The Bankwatch

The problem of derivatives is raised by Mark Mobius of Templeton at a speech in Japan.

Mobius: ‘Another financial crisis around the corner’

The total value of derivatives in the world exceeds total global gross domestic product by a factor of 10, said Mobius, who oversees more than $50 billion. With that volume of bets in different directions, volatility and equity market crises will occur, he said.

The global financial crisis three years ago was caused in part by the proliferation of derivative products tied to U.S. home loans that ceased performing, triggering hundreds of billions of dollars in writedowns and leading to the collapse of Lehman Brothers Holdings Inc. in September 2008. The MSCI AC World Index of developed and emerging market stocks tumbled 46 percent between Lehman’s downfall and the market bottom on March 9, 2009.

He makes the point of why it matters.  When there are that many bets as he calls it being made in so many directions, there has to be losers at some point.

This was a revealing conversation and useful in understanding better the focus that FaceBook has gained over the last few years.

e G8 – Closing conversation with Mark Zuckerberg (look for closing conversation with Mark).  The interviewer, Maurice Lévy (Chairman & CEO Publicis Groupe) is a bit annoying but you can zip over his attempts at humour.

Some key takeaways that I got:

• Mark is very focussed on what FaceBook is good at and remaining focussed on that
• He spoke of the company DNA, which reflects his majors

• Computer Science – Technology
• Psychology – Human social behaviour online

• Examples:  gaming (Zynga) which now has a larger market cap than Electronic Arts he notes.  He also mentioned they are working with Netflix to bring on to the FaceBook platform.  Netflix stock rose immediately on that comment.
• 

All in all a refreshing interview that displayed a clarity of vision and clear focus on core competencies of the company.  The vision of the Facebook Platform as the key growth strategy was clear.  Michael Wolf at GigaOm makes reference to that here too in slightly more grand terms (Social Operating System).

This document noted here contains a detailed description and analysis of the Koobface botnet.  It is run by people in Russia and other countries, and designed to make money.  Koobface is an anagram of Facebook which it levers liberally to encourage clicks and installation of their malware.

The operators of Koobface have been able to setup a stable botnet infrastructure that allows them to maintain tens of thousands of compromised computers and profit immensely from PPC and PPI, earning a total of $2,067,682.69 between June 23, 2009 and June 10, 2010.

The document has all the technical details based on their research of the actual files used by the botnet.

In simple terms, targets would receive an invite and link from compromised Facebook accounts.  This link would typically take the unknowing user to a fake youtube page located on a compromised server operated by Koobface.  This click installs the botnet server on users PC and they are now part of the network.

There are files that will locate users FaceBook and other social network credentials, and users Facebook account is now part of the Koobface network.

These affiliate networks pay the Koobface operators for advertisement clicks generated by compromised computers and for installations of fake security software (see figure 9). The monitoring system contains account information for 18 affiliate networks. There are also daily records for earned income organized by affiliates.

The data spans from June 21, 2009 to June 9, 2010, and indicates that a total of $1,994,355.86 was earned.  There were considerable variations in the total amounts earned from affiliates, although not all affiliates were active over the entire time span. Overall, Koobface operators earned roughly the same amount from rogue security software affiliates as they did from PPC affiliates.

Summary and who are the losers ?

Affiliate and Pay per click networks are an important part of internet advertising.  The irony of the Koobface story is that half their income comes from legitimate PPC networks.  Koobface uses techniques such as its installed malware to fake ad clicks.  They make use of bit.ly links to anonymise the target url. 

The other money they make is from fake ads promoting fake security software and charging for it.

Losers at a high level that I can identify are:

1. Google, Yahoo and Microsoft – paying out on fraudulent ad clicks
2. Advertisers – paying out on fraudulent ad clicks
3. Users – their computer is doing things behind the scenes unknown to them
4. Users – paying for fake security software

The dollars involved in this operation are relatively small.  That plus the spread of the criminals across Russia and Eastern Europe make policing this almost impossible, although there have been some successes documented in the doc.

We all take internet for granted.  I worry about where internet will be in the next few years.  The words ‘unintended consequences’ leap off the page on most things we read about regulation or freedom of expression online.

On the one hand we have the academic leaders of internet freedom in the US, and the counterpoint is probably the European contingent lead by France and Germany who want to control every cookie it seems.

So in concert with the G8, France produced the e-G8 that has some very interesting participants including Eric Schmidt, and Mark Zuckerberg, but also some others less well known in the west but influential nonetheless.

Internet chiefs set to address G8 summit

The e-G8, the first event of its kind, was organised by Publicis Groupe chief executive Maurice Lévy, who will be leading the delegation to Deauville along with Yuri Milner, the Russian entrepreneur and investor who founded Digital Sky Technologies, Stéphane Richard, chief executive of France Telecom, and Hiroshi Mikitani, chief of Rakuten, Japan’s largest online retailer.

While it is easy to write of French attempts to ‘control’ internet, the larger issue is the common set of beliefs that prevail online which are contradictory to many of the laws of each country.

The classic example is the ridiculous situation in UK right now.  If you are not aware we have injunctions and super injunctions.  The injunctions prohibit disclosure by mainstream media from mentioning affairs by famous figures such as Ryan Giggs with hookers.  Super injunctions require that media not mention that an injunction exists. 

Where do we start to describe the ludicrousness of this. The courts agreeing to stop people talking about legal rulings.  if we think this through, how can the court prescribe that people not talk about something that they know about as if it did not happen.  Court proceedings are public by design. 

The entire concept here is a result of government inaction on privacy, particularly in the UK despite changes driven by internet.  Enter the latest problem when twitter followers decided to react by publishing information about people under injunction en masse.  The latest is that Twitter might release the names of those who mentioned Giggs name to the police.

Where will all this go?

Payments might just get a little more interesting Thursday when Google promise to introduce a phone based payment method in partnership with MasterCard and Citi.

Google to unveil mobile payments Thursday:

Google invited reporters to attend a "partner event" on Thursday in New York to demonstrate what it called its "latest innovations." It plans to unveil a mobile payments system that will run on the Android operating system and be available on phones from Sprint Nextel Corp, Bloomberg reported on Tuesday.

What could make this interesting is the potential for international coverage.  However the devil will be in the details of implementation.  We know Android as NFC capability.  The question will be what device is on the merchant end and how they get paid.  Has Google found some way to solve that problem?

I am very interested in the topic of credit risk, and when the offer was made for Dr Jennings to contribute, I readily accepted.  The statistics graph is of particular interest.

_________________________________________________________

Dr. Andrew Jennings, chief analytics officer, FICO

Guest post for TheBankWatch.com blog

The global economic crisis has tested some core beliefs in traditional risk management. We’ve had a real-world stress test, not just of bank portfolios but also of the tools used to manage those portfolios.
As our risk-management models came under stress, regulators in the U.S. and numerous other countries changed the rules that govern business practices for many personal financial products and services. Regulators and bank risk professionals in turn started to ask more questions about the creation and governance of the modeling process.

We are all familiar with the conventional wisdom that has emerged over the past few years — models tended to under-predict risk as the economic crisis unfolded. Risk ranking of consumers held up well, but the rating side of the models didn’t do so well. The shortcomings in the risk models rekindled interest in the relationship between the macro economy and credit risk.

While many factors influence risk outcomes, a major contributor is the state of the economy and predictions for its future state. Of course this isn’t new, but the crisis has forced risk managers to think about the problem more explicitly than in the past. Research by FICO Labs has discovered specific, measurable relationships between macro-economic variables (e.g., unemployment rate, home-price depreciation, per-capita income, GDP growth) and credit risk.

In fact, this is an area FICO Labs has been investigating for a while, as I recently discussed in American Banker, and we are engaged with banks in the U.S., Europe and Asia to help them understand their risk exposure given the economic dynamics in their geographic regions.

Each 12-month period is a different color. In each 12-month period, there is a clear drop in delinquency rates as the scores get higher. This means the FICO score did its job. It correctly ranked people with higher scores as less likely to default.

The blue bars represent the early recession (right up to the chaos of September 2008). The red bars represent the depth of the recession when there were no jobs, no credit, and home prices were in a free fall. The green bars represent the bottoming out of the recession and the beginning of the recovery. In all three 12-month periods, the FICO score performed extremely well.

The key for banks everywhere is to create a framework in which they can apply various assumptions about the future values of key economic variables, and then transform those inputs into an understanding of future default risk for borrowers at any given score. Only then can a bank develop a meaningful strategy and plan to manage risk appropriately.

When the economic crisis started, the challenge was to contain risk. By and large, banks did this by simply shutting down originations, closing accounts, and stopping credit-line increases. As the global economy continues to improve, lenders need to adopt a smarter approach when it comes to relaxing credit policy. This will require thinking through the impact of the macro economy on credit risk, and not returning to pre-crisis business as usual, which would be the riskiest decision of all!

While banks march on apparently as if nothing happened in 2008 nor the years leading up to it, there continues to be a host of regulatory and investigative work continuing.  The latest is from the New York attorney general office who are pursuing an inquiry into pooling practices, ie, the dreaded derivatives and Asset Backed Commercial Paper in particular.

New York Investigates Banks’ Role in Fiscal Crisis | NY Times

Officials in Mr. Schneiderman’s office have also requested meetings with representatives from Bank of America,Goldman Sachs and Morgan Stanley, according to people briefed on the matter who were not authorized to speak publicly. The inquiry appears to be quite broad, with the attorney general’s requests for information covering many aspects of the banks’ loan pooling operations.

I suspect this inquiry in part will have derived from the WALL STREET AND THE FINANCIAL CRISIS: Anatomy of a Financial Collapse pdf 5.5 MB released in April this year.

As ugly and uncomfortable as this is, it makes sense.  Derivatives are the least understood soft underbelly of the banking crisis.

Customer service and marketing can easily get out of sync with each other.  We were trying to sign up for a movie tonight on Rogers and the service kept crashing.  I phoned the technical support group, and got the usual suggestion from the CSR to reboot the box. 

However when digging deeper with him he readily admitted that the Rogers service had capacity issues and had had service issues for the last several months.  The frustrating part of that conversation is that he knew why we had a problem before we began but the company still made him put us through the standard script of rebooting our box before I got the root issue that was the service capacity.

The message here is clear.  Technology and marketing are inextricably linked.  The example here is the promise from Rogers for all the latest movies, yet when you try they are not available.

I missed the rumour that Ally Bank is in talks with ING Direct.  It was put out there first by the NY Post on 10th May, 2011.

Sources told The Post that Ally, the automobile and home mortgage lender, is looking to acquire the online banking business to boost its deposit base and further fortify the lending giant, which accepted a taxpayer handout during the height of the financial crisis.

ING Direct could fetch as much as $10 billion in a sale, according to source

This follows the EU Commission requirement that ING in Holland divest its insurance business following receipt of €10bn during the banking crisis.  That funding was required for liquidity and potential bad debts resulting from poor quality US mortgage assets.

The Commission demanded a restructuring of the group after it received €10bn ($13.7bn) of state aid from the Dutch authorities during the financial crisis, as well as help with souring US mortgage assets.

The insurance part of the equation was a result of a 1991 merger.

Created in 1991 by the merger of the Nationale Nederlanden insurance group and NMB Postbank, ING always maintained a roughly equal weighting between its insurance and banking activities.

Of more interest here though is the ING Direct US part.  Back in 2009 it was never directly acknowledged but was suggested the divestiture of this arm was also from pressure directed by the EU Commission according to the FT in 2009.

Another key part of the restructuring – and one that ING came closer to acknowledging was authored in Brussels – is the disposal of ING Direct USA, one of the online banking operations that the Dutch group has built up in 10 countries.

The US bank ranked as the 17th largest by deposits at the end of the second quarter, with $74.8bn in customer deposits. It is the 18th largest US bank by assets, with $90.1bn.

It is seen as an attractive asset but selling it could be complicated by its business model, which involves attracting customers with high rates for their deposits who then generally give ING little business on the asset side.

These measures were designed to bring ING ‘back to basics’, which is a lesson that Citi and to a certain extent HSBC have taken a little longer to learn.  The EU have been much more direct in recognising the negative impact of the US mortgage space and basically telling ING they are better served to divest of that activity from the early 2000’s.

I am more curious to see what is in this for Ally (ex GMAC Finacial) which went through a $60 Bn restructuring in 2008 from various banks, a scant 3 months before the peak of the banking crisis in September of that year.  This was incredibly fortuitous timing.

GMACand Residential Capital, GMAC’s embattled mortgage lending arm, on Wednesday secured an urgently needed $60bn rescue financing package to help stave off the threat of a ResCap bankruptcy filing.

After weeks of negotiations, more than 50 banking institutions led by JPMorgan, Citigroup, Bank of America and Royal Bank of Scotland co-operated to overhaul GMAC and ResCap’s bank credit lines and shore up the two companies’ liq­ui­d­ity position with about $50bn of total credit capacity.

What would they have to gain from ING?  Certainly ING would be more heavily weighted towards deposits spread across many customers and that is attractive as Ally lead up to an IPO in coming months.

Some strategic shifts amongst the ‘universal banks’ (HSBC, Citi, Lloyds, Bank of America, JP Morgan).

The first is cost cutting.

Global colonisers stage retreat to corporate banking | ft.com

Increasingly, the heads of so-called universal banks – those that combine high street banking with corporate and investment banking – are deliberately shifting their focus away from foreign adventures in retail branches and on to corporate business instead.

HSBC is not alone. Citigroup, its main global competitor, is busy pulling out of a host of retail markets where it is overstretched, such as Spain, Greece and Belgium, and refocusing on just 100 cities around the world. Barclays, too, is on the retreat, announcing that retail banking operations in Russia and Indonesia should close.

Some of the reasons are obvious. Many banks have come out of crisis mode and are now in a cost-cutting phase – often under the direction of new management.

This is based on the economic realities setting in.

On top of the cost-cutting agenda is the pragmatic realisation that the global economy is moving in slow motion and that strategies need to look for whatever business expansion opportunities there are. Scant gross domestic product growth means scant consumer loan growth.

The other shift noted in this FT piece is within the investment & corporate banking groups of those banks, and that is being driven by both regulatory changes and a desire for greater risk transparency.

In a market that is more nervous of credit risk, corporate lending has the appeal of offering a bank far more transparency than consumer lending on the finances of a borrower, both directly and via credit-rating data. It may also be less capital-intensive.

But the draw is also part of a much more fundamental change – the redrawn lines of the global regulatory landscape. As investment banks are penalised with higher capital charges for trading activity, they need to find more solid sources of business with lower capital requirements.

Relevance to Bankwatch:

The fallout from the banking crisis is beginning to play out.  A shift of investment from retail to commercial banking does not bode well for innovation in consumer banking.  My earlier view of banks sorting out into utilities (majority) and innovators remains.