Economics and similar, for the sleep-deprived
A subtle change has been made to the comments links, so they no longer pop up. Does this in any way help with the problem about comments not appearing on permalinked posts, readers?
Update: seemingly not
Update: Oh yeah!
Monday, April 22, 2013
Sympathy for the Dijsselbloem
At some point, and the one-month anniversary of the fabled interview seems as good as any, I think we have to start taking seriously the possibility that the reason why we haven't had a generalized bank run in Europe is that we're not gonna to have one. And as I said at the time, if there isn't a massive bank run, then this idiot scheme starts to look a bit more like a genius solution. As the man said, it's such a fine line between stupid and clever.
I think the issue here is that, as the lady said, money talks and bullshit walks. It's pretty costless to speculate in your FT column (OI, MUNCHAU! NO!) that it's rational for everyone to run on their local banking system - if you're of an academic turn of mind you can even find a model to tell you how right you are. But in the real world, running on a bank is hella inconvenient, which is why people usually don't do it. Northern Rock was the anomaly.
(Quick finger exercise: it's been suggested to me more than once that corporate deposits are going to start "sweeping" cash balances on a daily basis out of places like Spain into a head office account in Germany, or even outside the Eurozone. Maybe. But say your cash float is EUR200,000 in a branch of a Spanish bank, and it has to be in that branch because you can't persuade your cashiers to walk to Frankfurt every evening (this setup is not impossible for, say, a supermarket). You are unlikely to get the bank transfers for less than EUR100 round trip. So if you sweep it daily, over the course of 200 business days you have given yourself a 10% haircut on that float, simply with the cost of bank transfers. You're protecting yourself against a Cyprus-like loss, but it isn't cheap insurance. This is true of retail customers too - shift your money to Rabobank? Now every time you go to an ATM in Rome, it's an international Cirrus transaction, which you will be lucky to get away with for less than EUR1.50 a go).
The frictional costs of running on even a single bank (let alone the logistical difficulties of running on an entire local banking system) are very significant. People run on banks when they're specifically worried about something nasty; they don't get round to it on the basis of general policy uncertainty. They hardly ever run on transactional deposits (as opposed to savings deposits) at all. Even last year in Greece, when there was a very genuine danger of getting one's entire deposits redenominated into drachma-denominated claims on a bankrupt guarantee scheme, nobody managed to get up anything much more than a "jog".
Furthermore, it's worth being aware that although the concept of a bail-in is brand new to the newspapers, it's actually been around for a couple of years .I can make a reasonable argument that careless handling of the original proposal was a contributing factor to the 2010 Irish bank run. The current proposal is up on the Commission website, and as long as you keep a clear head, it's pretty easy to understand, although in fairness, it is also very easy to get confused. The trick is (a very useful piece of advice given to me by a wise old head who was the Bank of England's tax expert at the time) to remember that official documents appear on the page as intimidating long lists of specific cases, but they are written as sets of general underlying principles, and if you keep your eye on the general principle then not only will you understand the reasoning much clearer, you'll be much better placed to spot the departures and loopholes and guess at the reasons for their exclusion.
In the case of the bail-in rules, the general principle is a division of the banking sector's liabilities into "basically risk capital" and "basically financial sector plumbing". You want to, if at all possible, restrict losses to the first category, leaving the payments infrastructure intact. Into the at-risk category falls equity (of course), subordinated debt and bonds, while the protected category ought to include short term interbank credit and retail deposits. Because this is Europe, nothing can be simple, so there are loads of weird and ambiguous cases like covered bonds and high-value deposits which might go either way, but the general principle is clear. So Cyprus isn't a "template" - it's the application of an already existing template to the particular oddity of the Cypriot financial system.
So, the more I think about this, the more I think that the risks of the new Dijsselbloem era in European policy are perhaps not as great as I initially thought that they were. The strength of a bridge is tested by the weight of the things you drive over it, and the fact that the European deposit system has survived not only Jeroen D's bumbling, but also considerable cheerleading for bank runs from the press should surely update our estimates of its underlying robustness. Even looking at the prices of term bank debt, or CDS on instruments which are indisputably in the "risk capital" part of the liability structure, I'm seeing a lot of discrimination; a few known peripheral problem children are trading at no-market-access levels, but the majority of core well-capitalised banks (including a number of peripherals) are basically unchanged on 18 March.
But ... "it doesn't appear to have blown the whole thing apart" is hardly the sort of thing that would justify a rating of "genius move" - even in the context of Eurozone politics, we've got to set the bar higher than that. So where's the genius bit?
It's about Spain. It's always been about Spain. This whole sorry spectacle has always been about Spain. Greece and Ireland, forgive me, are small. So's Portugal. But Spain and Italy are too big to be successfully yaddayaddaed. And the way that the contagion dominoes have stacked up, it has been clear for a few years that if you win the battle in Spain, you won't have to fight it in Italy, while if you lose the battle in Spain, you're probably not going to get a chance in Italy. And Spain (unlike Italy) has always been a case where it's basically a banking sector problem that has infected the sovereign, rather than basically a sovereign problem that has infected the banks.
There are "a few tens of billions" of real estate lending losses, which are hanging around in Spain. They are not meant to be on the credit tab of the Kingdom of Spain, but they are standing close enough to the Kingdom of Spain that people worry that they might be. To a first approximation, the Eurozone sovereign/bank crisis could be substantially ameliorated if this mountain of excess debt could be made to go away.
Now there are only three things that can happen to an excess debt problem. Either it gets inflated away, or someone else pays it, or it doesn't get paid. Monetisation, mutualisation or default. The ECB constitution means that monetization is off the table, and mutualisation (ie, Germany pays) is what we wasted most of 2012 finding out wasn't politically or constitutionally possible.
[we pause here for a short break in which readers may, if they wish, conduct a brief Three Minute Hate aimed at "Germany". Other countries, of course, are allowed to have democratic politics and to have constitutions and legislatures which constrain the ability of other people to write unlimited cheques on their behalf. But the Germans, of course, could make everything go away if they wanted to and only refuse to underwrite literally unlimited deficits with no control over how the money is spent because they are being awkward]
Anyway, "not politically possible", in context, means the same thing as "not possible", which narrows the space of possibilities down to "default". And so it really is a big win if Europe can overcome the taboo against banks ever defaulting on their creditors, a taboo which, we should note, does not exist in the USA. Ask IndyMac's uninsured depositors what they think about what happened in Cyprus, for example. The Kingdom of Spain needs to get the bank bailout liability shifted, in order to make room for a sane fiscal policy, and the way to shift it is going to involve some hefty defaulting; on bonds and "risk capital" instruments for choice, but on deposits if necessary, and I suspect that unless someone can come up with some fairly swift corporate-finance footwork, we are going to have to cut quite deep into the "plumbing" part of the balance sheet in some cases. Not nice, but there really never was a way out of this mess that didn't involve confiscating somebody's life savings, and doing it this way is no more morally shitehouse, and potentially considerably more practically effective, than letting it fester and putting the cost on taxpayers for the rest of forever.
I think my bottom line here is that this was a clearly high risk but potentially high return strategy for Europe, and all of the play-it-safe gradualist stuff had been tried and wasn't working. Dijsselbloem clearly talked out of turn, but what he was saying wasn't untrue, and the whole of Europe is going to have to be let in on the secret sooner or later. So maybe the guy is effing stupid, but he's stupider like a fox.
this item posted by the management 4/22/2013 06:15:00 AM
Wednesday, April 10, 2013
Upside down CDOs and leverage ratios
I thought I might as well expand on the tweet quoted here, as rather too many people seemed to have jumped on the bandwagon of assuming that anything "risk weighted" is in some way suspect and probably manipulated, while "straight" leverage is honest, simple, probably speaks with a Northern accent, et cetera.
Not so many people realize that under the Basel standards, you can often get risk weights of more than 100% assessed, even using those terrible internal models. This is because (as I alluded in that tweet), the question of what appears on a balance sheet is not a fact of nature - it's a control parameter itself.
Stretch your memory back to 2007(!) and Felix's explanation of how to make a CDO if you need to. Then consider a really simple transaction:
1. I'm a bank and I take 1000 loans, each with an expected loss of 5%, so the expected loss is 50.
2. I bundle them up and sell them to a special purpose investment company.
3. That special purpose investment company has two classes of debt - 500 of senior and 500 of subordinated.
4. I sell the 500 of senior to bondholders and keep the 500 of subordinated.
For reasonably normal accounting policies, my balance sheet will now show that I have sold 500 of my 1000 of loans, and will be smaller by 500. An accounting balance sheet is always going to show something like this, because the 500 that I've sold off are now on someone else's balance sheet and so shouldn't be on mine.
The risk-weighted balance sheet, though, will show no effect at all.
The regulator would argue thus:
1. The expected loss on this portfolio is 50.
2. The senior debt does not take any loss unless the realized loss on the loans is 500, ten times the expectation.
3. Therefore, the junior debt takes all the realized loss in all but a tiny minority of situations
4. Therefore, the 500 that is on my balance sheet is bearing substantially all the risk of the original 1000 of loans.
5. So the 500 asset on my balance sheet needs to be given a risk weighting of 200%.
Of course, as the man said "It's More Complicated Than That", but this is the idea. A regulation based on accounting leverage is very easy to game because the composition of the balance sheet matters. By the way, if you think that this is all a product of nasty investment banking and financial wizardry and could be stopped by sufficiently draconian Glass-Steagall type law, no luck there either.
All that is really going on here is that the leverage ratio doesn't distinguish between a loan to an ungeared borrower and a loan to a borrower that has loads of other debt. So it doesn't have to be a special purpose vehicle although that makes the problem clearer; historically it has been found that leverage regulations reliably give you a banking system with no surplus cash balances and loads of leveraged buyout loans. One of the things that they teach you in the relevant business school course is that you need to dig down to the leverage of the underlying "real" assets, and that's basically what Basel risk-weighting is all about.
There aren't any silver bullets. There's no substitute for an active, involved and self-confident supervisor. But "straight" balance sheet leverage is a real blind alley. It's a classic case of taking a set of information produced for one purpose and hoping it will be useful for another. As far as I can tell, the idea that people have is that they want "objective" measures, based on the financial accounts because they don't trust the banks not to fiddle the model. But if that's your problem, then that's your problem right there - if they're meant to work as a solution to a fundamental problem of trust, then leverage ratios are ludicrously inadequate.
 Pet theory alert; you'd be surprised at the extent to which a lot of financial regulation is all about the sublimated performance of masculinity.
 There are echoes here of the 2008-era religious horror of "Level 3" or "Mark to Model" assets. As in that case, refusing to model something (or to accept someone else's modeling of it) doesn't actually make the answer more objective, it just ensures that you will remain ignorant whatever information arrives.
 I have no idea how anyone says this with a straight face, and suspect that the answer might be lack of ever having seen a balance sheet prepared.
this item posted by the management 4/10/2013 12:41:00 AM