the taxpayer could be left with unknown legacy issues long after privatisation has come and gone.

So in final answer to Voter, I would say that you are right, there was a systemic failure, not just a failure of any given bank, but that the solution lies partly in greater diversity- in operations and ownership of different bank businesses that have recently been grouped under one umbrella. In the end both regulators and owners of these businesses have learned bitter lessons, but there is still at the moment too great a mixture of different risks in the larger banking groups. In my view these risk groups need to be separated, and that shareholders, acting in their own interests will do this. If they do not, then only then do I think that regulation will be required.

In the end though, the returns of the banking sector have proven to be illusory. As Nassim Nicholas Taleb points out, all the profits of all of the banks for all of the 20th Century were wiped out by the crash. If that, as an investor does not give you pause for thought about the whole basis of banking, then do by all means feel free to invest in the banking system now. I, however will not be joining you until I understand what the specific and systemic risks of any given bank and the banking system itself actually are.

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