The Bankwatch

We quickly forget about previous crashes, but over the period 1997 – 2003, $2.8 trillion in market value was wiped out from the telcoms as they experienced their own bubble through the dot.com times.  The Economist points out there are lessons for banks and for banking regulators too I would say.

Their conclusion is consistent with my view that there will be some innovative winners such as O2 that are able to re-energise with innovative measures, marketing and services.  However many will as the article say, slog along “against competitors and reinvigorated regulators”.  I have gone further and supported the idea that the inevitable nationalization of the sloggers, will result is a set of financial utilities, more akin to electricity and water providers to your home.

Lessons from the telecoms bubble (1) | Economist

Ideally, this revolution can be extended to reinventing brands and business models. But a depressing precedent has been set by incumbent telecoms firms, which, like most banks, are stodgy bureaucracies at heart. Despite endless product launches and reorganisations, perhaps only two firms, KPN (see article) and O2 (subsequently bought by Telefónica) were transformed by innovative managers. For most others, the decade since the bubble has been a slog against competitors and reinvigorated regulators. That is the lot of most firms in most industries. They face a constant battle to protect pockets of high profits and have few chances to grow. For telecoms, the glamour and infamy were followed by mediocrity. Banks are still staggering about in the limelight, but the same fate surely awaits them.

The other observation of note in the article is that all the senior management at the telcoms were replaced.

It is impossible to comprehend this amount of money.  $531 UPDATE $684 trillion represents 3 or 4 times the combined value of the worlds equity markets, bond markets, and world GDP.  It is a stunning number.

There is a possibility that we need to add in the combined value of homes and other assets in the world to come to terms with the number, but then we risk double counting assets which are already valued in equity markets.  Need to think that through some more.

This can only be described as ponzi money – money that is levered and based on multiplying and levering other money.  The underlying assets have been long forgotten.  This remains the unsaid problem with banks, and I believe represents a large part of why banks are not trusting each other yet.

That $531 $684 trillion represents off balance sheet lending by banks.  Each contract in those derivatives are guaranteed by a bank somewhere.  If added to bank leverage, banks would be bankrupt.

More on this as I root around.  Meantime here is the data from ISDA since 1987 to first half of 2008.

isda-market-survey-historical-data

UPDATE:  Information from Bank for International Settlements where they track a more complete view of Derivatives.

BIS http://www.bis.org/statistics/otcder/dt1920a.pdf

My next target is to try and highlight the derivatives market, and the status.  The size of the derivative market and in particular the infamous Credit Default Swaps represent a gigantic ponzi scheme of artificial liabilities between banks around the world.

Quietly banks have been unwinding those contracts, which by the way they could only do if there is no substantive asset behind them.  One dollar of debt can be translated into $3 + of derivatives as if by magic.

This from the Financial Times in January that I missed then.  But read on – this is only the beginning (yes that is 30 trillion)

$30,000bn of credit derivatives cancelled

Banks’ efforts to clean up credit default swaps began with modernising and speeding up the processing and confirmation of trades, then moved last year into pruning the large volumes of older, outstanding trades. The $30,000bn excised from the market last year was three times the $10,000bn taken out in 2007.

The first half of last year saw the first decline in outstanding notional volumes, which shrank from $62,300bn to $54,600bn by June 30 2008, according to the International Swaps and Derivatives Association, the main lobby group for the industry.

We are so accustomed to trillions now, so lets place these amounts in perspective.

• The total market capitalization of all publicly traded companies in the world was US$51.2 trillion in January 2007^[1] and rose as high as US$57.5 trillion in May 2008^[2] before dropping below US$50 trillion in August 2008 and slightly above US$40 trillion in September 2008 (wikipedia)
• World GDP $55 trillion (wikipedia)

To place in perspective the derivative markets referenced here were valued more than the entire value of all the stock exchange values in the world or more than all the GDP in the world.  The amount just unwound in this FT story is worth 60% of the entire World GDP.  Such is the insanity of financial markets over the last 20 years.

I feel for those I know at Lloyds firstly because I know them, and secondly because I used to work for Bank of Scotland (now HBOS, now Lloyds).

What is poignant is that Lloyds was the risk averse bank.  This merely validates the point that the banking model is broken when a strong bank can find itself in this sad situation.

Also note the reference to Darlings comment that Barclays are next.  Strange days indeed yet I still feel the root cause has not been ferretted out.  I see nothing in Central bank comentary about the derivatives market and the off balance sheet liabilities there.

Lloyds next for Treasury scheme | ft.com

Lloyds Banking Group, which has absorbed HBOS, is on Friday expected to reveal when it reports full-year results that the UK government is insuring up to £250bn of the bank’s assets.

… … …

Alistair Darling, the chancellor, hinted to MP that he expected Barclays to join the scheme.

Economists, even good ones, can sometimes state the obvious and leave a sense that the impossible can actually occur, which of course it will not.

The Economic Outlook for 2009 and Community Banks  Delivered February 6, 2009 in Hawaii | Janet Yellen, CEO, Federal Reserve Bank of San Francisco

It’s also important to acknowledge that banking organizations find themselves under intense scrutiny and are subject to conflicting pressures. At a time of nearly unparalleled challenges for financial institutions, you find yourselves called on simultaneously to preserve capital, avoid excessive risk, and step up your lending. Policymakers are mindful how difficult it can be to balance those mandates.

There are some dire predictions in this piece.  In any event it is a reasonable summary of the conditions that Community banks in particular in the US face.  I have pasted fairly extensively but bolded some key highlights for ease in locating points of interest. Note the reference to ‘systemically important” banks, and “removal of bad assets” which point in the direction of the large banks becoming financial utilities.

1. “Households are hunkering down. The personal saving rate has jumped from around zero early last year to about 3½ percent recently, as people have tried to rebuild lost wealth and some cushion to weather adversities, including possible job loss.”
2. On residential development:  Unfortunately, there is no end in sight. Housing starts have plummeted over the past year, falling by nearly one-half. It’s hard to see when starts will bottom out, since inventories of unsold new and existing homes remain at high levels relative to sales.
3. On house prices:  Unfortunately, futures contracts for house prices suggest that further declines are likely this year and next
4. With regard to credit, many companies, especially those with lower credit ratings, must now pay extraordinarily high rates in the bond market
5. The market for commercial mortgage-backed securities has all but dried up. Banks and other traditional lenders have also become less willing to extend funding.

On Banks:

1. To fulfill our role in providing liquidity, we have crossed traditional boundaries by extending the maturity of loans, the range of acceptable collateral, and the range of eligible borrowing institutions
2. It will support the issuance of securities collateralized by auto, student, credit card, and SBA, or Small Business Administration loans—sectors where the issuance of new securities has slowed to a trickle. This approach has the potential to be expanded substantially, with higher lending volumes and additional asset classes, such as commercial mortgage-backed securities.
3. guarantees against losses for several systemically important financial institutions including Citigroup, Bank of America and AIG
4. A lesson from past experience with banking crises around the globe is that the removal of bad assets from bank balance sheets, along with the injection of new capital, is needed to restore health to the banking system. As long as hard-to-value, troubled assets clog their balance sheets, banks find it difficult to attract private capital and to focus on new lending.
5. As a result, and given the outlook for the economy, I would expect to see more deterioration in corporate, commercial real estate, and consumer portfolios over the course of this year and into next year
6. Many community banks have significant commercial real estate concentrations, and these loans are a particular concern in the current environment. At present, the performance of such loans has deteriorated only mildly. But, as I suggested earlier, we can’t count on that situation to continue, since the downturn in commercial real estate construction is just getting started

Just for fun (ok rather perverse fun) I will keep a track of the extent of state ownership of the major banks.

Here is the first as of today:

RBS                          68%  (could go to 95%)

Lloyds                     43%

Bank of America   tbd

Citi                           tbd (potentially 40%)

Wells Fargo           tbd

Why do BofA allow themselves to be behind the politicians on this.  There is so much for relatively little cost that they could be doing to display mea culpa and appear sorry.  Inaction will continue to result in such headlines as this in tomorrows FT and the overall impression that they are “not sorry”.

BofA chief to be grilled on bonuses | ft.com

Ken Lewis, Bank of America chief executive, will testify on Thursday before New York state prosecutors, who will question him on what he knew about $3.6bn in bonuses paid at Merrill Lynch in December, just before BofA’s Jan 1 acquisition of Merrill.

More later, but the UK government are set to take £550bn in assets out of RBS and Lloyds and place into some form of state facility.  (thats close to $1 trillion btw).  The nationalisation word still remains unsaid.

State to insure £300bn of RBS assets | ft.com

Royal Bank of Scotland was preparing to inject loans and other credit assets worth more than £300bn into a government-backed insurance scheme on Wednesday night in an effort to stabilise the state-controlled bank while saving it from full nationalisation.

Lloyds Banking Group, which is expected to insure up to £250bn worth, is expected to unveil a similar deal when it reports its results on Friday.

Risk management has come under the microscope of late, and clearly new thinking is required.  Recently Andrew Haldane of the Bank of England reflected to the weeks and months that it took to work “stress test” models within banks and how that is clearly unacceptable.  He described stress testing as being less “regulatory arbitrage” and more “regulatory camouflage”. (my post summarising Haldane)  (Haldane – BofE pdf)

The Deloitte Center for Banking Solutions has a new report out that focusses on providing for an integrated approach across the enterprise.

Integrated Compliance and Risk Management Rethinking the approach

Unprecedented market turmoil in the industry has compelled financial institutions to rethink their existing compliance and risk management programs, many of which have failed to keep pace with evolving levels of risk. As a result, financial institutions are taking a critical look at how they manage compliance and risk to gain a better understanding of how their institution is impacted by the dynamic risk environment of a global financial community.

I think this is a great start.  The thinking will need to then focus on the methodology that will accommodate the other factors that Haldane spoke of, ie, disaster myopia, network externalities, and misaligned incentives.  These are important because current risk models do not adequately address those factors for most organisations.  This gets into the methodology that will have greater chance for success and that will operate at the speed and alacrity that the real-time world requires.

Just caught this during Bernanke testimony to the House Finance Committe.  Rep. Kanjorski asked Bernanke to confirm the events of Sept 18th (refer video below) following tghe collapse of Lehmans and the impact on the world financial system.

Bernanke responded (quote):

“… the actions we (Bernanke/ Paulson) took averted the collapse of the global financial system.  We came very close to a global financial meltdown”

Tracking the evolution of financial institutions? Sep 18th 2008 | Russian Missile Crisis – banking crisis version