FSA screw it up again

The FSA is irredeemably compromised. It has been captured by the financial services industry. As such, taxpayers can not rely on it to properly supervise banks. It must be abolished, with all its powers returned to the Bank of England.

This story from the FT, which highlights the government's disapointment with the FSA's so called crackdown on bonuses, further emphasises the need to abolish this pathetic institution as soon as possible.

Senior cabinet ministers are so disappointed with the Financial Services Authority’s new pay rules, released this week, they are considering whether legislation may be needed to crack down on bankers’ bonuses.

A number of ministers, including Lord Mandelson, the business secretary, are understood to be unhappy with the City regulator’s remuneration code, which toned down some earlier suggested measures.

Lord Mandelson thinks the guidelines, intended to reduce reckless risk-taking, have failed to reflect public concerns that the City is returning to “business as usual” after receiving billions in state support.

“Excessive risk taking had the results that we saw. Ordinary businesses are paying the price,” he said in an interview. “We have not heard the last word on this subject.”

His views are shared by other senior ministers, who suggest legislation may be needed to control short-term incentives for bankers unless the FSA shows it can pursue a tougher line.

Its both fascinating and horrible

Isn't it fascinating how quickly the rhetoric of politicians can change.

For years, the part time politicos on the monetary policy committee talked tough about monetary policy. They told us that central banks needed have credible counter inflationary strategies. They needed to be independent of governments, and relentlessly pursue price stability, regardless of the electoral needs of ruling parties.

Today's data on reserve balances tells of the horrible reality of central banking in the UK. Reserve balances of the Bank of England is not a rhetorical device; it is not cheap speech given at dinner of local business leaders. It is a key monetary policy instrument, which can be used for good or evil.

Today's MPC have been captured by the dark side. Reserve balances highlight the true inflationary intentions of the UK central bank. The BoE have created balances on an unprecedented scale, and used them to buy up government paper. In a few short months, the bank has injected around 10 percent of GDP in new money into the economy. Give that surge in liquidity about a year or two, and we will feel its full force in the inflation data.

As the reserve balanc number has increased, the old speechs about central bank independence have died away. There is no more talk of prudent monetary policy. Instead, central bankers talk of spectres like deflation and credit contractions.

And what about the credibility of the Bank of England? Where is its once proud independence. Naughty boys have word that begins with the letter B that seem to capture the essence of the relationship. I will use a more polite analogy, the BoE has become the Government's poodle.

Icesave - paying for other people's mistakes

Frankly, the UK does not come out of the Icesave collapse terribly well.

It used anti-terrorism laws to pressurize a small country to pay up on the debts of one of its bankrupt banks.

When these laws were passed, did anyone think that they would be used to settle a financial dispute? If New Labour are prepared to misuse this law in such a scandalous manner, how far would they go if they were really threatened?

It was classic Gordon Brown: "by any means necessary."

The FSA - technically capable, but politically weak

As the UK learns to live in the post-bubble world of collapsing asset prices and failing banks, there is some value in playing the blame game. How did we get into this mess and who was responsible? Perhaps, if we knew the answers to those questions, we might avoid a similar crisis in the future.

Today, the Telegraph provided an interesting insight into the role of the FSA during build-up of the commercial property bubble:

In a letter to the Chancellor on last month's collapse of Dunfermline, FSA chairman Lord Turner listed warnings made over five years from 2003 against "the dangers of commercial property lending", the risks of buy-to-let and "the dangers of mortgage book acquisitions".

Despite the FSA's concerns, Dunfermline was allowed to increase its commercial property book five-fold to £628m between 2004 and 2008 and buy mortgage books worth £467m from Lehman Brothers and GMAC. The watchdog finally intervened in October 2007 to prevent Dunfermline acquiring another £160m mortgage book from Credit Suisse.

Dunfermline was not alone in ignoring FSA recommendations. Seven of the top 15 mutuals increased their commercial property books by 15pc or more between 2006 and 2007, according to data from accountants KPMG.

The article reveals four interesting facts about the crisis. First, the FSA knew that weak regional banks, like the Dunfermline, were taking on excessive risks. Second, the FSA warned banks about the dangers. Third, the banks ignored those warnings. Finally, the FSA did nothing as the banks plunged further into the murky world of commercial property lending.

Does this help us answer our earlier questions? It tells us that the FSA has the technical competence to identify excessive risk taking by banks. However, it does not have the political willpower to restrict banks from making crazy lending decisions.

In other words, the FSA knew what was happening but failed to do anything about it.

FSA and the price of failure

Michael Fallon, MP for Sevenoaks and deputy chairman of the Treasury Select Committee, on the UK Banking crisis and the FSA.....

In the end, this was a failure of regulation and of government. Take Brown’s own creation, the Financial Services Authority (FSA). This super-quango employs 2,500 staff, costs us a staggering £415 million a year, and is supposed to supervise the banks. So far, five out of the big 10 banks have crashed – that’s some supervision.

More proof of FSA incompetence

Why does this not surprise me:

The City watchdog was warned that Icelandic bank Kaupthing was not "fit and proper" to run the UK bank Singer & Friedlander, MPs were told today. Tony Shearer, former chief executive of Singer & Friedlander (S&F), said he contacted the Financial Services Authority about his doubts in April 2005 during the takeover of the group by Kaupthing.

He said he and fellow directors took "every step that they thought was reasonable" to alert the FSA that they did not think Kaupthing was "fit and proper to run a UK bank". Overall, five of the seven members of the board made their concerns known in some way.

(From the Independent)

Isn't it about time that there was a public enquiry into the activities of the FSA. What exactly were they doing during all those bubble years?

So farewell, leveraged buy out loans

It wasn't just the housing market where banks were injecting silly amounts of money without fully understanding the risks. The leveraged buyout business was another favourite for reckless bankers.

The idea of a leveraged buyout is straightforward. A speculator raises huge money, either by issuing junk bonds or taking out loans, and then uses the money to take over a controlling interest in a target company. The speculator doesn't actually put up much of her own money -hence the title leveraged. Therefore, the speculator needs a ready source of credit. Until the credit crunch rolled into town, banks have been all too ready to provide money for these highly risky projects.

The leveraged buyout business has a long and grim history of financial failures. Towards the end of the 1980s, many buyouts proved to be highly unprofitable, leading to a number of horrific bankruptcies.

The chart above illustrates the explosive growth of leveraged buyout loans. In order to make the years comparable, the half yearly amounts have been inflation adjusted. The business peaked during the first half of 2007, and it has been sliding ever since. The stock of new loans during the first half of 2008 has fallen back to the level of 2004. It is likely that the market will have totally evaporated by the end of this year.

Leveraged buyout loans raises an old issue - bank supervision. Why did regulators allow banks to get involved in such a dangerous business?

So farewell, B&B

This morning's newspapers report that the Treasury is on the verge of nationalizing the Bradford and Bingley. Government intervention is inevitable. On Saturday, the bank experienced significant withdrawals of cash from its branches and online bank. By Monday, withdrawls would have snowballed into a full-scale run.

The bank reached the end of the road on August 29 when it published its half yearly interim results. Few were surprised to hear the bank report losses of ₤26 million. The arrears situation was deteriorating. The share price kept falling. Despite the recent rights issue and management claims of being well capitalized, no one was buying the happy talk from the B&B management. Last week, the credit rating agencies acknowledged that the bank was in trouble and belatedly downgraded the bank.

Thankfully, the B&B isn't in quite the same league as Northern Rock. As of June 30, the bank held about ₤52 billion of assets, of which around ₤39 billion are loans. Most of the loans are to buy-to-let customers. In terms of liabilities, the bank have some ₤20 billion in retail deposits. The Treasury should find this nationalisation less traumatic.

The real difficulty with B&B is the lending book. While the B&B had its own "organic" loans, which it generated through its own branch network, it also had a large amount of acquired lending; loans it bought from other institutions. The arrears numbers on these acquired loans are horrible. The bank also dipped deeper than most into the self-certification loan market. The arrears rate on these loans is high and rising. It is a lending book that will deteriorate further as the economy slows and borrowers run into payments difficulties.

According to media reports; the B&B's loan book is likely to stay on the government books for long time. The Treasury appears to have the good sense to understand that fire sale of bad loans would not be in the best financial interest of taxpayers. As for the retail deposits, the government will auction them off to the highest bidder.

I am curious how this latter transaction will work. Deposits, are of course, liabilities to banks. Presumably, these liabilities will be backed up by some form of government paper. It is just a guess here, but if this is how the Treasury will arrange this sale, then the B&B will add around ₤20 billion to government debt.

A second issue will be the remainder of the B&B's liabilities. Will the creditors receive a government bailout, or will they have to wait until the B&B is liquidated?

The demise of the B&B is a serious blow to the buy-to-let business. In future, investors will need to receive a significant risk premium if they are to be persuaded to invest in specialist BTL investors.

The end of the B&B also rules out any serious possiblity of banks recapitalizing via rights issues. Anyone who invested in the B&B earlier this summer would have literally thrown their money away. Investors won't make the same mistake again.

Like the NRK failure, the end of the B&B marks a major turning point on the road towards deflating the UK's housing bubble. Just as the NRK collapse signaled the end of the high LTV retail mortgage; the B&B signals the end of BTL loans to highly leveraged small time speculators.

We need a UK bailout strategy.

I've been surprised by the UK banks. In contrast to their American cousins, banks here have been noticeably quiet about the need for a generous tax payer financed bail out.

I wonder why? Perhaps, our banks have already quiet received assurances from the government that when the time comes, the taxpayer will be there for them. Both the government and the banking sector have good reason to keep quiet. A bailout will be extremely contentious and won't be an easy sell.

However, silence is the last thing we need right now. Instead, we need a serious debate about the appropriate circumstances when the government should intervene in a failing financial institution. If the Americans have taught us one thing this year, it is that an ad hoc, "take it as it comes" strategy simply doesn't work. The uncertainty about who gets bailed out only makes matters worse.

Nor is it tenable to say "we'll have no bailouts here". The consequences of a full scale bank run is just to horrible to contemplate. Besides, whether we like it or not, governments always come to the rescue of failing banks. The key question is how they bail out the banks.

Since a UK bailout is all but inevitable, here is my simple guidelines for the upcoming financial rescue of our largely insolvent financial system. The overriding idea is that the government should provide financial assistance generously, but brutally punish any bank who dares ask for it.

Principle one - All deposit taking institutions get bailed out. Everything else goes down in flames. So, hedge funds, SIVs, and the rest of the shadow banking system should understand that there are no government guarantees. They are on their own.

Principle two - Any deposit taking institution that asks for emergency liquidity should provide high quality collateral and pay an above market interest rate for any cash. If, in the opinion of the Bank of England, the bank would have difficulty paying the penal rate, the government should immediately nationalize the troubled institution.

Principle three - The shareholders of all nationalized financial institutions get wiped out. The value of shareholder equity goes to zero.

Principle four - The board of directors, the CEO and the CFO of any nationalized firm are fired immediately without compensation.

Principle five - The assets of all nationalized firms are sold only where the maximum value to the taxpayer can be reasonably assured. In some cases, this might mean holding onto assets for a very long time.

Principle six - Banks are nationalized before their net worth is zero. Every bank must keep a minimum capital adequacy ratio of 2 percent. Any bank falling below this threshold is immediately nationalized.

Principle seven - The head of the FSA is automatically fired if any bank fails with assets greater than 0.5 percent of total UK bank assets.

I hate speculating about the future of particular institutions. Bank failure is a nasty business. Judging by press reports this weekend, the UK government might need to think about a coherent bank resolution strategy very quickly.

The failures could start coming thick and fast.

Repossessions increase 41 percent

The Financial Services Agency have just begun to collect and publish data on UK mortgage activity. You would think that they would have started collecting these numbers the moment they assumed responsibility for overseeing the UK financial system. Well, better late than never.

The FSA did, however, make quite a splash in the world of economic data. Their numbers on home repossessions were positively ugly. Overall, repossessions are up 41 percent.

What does this mean?

The UK government has just published its views on financial stability and depositor protection. The document has this rather interesting paragraph (see para 2.67):

"The IASB (International Accounting Standards Board)has set up expert advisory panel to examine whether existing IASB requirements and guidance on the accounting and valuation of structured products could be improved. The advisory panel, which had its first meeting in early June, should draw upon the analysis undertaken by European banking and securities regulators. A specific area the Authorities call on the IASB to review is the current requirement that when any of an unrealised value loss on an available-for-sale security (broadly an investment security) is regarded as due to impairment, the entire loss has to be recognised immediately in the profit and loss statement. It is not clear this position is conceptually sound, and it creates an incentive for firms to delay timely recognition of impairment."

The government appears to be pushing the idea that the IASB should drop the requirement that any unrealized losses on marketable securities be recognized. This seems to be saying that banks can effectively conceal losses by recording the historical rather than market values, or have I missed something here.

Many thansk for McC, who sent me an email pointing this document out to me.

FSA - another damning report

How much longer can the FSA survive?

Today, the Parliamentary ombudsman trashed the hapless regulator in a report on Equitable life. In the report, the Ombudsman made ten determinations of maladministration naming explicitly the FSA, the Department of Trade and Industry, and the Government Actuary's Department in relation to their regulation of Equitable up to December 2001.

The FSA was probably the worst idea that New Labour conjured up when it was first elected in 1997. Under its watch, UK banks financed an unsustainable housing bubble, which is now unwinding, and threatening to bring the financial system down. It passively watched while the UK suffered the first bank run in over one hundred years. Now, we learn that it is guilty of maladministration over the Equitable Life fiasco.

The FSA's regulatory functions should be returned to the Bank of England. It is failed institution that will keep on failing until someone has the good sense to abolish it.

Rewarding failure

Last year, the UK had its first bank run in over a century. Meanwhile, the government agency charged with ensuring financial stability - the Financial Services Authority - gave its directors pay increases of around 22 percent.

I just loved the quote from Hector Sants after receiving his 37 percent increase. (He is now on a slightly-above-the-national-average wage of ₤661,000 a year.) "I am determined that the FSA will not be defined by the Northern Rock incident, but rather by our response to it."

What exactly was that response? The FSA gave supervisory responsibility for NRK to a couple of people working in their insurance department. Afterwards, it produced a report outlining a litany of appalling supervisory failures. Once the bank collapsed the Bank of England had to pile in with ₤35 billion to save the bank from total destruction.

The worst isn't over. With NRK's balance sheet deteriorating, and arrears rising, the UK tax payer is now bracing itself for massive losses. In other words, the FSA failed miserably, forcing the Bank of England to stabilize the situation and leaving the Treasury to clean up the long term mess.

What kind of collective failure would it need for FSA directors to pass on their bonuses? Would the total collapse of the UK personal lending market be sufficient? Do we need a couple of further bank failures? This kind of "paying for failure" is so deeply ingrained into public life that no one cares any more.

Where is the outrage?

financial weapons of mass destruction

I will freely admit to having only a limited understanding of derivatives.

In the past I was be comfortable with my ignorance. Since I didn't buy them, I didn't worry about them. However, the market for these products appears to be expanding out of control. Moreover, I am beginning to think that I am not alone in my ignorance. I suspect that financial market regulators, as well as the banks who buy these products, are just as clueless. No one can fully articulate the multitude of financial chain reactions that these products could potentially produce. UK banks are building up risks that no one understands.

The numbers are jaw-dropping. As of March this year, UK resident bank total derivative liabilities stood at ₤3,561 billion. That number is 2.6 times larger than UK GDP in 2007. Since March 2001, which really isn't that long ago, total derivative liabilities increased by 372 percent.

It gets worse, in the three months between December 2007 and March 2008, banks wrote derivative liabilities amounting to ₤1,212 billion - which is 87 percent of GDP. Think about that for a moment - UK banks wrote derivative contracts worth almost the entire output of this economy in just three months.

Here is the picture; sit back, take a deep breath and be afraid, be very afraid.

If the total derivative liabilities chart is bad, the following is even worse. Take a look at total credit derivative liabilities:

Yes, those are billions not millions. By March 2008, UK banks had written ₤427 billion worth of credit derivatives. A year earlier, the market was writing around ₤6 billion. The market has grown from virtually nothing to one amounting to 31 percent of GDP in just one year. Bubble! There is no word in the English language that can accurately portray this kind of growth. Exponential growth doesn't even come close.

Credit derivatives are essentially insurance contracts. As wikipedia neatly puts it these transactions are "financial instrument or derivative whose price and value derives from the creditworthiness of the obligations of a third party, which is isolated and traded." These contracts insure against default.

This products are, which has appeared literally overnight, is trading on the "creditworthiness" of third party obligations. In other words, it is market built upon the risk of failure. In an economic downturn failure tends to be quite common.

I suspect that the total market size of the underlying assets could well be smaller than the size of the credit derivative market. Suppose an economic downtourn led to a significant increase in the default rate of the underlying assets. The credit derivatives would have to payout. If there are more credit derivatives contracts than underlying assets, the default will amplify the losses for the banks who wrote these contracts. Maybe I am wrong about this, but I suspect that these credit derivatives have the potential to exacerbate default losses.

This brings us to another question, who could possibly hold the other side of these transactions? Well, it is UK banks, who are writing derivative contracts with each other on a massive scale. How do we know this? Here is a final chart. It is the net asset position of derivative contracts for UK resident banks with counter parties.

The net asset position is still large, but here we are taking tens of billions, not thousands of billions. It looks erratic, risky and even dangerous, and probably should generate some serious concerns among regulators. It also suggests that banks are collectively writing contracts between themselves.

Perhaps, the famous US investor - Warren Buffett - summed up the situation best when in 2002 he said

"I view derivatives as time bombs, both for the parties that deal in them and the economic system. The derivatives genie is now well out of the bottle, and these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear. In my view, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal"

Financial weapons of mass destruction offering mutually assured destruction to both counter parties. Perhaps, someone should wake up those jokers over at the FSA and tell them that there might be a problem brewing with credit derivatives.

Never say never

The UK banking system is scambling for capital. Today, Barclays bank signaled to the market that it may have to raise more money to cover its growing pile of losses. Chris Lucas, Barclays finance director, said: "We’re not going to rule in or rule out any option at this stage."

Barclays better move quickly. Markets tend to be fickle, and will soon become bored, as one failing bank after another looks for more money through issuing new shares.

Barclays do need the cash; they have just written down £1.7 billon due to sub prime and other bad investments. Furthermore, their tier 1 capital adequacy ratio has fallen to just 5.1 per cent. If the ratio falls further, the Bank might find itself receiving unwelcome attention from the regulator.

The FSA discovers excessive concentration

If the UK slips into a systemic banking crisis, we won't be short of people to blame. Top of the list of guilty institutions will be the FSA. Since the FSA took control of financial sector regulation back in 1997, banks and building societies have run amok. At times, the FSA's lack of capacity and judgement reaches almost comical proportions.

The FSA's naivety was again on public display this week. Hector Sants, chief executive of the FSA,was guest speaker to the Building Societies Association's annual conference. He took the opportunity to "warn" his audience about the dangers of "excessive concentration in the buy to let market."

Over the last ten years, the number of buy to let mortgages has risen from a smidgen above zero to over one million. The time to warn about "excessive concentration" was about five years ago, just as the market was taking off and it became obvious that banks and building societies were taking on a potentially dangerous level of risk. Warning the building societies today, when they are struggling with liquidity and rapidly depreciating collateral is just a little too late.

His wisdom didn't stop at warning about "excessive" lending concentration in housing speculators. Saints also gave the building societies some advice on funding strategies. He took particular aim at building societies' over dependence on the wholesale market for funding liabilities. "If wholesale funding is being utilised, it should be in a proportionate manner and the overall funding model sensibly diversified. In particular, the wholesale component should be diversified in term and maturity."

Hello!!! Is there anyone in there? It is the FSA's job to ensure that the financial sector has appropriate liability management. The FSA should be monitoring key financial sector indicators like maturity structure, credit and default risk. When banks step out of line, it is the FSA's job to hammer them with fines.

The FSA isn't an advisory service for the financial sector. The FSA should regulate these institutions. It should protect the rest of society from dangerous risk taking by greedy banks, blinded by the profit motive. It needs to prevent banks from pushing out loans to individuals who have a high propensity to default. It needs to ensure that banks behave.

It is time to call a halt the FSA. Financial sector regulation should be returned to the Bank of England. Mr. Saints should be cut loose from the public sector and allowed to pursue a career more suited to his talents, which appears to be some kind of low level management consultant working within the retail banking sector. It is time we had a financial regulator that knew what it was doing.