The Arcane World of Risk Weightings

Recently there has been a lot of discussion about the need to decrease the onerous capital requirements on securitisations as proscribed by Basel 2.5.  Of course it must be said that the voices clamouring for the loosening of the restrictions are the banks and their lobbyists.  That banks and their minions would be working behind the scenes, and in front of them, to try and push through changes which would decrease capital requirements is not in and of itself worrisome.  Lower requirements mean increased leverage means, theoretically, increased profits.

Until something goes wrong.

But that is a topic for another day. 

What I am interested in is why the Swedish central banker, Stefan Ingves, who is head of the Basel Committee on Banking Supervision, is speaking up on the topic in such august forums as the Financial Times, and even more importantly why is he suggesting softening the rules. 

A bank is required to hold a capital reserve of 8% against its "standard risk-weighted" assets. This means, essentially that a bank by definition is

The Basel committee  of which Mr Ingves is head has requested that the world's largest banks actually hold 9.5% capital versus their risk assets which gets the leverage down to 10%. 

This is because Basel is already a bit disturbed by the fact that banks, as is their wont, are constantly redesigning their risk models to achieve the lowest possible capital requirement for their assets, regardless of their riskiness.  Thus, depending on the bank, its national regulators, and the aggressiveness of its management the same portfolio of assets can have quite different capital requirements.

There is even a movement, championed in the editorial pages of the FT on July 10, 2013 suggesting that the somewhat blunt instrument of leverage ratios be instituted regardless of the risk weighting of the assets.  The number being bandied about is 3% which equates to a leverage bordering on 35 times. 

Given that banks, through their use of clever models, and pressure on their regulators have been able to carve out a niche where at the extreme they can avoid all capital requirements a minimum of 3% looks promising from a regulatory and bank solvency point of view relatively speaking.

The editorial goes on to suggest that leverage ratios are not perfect because they encourage lenders to focus on the riskiest assets available thus achieving the highest returns for a set amount of capital.  Hmmm.  Isn't that what banks always do?  It's certainly what they are doing, and, more importantly, what they are being allowed to do, perhaps even encouraged to do, by the Basel Committee in that they are allowed to use their "approved" models.

So, back to my original question, given that the Basel committee is responsible for the security/solvency of the global banking system, why is Mr Ingves opening the door even wider for increased leverage rather than being the bulwark of the system I would hope the Head of the Basel Committee on Banking Supervision.

I don't know.




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Quantative Easing to Infinity and Beyond?

Last week, to the total dismay of many in the market the Federal Reserve "surprised" the market by not initiating a reduction in their great stimulus program know as Quantitative Easing (QE). Among the reasons for the market to presume that a "taper" would begin was that in their Federal Open Market Committee (FOMC) minutes from previous meetings they mentioned that they had discussed the idea of a taper.

The market's reaction to this suggestion that they might start to taper QE was to drive mortgage rates from approximately 3.5% to 4.5%-still low-but a large jump relatively speaking, and to make the 30 year treasury trade off quite sharply.

Now to taper or not to taper was a 50/50 bet from the outset. The economic news in the US is constructive, but certainly not creating any stresses in the system. Unemployment is down, but I would draw your attention to the fact that many people seemed to have stopped seeking employment and so fall out of the pool, plus temporary as opposed to permanent employment growth seems to be the flavour of the recovery.

Add to this an almost pathological fear of deflation by the current Bernanke Fed, which will most likely be continued by a Yellen Fed, and I believe the market seriously got ahead of itself and fell into that most dangerous of traps-believing your own hopes to be facts.

So is the long end of the treasury curve artificially low?  A resounding Yes!
Is there the potential that if the Fed were to continue to purchase the long end in their QE quest that they would be creating serious inflationary pressures?  Again a resounding Yes!

But did I believe that the economic recovery has shown any real inherent strength strong enough to warrant essentially putting a break on economic potential? A resounding No!

Do I believe the inflationary pressures are such in the US that the Fed has no choice but to start to taper QE?  You guessed it.  Another resounding No!

At some time the Fed will start to taper.  There is no way that they can continue ad infinitum in their QE washing machine.  But before they start they must coordinate with the Treasury.  In order to help stimulate the economy which is run by two ends of the yield curve- Fed Funds and 30 year Treasury yields, the Fed instituted a "twist" which essentially extended the maturity of the Fed's portfolio thus driving down yields at the long end while Fed Funds have been held excessively low in the front end.

In this case the artificially low yields in the long end must be kept somewhat low, again through artificial means.  The Fed has to get the Treasury to agree to stop issuing long dated debt.  The Fed will stop it's purchases in the long end, moving down the yields curve thus keeping the front end low and allowing/forcing all the index driven investors to purchase long dated securities from the Fed's balance sheet.

Once this reverse "twist" has taken place, the Fed can start to taper it's purchases of the front end of the curve and thereby ease the transition into higher yields without panicking the market or crushing the recovery.

I know, the question is why did all those prop traders really think the Fed would taper?  Why did they make blatantly 50/50 bets?  Believing your own rhetoric is truly dangerous!

Manufacturing Consent FT Style

The headlines of yesterday's Weekend FT screamed out at the British public in a ploy to support the Conservatives from the narrow minded political Luddites of the United Kingdom Independence Party (UKIP) with a jingoistic "Cameron wins rare victory in Europe". 
On page two there is a picture of Cameron and Merkel, she looking up to him- again demonstrating British "superiority".  The devil, as always, is in the detail. 
The caption to the picture whispers that Merkel got the budget deal she wanted by giving her backing to David Cameron.  In the article it goes on to say how important Ms. Merkel was as "the broker in the talks (who) won almost precisely the budget she wanted".
The British public and Mr Cameron won a boost to their ego's which in this case I appreciate the need for.  I also appreciate the need to play down Ms. Merkel's role in this on the front page but it is unfortunate that it is necessary.
Merkel might be a bit obsessed with power but damn if she doesn't tend to use it in a pragmatic and constructive way balancing domestic and international-dare I say intranational in the EU- context.
Yesterday domestically she had to "accept" the resignation of the Minister for Education who's doctorate was questioned for its' originality which is a whole other story.  What was interesting was to see how Merkel was visibly upset by having to lose a competent cabinet minister, and yet was not going to let it fester as so many political leaders do.
No, realpolitik is alive and well in Germany- and Mr Cameron happened to fit in nicely.
One can only hope he continues to do so.

The Cost of Austerity

Last week in Neuss, Germany a disgruntled long-term unemployed man apparently cracked under the relatively relentless pressure being applied by the German government to "force" the unemployed into employment.

It began with a change in the welfare and unemployment  payments paid once  unemployment insurance ran out under the new Hartz IV  laws (January 2005) which became dependent upon seeking/finding/accepting work through the new federal employment agency.

The most striking of the conditions is that within a codex of human rights including human dignity there are a number of jobs which if offered to recipients of Hartz IV payments and not taken up by them will result in their payments being reduced or totally curtailed.

Having lived in Germany and visited it often I can patently say that the general quality of life level is good given the amount of money spent on public infrastructure, transportation, health, education and society in general which was a result of a Sozial Marktwirtschaft or social market economy in which the state steps in to try and ensure that social inequities are kept within reason in conjunction with a vibrant market economy.

This functioned extremely well in Germany where it was combined with a strong work ethic, a pride in employment and an underlying understanding of the rights and responsibilities of its' citizens.

As with all systems which try and deal with broad problems in a "one size fits all" approach there has been much slippage one manifestation of which has been the occurrence of third generation welfare families.

Hartz IV was supposed to deal with this problem, among many others hence the "workfare" aspect of the new law.  As with many things German there are procedures to be followed which often means an almost endless filling (and apparently re-filling) in of forms in order to keep current payments.

So last week in Neuss, at what is essentially the Federal Employment Agency a 50+ year old unemployed unskilled labourer decided that the state was out to get him and the jobs center case worker assigned to him was the medium through which the state was acting and so took out a knife and stabbed her to death.

The office continues to receive death threats and there have been instances in other centers where the police have been able to detect and disarm knife-carrying men attempting to enter.

I am not suggesting that Hartz IV is responsible for these acts of violence.  I am saying that there is a segment of society even within a reasonable wealthy Germany which is being squeezed- apparently in some cases to the breaking point.

We have seen the result of debt reduction packages in the less wealthy southern European states such as Greece, Portugal and Spain.

It is what England's Cameron is trying to implement, and what America's Romney wants to implement- the removal of the State as a social "equaliser".  

Desperate times call for desperate solutions.  Desperate men also turn to desperate solutions-those on the top-and those on the bottom.

The Wrong Trousers

Upon my return from vacation in the US this English news story caught my attention.  Apparently the Tory House Whip, a  privately educated Oxbridge graduate from a privileged background took offence when a policeman told him he would have to dismount from his bicycle if he wanted to enter Downing Street.

Allegedly he responded somewhat testily adding the remark that the policeman was a "pleb" thereby insinuating, or at least immediately being interpreted by the press and then the Labour Party as an example of the rift between the classes in Britain and how "out of touch" the Conservative Party is.

Maybe it was because I had been out of the country and was missing something but it seemed to me that the media and by extension Labour had gotten the wrong end of the stick.  To reduce the alleged incident to class warfare completely misses the point.

I believe one of the biggest threats to society  in general and certainly to British society is the lack of respect for authority, for public institutions, and frankly for one another.  These were two public servants, both of whom should command respect, and yet one appears to have decided the rules didn't apply to him.

In my experience if a policeman tells you to stop doing something which is contravening some rule, the correct response is to acknowledge the fact and to stop whatever it was that was not allowed.

To enter into a discussion with the policeman, and then to insult him is to insult the public institution which he is representing.  This is not class warfare.  This is disobeying authority.  It is rampant in society.  Everything is reduced to some form of human rights where there is a huge sense of entitlement, through every strata of society, and no sense of responsibility. 

The social contract is what is at stake here- not a sideshow of class warfare.  Yes there are haves and have-nots.  They are all supposed to be equal before the law.  Stop prattling on about the insult.  Give the bastard a summons for not dismounting his bike when instructed to do so and then insulting an officer and get on with it.

Retirement Take Two

I have retired again, for the second time, after a very interesting and dare I say taxing two years with an agency broker in London where I ran their European Fixed Income Business. As is normal for Europe I am now on garden leave for the 30 days and so am on vacation for the moment and will be back in the "writing saddle" on I hope what will be on a more regular basis sometime early October. After almost 18 months of trying to rebuild a fixed income business under somewhat extreme circumstances I am looking forward to having time to reflect and analyse what is going on around me instead of tring to put out fires with gasoline. The world has not gotten any saner....

The End of our Dreams?

I met recently with a senior member of a major european bank who has to deal with his regulators in numerous jurisdictions. As is often the case in my meetings our discussions were wide-ranging. In this case we focused on the precarious state of the Euro in general and Spain's position as the next line in the sand. He was not optimistic and didn't mince his words. His opinion hung between two main pillars-the pure bloody mindedness of the national regulators and his conviction that the experiment was doomed from the start. His recent experiences with the regulators demonstrated that regardless of the the protestations of their national politicians that the Euro was sacrosanct and that they would do whatever necessary to protect it the fact of the matter was that behind closed doors their interest was always to protect their taxpayers above else, and defintetly at the expense of other the Euro nations. This was a perfect backdrop as to why he felt the euro experiment was doomed to failure. Monetary union without fiscal and political union was never going to work. And the only way to fiscal and political union would be to surrender sovereignty. What politician was going to run let alone win on that platform-unless he had 100 armored divisions at his back. Unfortunately the only thing constructive from the conversation was that despite his prediction that after the Arab Spring we would have the European Fall-a complete social disintegration brought about by austerity programs-it would not result in a continental war. No, he foresaw a slow collapse of Euro, perhaps of the European Union, dragging on for the next couply of years. Sell bank shares. Sell the periphery. And I guess buy Germany.