Thursday, October 24, 2013 - Liquidity and Leverage and a bit of Levity

Liquidity and Leverage and a bit of Levity

by Sinclair Noe

DOW + 95 = 15,509
SPX + 5 = 1752
NAS + 21 = 3928
10 YR YLD + .04 = 2.52%
OIL + .37 = 97.23
GOLD + 13.60 = 1348.30
SILV + .16 = 22.82

“Liquidity is essential to a bank's viability and central to the smooth functioning of the financial system," so says Fed Chairman Ben Bernanke; and so today the Fed proposed that big banks keep enough cash, government bonds and other high-quality assets on hand to survive during a severe downturn like we saw in 2008, and the idea is that we avoid a global financial meltdown like we almost saw in 2008. Liquidity is the ability to access cash quickly; that's important when nobody is sure about what the bank truly has in the vault. Liquidity is what prevents a bank run; liquidity averts a financial meltdown or credit crunch.

The Fed proposal today subjects US banks for the first time to liquidity requirements. The big banks, with more than $250 billion in assets, would be required to hold enough cash and securities to fund their operations for 30 days during a time of market stress. Smaller banks, those with more than $50 billion and less than $250 billion, would have to keep enough to cover 21 days. Fed officials said the rules are stronger than new international standards for banks. The public has 90 days to comment on them. After that, they would be phased in starting in January 2015. The requirements were mandated by Congress after the financial crisis.

The proposal would require setting aside about $2 trillion, and the Fed estimates US banks are currently $200 billion short. The Basel Committee on Banking Supervision in January agreed on a liquidity coverage ratio meant to ensure banks can survive a 30-day credit squeeze without bailouts like 2008. That standard would let lenders go beyond cash and low-risk sovereign debt to include some equities and corporate debt.The US version would permit a limited amount of government-sponsored enterprise debt while excluding private-label mortgage-backed securities; so some Fannie Mae and Freddie Mac. The US version is considered a bit tougher than the international version as far as what can be considered reserves.

Where this starts to get interesting is in the requirements dealing with what the banks have to hold to be considered liquid. It's not just cash; it's cash and securities and other high quality assets.

Bank regulation has moved to a system where bank assets are measured on a risk-weighted basis. This is the mechanism that encouraged Eurobanks to buy toxic AAA rated CDOs and sovereign debt; both had zero risk weights under Basel II; and because there was no risk, the banks could and did leverage those no risk positions. The US did not implement Basel II prior to the crisis, but similarly focused on risk-weighted assets rather than simpler total leverage measures.

The credit risk weightings mean that instead of reserving the standard 8 percent of capital in respect of a debt, the bank can cut that by the weighting applied to the asset class. Effectively, the reduction in credit risk weighting operates as a powerful subsidy to the borrowers and equally powerful incentive to over-leveraging the lenders. So the 2008 crisis started with bad mortgage debt, spread to bad bank debt, carried over into bad agency debt, and now encompasses bad sovereign debt. Each of these categories was given preferential capital weighting under the Basel Accords, and now all are open sores on the financial system and the stability of excessively indebted governments. Not only did the Basel weightings encourage poor risk assessment, they directly contributed to the inadequate capitalization of banks for the risks they assumed.

So, the idea of increasing capital reserves sounds good in theory, and to a certain extent in practice, but it only goes so far. It's a good thing to have the banks have a lot more equity capital, so they're not just gambling with other people's money. The problem is that high-quality assets are only high quality until they aren't. A system in which banks or bank-like institutions are tightly coupled with one another, and in which those institutions have too much debt relative to equity, is prone to meltdowns that can spill into the real economy and cause massive damage. Whether these liabilities are in the form of derivatives and off-balance-sheet assets or overvalued tulips pledged as collateral, too much debt without loss-absorbing equity to match it is simply too dangerous to exist.

It is difficult to measure the exact cost to society of our undercapitalized large banks blowing up during the most recent financial crisis, but it was certainly enormous. The nonprofit advocacy and research group Better Markets pegged the cost at roughly $12 trillion, whereas the U.S. Government Accountability Office put it at $22 trillion. Regardless of which figure one uses, it is obvious that the United States is a much poorer society because there was too much leverage backed by over-valued collateral in our financial system. The proposed rule strikes at this problem.

In a crisis the market cares about the leverage ratio, not risk-adjusted capital. Risk weights are prone to manipulation by internal bank models. In 2008 there was a steady downward trend in risk weights and upward trend in leverage leading into the crisis, and less-capitalized banks manipulated risk weights after their internal models were approved by regulators. The use of a leverage ratio in the United States by regulators meant that American banks were, relatively speaking, better capitalized than their European counterparts.

Risk-weighted capital ratios also have the added downside of increasing, rather than reducing, systemic risk. Regulators deemed certain asset classes as less risky than others. Mortgage backed securities, some sovereign debt, agency debt, and interbank debt all effectively received subsidies because regulators determined that banks had to hold limited capital against them. Risk-adjusted capital allowed banks to treat Greek sovereign debt as bearing the same risk as German sovereign debt. Regulators cannot predict the future, but risk-adjusted capital models require them to. Leverage ratios do not. So, a crisis beginning in mortgage debt spread through agency debt, interbank debt and into sovereign debt. Everything fell apart because the chain was only as strong as the weakest link.

This also takes us back to the differences between insured depository institutions that are subsidiaries of bank holding companies and the holding companies themselves; another way of looking at it is the difference between FDIC insured bank accounts and the trading desk of a bank such as the London Whale trading desk. We need firewalls between these institutions. The less interconnected the system is, the less risk it poses to the real economy. The greater the interconnection and the reliance, and the ability to dip into insured accounts in times of trouble – the greater the risk. We used to have a great firewall; it was called the Glass-Steagall Act. We should consider it again.

Fed vice-chair Janet Yellen, who has been nominated to replace Fed chairman Ben Bernanke, expressed concern that there could be a shortage of high quality liquid assets if the Fed tapers and reduces its reserves. Fed officials said that was a concern but that is why the products covered under high-quality liquid assets are varied to include invest-grade corporate debt securities, among other instruments. What that means is that not much has really changed with the vulnerability of banks over the past 5 years, and also that the Fed is not yet ready to taper. So, for today at least, it was risk on.

Now, one more bit on the banking front today, we've talked a bit about the $13 billion settlement over JPMorgan's mortgage practices. It looks like Jamie Dimon wants to clear the decks of all the legal problems. You may recall the Bernie Madoff case. Madoff's bank of choice for about 20 years was none other than JPMorgan Chase; perhaps he liked them because they didn't scrutinize his Ponzi Scheme. 

Federal authorities are preparing to take action in a criminal investigation of JPMorgan, suspecting they turned a blind eye to Madoff's shenanigans.

Prosecutors are reportedly weighing criminal charges against JPMorgan employees who did business with Madoff. It is unclear which employees are under investigation. Prosecutors and JPMorgan have held preliminary discussions about a so-called deferred prosecution agreement. Such an arrangement would suspend criminal charges against JPMorgan in exchange for a fine, certain other concessions and an acknowledgment that the bank will face charges if it fails to behave. Prosecutors may also require JPMorgan, which has repeatedly said that “all personnel acted in good faith” in the Madoff matter, to hire an independent monitor.

Prosecutors could demand that the unit plead guilty to a criminal violation of the Bank Secrecy Act, a federal law requiring financial institutions to report suspicious activity to the government. Prosecutors have reportedly discussed the ramifications of criminal charges with one of JPMorgan’s regulators.

The actual repercussions would depend on the underlying criminal charge. The most serious potential violation could complicate JPMorgan’s business with certain clients, possibly forcing investors like pension funds to withdraw some money from the bank. But a lesser violation would be likely to have more of a reputational consequence.

For the government, it would represent an extraordinarily rare show of force. Ever since a criminal indictment led to the demise of the accounting firm Arthur Andersen, Enron's auditor, the government has been wary of imposing criminal charges on big corporations for fear that it would imperil the institution and have ripple effects on the broader economy. Under federal guidelines, prosecutors must weigh “collateral consequences,” like job losses and economic implications, in such an action.

Ok, I've been talking quite a bit about JPMorgan and their $13 billion settlement. I tend to be a bit serious when I talk about the banksters. Sometimes I wonder if the rest of the world realizes what's going on. Well, last night Jon Stewart of the Daily Show talked about the media coverage, specifically the coverage by CNBC. Stewart showed a clip of Alex Pareene, a reporter for Salon, questioning whether Jamie Dimon should lose his job as chief executive of the bank. And Maria Bartiromo, acting as the great defender of JPMorgan. And then, they went to the videotape from 2008, where CNBC's Jim Cramer waxed eloquent about how Jamie Dimon got such a great deal when he purchased Bear Stearns in a deal with the Federal Reserve. I have to say that a takedown of Maria Bartiromo is probably easier than shooting fish in a barrel. Still, it was entertaining, so click here to link to the videotape.