The Bankwatch

For the record – 2,200 pages in all its glory.

Lehman Brothers Holdings Inc. Chapter 11 Proceedings Examiner’s Report

Jenner & Block is providing links to the Report of the Examiner in the Chapter 11 proceedings of Lehman Brothers Holdings Inc. The Examiner’s report is divided into nine volumes, which are reproduced below in individual Adobe Acrobat PDF files.

Included in this from the introduction that sums up banking, not just investment banking.  Investment banking just happens to be an extreme version of this.

Lehman’s financial plight, and the consequences to Lehman’s creditors and shareholders, was exacerbated by Lehman executives, whose conduct ranged from serious but non‐culpable errors of business judgment to actionable balance sheet manipulation; by the investment bank business model, which rewarded excessive risk taking and leverage; and by Government agencies, who by their own admission might better have anticipated or mitigated the outcome.

Lehman’s business model was not unique; all of the major investment banks that existed at the time followed some variation of a high‐risk, high‐leverage model that required the confidence of counterparties to sustain. Lehman maintained approximately $700 billion of assets, and corresponding liabilities, on capital of approximately $25 billion.   But the assets were predominantly long‐term, while the liabilities were largely short‐term.  Lehman funded itself through the short‐term repo markets and had to borrow tens or hundreds of billions of dollars in those markets each day from counterparties to be able to open for business.  Confidence was critical. The moment that repo counterparties were to lose confidence in Lehman and decline to roll over its daily funding, Lehman would be unable to fund itself and continue to operate

The proposal to replace banks with non levered Mutual Funds was floated last December (noted on the blog here) and now here is the book.  This fits with the view of this blog for utility or limited purpose banking providing basic banking and payments services much along the lines of water and electricity.  Reliability over concern for safety.

BU economist: U.S. must rethink banks | Boston Herald

The basic premise of limited purpose banking, which is beginning to win over some academic adherents, is that banks should be run like mutual-fund companies, such as Boston’s Fidelity Investments, acting merely as pass-through institutions – middlemen between those who want to save and those who want to invest.

Banks would be effectively banned from leveraging other people’s assets on big financial bets, reducing the risk of systemic bank failures that can bring entire economies to their knees, Kotlikoff says.

Relevance to Bankwatch:

I am almost done with This Time is Different and will be doing a post shortly.  The nice thing about that book is that its not an opinion.  It is a detailed review and analysis of economic and banking crises, mostly since 1800, and with other examples going back to 1340. 

The clear unequivocal lesson, and hence the ironic title, is that it is never different.  There are a set of core fundamentals (excessive debt, dramatic shifts in capital movements, inflation) that always beget crises, not sometimes, but always. 

Banks continue to have excessive leverage especially when the off-balance sheet liabilities are included.  No amount of regulation tweaking will resolve that basic fact, so at least the Kotlikoff proposal is a refreshing alternative.

I have spoken at length here about the insidiousness of derivatives and Credit Default Swaps.  So this new statistical reference frankly awed me.  It is from a Levy paper on the recent shift over the last 50 years to a shadow banking system, that has largely replaced bank balance sheet lending with Money Managers.  As I read this paper, while I am also reading ‘This Time is Different – eight centuries of financial folly’, there is little to feel good about in the apparent economic rebound that the government keeps telling us about.

The data on derivatives is impressive. JPMorgan Chase, for example, held derivatives worth 6,072 percent of its assets at the peak of the bubble in 2007. The other two giants, Citigroup and Bank of America, although still far behind Chase, had 2,022 percent and 2,486 percent respectively. Goldman Sachs, the other giant, had an astonishing amount of derivatives on its balance sheets: 25,284 percent of assets in 2008 and 33,823 percent as of June 2009. Citigroup and BOA now have more of this risk on their books than before the crisis (FDIC SDI database).

The part that awed me, is that BofA and Citi now have more derivative exposure than they did in 2007!  Huh!   What is Timothy Geithner being paid for?  I have to admit after TARP and the apparent hands on approach I like most assumed things were being fixed, but apparently not. 

This simply adds to the point that despite all the histrionics and efforts in Washington, nothing has been learned and the American Banking system is now at least at as much risk now as in 2007, pre crash.

Incidentally when trying to understand derivatives, simply assume off balance sheet debt.  There is all kind of rationale as to why that off balance sheet debt is not dollar for dollar, but the important point is that no-one argues that derivatives are worth zero.  There is an intrinsic liability that frankly few bankers can explain to you, so you must begin with the face value of the liability, and banks are guilty until proven innocent on that one.

As an accountant, the notion of off balance sheet debt is a contradiction in terms.  Is it a liability?  If yes, it should be on the balance sheet.

Often I find news headlines are framed in political and ‘we are good and they are bad’ headlines but it is both reassuring and interesting to actually see the impacts of tinpot dictators on their countries, and how corrupt behaviour produces results is a leveling effect on the world. 

This from a longer piece outlining how lack of attention and investment means Venezuela is running out of electricity.  His answer of course is to arrest everyone. 

Colombia, Venezuela: Offering Power — For a Price | Stratfor (Subscription)

While blaming the crisis exclusively on the weather (and ignoring years of lack of investment and government mismanagement of the electricity sector), Venezuelan President Hugo Chavez has made repeated calls to his citizens to cut their shower time to three minutes, turn the lights off and reduce work hours to get through the crisis. Those that do not reduce their electricity demand have been threatened with fines and arrest. According to la Gaceta Oficial, an official government newsletter, Caracas Electricity (EDC) will initiate 24-hour power cuts to the 8,000 businesses in Caracas that have been deemed heavy electricity consumers and have failed to meet the government’s demand to cut consumption by 20 percent.

Relevance to Bankwatch:

This stuff is important because we are in a global economy.  A butterfly flaps its wings here and the impact … etc etc.  If you are running a bank, the cause and effect of everything is important.  It is important because Chavez actions impact currency, oil, interest rates and inflation.  It all matters.

This is one of those nondescript headlines that is probably the single most important one following the 2007 economic crisis.  It sets the stage for (obviously) currency shifts and (less obviously) price pressures in the west.  Those countries that import from China will pay more for those imports, and therefore will suffer currency and interest rate pressures.

Beijing looks at severing dollar peg | ft.com

China’s central bank chief laid the groundwork for an appreciation of the renminbi at the weekend when he described the current dollar peg as temporary, striking a more emollient tone after months of tough opposition in Beijing to a shift in exchange rate policy.

Why is this happening?  China is in a bubble economy right now, with real estate prices exploding to 2005 Manhattan levels.  Government spending is at unsustainable levels following attempts to replace reduced exports.  This in a country that is largely third world is not going to fly, and is causing unsustainable social pressures between urban and non-urban areas.

For a good explanation of how China has accomplished this Kimberley explains:

China has fixed the value of its currency, the yuan, to the dollar. Currently, a dollar is worth 6.8 yuan. Many analysts think it is artificially low. If China allowed its currency to float freely, it would be more valuable than the dollar because of China’s strong economy, and it would rise. China does this to keep its products cheaper than U.S. products, thus increasing its exports to the U.S.

The only way China can keep the yuan artificially low is to promise to redeem dollars for yuan at the fixed rate. To do so, it must keep a good supply of dollars in reserve. Instead of holding dollar bills, it holds U.S. Treasuries, which it can quickly sell for dollars. As China’s economy grows, it must buy more and more U.S. currency to meet the growing number of yuan.

Why do we care?  China will stop buying US currency?   Of course this is impossible, because US represents over 20% of the world economy so, US will increase the interest rates on Government securities.  It will buy more Euros and invest more domestically but the result will be higher interest rates in the west.  Higher interest rates impact everything.  Think trillion dollar debts that are mostly short term, and require to be rolled over at current rates.

Once (if) China accepts natural exchange rates this impacts retail prices,  dollar denominated government securities, cost of oil and everything that countries pay for in a relatively reduced worth US dollar.

Relevance to Bankwatch:

Rest assured this is probably the biggest economic story of 2010.  Consumers are locked into a cycle of short term rate mortgages and those will need to be renewed at higher rates.  Mr. Bank … what cushion for higher rates did you incorporate into your credit decisions when you made your loan to value ratio decision?

Something that is holding up ecommerce and development of serious commercial actiivty online is the matter of identity.  There are many proposed solutions but the fact remains that they are disparate and all fail in the sense that you cannot have one identity online and choose which parts to share with those sites you visit.

So at first glance this identity exchange proposed by Paypal, Google and Equifax has merit.  the involvement of Equifax is key because they are a repository of personal information which is known in total only to the person.

PayPal, Google and Equifax back launch of Open Identity Exchange | Finextra

Finextra verdict It’s what the world’s been waiting for. The creation of a workable federated identity standard will provide a major boost to the digital economy. But let’s not get too excited. Don’t forget, we’ve all been here before.

I share Finextra’s skepticism.  The basis of the identity sharing is OIX [OpenID Foundation (OIDF) and Information Card Foundation (ICF)]. OIX was announced today at the RSA conference by Google, PayPal, Equifax, VeriSign, Verizon, CA, and Booz Allen Hamilton.  There is a website at http://openidentityexchange.org/

OIX has been accepted by the US government for access to personal records.  This is a step.  When we look at the model and the participants, though the first question I have is ‘who are the identity providers.  Equifax, Google and Paypal each know something about people, but do each know enough to identify people?  I have a Google identity but they have never met me, and cannot associate what they know about me sufficiently to entrust private government records to that identity.

Equifax know a completely different set of data about me.  Is that enough in and of itself?

The White Paper recognises the issue and lays out a framework, summarised here as ‘assessor qualifications’. 

Assessor qualifications — the professional credentials, experience, and other requirements assessors must fulfill perform certifications

All in all a good framework but the devil will be in the details.

This kind of post drives me nuts.  Datamonitor release a press release announcing that banks need to take social media seriously.  This is a headline from 2006. 

Banks need to start taking social media seriously – Datamonitor

Anna Large, analyst, Datamonitor, says: "Banks have adopted a "bury-their-heads -in-the-sand" approach to the part social media could play in both retaining and obtaining customers. At the heart of this is the idea that social media is just a fad, that consumers are essentially non-committal. However, the fact that 50% of UK consumers are using online tools to make their financial decisions indicates that banks need to start appreciating the power of sites such as Twitter and Facebook."

The general Arrington/Scoble/Jeremiah consensus is that social is spammed out, lacking direction, and as Arrington says looks like the web did in 1999 through Alta Vista – a mess. The challenge of social media is spam and credibility.

Relevance to Bankwatch:

The answer to social media is deeper than “get involved”.  That was the 2006 message.  Now its 2010.

http://audiovideo.economist.com/?fr_story=f3bb24bf00b55a124ac079d7f5d235bbe999f947&rf=bm

The British banking system has changed beyond all recognition.  It was not a difficult prediction that I concluded last year, but it has come to be sooner than even I thought.

RESTORING LOYALTY, TRUST AND INDUSTRY PROFITABILITY | IBM / BBA

Hand-in-hand with this increase in consolidation and government ownership, we have also seen a major new entrant arrive – Banco Santander now has over 1,300 branches through its acquisition of Abbey National, Alliance & Leicester and Bradford & Bingley – and non-banking groups flexing their muscles in the banking space. Tesco Bank has now exited from its joint venture with RBS and announced its intentions to offer a mortgage and current account. Virgin Money is one of 53 new applicants for banking licences in the UK, while the mobile operator O2 has launched a pre-paid card ‘powered by NatWest’. There is also renewed discussion about the role of the Post Office in supplying banking services.

The prediction was that we would see two types of institutions form:

This will effectively split the financial community into two distinct sets:

1. financial utilities – significant operating restrictions in light of implicit and explicit government guarantees underpinning the business
2. risk takers – not clearly defined as yet – will be dependent on regulation applicability

Lloyds and RBS are the former.  Virgin and Santander are examples of the latter.

One thing I did predict and has not occurred yet in any meaningful way despite public outcry is the enforcement of government requirements on bank actions that come with their new found ownership responsibilities.  This surprises me, and I suppose is due to discomfort with being in an ownership role, but it will come in time.

Anyhow the paper looks at customer perceptions and impact of regulation. 

I looks at at what customers will pay for ….

and how to create value from customer information.

Their conclusion:

Conclusions
Now, more than ever before, there is the potential for significant change in the retail banking landscape. In our view, the winners will be those who:

• Focus their cost reduction efforts intelligently on the areas we have identified: continuous improvement techniques, empowered workforces, and the right technology and data foundations for their operations
• Build targeted customer propositions to gain significant wallet share, using ‘fine grain’ pricing techniques
• Meet regulatory requirements effectively
• Exploit the potential of smarter banking models that are instrumented, intelligent and interconnected.

To help enable these smarter banking models to work requires the fuel of high quality, accurate data, plus an
ability to look across the different product and geographical silos that still operate in many banks. When banks have the data to serve customers better, they also have the basic building blocks required to meet regulatory (and board) reporting requirements.

To win will require significant investment and management effort by both the established UK players – challenging at a time when they have to meet enhanced capital requirements and sort out mergers and divestments – and the challengers.

Banks prepared to make bold plays on this agenda, with clear strategic intent, will force the competition to respond. The competitive dynamic will lead to a smarter banking industry that we can all be proud of and which customers will trust.