Working from the offices of the New York Fed Bank, the Fed orchestrated a bailout of LTCM by private-sector banks. LTCM had earlier rejected a bailout offer from Goldman Sachs, AIG and Berkshire Hathaway. Greenspan could not or would not tell Congress the details of the bailout, apparently because the nation's central bank produced no detailed public records of its actions. Hundreds of lawyers and many large financial firms were evidently involved in this operation. These actions put the Greenspan Fed in the same league as the tycoons of an earlier age, such as John Pierpont Morgan (1837-1913), whose enormous financial deals, which had widespread economic effects, were made out of sight of the public or its elected representatives.

Deception and Abuse at the Fed: Henry B. Gonzalez
Battles Alan Greenspan's Bank
Robert D. Auerbach
University of Texas Press (2008)

The management changes at Wachovia Bank (NYSE:WB) and Washington Mutual (NYSE:WM) illustrate how the subprime debacle, a slow-motion systemic market event which has already affected thousands of people and destroyed as many livelihoods, is slowing decimating the CSUITES of most major banks.  

The carnage reminds us of the wisdom shared with us back in April 2007 by a veteran Sell Side operations officer ("Subprime Tsunami: Spreads Kill You, Not Defaults"), namely that the real risk in financial markets comes from changes in the relative relationships between securities, that is, spreads, not from actual defaults.

Now obviously the view that market risk is a bigger concern than old fashioned realized losses reflects a New Era bias, a bull market view which assumes that markets are liquid and functional on a continuous basis - a belief which may not really be valid.

But what really strikes us watching the corporate body count grow is this: perhaps the risks created from choices made - or not made - in terms of how we organize global market structure, and thus define market liquidity, are even greater than market risks posed by a change in spreads, even a vast explosion in credit spreads such as observed over the past year.

Changes in yield spreads on hundreds of billions of dollars in complex structured financial transactions have caused massive losses to global banks and investors since last year, but aren't these bad results just symptoms of a larger aliment? As far back as 2004, global regulators expressed concern that complex structured assets represented a potential source of risk, thus we wonder that the Financial Stability Forum persists in calling such losses "unexpected."

Gillian Tett writing in the Financial Times reports that global regulators, now awake to the dangers posed by structured finance activities by banks, want to make it more expensive for banks to warehouse assets "available for sale" or AFS on the trading book. But as with the nature of such losses being "unexpected," do global regulators understand that the risk was created not by the fact of bank purchases of subprime assets for securitization, but rather by the deceptive way in which these securities were constructed and sold?

Fundamentally the gruesome "mark to market" losses of the past year result from a change in the level of investor confidence, not any unanticipated change in the underlying assets.  The subprime crisis proves that if investors lose confidence in the representations made by banks with respect to any asset class, then markets will become inefficient or entirely dysfunctional, banks will then take large economic losses or fail entirely, and all investors suffer.  

The losses suffered by organizations and people represent the very real cost of deliberately embracing inefficient market structures. Ironically, the progressive rule of "fair value" accounting may not accurately measure the true value of illiquid structured assets, but it certainly is a great measure of operational and reputational risk taken by banks with large trading books!

David Einhorn, in his remarks at the conference held by Grant's Interest Rate Observer, notes that in the case of Carlyle Capital, the publicly traded fund collapsed due to the noxious combination of agency securities and 30:1 leverage. "Given the historical safety of instruments, Carlyle and its lenders judged thirty times leverage to be appropriate," said Einhorn, who added that the world learned as a result that "investment companies with thirty times leverage are not safe."

Well, maybe. If the regulators represented by the Financial Stability Forum deliberately allow and encourage the growth of opaque OTC markets, then should we be "surprised" that true levels of probable loss in all financial assets is many times the normal range assumed in contemporary models?  Or put another way, should not the entire financial community see its ability to employ quantitative tools at all threatened by the growth of inefficient markets?

As regulators and investors try to grapple with the deepening losses caused by the collapse of the structured asset bubble, it's worth noting that our shared pain comes not because the models "did not work," as Einhorn and many other observers state.  Models never really work 100%. Rather, we should consider whether a market that is illiquid and inefficient makes financial modeling irrelevant.  That possibility should cause the entire Wall Street community to tremble at our collective stupidity.

Whether you are talking about calculating capital adequacy for Basel II or trying to price a structured asset, a market which is opaque and does not provide investors and regulators with timely information stifles the very type of innovation and safety and soundness all investors depend upon.  Watching some ratings vendors try to "fix" these systemic problems with arbitrary fudge factors reminds us that many people on Wall Street still use the 100bp either way range for model stress testing, a method we submit is no longer adequate.

In view of the new economic construct enumerated by our friend Dick Alford in last week's issue of The IRA ("Fed Risk: Interview with Richard Alford"), and a lot of calls we've been receiving, it is clear to us that hard measures of solvency and credit performance are among the most sought indicators. The search for hard reference points is why we included detailed data on non-performing loans in the third component of the Compendium of Bank Risk.  The ratio of actual losses to provisions, for example, is the focus of global markets as US banks move from the economic world of mark-to-model to the harsh world of realized losses.

With net charge-offs reported to the FDIC by all US banks running at 1% vs. 0.59% for all of 2007, the expected rate of change of actual losses for the rest of 2008 is clearly the key question.  Bet you'd like to know the revised Economic Capital metrics for all US banks in The IRA Bank Monitor as of Q1 2008, but telling would not be fair to the growing crowd of those who actually buy tickets.  Suffice to say that bellwether Citigroup (NYSE:C) was just this side of 0% RAROC for Q1 2008 vs. 3% at year-end 2007.

As Graham & Dodd wrote many years ago in their 1938  classic, Security Analysis, the more speculative a given financial problem, the less analysis matters in shaping the outcome. Global regulators must accept that no amount of incremental tweaking, such as raising capital requirements or stapling a centralized clearing solution onto the broken OTC structured asset model, will address the collapse of the market for complex securitizations and its widening economic effects.  At the end of the day, market liquidity is all about market structure and transparency.

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