Thursday, July 12, 2012

Economic Recovery Means Learning to Export Unemployment

As the 2012 political debates turn inevitably uglier and important national issues become ever more politicized, it's important to ressurect the fact that the national interest does not recede merely becasue trill makes it less visible. -- Dennis Santiago, July 12, 2012.

Originally published October 27, 2011 in the Huffington Post:

One of the sad things about the state of the U.S. economic engine as it sits with the gearbox in neutral is that we seem unable to break so many bad habits.   For decades, we have exported jobs by outsourcing first manufacturing and then services gaining cheap goods by ultimately paying for them with the most precious trade good of all: quality of life.

We became addicted to a disposable economy based on strategic corporate principles like "a 100-percent replacement of the installed base every 10 years" and "just-in-time supply chains seeking the lowest mathematical cost of execution."    The engineering design principles for product development and maintenance have changed from the old hallmark of American-made durability to "buy it, use it, trash it," particularly in consumer goods where designed-in-obsolescence has been elevated to a business strategy.

The old joke about contracts being awarded to the lowest bidder has become our nightmare as it idles companies, their workers, the commercial real estate they sit on, the durable goods they invest in to manufacture things, and the secondary economic accelerators like housing, education and the rest of the infrastructure that defines the vision of the American way of life.

When I talk to bankers about this and ask them why they aren't lending to domestic commercial and industrial borrowers, they tell me they'd love to but there's no demand to borrow.  The bottom line is that U.S. businesses have so little faith in where the economy is headed right now that they don't want to take the risk of new debt.   And why should they if all that will happen is that their good efforts will get outsourced and come back as a cheap replica for half the price that lasts a third as long.  You math folk can work out how the lifetime value of the customer is boosted by that trick.   So the banks sit on excess deposits to lending ratios on their books, waiting for the day business owners believe it's time to put the engine back in gear again.   In the meantime, "Third World America."

This is a mess we made for ourselves, to be sure.  It was fueled by academic theories that valued the unfettered circulation of money far more than the preservation of culture and lifestyle.   And so sits one of the world's most important economies suffering from having mined out the hole of the disposable society to the point that it doesn't make a lot of sense to people anymore.  We spent our piggy banks on garbage, and it's bothering every one of us.  And not just in the United States.  Every other economy on the planet knows full well that since 1945, the world has needed a healthy and viable U.S. economy around which to organize and calibrate their socio-economic strategies.   We unhinge for an extended period of time, and it will have enormous complications for the human race.
But here's the thing.  What was done can be undone.  And personally, I think that the damage isn't that great.  My bet is that repatriating 5 percent of the U.S. manufacturing and services sectors will more than put the U.S. economy back on track, and that will have positive implications worldwide.
But how can it be done?   What American ingenuity can make this happen?  Here are a couple of ideas to ponder that will hopefully spark imagination and innovation.

It's time to shift gears away from the false god of disposability.  We should consider demanding changes in our engineering design and product-support strategy expectations.  What I mean by this is to retrain our industries and designers to emphasize aspects of products that focus on making products more durable and maintainable.  Or to put it another way, American-made quality again.   The jargon that goes along with this are things like "fault tolerance," "doubled mean times between failure," "designed for maintainability" and other techno-babble.   But what it ultimately does is change the balance on the products we use so that instead of buying and trashing three of them every seven years, more of them will be bought once and maintained for five years.   This restarts what used to be a healthy and viable repair-shop industry in this country that got blown away in the last couple of decades.

It's also a very green-conscious strategy, by the way.  The highest carbon emission cost for a manufactured good is the initial production event, so deliberately redesigning a fraction of our consumer products inventory to two carbon hits per decade, down from three to five per decade, is worth taking a look at.

And there's nothing that says cost and quality of production won't continue to improve even within such design guideline changes.   There's a whole new generation of technologies that, if applied creatively, can leverage one American worker to have the output equal to that of several overseas workers, possible even enough to equalize our folk to teams of other folk on a per capita GDP comparison basis.  That sentence means it will make economic sense for companies to choose to manufacture in the United States again.   Can you say improved aggregate quality of life?
Speaking of disruptive technologies that could change the foundations of many service industries away from outsourcing, I point out the parting gift of Steve Jobs.    His girlfriend SIRI may just be the solution we've all been waiting for instead of talking to some overseas call center that can't really help you, anyway.   And she's sassy.   The implications are tremendous.  I'd say tidal.  The question to me is: will we be able to reap it properly?

I'll close with a loud and clear challenge to academia.   One of the things the U.S economy desperately needs is for U.S. schools that teach engineering, business and public policy to begin to devote more research to this line of thinking.   A little disrupting the status quo from time to time is a good thing.  Earn your keep.  Push the edge in new directions.  Never mind occupying Wall Street; we need solutions for Main Street.

On Sensitivity to Market Risk, Susceptibility and Vulnerability

Reprinted with permission.

In this issue of The Institutional Risk Analyst, IRA CEO Dennis Santiago talks about the implications of the revelations about a rogue hedge fund operation at JPMorgan Chase.

It was a bit of a shock to me and many of our readers when the current trouble in JPMorgan’s derivatives desk erupted. Not because the vulnerability to this type of problem in the desks of these big banks was not there – IRA’s stress testing methodology has tracked off-balance sheet exposure as part of our CAMELS analysis regime for years -- but because I had not expected that this particular bank would be the one where this risk would first realize in the market place. In retrospect, that aspect of the letter S in the term CAMELS which stands for “sensitivity to market risk” is in fact uniformly distributed among the participants in derivatives market making and the susceptibility to a future beta event remains for any of them.

The question at this point is not whether the rest of the banks have this risk. The going forward questions are more appropriately, how should banks manage their susceptibility and vulnerability to this class of risk? How should insurers and markets price the risk-reward nature of such exposures? And in what direction should regulators aim the going forward definition of safe and sound practices?

IRA has commented a number of times in the past that we believe that risk and stress testing needs to be done in the context of benchmarking as opposed to the myopia of internally focused analysis. In this case, the need is even more acute given the fact that the banks (a) have trillions upon trillions of notional balances exposed and (b) bank counterparties view these derivatives exposures as material investments. So let us look at a catalog of banks so exposed. As is the case whenever it’s an IRA analysis, we winnow from a census of all the active banks and look at the individual FDIC Certificate holders. In this particular illustration of systemic vulnerability, the unit institutions with assets over $10 billion – the Dodd-Frank stress testing and reporting threshold – that have derivatives operations that reported a fair value estimates of the traded portion of their exposures in the 1st Quarter of 2012 reporting cycle.

Table 1 – Over $10B Asset FDIC Certificate Holders, 1Q2012
JPMORGAN CHASE BANK NA 63,650,436,000 6,735,675,000 70,386,111,000
CITIBANK NATIONAL ASSN 48,584,581,000 3,127,381,000 51,711,962,000
BANK OF AMERICA NA 40,110,943,370 6,229,087,191 46,340,030,561
GOLDMAN SACHS BANK USA 42,270,359,000 483,791,000 42,754,150,000
HSBC BANK USA NATIONAL ASSN 3,777,639,035 624,804,016 4,402,443,051
WELLS FARGO BANK NA 3,085,841,000 603,658,000 3,689,499,000
MORGAN STANLEY BANK NA 2,543,674,000 23,167,000 2,566,841,000
BANK OF NEW YORK MELLON 1,324,329,000 48,569,000 1,372,898,000
STATE STREET BANK&TRUST CO 912,454,345 6,075,991 918,530,336
PNC BANK NATIONAL ASSN 144,085,198 245,974,999 390,060,197
SUNTRUST BANK 212,838,953 54,670,445 267,509,398
NORTHERN TRUST CO 236,579,751 6,063,973 242,643,724
REGIONS BANK 126,481,777 23,191,409 149,673,186
U S BANK NATIONAL ASSN 69,801,437 42,854,555 112,655,992
KEYBANK NATIONAL ASSN 67,703,029 16,040,052 83,743,081
FIFTH THIRD BANK 46,571,169 22,149,571 68,720,740
BRANCH BANKING&TRUST CO 23,132,303 45,959,894 69,092,197
UNION BANK NATIONAL ASSN 40,620,251 10,150,020 50,770,271
RBS CITIZENS NATIONAL ASSN 29,700,353 7,884,815 37,585,168
BOKF NATIONAL ASSN 26,262,687 91,000 26,353,687
CAPITAL ONE NATIONAL ASSN 16,312,132 12,524,821 28,836,953
BMO HARRIS BANK NA 22,921,436 4,375,739 27,297,175
HUNTINGTON NATIONAL BANK 16,632,280 9,623,040 26,255,320
DEUTSCHE BANK TR CO AMERICAS 22,350,000 0 22,350,000
COMERICA BANK 13,346,622 2,384,148 15,730,770
COMPASS BANK 13,950,591 2,307,861 16,258,452
FIRST TENNESSEE BANK NA 12,575,654 7,009,789 19,585,443
MANUFACTURERS&TRADERS TR CO 15,476,745 1,987,079 17,463,824
BANK OF THE WEST 9,671,287 5,306,737 14,978,024
FLAGSTAR BANK FSB 12,541,133 68,954 12,610,087
WEBSTER BANK NATIONAL ASSN 7,557,676 812,904 8,370,580
CITIZENS BANK OF PA 5,909,044 1,659,980 7,569,024
PRIVATEBANK&TRUST CO 6,529,482 426,069 6,955,551
ASSOCIATED BANK NA 3,393,915 1,140,487 4,534,402
FIRST NIAGARA BANK NA 2,414,551 1,942,247 4,356,798
ONEWEST BANK FSB 21,000 4,188,151 4,209,151
ZIONS FIRST NATIONAL BANK 2,533,297 1,007,383 3,540,680
FIRSTMERIT BANK NA 2,498,353 248,033 2,746,386
FROST NATIONAL BANK 1,315,800 90,968 1,406,768
SYNOVUS BANK 1,420,627 337,803 1,758,430
RABOBANK NATIONAL ASSN 1,289,000 141,000 1,430,000
SILICON VALLEY BANK 1,086,802 281,065 1,367,867
FIRST NB OF PENNSYLVANIA 1,398,124 16,282 1,414,406
MORGAN STANLEY PRIVATE BK NA 580,857 436,198 1,017,055
FIRST REPUBLIC BANK 602,163 364,780 966,943
AMEGY BANK NATIONAL ASSN 575,434 129,561 704,995
CALIFORNIA BANK&TRUST 271,851 418,713 690,564
BANK OF HAWAII 538,673 147,407 686,080
COMMERCE BANK 73,942 557,407 631,349
WHITNEY BANK 616,524 0 616,524
ING BANK FSB 4,226 445,031 449,257
STATE FARM BANK FSB 215,171 0 215,171
SIGNATURE BANK 70,000 0 70,000

As can be seen, within this group, there are four large players followed by five medium sized players and then a collection of lesser – but still exposed – participants. All told, fifty three banks in this highly focused peering. Biggest of them in terms of the size of the notional derivatives book is JPMorgan Chase Bank N.A.
What is far more important to understand though is the context of the risk undertaken by JPMorgan versus this peer group. Was it extraordinary? Does analysis of it help us understand where the line of what is systemically unsafe might lie? For that we first turn to leverage. For this we look at the ratio of these institutions’ traded derivatives to the fair value envelope of these instruments as reported in their CALL reports. The resulting number is an indicator of “the amount of scrambling that is likely to have to happen in the event of a glitch in the Matrix”. The larger the total notional balance size combined with the leveraging factor help quantify the potential nightmare of each billion of realized loss. It’s the kind of thing that makes a Tums and Xanax a food group for Chief Risk Officers; maybe for corporate treasurers too.

Table 2 – Derivative Desk Operating Leverage Multiplier Estimates, 1Q2012
JPMORGAN CHASE BANK NA 153,680,000 458.0 14,706,574
CITIBANK NATIONAL ASSN 111,839,000 462.4 6,763,680
BANK OF AMERICA NA 45,531,246 1,017.8 6,120,369
GOLDMAN SACHS BANK USA 32,116,000 1,331.2 363,413
HSBC BANK USA NATIONAL ASSN 15,133,688 290.9 2,147,805
WELLS FARGO BANK NA 44,542,000 82.8 7,287,747
MORGAN STANLEY BANK NA 169,000 15,188.4 1,525
BANK OF NEW YORK MELLON 9,186,000 149.5 324,973
STATE STREET BANK&TRUST CO 7,400,437 124.1 48,953
PNC BANK NATIONAL ASSN 1,958,763 199.1 1,235,211
SUNTRUST BANK 2,155,245 124.1 440,464
NORTHERN TRUST CO 1,253,612 193.6 31,329
REGIONS BANK 988,166 151.5 153,113
U S BANK NATIONAL ASSN 1,558,409 72.3 592,822
KEYBANK NATIONAL ASSN 1,466,130 57.1 280,821
FIFTH THIRD BANK 2,026,473 33.9 653,158
BRANCH BANKING&TRUST CO 1,403,773 49.2 933,785
UNION BANK NATIONAL ASSN 1,944,329 26.1 388,711
RBS CITIZENS NATIONAL ASSN 1,829,382 20.5 383,777
BOKF NATIONAL ASSN 355,222 74.2 1,227
CAPITAL ONE NATIONAL ASSN 716,553 40.2 311,222
BMO HARRIS BANK NA 952,920 28.6 152,753
HUNTINGTON NATIONAL BANK 518,196 50.7 189,928
COMERICA BANK 863,140 18.2 130,817
COMPASS BANK 1,137,550 14.3 161,473
FIRST TENNESSEE BANK NA 263,981 74.2 94,481
BANK OF THE WEST 804,388 18.6 284,996
FLAGSTAR BANK FSB 83,122 151.7 455
CITIZENS BANK OF PA 388,152 19.5 85,127
PRIVATEBANK&TRUST CO 197,914 35.1 12,123
ASSOCIATED BANK NA 144,105 31.5 36,245
FIRST NIAGARA BANK NA 117,873 37.0 52,547
ONEWEST BANK FSB 203 20,734.7 202
ZIONS FIRST NATIONAL BANK 152,286 23.3 43,328
FIRSTMERIT BANK NA 116,959 23.5 10,563
FROST NATIONAL BANK 150,759 9.3 9,749
SYNOVUS BANK 152,092 11.6 29,218
RABOBANK NATIONAL ASSN 70,000 20.4 6,902
SILICON VALLEY BANK 21,521 63.6 4,422
FIRST NB OF PENNSYLVANIA 97,906 14.4 1,127
FIRST REPUBLIC BANK 27,201 35.5 10,262
AMEGY BANK NATIONAL ASSN 30,214 23.3 5,553
CALIFORNIA BANK&TRUST 9,426 73.3 5,715
BANK OF HAWAII 66,923 10.3 14,379
COMMERCE BANK 2,182 289.3 1,926
WHITNEY BANK 25,922 23.8 0
ING BANK FSB 22 20,420.8 22
STATE FARM BANK FSB 15 14,344.7 0
SIGNATURE BANK 115 608.7 0

Notice that there are a variety of strategies with regards to derivatives that begin to be exposed by this relatively simple calculation. There are institutions that clearly pursue very conservative approaches to these instruments and others that make use of them more aggressively. That’s not an unexpected result for anyone that has taken the time to understand that the pathways to operating a financial institution are not at all homogeneous, never have been.

Among the big four houses, there seem to be two schools of thought on this ratio, JPMorgan and Citibank electing to run their desks at one ratio and Bank America and Goldman Sachs operating at another one. It implies that a future beta event of similar magnitude as what beset JP Morgan would impact Citi similarly and the other two would have to scramble twice as hard. These are consequence management planning factors and are in fact most useful for costing how much to put into things like compliance oversight and risk taking authorization in the now so as to mitigate consequences if and when.

As one goes down the food chain the differences in strategy become broader straddling the middle ground of the big four with a few institutions electing higher leverage while most seek a more conservative path. Notable among these are the computed ratios of Well Fargo NA and Morgan Stanley NA which exhibit computational differences in the fair value estimates reported to the FDIC. Morgan Stanley basically says the balance sheet value is next to nothing. They may or may not be right but from a benchmarking standpoint, it is a real artifact in the numbers. A number of other smaller institutions also have this reporting approach.
Wells Fargo NA is notable because it pursues the most conservative leveraging approach even as the bank competes head on against its commercial banking competitors. In relative terms, the Wells Fargo desk would have to make a positioning error maybe five times the magnitude of what happened to JPMorgan to realize the same amount of turmoil. Interestingly, it indicates to someone like me to caution that Wells Fargo be the one most on guard against future complacency. Their competitors have incentives to be more hyper-diligent going forward and in the competitive space of derivative zero sum games, that means something.

Finally let’s look at how much of the real balance sheet is affected by these derivatives. Using the assumption that the traded leverage ratio is a fair indication of leverage in the remainder of the derivatives book, we can perform a CALL report based apples-to-apples estimate of the book value of these instruments. The caveat is that this analytical assumption may or may not be true but confirming this would have to involve performing a proprietary review to increase the fidelity of the calibration. Still, the question of just how much a derivatives desk impacts the overall portfolio of a bank is an important piece of information to have.

Table 3 – Portfolio Analysis of Estimated De-Leveraged Derivatives Value vs. Total Assets
JPMORGAN CHASE BANK NA 1,842,735,000 168,386,574 9.1
CITIBANK NATIONAL ASSN 1,312,764,000 118,602,680 9.0
BANK OF AMERICA NA 1,448,261,695 51,651,615 3.6
GOLDMAN SACHS BANK USA 101,927,000 32,479,413 31.9
HSBC BANK USA NATIONAL ASSN 206,808,958 17,281,493 8.4
WELLS FARGO BANK NA 1,181,817,000 51,829,747 4.4
MORGAN STANLEY BANK NA 67,651,000 170,525 0.3
BANK OF NEW YORK MELLON 229,715,000 9,510,973 4.1
STATE STREET BANK&TRUST CO 183,994,204 7,449,390 4.0
PNC BANK NATIONAL ASSN 287,766,197 3,193,974 1.1
SUNTRUST BANK 172,289,330 2,595,709 1.5
NORTHERN TRUST CO 91,340,913 1,284,941 1.4
REGIONS BANK 124,712,987 1,141,279 0.9
U S BANK NATIONAL ASSN 330,227,426 2,151,231 0.7
KEYBANK NATIONAL ASSN 84,838,858 1,746,951 2.1
FIFTH THIRD BANK 114,402,170 2,679,631 2.3
BRANCH BANKING&TRUST CO 169,026,116 2,337,558 1.4
UNION BANK NATIONAL ASSN 91,575,684 2,333,040 2.5
RBS CITIZENS NATIONAL ASSN 106,242,373 2,213,159 2.1
BOKF NATIONAL ASSN 25,733,983 356,449 1.4
CAPITAL ONE NATIONAL ASSN 133,000,029 1,027,775 0.8
BMO HARRIS BANK NA 94,826,410 1,105,673 1.2
HUNTINGTON NATIONAL BANK 55,584,664 708,124 1.3
DEUTSCHE BANK TR CO AMERICAS 39,839,000 1,755,000 4.4
COMERICA BANK 62,503,279 993,957 1.6
COMPASS BANK 65,360,552 1,299,023 2.0
FIRST TENNESSEE BANK NA 25,439,984 358,462 1.4
MANUFACTURERS&TRADERS TR CO 78,221,757 918,872 1.2
BANK OF THE WEST 62,342,865 1,089,384 1.7
FLAGSTAR BANK FSB 14,030,798 83,577 0.6
WEBSTER BANK NATIONAL ASSN 19,109,508 93,451 0.5
CITIZENS BANK OF PA 33,062,054 473,279 1.4
PRIVATEBANK&TRUST CO 12,587,678 210,037 1.7
ASSOCIATED BANK NA 21,617,331 180,350 0.8
FIRST NIAGARA BANK NA 35,463,055 170,420 0.5
ONEWEST BANK FSB 25,009,840 405 0.0
ZIONS FIRST NATIONAL BANK 17,179,085 195,614 1.1
FIRSTMERIT BANK NA 14,646,838 127,522 0.9
FROST NATIONAL BANK 20,472,031 160,508 0.8
SYNOVUS BANK 26,796,938 181,310 0.7
RABOBANK NATIONAL ASSN 11,646,000 76,902 0.7
SILICON VALLEY BANK 19,608,406 25,943 0.1
FIRST NB OF PENNSYLVANIA 11,525,969 99,033 0.9
FIRST REPUBLIC BANK 29,718,987 37,463 0.1
AMEGY BANK NATIONAL ASSN 12,005,462 35,767 0.3
CALIFORNIA BANK&TRUST 10,933,126 15,141 0.1
BANK OF HAWAII 13,760,753 81,302 0.6
COMMERCE BANK 20,370,170 4,108 0.0
WHITNEY BANK 12,813,700 25,922 0.2
ING BANK FSB 95,828,916 44 0.0
STATE FARM BANK FSB 14,455,112 15 0.0
SIGNATURE BANK 15,280,367 115 0.0

What reveals is a story of concentration risk. Of the fifty-three banks of this peer group, only four have derivatives as a proportion of their total assets exceeding five percent. One of them is JPMorgan Chase NA. Of the remaining three, Citibank NA is similarly sized. Goldman Sachs is its own unique investment banking model. HSBC Bank USA NA is a significantly smaller entity. Notable is that both Bank of America NA and Wells Fargo NA are the asset giants among a group that allocates between two to five percent of the portfolio to these instruments; the remaining banks live in the noise indicating hedging as opposed to investment or market making purposes for this asset class. A possible exception might be those banks that reported near zero fair values.

So in context let’s look again at JPMorgan Chase. It’s definitely the biggest operation dwarfing every other. While the business was run on the higher end of the leverage spectrum, it was not the highest model in operation. In terms of tangible exposure to the balance sheet, it is or was the segment leader. The combination of the three factors is the signature of high susceptibility to event risk and high vulnerability to significant stress in the event that risk manifests. In the end it was a mistake to have ever believed that mass and reputaion were that much protection against this type of risk. It’s a painful lesson to be sure and one that other banks should heed based purely an objective assessment of their own numbers in the context of these types of inconvenient truth benchmarks.

Questions? Comments?

Copyright 2012 - Institutional Risk Analytics - All Rights Reserved

Wednesday, March 16, 2011

FDIC Bank Assessments Change on April 1st as Dodd-Frank Comes to Banking

The Federal Deposit Insurance Corporation (FDIC) is the buck stops here office of U.S. bank regulation. Chairman Sheila Bair and company are checkbook behind the sign on every bank’s door sign guaranteeing that your deposit is FDIC insured. Funding America’s Deposit Insurance Fund (DIF) is done by charging banks an insurance premium. It’s this cash paid by the banks themselves that is supposed to maintain the DIF’s reserve. Come April 1st the rules for how banks get charged will be changing dramatically.

The FDIC approved 2011 Final Rule changes to 12 CFR 327. The rule is effective April 1, 2011, and will be reflected in the June 30, 2011 fund balance and the invoices for assessments due September 30, 2011. The final rule incorporates many policy changes based on the intent of the Dodd-Frank Wall Street Reform and Consumer Protection Act.

The most important change of all is in something called the “base assessment amount”. In the past this number was – and until March 30th is – the domestic deposits held by a bank. But as Dodd-Frank recognizes, banks have become more complex and leveraged. Most importantly, since the demise of Glass-Steagal, many of the larger institutions have incorporated the complexities of investment banking into their business models. The FDIC assessment methodology essentially gave a free ride to these aspects of a bank’s operations. Well come April Fool’s Day, the free ride is over. The “base assessment amount” changes to a new formula. From now on it’s the bank’s total assets minus its tangible common equity (TCE) that determines the base amount. I do note though that it’s actually the Tier 1 Capital that the FDIC will be using at first because despite the popularity of the notion of TCE by Wall Street, the Treasury and the Federal Reserve, no one’s quite sure how to properly calculate a TCE for an FDIC unit certificate holder just yet. We ran the computations both ways using IRA’s methodology for unit level TCE estimation just to confirm that the Tier 1 approximation is, as they say, close enough for government work. It is.

The no more free ride for investment banking policy slant of the 2011 rules is a huge shift. And yes it affects the largest complex banks most. We completed an estimation method – available in our Professional IRA Bank Monitor product – that looks at the change in assessment base and also implements the guidance of the new rule to estimate the DIF premiums. As with all IRA analytics, data is available for all 7,500+ FDIC certificate units plus 4,500+ bank-only components of BHC’s. Just for grins, we back computed “what would it have been” data for prior periods quarterly to 1995. Looking at this new mass of data we saw the following,

• Smaller banks that have traditional unleveraged business operating models generally see little change from the new rules.
• Mid-size and larger banks, over $10 billion assets, generally see an increase in their assessment base.
• Within the largest banks, the ones that are heavily involved in investment banking are most impacted by the new rules.

There’s also an important second point embedded in these new rules. The math for estimating risk category assignment is done using FDIC’s CAMELS scoring system. CAMELS stands for Capital Adequacy, Asset Quality, Management, Earnings, Liquidity, and Sensitivity to Market Risk. It uses privileged data and is sharable only between a bank and its regulator. For those of you that are old Basel II aficionados, think of it as “everything is IRB”.

So what’s the big deal about this?

The “2011 Final Rule” specifically states that the going forward process eliminates “the use of long-term debt issuer ratings for calculating risk-based assessments for large institutions”. The methodologies of the Nationally Recognized Statistical Rating Organizations (NRSRO’s) are no longer part of the process. This reduction in official dependence on rating agencies that failed to detect the last wave of systemic risks is also consistent with the intent of Dodd-Frank.

For our estimator tool, we used IRA’s public data “Shadow” CAMELS methodology we developed in 2009 as part of a contract to support the Securities and Exchange Commission to set up our Risk Category analysis. That contract requires us to compute these shadows for every bank unit and bank holding company in a timely manner every quarter. It turned out to be fortuitous for our look into the FDIC 2011 Assessment Rule. SEC specified we compute “Shadow” CAMELS to 1/10th’s and this allows our tool to pick off a point within the cap/floor limits of the assessment rate range specified in the statute to set up a better 2011 FDIC Initial Base Assessment Rate or IBAR. This refines the remainder of computations that depend on this number. Yes good people. That is math talk for the deep end of the pool. Translation to English = blah-blah-blah.

Thursday, February 17, 2011

CFO’s, Treasurers, Bank Risk and the Adequacy of Internal Controls

The only constant about risk analysis is that it is ever changing. It’s 2011 and make no mistake about it keeping up with understanding bank risk continues to evolve. The FDIC just released 2011 Rule 1 that updates the bank assessment rules to protect the Deposit Insurance Fund (DIF). Banks must now begin to adapt to these new statutes. For everyone else, it would be prudent to keep paying attention.

As of Feb 16, 2011, since the beginning of 2008, three-hundred and forty banks have failed in the United States. As banks have failed, we’ve been making forensic summaries available on our website to help improve transparency over what happened. We have seen the focus of worry facing the banking industry’s customers shift from looking at operating stresses stemming from unsafe or unsound operating practices – the primary objective of IRA’s Bank Stress Index (BSI) testing approach -- to looking for tactical warning about when banks are degrading in condition and in danger of failing.

Mathematically, the crux of the demand is to deliver analytics capable of maintaining linear tracking of banks past something called the investment grade threshold deeper into the degradation curve of the system. In English, people want to know when to get out of the way of the icebergs because it’s become all too clear that there’s no such thing as a ship that is too big to fail. To respond to this need we have constructed a Counterparty Quality Scoring (CQS) measure that provides tactical warning as to when it may be prudent to consider reducing exposure in case there is an FDIC failure. IRA’s CQS is less sensitive than our bomb detector dog nose BSI technique but it reveals something very interesting about the FDIC. Most of the time a bank will fail while there’s still some meat on the bones so that a pre-packaged resolution makes sense. And while there are the occasional oddballs, most of the time, the stress and trouble writing on the wall is clear as day with sufficient time to react.

For CFO’s and Treasurers, we are finding that companies are beginning to become aware that their corporate treasury “investments” in banks are in fact “bank liabilities” potentially subject to loss in the event of a bank failure. We did see a few instances in 2010 of companies calling up to subscribe to our system “right now” because they had taken a real loss following a failure and found out the hard way what the term uninsured deposits really means. We’ve talked to a number of companies now and we think it’s important to begin to explain the variety of internal controls strategies we’ve been running into.

First of all, corporate America can have some very complex interrelationships with banking. The classic notion that a company only needs one “too big to fail” banker to tend to all their needs turns out not to be how things work in real life. For certain things, these large institutions provide efficient solutions and integration costs can lead to very stable and sticky long term relationships indeed. But we also found that companies can and do shop around among the services offerings, a finding that validates the assertion that there’s no such thing as “run off proof” deposits, not even for the most cozy of historical banking relationships. The bottom line is that even for those for whom “size matters,” there are many horses to bet on.

We’re also finding that America’s companies carry a lot more exposure to middle and small sized banks than most people think. Certain industries such as retail, franchising, and integrated supply chains -- to name a few -- have business models requiring dozens and in extreme cases hundreds of separate bank interactions. In a number of cases, maintaining good “local” geographic presence is responsible for enlarging the number of banks a company interacts with.

Lastly we are finding that, in our opinion, far too few corporations practice active risk mitigation. The penchant to “find comfort” and nest in it remains very much a characteristic of U.S. business at this time. There’s even a component of the old culture of “plausible denial” that continues to permeate the system – something that the rules governing the “adequacy of internal controls” of Sarbanes-Oxley should have long driven out of corporate America. We also find a number of companies relying on indirect measures testing techniques to gain their comfort about the banks they do business with. The most common of these is relying on their investment bankers who package their corporate bonds to use market inference indicators to imply the soundness of their banking relationships. So things like stock price and CDS indices substitute for looking at the real FDIC CALL reports.

But we've also seen that some companies do avail themselves of approaches out of the banking world that have mitigating effects protecting against bank failures; the most common of these being to engage in forms of deposit risk placement spreading either directly or via a brokered deposit program technique. So not everyone is behind the curve.

With all this as a backdrop, we find ourselves reminding companies that it’s critical to “know” not guess about how healthy their banks are, what their alternatives are, when they need to act and how they will act if they have to.

First, companies need to remember that risk surveillance is only useful when it’s reporting on reality. The consequences of the “Imagineering” of Wall Street have already wreaked havoc on the U.S. economy and the days of granite reputation banks are long gone. The characteristics of what constitutes risk behavior in banking are understood well enough that they’re codified in legal statutes. Interpreting it is somewhat of an art form but ultimately there’s no valid business reason not to know. What is important to do is focus surveillance on the action thresholds. If all banks were healthy, the focus would be on the best yield/services offering bundle. But, given the state of things, asset preservation or loss avoidance is presently equally important.

We believe that when it comes to loss avoidance with one’s bank(s), marking to reality means looking at FDIC data. Secondary market surrogate measures can have volatile spin in them that could cause false alarms. Next to realizing a "Black Swan" loss because you weren't looking, the next worst thing to do is mistakenly abandon a banker who was acting in your best interest. It’s a waste of opportunity cost best avoided by any depositor, business or consumer.

We further believe that it takes two surveillance data points to gain perspective on a bank’s soundness. One should be an early indicator that allows one to assess confidence in a bank’s operational leadership before trouble ever happens. Second is a present state indicator benchmark that delivers a relevant warning to act while there’s still time to do so. One thing we will note for those wishing to do internal analysis is that certain regulatory benchmarks like capital adequacy are designed to be lagging indicators of strength and soundness. If you look at those forensic reports on the failed banks, you’ll see they tend to falter only at the very end of the life cycle. Acting in a rush is no way to manage one’s larder. So if you choose to read those CALL/TFR reports directly off the FDIC website and gain comfort yourself you’ve been warned. Also, remember that things like TCE’s and Texas Ratios are investor’s analytics tools. That’s potentially useful stuff if your company’s trading desk book holds stock or debentures in a bank but it’s not quite the same thing as treasury asset protection of your cash and cash equivalents.

If you’re really lucky it’ll never happen, but real world odds are that sooner or later everyone will ponder what valid alternatives there are to one’s current bank relationships. Bear in mind that change events also happen for positive reasons. Ideally, for every bank you are in, you want to know what the next three best alternatives are to that institution in case you decide to move your money. Your criteria may have minimum/maximum size, geographic, service offering set, switching cost and other narrowing criteria, but you still always want to know your short list of where to go if you have to. We believe your list should always include apples-to-apples quality benchmark soundness criteria so if you elect to deviate from the norm you’ll know it and by how much. Of course, you may have to explain why at the next shareholders meeting. And please remember that while IRA is authoring is this article, it’s not the only bank ratings company focusing on a next generation of tools for independently risk testing banks. The point of this note is that having a rational basis for knowing one’s alternatives is good internal control procedure. Whether you use external reference sources or do it yourself is up to you.

And last but not least of course, have specific, measurable, actionable and achievable plans to act for each option you intend to execute.

Tuesday, February 8, 2011

XBRL Usability Part 2: Checking the Extension Cord

In our previous installment of IRA’s testing of U.S. XBRL filings we reported that one only needs the EDGAR Accession file to be able to properly monitor and locate SEC filings both with and without xml exhibits. We are now confident enough to cease monitoring of the SEC’s experimental XBRL feed and begin using a true production version to process filings via the standard EDGAR system.

As we await the arrival of a new wave of filings in June 2011 we thought we’d check out the library of variables that will be available. In addition to US-GAAP data elements, filers are allowed to add “extensions” to their submittals. These extensions are independently defined by each company and do not require external coordination or rationalization at this time. The way extensions are added to a filing is via the xsd file, an XBRL definitions file that starts with statements to bring in standardized taxonomies followed by the company’s independent extension set. Every SEC filing with an XBRL exhibits file set has an xsd file. Not all of them have extensions.

We instructed our computer to count up the population of 10-K, 10-Q and 20-F filings for the past year and rummage through the xsd’s. On the particular test run we did there were 36,136 SEC filings meeting our test run criteria in the Accessions tape. Of these 3,880 included XBRL exhibit attachments representing 1,488 Central Index Key (CIK) SEC Registrants. This was roughly one fifth of the population expected to start submitting in June 2011.

Of the 3,880 filings, we found that 3,039 (78%) contained extension elements. The remainder only used primary taxonomies in their construction. The number of extensions in these documents ranged from a low of one extension to a high of nine hundred twenty-two extensions in a single filing. The total number of extension elements created by the sampled filings was 183,846.

Extrapolating this to an estimated 8,100 companies submitting beginning in June 2011 (8,100/1,488 = 5.44X) says that we are looking at an annual extension library to keep track of just over one million independently created elements in addition to the US-GAAP set. Wowie!

This actually doesn’t bother us that much. We have expected for a long time now that the extensions work around for the taxonomy architects not being able to anticipate every possible data element would create this type of algal bloom in the data. It merely points out two things.

First, unless one is doing merger and acquisition work, one can probably ignore most of these extensions and do most first and second level screening analytics just using the US-GAAP subset. This replicates – if not surpasses – the detail coming out of the best of the fundamental feeds. Besides if you are doing M&A diligence, you are looking at more than just financial reporting filings anyway.

There’s always been the notion among analysts that the first true use of XBRL filings exhibits would be based on subset analytics as opposed to extreme diligence tracing of every nuance item in a filing. From what we see, the June 2011 filings population should provide the first near-census test opportunity to do aggregate and sector analysis on U.S. public companies where the data goes directly from SEC’s EDGAR system to the research department without needing to pass through an intermediary processor. And it is chain of process traceable to the government evidentiary source. We like that!

Second, from our cursory inspection we believe many of these company created extensions are undoubtedly common in nature. They can – with proper effort - be aligned into new standardized taxonomy elements over time. As these winnow down, we expect what remains will be the types of specifics that are truly company unique. Still, seeing a million data elements to catalog is once again a good lesson to all that in data management for information to be usable, less is more.

Monday, January 24, 2011

SEC Interactive Data: Approaching Usefulness in 2011

By the second quarter of 2011, we will see another wave of machine-to-machine interactive financial data become available directly from the U.S. government. In June 2011, approximately 8,700 companies will begin to file supplementary “xml” files accompanying their quarterly and annual financial statement filings with the Securities and Exchange Commission. XML files can be read directly by computers allowing instant absorption by the analysis programs -- institutional and individual – to evaluate public companies. At its most grandiose, it means that investors, litigants and policy makers will be able to examine and assess the official legal version of these filings as fast as Regulation FD (Fair Disclosure) will allow.

This latest technological jump in financial information transparency is the result of a number of years of work by the SEC. The process included having to develop a specific sub-dialect of xml called XBRL, a many year exercise to turn the free form reporting of the U.S. Securities Act into a workable codified set of data construction rules. Because it blends management statements, the legal requirements of speaking about both “Financial Statements” and “Safe Harbor” discussions, and numerical precision of form-like data enhanced by company unique extensions, it is the most complex attempt of this type to date.

Not that the SEC is a stranger to XML. It originally started the process by requiring the relatively simple Forms 3, 4 and 5 that report on company ownership to be submitted per an XML specification via an online form. Hundreds of thousands of these documents have been filed and machines capable of reading them are able to render who has what at the most complex companies transparent. The SEC is also working on the XFDL specification that will codify many more form types submitted to the SEC.

Prior to this the most complex government financial data collection exercise took place in the parallel universe of the U.S. Banking Act. The FFIEC had brought the reporting of FDIC Call Reports into a Central Data Repository (CDR) and pioneered a three tongued publishing methodology that delivered perfect synchronization among a human viewable HTML file and two computer readable data files, one in xml format and one in CSV format thus covering 99.99% of possible downstream analysis interfacing cases. It set a high standard for all direct government-to-public dissemination to follow.

Getting Ready for Prime Time

One of the true tests of a new idea is whether or not it still works when one shuts down all the “experimental versions” of the process. The U.S. government version of this is beginning this phase now. Being analysts who use filings data to assess companies as opposed to XBRL developers seeking to make a living by filing documents with the SEC, we decided the time has come to do a “production acceptance test” of things as we wait for June 2011 to arrive.

Test number one was to ignore all experimental filings data feeds from the SEC and ask the key question, “ Is it possible to find and catalog these documents using only the official EDGAR Accessions file?“ And our favorite follow up government accessibility and transparency question, “Is what it takes to do that sufficiently low hurdle that anyone can do it for free or near free?” This is a critical operational issue because in the end, if it doesn’t work via a truly publicly accessible librarian pathway it isn’t soup yet.

We are happy to report that the answer is yes and yes. One needs nothing more than the SEC Accessions Catalog file to generate a complete table of the URL pointers to every xml filing. It’s implementable as a lights out program and we plan to create a look up utility with the link pointers to all the xml support files that will be incorporated into our site. Each filing has a set of xml files that together constitute the XBRL submission supplement to the main filing document.

The SEC’s implementation of downstream transmission support does not presently have the CSV check file version of the data alongside the xml as is done by the FFIEC. For one thing that makes it slower to process back into an RDBMS but that’s just an inconvenience and not a show stopper. What bothers us on this one is that we would like to see the CSV check file accompanying the xml file set – or at least the main xml file with the blocked data elements in it -- because having two machine readable versions of the same output file from the evidentiary source will help immensely for downstream users who need to automate testing for internal consistency in the incoming reports. We recommend that SEC OID look into this as a production feature to come online hopefully by the end of 2011.

We did note that the earliest 1,503 companies from the first and second wave of these filings did something odd … to us anyway. They prefixed the filenames of their xml files with their stock ticker symbols, an identifier that is not an internally verifiable construct – CIK is the real U.S. Securities Act legal identifier and is already in the header of the filing. You have to look up the stock symbol using an external “private” source and we flagged it as something that will become a “human reader” issue later on. There will come a point when the filers reach beyond just the major exchange traded public companies to what we like to refer to at IRA as the remainder of affected SEC Registrants.

It’s not an issue for machine-to-machine reading by the way. Computer programs don’t read and any unique string of text constituting a valid filename is sufficient. The bottom line is that locating usable URL links to XBRL xml file sets in an SEC filing is not a make or break issue requiring any sort of global Legal Entity Identifier. The xml files accompanying each filing could be named “Fred” and can still be successfully targeted by any well programmed computer. The SEC Accession Catalog is dandy and we look forward to our program – and ones written by others -- reading out and data basing the links to xml from these filings as they continue to appear.

Next installment, we’ll talk about what’s in the files themselves and what we think about using them to do surveillance and assessment analytics. Once you know where the files are the next question is, “Can you do anything with them besides print them out?” The real value after all is in the distillation.

Thursday, January 20, 2011

A Deepening Dearth of Lending

I was on Canadian network BNN last week. It is earnings time for banks and as much as I loathe talking about economic safety and soundness through the distorting lens of equities I attempted to field questions. It seems that “earnings per share” is looking better at some banks this quarter and people are asking if the time is “now” to get in on the gamble. The buzz must be hot to get people to pony up because I’m getting emails asking if I think this is the bottom of the well. Just a reminder, brokerages earn a living by charging commissions on the volume of transactions, not on the gain or loss of the investment.

As I tried to explain on air, picking through the lint in my belly button I’m not sure that today is the equivalent of the day Ford was at $1.00/share for the banking sector. We’re still seeing a lot of accounting based earnings coming from numbers in a computer being moved from one ledger to another creating what – in the time of Sarbanes-Oxley (remember that?) – would be categorized as one-time events. As for me, I still see banking as a supporting cast service provider to the economy. I’m waiting to see indicators of fundamental change in the direction of Main Street. Everything else is what the Wall Street townies call “optics” when happy hour comes around.

The continuing decline of domestic economic reinvestment

It’s not looking all that great on Main Street. Domestic economic reinvestment continues to slumber like Sleeping Beauty waiting for true love’s kiss. It’s weird really. How else can one explain the juxtaposition of “exceeds analysts expectations” with “six one-hundredths of a percent of real growth” in the same news cycle? These are the times when the solace of perspective is best found by ignoring volatility and focusing on the deeper trend lines.

Just so you know the overall amount of commercial and industrial lending by banks in the United States eroded by about 1/3rd from roughly $1.4 trillion in Dec-2007 to a bit over $1 trillion at the end of Sep-2010. Not to make light of a $400 billion dollar loss in going concern domestic economic investment by the banking system, but the really shocking numbers are in the unused line of credit commitments of banks to U.S. business. This is the canary number I like to look at because it is a direct expression of banking and finance confidence in Main Street industry. It’s gone from $92 billon in Dec -2007 to just $24 billion as of Sep-2010. More importantly, the vast majority of this contraction of credit availability to American industry has been by the larger banks, C&I LOC from $87B down to $18.8B by the institutions with assets over $10B. Poof!

We are now entering the fourth year of our saga. The kicking the can down the road approach to preserving banking infrastructure as a vital national resource continues. It’s now been husbanded by both a Republican and a Democratic White House. Both have succeeded in preserving banking. The “can” itself – the US domestic economy -- is still getting smaller. Is that really the best plan we can come up with?

So what can you do?

Next time you interact with your bank, ask them to tell you more about they are doing about expanding loan production. Ask specifically to tell you some details about what they are actively doing to clear away their remaining impediments to new lending. Are they modifying or disposing of whatever non-performing assets they have to get them back on track? How else are they using their resources to invigorate the Main Street economy? How are those line of credit commitments to small business commercial and industrial borrowers coming along towards recovering to pre-2008 levels?

Some bankers will balk that you'd dare to ask such questions. Others will gladly wax on about all the things they are doing to make things better. You'll certainly learn something about who's being a responsible banker and who isn't. Be prepared to be both disapppointed and pleasantly surprised.

Bear in mind that these questions aren't about small versus large. They are about discovering where decency and responsibility still are in America. It's there. The task at hand is to find and reward it. Remember that in America the voices of ordinary people still matter. Don't let anyone tell you otherwise.