The Great Debate

Two years after Lehman, risk of financial collapse is still high

By Mark Williams The opinions expressed are his own.

Events unfolding in Europe — including Greece, Portugal, Spain, Italy, and most recently Ireland — are alarming reminders that systemic risk is the most pressing of this decade.

While it’s been two years to this day since the death of Lehman Brothers almost brought down the entire financial system, global systemic risk — the chance that a single event or series of events can collapse the world financial system – remains quite high.

In response to this threat, international banking regulators just approved higher Basel III capital requirements as a step in reducing global systemic risk. Banks with more capital are being forced to make more room to absorb losses, helping to increase economic stability. Under this tougher standard, banks need to maintain a minimum tier one (core) capital ratio of 4.5 percent, more than double the previous requirement.

As further risk mitigation, dividend and discretionary bonus payments will be restricted unless core capital ratio is 7 percent or higher. Unfortunately the phase-in period for these stronger capital standards is from 2013 to 2019. So this multi-year time gap allows for plenty of systemic risk to persist and grow.

Domestically, the Dodd-Frank Act passed in July also attempts to address systemic risk by setting up a Financial Stability Oversight Counsel (FSOC) made up of major financial firefighters like the Fed, SEC, FDIC, and the Treasury. For the first time, managing systemic risk and its impact on the economy is an official U.S. regulatory policy.

Michael Lewis’ Big Short an unsettling experience

Hardy Green

Mar 11, 2010 13:38 EST

Henry Paulson didn’t see it coming. Nor did Timothy Geithner foresee the meltdown of the financial markets. According to Standard & Poor’s President Deven Sharma, testifying before Congress in the fall of 2008: “Virtually no one – be they homeowners, financial institutions, ratings agencies, regulators, or investors – anticipated what is occurring.”

Why? Perhaps “it took a certain kind of person to see the ugly facts and react to them – to discern, in the profile of the beautiful young lady, the face of an old witch,” says Michael Lewis, author of numerous best-sellers including 1980s Wall Street memoir  Liar’s Poker and now The Big Short: Inside the Doomsday Machine (W.W. Norton, $27.95).

Lewis’ new volume is an entertaining and very edifying look at several such insightful people — the tiny handful of investors “for whom the trade became an obsession.” These were unusual, “almost by definition odd” folks, soon to make big money on the cataclysm: There is Steve Eisman, the former Oppenheimer analyst who regularly demonstrated a prodigious “talent for offending people,” notably in a tendency to trash subprime originators as early as 1997.

Next up is Michael Burry, a compulsive, “one-eyed money manager,” a man profoundly uncomfortable around other people who could only work alone in his office with the door closed and the shades drawn. Poring over obscure corporate documents, Burry saw the insanity in the financial markets and in 2005 began prodding big Wall Street firms to offer credit default swaps, or financial insurance policies, against the failure of mortgage-backed derivatives. Finally, there’s the “weirdly like-minded” threesome who made up the money-management outfit they called Cornwall Capital Management. They were “sweet-natured, disorganized, inquisitive” –”the kind of guys who might turn up at their fifteenth high school reunions with surprising facial hair and a complicated life story.”

This band-of-outsiders conceit is familiar — reminiscent of everything from Huckleberry Finn to The Dirty Dozen – and if The Big Short were no more than a collection of such profiles, it would satisfy many readers. But Lewis’ volume has lots more to offer thanks to its clear explication of exotic derivatives and meltdown events.

Much of this may be familiar to regular readers of the financial press, and may remind some of Wall Street Journal writer Gregory Zuckerman’s much lauded account of hedge-fund trader John Paulson’s $15 billion coup, The Greatest Trade Ever. But even these readers are likely to admire the lucidity of Lewis’ book. Here, for example, is how Lewis explains the two financial instruments at the heart of the mess. The subprime mortgage-bond-backed collateralized debt obligation, or CDO, was “so opaque and complex that it would remain forever misunderstood by investors and rating agencies.”

It was a bunch of mortgage bonds, often rated triple-B, used to construct an entirely new tower of bonds, which ratings firms like Moody’s and Standard & Poor’s were persuaded to rate triple-A. The CDO, which hid huge risks via obfuscation, “was a machine that turned lead into gold” for Wall Street, writes Lewis. The credit default swap, meanwhile, was effectively an insurance policy with semiannual premium payments – but also an asymmetric bet. As in roulette, “the most you could lose were the chips you put on the table; but if your number came up you made thirty, forty, even fifty times your money.”

Big banks aren’t bad banks

— Mark T. Williams, a former Federal Reserve Bank examiner who teaches finance at Boston University School of Management, is the author of the soon to be published “Uncontrolled Risk” about the fall of Lehman Brothers. The views expressed are his own. –

Too big to fail has become nothing more than a political sound bite and the title of a best-selling book. Unfortunately, in the process big banks have gotten a bad rap. The proposed Obama administration plan to limit bank size is just another example of big-bank bashing by high-level politicians.

Policy that simply focuses on downsizing big banks overlooks an important point. The problem is not that banks are too big; it is that banks are taking excessive risk. This includes big and small banks. Since 2008, more than 170 banks have failed, including big banks such as Lehman Brothers, Wachovia, and IndyMac. But most on this list – such as Citizens State Bank, Republic Federal Bank, and First State Bank — are smallish. They didn’t make big headlines. No books were written about them or movies made.

The fact that a bank is big should not automatically mean they are a threat to the financial system. It’s true that Citigroup, once our nation’s biggest bank, needed a massive government bailout. But this singular sample size is not large enough on which to base far-reaching policy changes.

Big banks offer many advantages over smaller ones. They provide consumers with a greater array of desired services and economies of scale allow them to deliver more for less, and they tend to have greater capital to protect them against unexpected losses. In many countries in Europe and elsewhere, the universal banking system (another phrase for big banks) dominates the market. In these countries, a universal big-bank system works.

In Canada, the top five banks represent 90 percent of the market. During the Great Credit Crisis of 2008, not a single bank failed in Canada (nor did any fall during the Great Depression). A decade ago, no Canadian bank made the North American top-ten list. Today, four are Canadian. The lesson from our northern neighbors is simply that they had tighter lending standards, lower leverage ratios, and better regulatory oversight. They also taught us that slow and steady is a better risk strategy than fast and wobbly.

Using Canada as an example, the real concern should not be bank size but the level of risk taking. Banks make money only three ways — providing loans, proprietary trading, and/or charging fees for services. The main driver of the recent financial crisis was neither proprietary trading nor fee charges, but risky lending practices.

Obama disappoints on bank reform

— Peter Morici is a professor at the Smith School of Business, University of Maryland, and former Chief Economist at the U.S. International Trade Commission. The views expressed are his own. —

President Obama announced he wants to prohibit banks from forming hedge funds, private equity funds and trading securities on their own accounts, and he wants to limit the size of banks and financial institutions generally.

Hedge funds, private equity funds and proprietary securities trading did not cause the banks to get into trouble, and the size of banks did not cause the credit crisis.

Banks, small and large, failed or required bailouts because of poorly considered loans, and the kinds of engineered products that were created from those loans by non-bank entities.

Collateralized debt obligations and swaps created and marketed by non-bank financial institutions, such as Lehman Brothers and Goldman Sachs, compounded the errors of foolish bankers. Later, Goldman Sachs and other financial institutions became banks to access inexpensive credit from the Federal Reserve, but those decisions could be reversed if bank holding companies are not permitted to trade on their own accounts.

Prohibiting securities trading by banks and limiting the size of the banks would not keep those mistakes from happening again.

Many smaller banks invested in risky securities-commercial mortgage backed securities. They did that and could do it again without a proprietary trading arm.

from The Great Debate UK:

2010: Another year, another crisis

Laurence Copeland

Dec 21, 2009 13:19 EST

- Laurence Copeland is a professor of finance at Cardiff University Business School and a co-author of “Verdict on the Crash” published by the Institute of Economic Affairs. The opinions expressed are his own. -

If the financial crisis were a theatre production of Hamlet, we would now be at the end of Act III.

But look . . . the audience is already standing up, applauding wildly and putting on their coats. They obviously think it’s all over. Little do they know how much blood remains to be spilled . . . Look at the facts.

The FTSE is up by nearly 50 percent since March, so that it is now more or less back to where it started 2006.  The same is true of gilts, corporate debt, and more or less every other financial asset on both sides of the Atlantic and across the globe. Even the housing market, where it all began, seems to be reviving.

So the crisis must be over, right?

But the jubilation may be premature, because, since Lehman Brothers collapsed in September 2008, policymakers have used every conceivable tool of monetary and fiscal policy so as to restore the status quo ante. Indeed, the success or failure of these policies has largely been judged by the criterion of how far the numbers look normal – where the norm has been redefined to mean “similar to the levels of 2005 and 2006”.

In these terms, the policies, especially quantitative easing, have been extremely successful. In many respects (not just bankers’ bonuses), the clock has indeed been turned back to 2005.

from Commentaries:

Securitization survives the fall

Agnes Crane

Sep 11, 2009 11:24 EDT

A year after the government's seizure of Fannie Mae, Freddie Mac and AIG , not to mention the bankruptcy of Lehman Brothers that sent the global financial system into a tailspin, very little has changed to prevent debt from being sliced and diced, again and again.

This is a mistake. Although there were many factors contributing to the downfall of the global financial system, the repackaging of toxic debt into esoteric financial products was at the heart of the credit crisis when it erupted in 2007.

It's easy to forget, particularly when many are focused on anniversary tick-tock accounts of the last days of Lehman Brothers, how nasty CDOs -- or worse, CDO squareds -- became so incredibly popular in the first place.

Yet, after all the damage, the trillions of dollars lost and the biggest state intervention in financial markets since the Depression, there has been no movement to ban their creation.

Securitization in its broadest form -- taking underlying collateral, bundling it together and selling it as tradable debt -- is still hailed as an important 20th-century invention that has helped worthy borrowers get the credit they need to buy a home, car, or education that would otherwise be out of their reach.

Policymakers, understandably, are anxious to get it started again after the market snapped shut last year. Wall Street, and investors taking advantage of generous financing from the Federal Reserve, are happy enough to oblige.

And it has worked. As of last week, new bonds backed by consumer debt reached $100.5 billion for the year, according to Barclays Capital. While a fraction of the pre-crisis market, that deal volume represents a healthy revival of a near-dead business. Three-quarters of the new deals are eligible for Fed financing.

from Commentaries:

‘Living wills’ easier said than done

Margaret Doyle

Sep 10, 2009 12:37 EDT

In the wake of the widespread chaos that accompanied the bankruptcy of Lehman Brothers last September, regulators have sought to find a better way to unwind global financial giants. One approach is that the banks themselves should prepare for their own orderly demise -- a kind of "living will".

That idea has been gathering steam of late. The G20 group of finance ministers and central bankers meeting in London over the weekend agreed to require "systemic firms to develop firm-specific contingency plans."

The concept has wide appeal. The crisis has convinced politicians and regulators of all colours that even large financial institutions must be allowed to fail without imposing a huge burden on taxpayers. Many bankers see such a regime as a preferable alternative to more intrusive regulation.

However, drawing up a detailed "living will" is easier said than done.

Simon Gleeson of Clifford Chance argues that it is more important for regulators and legislators to establish a cross-border crisis-management and resolution regime than it is for individual firms to prepare for their own demise.

The mandate of the Financial Stability Board (FSB), the international body comprising finance ministries, central banks and financial regulators, was recently expanded to include contingency planning for cross-border crises. It published a series of relevant principles in April. However, as the Institute of International Finance (IIF) noted, it is "clear from the high-level nature of the principles and the aspirational language [that] there remains a lot to be done."

The IIF is calling for the FSB to develop a convention on crisis management that would include detailed rules, including on early intervention. It also wants the FSB to run cross-border crisis simulations of the sort routinely carried out by domestic regulators.

from Commentaries:

Banking? Keep it simple stupid

Christopher Swann

Sep 10, 2009 12:07 EDT

In 1873, Walter Bagehot wrote that "the business of banking ought to be simple; if it is hard it is wrong." He would have struggled to recognize today's banking system.

It is not just ever more ornate derivatives that bend the mind. Financial firms themselves have become fabulously complicated. Citigroup lists 2,061 subsidiaries and affiliates while the institutional chart of JPMorgan Chase is 267 pages long.

Complexity -- as Bagehot predicted -- has become a curse. If nobody can understand financial firms, they will become ever more accident prone.

The crisis that exploded a year ago offered a salutary lesson in the dangers of complexity. Many shareholders and creditors simply did not fully comprehend their investments. Instead they were forced to trust managers and the rating agencies.

Regulators too could be forgiven for scratching their heads.

"Supervisors are at a decided disadvantage in understanding risk-taking and compliance for firms that might involve dozens of jurisdictions, hundreds of legal entities and thousands of contractual relationships," former Fed official Vincent Reinhart has written.

Indeed Basel II -- the international capital code -- was an admission of defeat by regulators. The message from the banking accord was that institutions had become so convoluted that only they were able to understand the risks they were taking.

Winning back the public’s trust

– Aron Cramer is president and CEO of BSR, a global business network and consultancy focused on sustainability. The opinions expressed are his own. –

The fall of Lehman Brothers last September triggered a collapse in financial markets, and then the real economy. It also signaled a further decline in the public’s trust in business. One year on, has anything changed?

At the start of 2009, only 36 percent of the U.S. public trusted business to “do what is right”—down dramatically from 59 percent one year before—according to surveys from the PR firm Edelman. But as of this July, trust levels in business had recovered somewhat, to 48 percent. Yet just as with the economic recovery overall, it is far too early to declare victory.

This is about more than winning a popularity contest. Without the public’s trust, business faces cynical consumers, unhappy employees, and public officials that tap into this mood with punitive legislation: hardly the conditions most companies want and need.

Before considering how to make further progress, it’s best to diagnose how this happened.

Inevitably, an economic decline brings a fall in trust. When large swaths of the public feel insecure economically, business suffers, too. We like the private sector a lot more when unemployment is at 5 percent than we do when it nears 10 percent.

Business is also represented by some rather unsavory figures in the public mind right now.  Bernie Madoff and John Thain symbolize this economic downturn, and for some, they symbolize the entire business community, regardless of whether their sins are widely practiced.

from Commentaries:

Time to get tough with AIG

Matthew Goldstein

Aug 28, 2009 15:00 EDT

It's time for someone in the Obama administration to read the riot act to Robert Benmosche, American International Group's new $7 million chief executive.

Since getting the job, Benmosche has spent more time at his lavish Croatian villa on the Adriatic coast than at the troubled insurer's corporate offices in New York.

And in the short term, Benmosche's vacation strategy appears to be paying dividends.

This week, AIG's shares surged 44 percent, to nearly $50, after Benmosche said that he intended to move slower than his predecessor in selling off AIG's still viable divisions.

Maybe Benmosche should consider relocating AIG's headquarters to Dubrovnik.

But the big run-up in AIG shares is merely a sideshow for momentum players, speculators and Hank Greenberg, the former AIG chieftain who controls about 11 percent of the company's outstanding shares.

The reality is that AIG exists today only because of the $180 billion lifeline the insurer has received from the federal government. Even Benmosche acknowledges that, telling The Wall Street Journal: "If the U.S. government doesn't continue to support AIG, we will fail."