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The Institutional Risk Analyst
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Questions for the Fed on JP Morgan; Walker Todd on Bernanke, Ed Kane on TARP May 14, 2012
"Depositors also used to be senior creditors. Not now. Consider the pensioners and candy store owners who were depositors in Bankia, the just-nationalised Spanish bank. Less than a year ago, bank employees who looked like cashiers sold them Bankia shares that many assumed were money good. As for the deposits they have left, those are backed up by collateral. Not that much collateral, since the ECB and other well-lawyered funders made sure that their advances were over-collateralised, which means, given the losses of equity value, that the depositors are under-collateralised. The under-lawyered should look for spiritual, not financial, comfort."
John Dizard
In this issue of The Institutional Risk Analyst, we comment on the JP MorganChase trading fiasco and then feature some comments from our friends. First Walker Todd, research fellow at American Institute on Economic Research, holds forth on the way that the Fed panders to the largest banks. Ed Kane then talks about how to reckon the cost of TARP and other bailout programs contrary to the convoluted presentation from the US Treasury.
Obviously the situation with JPM's $2 billion trading loss deserves some comment. IRA co-founder Chris Whalen talked about the JPM loss on CNBC "Squawk Box" Friday, "Joe Kernan, Becky Quick & Andrew Ross Sorkin: JP Morgan's Impact on Street."
If you are looking for last week's comment on the bankruptcy of Madoff and MF Global, "It's All About the Fraud: Madoff, MF Global & Antonin Scalia," click here to go to the evergreen post on Zero Hedge. We're not going to stop talking about the issue of fraud in brankruptcy any time soon.
As you might imagine, we've been hearing from other members of the Herbert Gold Society in this regard over the past few days. Here are some questions we'd like to ask both JPM management and the regulators equally.
First, in what legal entity did the loss at JPM occur? Nobody seems to care if it was the bank or a non-bank holding company subsidiary. Given the Fed can only prop up banks (though not in recent practice), but not affiliated entities, someone should be asking if the booking entity for this trade was in or outside of the bank legal entity. What if it were $20 or $200 billion?
Second, when did the exposures that caused the loss first exist? How long did it take for JPM management to identify the loss? The JPM trading loss certainly seems to confirm the economic capital model in The IRA Bank Monitor, which has always suggested that trading losses were an outsized risk for this large bank holding company.
A loss of $2 billion is not nearly as significant as some politicians and members of the Big Media would like to believe. But the number could have been much larger given the risks we understand that the CIO's office was taking over the past several years. Does the loss suggest that JPM needs to increase capital for trading activities? Or does the implementation of the Volcker Rule obviate that concern?
Third, which regulator approved the apparently faulty VaR model which allowed JPM to take this loss? According to 2009 guidance from the Fed (See Federal Reserve SR09-01):
"Notification and Approval Requirement for use of Regulatory VaR Models Banking organizations applying the MRR must demonstrate to the Federal Reserve (e.g., with documented approval from the Federal Reserve) that their VaR models meet the requirements of the MRR for risk-based capital purposes. This requirement is applicable at the individual product/model level."
As such, someone at the Fed should have at least secondary accountability for the JPM losses if the VaR model/process was faulty. Is there any accountability for incompetent, badly managed federal bank regulators? As our colleague Janet Tavakoli wrote in the Huffington Post: "The U.S. can count on JPMorgan to continue both long and short market manipulation and take its winnings and losses from blind gambles. Shareholders, taxpayers, and consumers will foot the bill for any unpleasant global consequences."
We think that the loss by JPM is ultimately yet another legacy of the era of "laissez-faire" regulation and even overt Fed advocacy for the use of OTC derivatives by US banks. Fed officials such as Pat Parkinson, who retired as head of the Fed's division of supervision and regulation in January, were effectively lobbyists for the large banks and their derivatives activities. It seems a little ridiculous for the same Fed officials who caused the problem over the years to now be tasked with investigating JPM, much less regulation of large bank dealings in OTC instruments.
Were there any specific modeling/proxy errors in the VaR model as discussed by SR09-01? If so, why weren't JPM and Fed personnel on top of these issues? Was the examiner in charge (and on site) at JPM aware of these risk exposures, say, about six months ago, when changes related to the Volcker Rule started to occur in the office of the CIO? People cannot use the excuse that "they didn't know" weaknesses could be significant (a little early on the heels of the crisis for that). The relevant portions of the Fed guidance are below:
Required Capture of Significant Price Risks within VaR
For regulatory capital purposes, a banking organization subject to the MRR must capture all significant price risks within its approved VaR model(s).10 This includes basis risks, as well as directional market risks. For banking organizations with a greater breadth and sophistication of trading activities, this requires a high level of model complexity and utilization of numerous data series to minimize proxy and other estimation errors. Banking organizations should map or reference each covered-position type to appropriate and sufficiently granular historical data series to ensure proper estimation of potential price volatilities and correlations with other positions. Proxy time series utilized in VaR modeling should reflect all significant sources of price risk, including potential price moves driven by changes in market liquidity. Proxy choices should be supported by documented analysis and reassessed periodically for continued appropriateness."
Proxy Error Discussion:
Certain potentially significant basis risks and related proxy errors are identified below. The use of overly broad proxies that fail to capture potentially significant price risks within regulatory VaR models is inconsistent with MRR requirements. Furthermore, proxy errors within stress-testing programs can result in significant misestimation of extreme downside risk. The list below should be considered illustrative but not comprehensive.
o Structured-Linear Basis Risk. Mapping a structured or leveraged position, such as a CDO tranche, to the time-series data of a linear or unleveraged position, such as a corporate bond.
o Cash-Synthetic Basis Risk. Mapping a derivative position, such as a credit default swap, to the time-series data of a cash credit position, such as a corporate bond (or the reverse)."
Fourth and most important, we'd like to see a congressional investigation into whether the implementation of the Volcker Rule actually contributed to the loss at JPM. Specifically, has management distraction and operational changes made since the end of 2011 directly due to the Volcker Rule implementation contributed to the loss at JPM?
Was the fact that the CIO and other JPM personnel spend the largest single part of their time in meetings with regulators or lawyers a contributing factor in the lack of oversight for these trading activities? Were the firings of traders and risk personnel in the JPM office of the CIO over the past six months a contributing factor to the losses? What is the investment strategy of the CIO now?
Walker Todd on Bernanke
Despite the horrific developments at JPM, the level of deference still shown by regulators to the large banks might surprise readers of The IRA. On May 10, Fed Chairman Ben Bernanke addressed the 48th Annual Conference on Bank Structure and Competition at the Chicago Fed, prompting this reaction from Walker Todd:
The IRA: What did you think of the Bernanke speech on bank supervision?
Todd: Not a bad speech, but the question is what would be said if bankers treated their customers with the same kid gloves that the Fed uses with bankers before initiating or implementing rules changes. How many of us in recent years opened envelopes from bankers asking us to agree to their "right" to change the lending rate or the loan ceiling "at any time and for any reason"? Wonder what the bank lobbyists would say if the Fed told bankers, "We're going to change the capital or reserve requirements at any time and for any reason"?
The IRA: You think the Fed is too nice to the big banks?
Todd: Yes. One of the things that grates most on the public in recent years is the understanding that the Powers That Be seem to have one set of rules for the rich and the well-connected and a different set of far more onerous rules for everybody else. Common courtesy, to the extent that it exists in banking, is extended by the Fed toward bankers, but bankers in turn all too rarely extend it to their own customers, even those who dutifully have been paying their loans for thirty years and more. As Apple Annie says in the musical, "Oklahoma," "With you it's all or nothin'; all fer you and nothin' fer me!" That aptly sums up the banker-customer relationship these days."
The IRA: Is there any hope here or are we doomed to stagger unconscious from one fiasco to the next?
Todd: "At least Bernanke did not talk here about another round of Quantitative Easing (known to the cognoscenti as "excess reserve raising"). But we know he's thinking about it. He mentions the comparative boom in commercial and industrial loans (C&I loans), but that "boom" has resulted in a reduction of only a little over $100 million on the $1.5 trillion base of excess reserves at the Fed.
The IRA: Why do you think the reserve number has not moved?
Todd: The Federal Reserve Bank of New York has put out a video on why the foreign exchange swap lines are in the national interest of the United States. Chief among those reasons is supposed to be the $700 billion-plus of loans that European banks allegedly make to U.S. residents. Separately, from other sources, we know that at least one-half, maybe far more, of the excess reserves are held by foreign banks. So let us get this straight: We extend the swap lines to encourage foreign loans to U.S. residents, we know that they have the wherewithal to lend because they hold most of the excess reserves, C&I loans are going up, but the excess reserves don't shrink very much (which I would have predicted from my study of excess reserves in the 1930s).
The IRA: Wait, you don't think the Fed is telling us the truth?
Todd: Pardon my cynicism, but I think the C&I loans are not being made by foreign banks in the U.S.A.--if they were, the excess reserves pool would be shrinking (unless they were funding the C&I loans from the proceeds of swap drawings, but that is a pretty roundabout way of funding domestic loans).
The IRA: You are absolved. Thanks Walker.
Below is the report last week from the Shadow Financial Regulatory Committee on how Treasury mismanages and mistates the financial reporting on TARP and other bailout programs. Thanks to Ed Kane of the SFRC.
Treasury Mismeasurement of the Costs of Federal Financial Stability Programs
Shadow Financial Regulatory Committee | Statement No. 327"Holdouts get paid, the rest can pray" Financial Times May 07, 2012 On April 13, 2012, the US Department of the Treasury released new cost estimates for the Troubled Asset Relief Program (TARP) as part of a series of charts describing the combined impact of Treasury, Federal Reserve, and FDIC financial-stability programs. Looking principally at actual and projected contractual cash flows, the document concludes that: "Overall, the government is now expected to at least break even on its financial stability programs and may realize a positive return." The Shadow Financial Regulatory Committee believes that the Treasury has made four fundamental errors in reasoning. These four errors are not only inconsistent with basic economics and accounting principles, they are also inconsistent with standard practices for government assessments of the costs and benefits of such programs. First, the cash-basis calculation of cost provided in the Treasury's analysis wrongly deducts Federal Reserve interest revenues as a contra-cost in measuring cost. Second, the cash-basis calculation of cost ignores the projections of the Special Inspector General of TARP, which contemplate larger cash-on-cash losses from TARP lending, and understates prospective losses from government funding of Government-Sponsored Enterprises' (GSE) losses. Overall, taking these two errors into account, the Treasury's estimates understate the true cash-basis cost to taxpayers by at least $200 billion, and probably much more. Third, it is inappropriate to measure taxpayers' costs on a cash basis. Fourth, the Treasury asserts - but does nothing to show - that the benefits and net gains to society from the programs were large. The first error relates to the inclusion of $179 billion in transfer payments from the Federal Reserve to the Treasury. Federal Reserve transfers do not belong in the calculation of cash-on-cash program returns. Treating Federal Reserve transfer payments as income to the Treasury is a sleight of hand that would make Bernie Madoff proud. Since the Federal Reserve is not permitted to lend to the Treasury directly, it purchases government securities in the open market, effectively replacing Treasury debt held by the public with Federal Reserve debt in the form of commercial-bank deposits held at the central bank. From taxpayers' perspective, to assess the costs of financial stability programs and score the net transfer of funds between the two government agencies, the Federal Reserve balance sheet and income statement should be consolidated with those of the Treasury. The Federal Reserve purchases government debt and receives interest as a transfer payment from the Treasury. The Fed deducts operating expenses from the interest it receives and returns the remainder to the Treasury. On balance, therefore, the Treasury underwrites the cost of Fed operations. It is a mischaracterization to say that the Fed earns a profit on its Treasury holdings. In fact, there is a regular net flow of payments from the Treasury to the Fed. The second error is the underestimation of prospective cash-on-cash returns for the TARP program. The Treasury's calculation conflicts with CBO estimates and with the testimony of Christy Romero, the Special Inspector General for TARP. Her recent testimony indicates that taxpayers are still owed some $118 billion, and that 351 small banks with roughly $15 billion in outstanding loans face a "significant challenge" in being able to raise funds to repay the government (Wall Street Journal, April 25, 2012, pp. C1-2). Furthermore, the Treasury's projected cost of bailouts for the GSEs is unrealistic; the projected cost of only $28 billion through 2022 assumes a remarkable improvement in GSE performance, given that costs to date are roughly $180 billion. Third, the true cost to taxpayers is still bigger, because the Treasury does not consider the risks that taxpayers bore in supplying federal guarantees and emergency credit support to troubled firms. Both forms of support were offered on highly subsidized contractual terms. At the time taxpayer funding was extended, the risk was substantial and deserved a high rate of compensation. Mischaracterizing bailout costs, as the Treasury does, not only flies in the face of economic and accounting principles, it ignores specific reporting requirements embodied in the Emergency Economic Stabilization Act of 2008, which was the empowering legislation for TARP. This Act requires the Congressional Budget Office (CBO) and Office of Management and Budget (OMB) to measure subsidies by including the cost of market risk when estimating the budgetary cost of TARP. During the height of the crisis, few institutions were willing to commit funds in large amounts even on overnight terms. Acting on behalf of taxpayers, government agencies created new FDIC guarantees, TARP funding, and Federal Reserve lending and guarantee programs. Those programs supported extremely large amounts of financing at below-market terms for substantial periods of time. If those funds and guarantees had been priced at or near their true market value, taxpayers would have been entitled to substantially higher rates of return. The true cost of credit-support subsidies can be measured in several ways. The simplest way to think about this cost is as a return that private investors would have demanded to be paid for filling in the capital shortfalls that existed at the distressed firms if private investors, rather than taxpayers, had funded the interventions in question. Another way to think about the true opportunity cost is that it would equal the return that taxpayers could have required had they hired a team of properly incentivized private agents to deploy funds in comparable efforts to stabilize the financial sector at the time that TARP and other federal commitments were made. Indeed, studies conducted by the CBO routinely show that the value of the subsidies in these and other deals can be determined by comparing these measures with the much-lower payouts authorities actually contracted for. Fourth, a full economic analysis of assistance programs such as TARP requires an assessment of benefits as well as costs. Best-practices reporting standards for quantitative and qualitative costs and benefits in regulatory reviews are set by OMB Circular A-4. This circular states that a "good regulatory analysis is designed to inform the public and other parts of the Government (as well as the agency conducting the analysis) of the effects of alternative actions." Economically, OMB Circular A-4 sets a sterner test than the mere avoidance of financial collapse or macroeconomic depression. It insists that agencies explain how policy actions "are linked to expected benefits." To be sure, during the height of the crisis, the market was demanding extraordinary risk premiums and if bailout support had been priced consistently with then-prevalent market terms, it would have defeated the purpose of the programs. But if private agents had been asked to negotiate such a deal on taxpayers' behalf, to meet the OMB standard the government's contracting authorities would have been obliged to make the private agents establish just how these highly subsidized deals actually promised to produce greater benefits for society. Otherwise, authorities would have had to deem the agents' handling of taxpayer resources negligent or even grossly negligent. Here and in Europe, bailout deals have left piles of taxpayer money on the deal making table and a substantial proportion of this money ended up in the hands of the traders and other executives whose aggressive risk-taking had turned their firms into basket cases. Whether or not these huge subsidies can be shown to be worth their cost, it is dishonest to pretend that no subsidies existed. Treasury's emphasis on cash flows rather than economic costs egregiously misframes the financial and economic public-policy issues. Rather than trying to mislead the voting and taxpaying public with false claims of bailout profits and clever policymaking, officials should be trying to identify the true costs and benefits of each rescue program so that, here and abroad, future episodes of financial instability can be handled more effectively. Questions? Comments? info@institutionalriskanalytics.com About IRA Products and Services IRA for Banking and Finance Professionals - We offer enterprise grade analytics and privileged process support for risk surveillance, compliance testing and investment research via subscription products such as the Professional IRA Bank Monitor. IRA also offers custom analytics services, hosted component tools, and bulk data feeds to clients for use in their internal systems. For more details, please call our Torrance, California office at (310)676-3300. IRA for Business - Corporate risk management is an ever vigilant concern as the economy continues to evolve. We offer corporate CFO's and Treasurers online tools to monitor the health of their banking relationships whether they be credit facility providers, depository relationship banks, or investment counterparties. It doesn't whether you deal with only with TBTF's or local community banks, we cover them. Contact Diana Waters at our Torrance, California office for more details and to arrange a demo for your team. IRA for Consumers - IRA believes that "ordinary people" matter. We provide consumers the same analysis horsepower to render banks transparent via an easy to buy online reports website at IRABankRatings.com system. The Institutional Risk Analyst is published by Lord, Whalen LLC (LW) and may not be reproduced, disseminated, or distributed, in part or in whole, by any means, outside of the recipient's organization without express written authorization from LW. It is a violation of federal copyright law to reproduce all or part of this publication or its contents by any means. 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