Wednesday, January 28, 2009

The thing about economics ...

Humans are creatures of hope. It occurs to me that we place too much blind faith in things sometimes. Take economics. The thing about macro models is that they depend on input that has been smoothed and homogenized far below the noise levels of real life. Sort of like smoothing loan collateral pool risk into simplified spreadsheet factors. Economics too often depends on the systems finding balance presuming computational isolation from discontinuitues, externalities and outliers. The law of unintended consequences always applies when we simplify. Murphy's leverage is amplified by the alchemy of theories reaching far beyond their stable linearity. When you hear someone say "it's not perfect but it's better than nothing" that's the sound of a match being lit in a room full of dynamite. Sometimes we forget that we are the monkeys with keyboards trying to write Shakespeare.

So here's one for you to ponder. The same colleges that train some of the best economists also train some of "the best" structured finance designers. It's the same math. I'm just sayin'.

- D

Thursday, January 15, 2009

TARP and Tangibles

Here's something interesting. We computed the IRA Tangible Equity Capital Ratios for Largest Bank Holding Companies
. The link takes you to an excel file containing four worksheets covering 3Q2008 and year-end for 2007, 2006 and 2005.

The technique for this requires rolling up the bank only assets of each of the units of a BHC to make the computation. We actually set the computers up to run the metric for all 5,000 or so bank holding companies for every reporting quarter we have in our databases. Naturally the popular press seems fixated on the top tier. The "Prime Solution" for the U.S. economy probably lies in deploying TARP money among the best of breed of the 5,000 though.

Enjoy the peek at the tip of the iceberg.

- Dennis

Tuesday, January 13, 2009

IRA Bank Stress Ratings. Why Letter Grades?

Professional bankers live and die by their CAMELS rating. The system uses a grading method ranging from 1 to 5 (1 = best) and is used as part of official interactions between the bank and its' regulator. The six factors in a CAMELS are,

C - Capital adequacy
A - Asset quality
M - Management quality
E - Earnings
L - Liquidity
S - Sensitivity to Market Risk

CAMELS include privileged information on objective numerics, subjective discussion and judgement and external exposure analysis measures that help the regulator determine whether a bank is being run adequatetely or requires prompt corrective intervention.

Pattern Analysis to find "The Signal in the Noise"

IRA analysis uses publicly available information to perform similar analyses to the CAMELS process but using an outside observer approach. We opted to design a system that concentrates on bank stress indicators because this is what "main street Americans" actually worry about.

Unless one is a regulator, it's impossible to talk in detail to every bank in the United States. So we designed a more clinical statistical analysis approach to characterize behavior patterns at the census level (looking at all FDIC filers ... yes all!) to replace one-on-one subjectivity. The objective of our system is to allow a consumer to locate a bank's performance both in terms fundamental safety and soundness and in competitive context with its' peers. We believe this improves transparency for depositors as well as the decision matrix process for investors.

Why letter grades?

When we looked at how to set up the final grading scale we were sensitized to the need to make the grading system intuitive for consumers by the media. So instead of emulating the CAMELS 1 to 5 scale we opted for the more familiar report card of A to F letter grades.

In the CAMELS system a bank is considered well run if it has an overall CAMELS rating of 2 or lower and has issues if that rating slips to 3 or higher. Anecdotal comparisons to the IRA Bank Stress Index rating system indicate that one can expect the following,

IRA A+ generally finds banks with CAMELS 1
IRA A finds banks with CAMELS 1 and 2
IRA B finds banks with CAMELS 2 and 3
IRA C thru F corresponds to banks with CAMELS ranging from 3 to 5

CAMELS ratings seem to move more slowly than IRA Risk Ratings which are computed on a per period basis algorithmically. This makes sense given that CAMELS involve deeper private information examinations of an institution to complete.

We think the IRA rating may function like a leading indicator but it's hard to tell because one cannot get a look at all the CAMELS and their inputs unless one is at the FDIC. We do have the structure of the EXAM table in our computers, but not the content. Doesn't matter. If we did the law is such that we could only show the results to the regulators anyway.

- D