"A Banker," explained Sir William Petty, co-founder of the Royal Society and author of Political Arithmetick, in 1682, "is honest only upon the Penalty of losing a beneficial Trade, founded upon a good Opinion of the World, which is called Credit." Credit, by definition, cannot easily be restored; its nature is to shift somewhere else. We should be less concerned with loss of money and more concerned with loss of trust. If we have to start over with more trust and less money, is this really so bad? "Is not a Country the Poorer for having less Money?" asked William Petty. "Not always," he answered, "For as the most thriving Men keep little or no Money by them, but turn and wind it into various Commodities to their great Profit, so may the whole Nation also.

THEORY OF GAMES AND ECONOMIC MISBEHAVIOR
George Dyson
Edge
7/22/99

August 2009 marks the sixth anniversary of the founding of Lord, Whalen LLC and our primary operating unit, Institutional Risk Analytics. We want to take this opportunity to thank all of our customers and readers for your support over these exciting and at times challenging times.

IRA began its life as a consulting firm, but over the years we have steadily accumulated a portfolio of products and enabling technologies that are designed to help investors, banks, and consumers discern risk in a wide variety of products and companies. The company was in fact originally formed in 2003 anticipating a need for banks to be able to assess counterparty risk among each other and commercial companies as part of a booming "global economy" promised under the rubric of Basel II.  Instead we uncovered an industry approaching a tipping point of unsustainable leverage. The financial services industry was a business covered by a ratings process lacking objectivity.  Indeed, the major ratings firms were actually party to covering up the volcano of risk which was preparing to erupt within the banks, leading to the collapse and/or nationalization of some of the largest and oldest names in finance.  Our mission became clear.

We saw a dire need for an objective rating process that recognized the banking business as the varied and risk laden industry it had become. Only through brutal transparency was there any hope to bring back market discipline that could, in our 2004 thinking, "preserve" economic stability.  In order to accomplish this, we deliberately went against the grain of contemporary risk management tools and methodologies, which are mostly dependent upon the efficient market hypothesis, preferring instead to develop new strains of heuristic methods that distill the growing body of structured financial data now available to the public.

For decades, the global community of analysts and economists devoted to finance has grown based upon the availability of copious amounts of market and financial statement data. The US market has been a leader in this area because of the culture of disclosure that has evolved since the 1930s to provide information that is sufficient for investors to make informed decisions. But the trend over the past decade or more toward opaque, non-public OTC markets seriously damaged the position of the US markets in terms of transparency and reliability of public company disclosure. As we wrote in The IRA in February 2004:

"Over the past half century, Wall Street has based its existence upon the assumption that the information provided by listed companies to the investing public was generally accurate and true. With the democratization of the equity markets in the 1990s, though, the standards for corporate governance and public disclosure have "reverted to the mean." The efficient markets described by Dr. Merton and behind many Wall Street risk models depend fundamentally on the veracity of financial information. If we convince investors and analysts that published financial reports cannot be trusted, then the financial markets will cease to be efficient."

One of the important ways in which we have tried to address the volatility that we all see in the valuations and financial statements of banks is to recognize an empirical truth: There is great diversity in business models among banks. Ratings that assume a certain degree of homogeneity in bank business models suffer from the fallacies present in all Merton-type models, which are still popular among the largest rating agencies.

We know that it takes as little as nine months for a bank's business model to collapse under systemic stresses.  Ratings constrained by deal participant assurances and covenants can't respond objectively to these real world effects. By approaching bank ratings using consistent computation formulae applied to all depositories over long observation horizons, the quarter-by-quarter ratings changes do reflect the underlying shifts in these bank's business models.

IRA believes that we better serve decision support needs of consumers with these distilled ratings -- be they institutional investors, managers of family offices or consumers. To us, by providing different perspectives on a given institution, we help to better inform the markets with the kind of increased transparency that can, in the end, create substantive and positive risk discipline outcomes.  And we have taken the time to reduce it all down to the kinds of simplified letter grades consumers can grasp.  After all, if you don't understand the message of the financial disclosure, then there is no transparency no matter how much data is provided.  Or as we say on the masthead of our new retail web site built specially for users of the IRA Bank Cart, "Confidence doesn't take trust, it takes transparency."

Of note we are seeing a positive shift in the public's concern.  Last year people seemed primarily worried about the bank in which they kept their money.  Now they are beginning to express an interest in redeploying their capital to reward best of breed banks with their business and they are looking to find out who the healthy survivors will be.  Responding to the call to action, we have just implemented a new, $1,000 per year option that enables users of the Bank Cart to run searches by characteristics then see all of the summary reports meeting their criteria within the IRA Bank Ratings service, including our Banking Stress Index and public data CAMELS ratings, and our Economic Capital benchmarks. For more details, visit www.irabankratings.com

Of interest to professionals, preliminary Bank Stress Indices are now available from IRA's proprietary tool for harvesting and distilling stress test ratings from the FDIC's Central Data Repository. This process produces information beginning about the 15th day after the quarter close and builds to cover the bulk of the industry by the 30th day after the quarter end.  That's almost a month sooner than the FDIC's master file is being released and a lot closer to the dates bank SEC filings reach public eyes.  As of today, we've gathered and rated over 6,900 CDR sourced bank CALL reports for Q2 2009. Preliminary Banking Stress Index ratings for these banks are available to users of the professional version of The IRA Bank Monitor. If you are logged-in to the Bank Monitor, click on this link to view the preliminary Banking Stress Index ratings:

http://us1.institutionalriskanalytics.com/Monitor/Prelim_List.asp

In general, the preliminary stress ratings for Q2 2009 are significantly higher than for Q1, with charge-offs and degradation of efficiency the leading factors as opposed to ROE in previous periods. There are several large regional banks with Banking Stress Index ratings a full order of magnitude above the industry average, which is itself higher than at any time in the past 20 years.  We suspect that the primary regulators will be compelled to resolve these institutions sooner rather than later, but we also have great confidence that the primary supervisors and the FDIC are ready to do the job.  Look for fewer loss sharing agreements and more liquidations in the months ahead.

One institution in the large bank peer group located in AL saw the Stress Index score for charge-offs double from 5.1 in Q1 2009 to 13.1 based on Q2 preliminary data (1=1995). The same institution reported a degradation of efficiency such that its Stress Index score went from 1.1 in Q1 2009 to 2.7 based on Q2 preliminary data.  This basic change profile is repeated many times among institutions in the Q2 2009 IRA Stress Index test survey.< /P>

Given our observations of the preliminary Stress Index ratings, it probably comes as no surprise that regulators are preparing for a second round of bank stress tests.  As we told subscribers to the IRA Advisory Service earlier this week, the next round of bank stress tests will employ Q2 2009 data and will be focused on all banks, large and small.  The key question for the upcoming stress tests seems to be whether the main assumptions used by the Fed in the Supervisory Capital Assessment Program or "SCAP" process regarding income and capital available to absorb fututure losses remain valid now that many banks are nearing the Fed's 9% maximum loss rate assumption. When we assess the loss rate, we combine current charge-offs on an annualized basis with non-performing loans and REO.

Some of our clients are a little shocked by this approach, but as we've said all along, the magnitude and the duration of bank losses during this cycle will be far higher and longer, respectively, than in any previous cycle since the 1930s.  The peak loss rates now approaching won't be as bad as the 1930s, but they will be a lot worse than the early 1990s as we have long predicted.  Thus looking at current period charge-offs, NPLs and REO seems to us a conservative approach to understanding where financials are headed by year end. We commented on same last week from Leen's Lodge during an interview on CNBC with Steve Liesman.

The other relationship that we use to inform our views of safety and soundness is the balance between charge-offs and provisions, a key metric in The IRA Bank Monitor that tells you whether the bank in fact has sufficient revenue to stay ahead of rising realized losses.  At the moment, it is pretty clear that regulators are "managing" the relationship between loss realization and provisions for future losses because, as we tell our clients almost every week, the rate of increase in loss rates is moving faster than the ability of banks to fund these losses.  More on this evolving trend within the industry in future editions of The IRA. 

Regulation of OTC Derivatives

We can't end this week's comment without focusing on the latest proposal for regulating OTC derivatives.  Our colleague Dawn Kopecki of Bloomberg News reports that "The Obama administration is asking Congress to subject derivatives users to new capital rules and to require all standardized derivatives products to be cleared through regulated clearinghouses and executed on a regulated exchange or trading platform. Customized products that can't be centrally cleared would carry higher capital and other requirements."

The IRA asked Josh Rosner or Graham Fisher in NY about the implications of the final version of the OTC legislation from the Obama Administration. "The proposal clearly is supportive of the SEC, CFTC and FDIC positions on OTC derivative contracts," says Rosner, who believes that the end result will be to push most contracts onto regulated exchanges and clearing houses.

Rosner believes that there is still some "wiggle" in terms of the transparency of pricing and how frequently this data will be made available to investors and the public generally, but he is encouraged by the fact that the regulators will set the margin requirements.  Rosner also believes, as we do, that the fact that the Fed did not fight this latest proposal indicates that the Board of Governors is finally realizing that they are better off leaving the OTC swamp to the securities regulators at the SEC.  We are particularly pleased to see the proposal suggest harsh limits on the sale of complex derivatives to public sector clients, a position we took in our comments at AEI last year (What is To Be Done With Credit Default Swaps?).

But the bottom line on these changes to the regulatory regime for OTC derivatives is that it, if enacted, they will significantly impact and reduce the supra-normal profits earned by the major OTC derivatives dealers such as JPMorgan Chase (NYSE:JPM) and Goldman Sachs (NYSE:GS).  Indeed, if as seems likely the latest proposal from the Obama Administration is enacted into law, we would treat that event as reason to downgrade our subjective outlook for both GS and JPM.  We'll be addressing this issue in the  next issue of the IRA Advisory Service.

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