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.
Thursday, February 17, 2011
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.
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
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 IRACorpFilings.com 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.
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 IRACorpFilings.com 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.
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.
Tuesday, June 8, 2010
Bank Failure Observations Worth Noting ...
In case you didn't see it, the last few days have seen some interesting things happen over in FDIC land.
Last week, the FDIC took down two micro banks. These small institutions basically imploded in one quarter, a pattern that has not been the norm in terms of bank closures. Most are allowed to struggle along for as many as 5 to 8 quarters before facing the inevitable. These are different. Disaster strikes quickly. The pattern first appeared with the demise of La Jolla Bank in San Diego when a large fraction of their commercial R.E. loans went sour en masse. The question I asked at the time was "how many other banks on the edge are looking at 'walk away obligor' risk?"
Last week tiny Arcola Homestead Savings Bank in Illinois and First National Bank of Rosedale, MS also did dramatics power dives to oblivion. Also last week the FDIC shut down long struggling Tier One Bank in Lincoln, Nebraska.
You can look at them on IRA's Casualty List Forensics page if you like.
http://us1.institutionalriskanalytics.com/pub/Forensic.asp
Last week, the FDIC took down two micro banks. These small institutions basically imploded in one quarter, a pattern that has not been the norm in terms of bank closures. Most are allowed to struggle along for as many as 5 to 8 quarters before facing the inevitable. These are different. Disaster strikes quickly. The pattern first appeared with the demise of La Jolla Bank in San Diego when a large fraction of their commercial R.E. loans went sour en masse. The question I asked at the time was "how many other banks on the edge are looking at 'walk away obligor' risk?"
Last week tiny Arcola Homestead Savings Bank in Illinois and First National Bank of Rosedale, MS also did dramatics power dives to oblivion. Also last week the FDIC shut down long struggling Tier One Bank in Lincoln, Nebraska.
You can look at them on IRA's Casualty List Forensics page if you like.
http://us1.institutionalriskanalytics.com/pub/Forensic.asp
Friday, May 14, 2010
2009 Commercial and Industrial Lending Trends at Large and Mid/Small Banks
I decided this blog would be a good place to take on answering more questions. This week a compare and contrast request about what's been going on in commercial and industrial lending and how reactions to market pressures in 2009 affected the large and small strata of the banking industry.
Here’s my take on it:
During 2009, C&I loans outstanding by large institutions declined from $1,200B to $953B between 12/2008 and 12/2009 confirming the Federal Reserve’s observation of a 20% contraction in lending. Of note, this shrinkage is equal in magnitude to the lending of the entire mid and small bank lending base. During the same period, the under $10B asset banks went from $310.8B to $281B in C&I loans outstanding, an estimated contraction of only 9.5% based on an IRA examination of the universe of FDIC CALL/TFR Reports from the period. On the surface that would seem to single out the big banks as being the sole culprits of diminishing credit availability in the U.S. That’s not quite true and here’s why.
Another important part of the credit availability story for U.S. business in 2009 reveals itself more clearly if one looks at unused commitments for C&I Lines of Credit (LOC). During 2009, large bank C&I LOC commitments went from $46.7B up to $49.8B for the year even as their annualized gross experience factors tripled from 113.1bp at the beginning of the year up to 294.9bp by December. Granted the terms demanded by these big banks became more onerous. However on the mid/small bank side of the industry, credit availability completely collapsed in 2009. LOC commitments for these banks plummeted from $17.3B at the beginning of the year to $8.8B by year end. For them, gross defaults only doubled going from 98.9bp to 218bp for the year but it still resulted in a more severe commitments contraction.
The real question then is what’s behind the disparity in reaction patterns to what I personally believe are actually two parallel sub-groups within a larger complex industry?
Smaller banks don’t have the reserves depth of their larger counterparts so their reaction to systemic stress is to pull back from risk taking. They embark on a flight to quality and that ultimately results in fewer, but not that much fewer, loans and tighter limits on commitments to lines of credit. Borrowers are faced with the task of overcoming much higher acceptance standards.
Big banks, who had been far more liberal in their lending when winning market share was the mission at all costs, begin to cull their lower quality loans under the pressure of improving operating risk management. They can then draw on government subsidies and use them to issue new loans on more onerous terms because portfolio theory dictates they need these higher terms to recoup the loan quality mistakes now manifesting as higher default rates. To attract customers, they grant somewhat more liberal lines of credit that are of course shrouded in covenants designed to make actually trying to use these lines an obstacle course. That’s what’s meant by “loss management” strategy.
The net result from these independent parallel responses to the common systemic shock? U.S. commercial industry is more difficult and costly to conduct.
Here are the reference data links:
Large Bank C&I
http://us1.institutionalriskanalytics.com/Widgets/Factoid.asp?view=112
Mid/Small Bank C&I
http://us1.institutionalriskanalytics.com/Widgets/Factoid.asp?view=113
Here’s my take on it:
During 2009, C&I loans outstanding by large institutions declined from $1,200B to $953B between 12/2008 and 12/2009 confirming the Federal Reserve’s observation of a 20% contraction in lending. Of note, this shrinkage is equal in magnitude to the lending of the entire mid and small bank lending base. During the same period, the under $10B asset banks went from $310.8B to $281B in C&I loans outstanding, an estimated contraction of only 9.5% based on an IRA examination of the universe of FDIC CALL/TFR Reports from the period. On the surface that would seem to single out the big banks as being the sole culprits of diminishing credit availability in the U.S. That’s not quite true and here’s why.
Another important part of the credit availability story for U.S. business in 2009 reveals itself more clearly if one looks at unused commitments for C&I Lines of Credit (LOC). During 2009, large bank C&I LOC commitments went from $46.7B up to $49.8B for the year even as their annualized gross experience factors tripled from 113.1bp at the beginning of the year up to 294.9bp by December. Granted the terms demanded by these big banks became more onerous. However on the mid/small bank side of the industry, credit availability completely collapsed in 2009. LOC commitments for these banks plummeted from $17.3B at the beginning of the year to $8.8B by year end. For them, gross defaults only doubled going from 98.9bp to 218bp for the year but it still resulted in a more severe commitments contraction.
The real question then is what’s behind the disparity in reaction patterns to what I personally believe are actually two parallel sub-groups within a larger complex industry?
Smaller banks don’t have the reserves depth of their larger counterparts so their reaction to systemic stress is to pull back from risk taking. They embark on a flight to quality and that ultimately results in fewer, but not that much fewer, loans and tighter limits on commitments to lines of credit. Borrowers are faced with the task of overcoming much higher acceptance standards.
Big banks, who had been far more liberal in their lending when winning market share was the mission at all costs, begin to cull their lower quality loans under the pressure of improving operating risk management. They can then draw on government subsidies and use them to issue new loans on more onerous terms because portfolio theory dictates they need these higher terms to recoup the loan quality mistakes now manifesting as higher default rates. To attract customers, they grant somewhat more liberal lines of credit that are of course shrouded in covenants designed to make actually trying to use these lines an obstacle course. That’s what’s meant by “loss management” strategy.
The net result from these independent parallel responses to the common systemic shock? U.S. commercial industry is more difficult and costly to conduct.
Here are the reference data links:
Large Bank C&I
http://us1.institutionalriskanalytics.com/Widgets/Factoid.asp?view=112
Mid/Small Bank C&I
http://us1.institutionalriskanalytics.com/Widgets/Factoid.asp?view=113
Tuesday, April 27, 2010
Bank Crisis Casualty List
Here's the link again for the failed banks casualty list with the IRA forensics reports.
http://us1.irabankratings.com/pub/Forensic.asp
http://us1.irabankratings.com/pub/Forensic.asp
After Bastille Day: Is There a Future for Big Banking?
As bank reform continues to grind through Congress something sorely lacking so far is concentration on safely managing down "points of risk" from Too Big Too Fail business models. We are awash in anger but remain devoid of constructive action. Perhaps it's because finding better basis for the role that big banks play in the U.S. economy is so important that we are paralyzed? And in this I'm including both the government and industrial side of the fencing. We all know this is the next step in the evolving theater so why aren't we infusing this latest round of legislation with constructive guidance and authorization to put the U.S. on a path to a solution? Possibly because we need someone to define a better mousetrap. Here's my stab at thinking about what that might be.
I've been observing with great interest the Johnson and Kwak hypothesis about limiting maximum bank size as a function of risk to U.S. Gross Domestic Product (GDP). The thesis is that we need to somehow cap TBTF exposure so that it's no more than 4% per business entity. It's an intriguing thought that causes me to wonder - as many other people are - about how one might go about slicing up the population of TBTF's to achieve this in a way that does not trigger unwanted side effects to the remainder of the economy in the process.
Over the years IRA has piled up mountains of data on banks and I've designed tools to support all manner of what-if modeling for acquisitions and divestitures. Some of these tools were used to confirm that the objectives of the Move Your Money initiative would indeed be positive contributors to the economy before we committed to donating our support to this cause. The tenets of building solutions strategies that are stable and achievable are central to my own comfort zone going all the way back to my Cold War days as a strategic military analyst. These cautions apply even more so when it comes to turning screws on the nuclear devices of finance, the TBTFs.
So the thought hit me that it might be interesting to ponder the stoichiometry - the math behind the chemistry - of the TBTF rebalancing issue. Butchering mastodon into chewable portions along logical lines turns out to be a rather complex process of avoiding unintended consequences. It's clear that doing careful impact analysis on things like regional competitiveness and market share up and down the national to local strata of the economy is critical. We do not want "machete-scale" TBTF action at the high end to cause undue damage to other parts of the banking and finance system.
For instance, parametrically slicing any one of the big banks is probably a combination of separating lines of business, dividing operating geographies and in some cases further dividing share within over dominated specific markets. The appropriate sizes and lines of business combinations are in turn driven by the landscape of incumbent competitors, large and small as well as healthy and stressed, within the affected sub-markets. Because we still do want to improve economic system efficiency not degrade it, there remains an overarching need to preserve whatever economies of scale and technology leverage have been gained from these big banks' combined corporate learning curves.
While the populist thinking is to send these banks to the gallows, that's not necessarily the safest or even achievable approach to furthering long run U.S. economic stability. Note that one does not necessarily need to legally slice up the institution to accomplish many of these risk management objectives. In fact, in some cases, it might be strategically counter-productive, causing a disastrous series of "knee jerk" responses further destabilizing the system. What's important to consider here is what's in the best "national interest".
As the nation ponders bank reform, I suggest that opening a line of discussion about a series of stringent rules imposed on banks that are either over a certain size or if they engage in certain combinations of lines of business. Such a discussion would say that they must set up set up certain new "walls" between segments of their business and run them as silos might be enough to bring some aspects of net risk to GDP per institution into better alignment. In other aspects of the process, forcing the creation of true arms length separations might be more appropriate.
I also believe that both government and banking need to be exploring this, if not together, then certainly in parallel. TBTF banks can make it proactive corporate policy to set up internal controls so that no single silo within their business can generate a "bail out" triggering risk. Banks within a certain exposure class can do the right thing and elect to disclose more transparent data so their combined systemic risk exposures can be tracked by both regulators and markets to emphasize promoting - as opposed to hiding - earlier warning and avoidance of future broad crisis conditions. Just like we did with things like Sarbanes-Oxley give them a fixed number of years to change, instruct the regulators to track the changes and adjust the regulations during that period to take advantage of what's learned during the process, then make the resulting more stable rules mandatory. Anyone who resists the tide? That's what liquidation is for. Now you've got a true carrot and stick enforcement strategy with a specific and actionable set of objectives. Better mouse trap.
Only in this way can government once again begin to operate as a guiding hand instead of a slapping one. If we don't do this we're going to break something. This is industrial engineering on a grand scale no less far reaching other great things in America's history. It cannot be done by the seat of one's pants or the smell of one's nose. But it can be done.
I've been observing with great interest the Johnson and Kwak hypothesis about limiting maximum bank size as a function of risk to U.S. Gross Domestic Product (GDP). The thesis is that we need to somehow cap TBTF exposure so that it's no more than 4% per business entity. It's an intriguing thought that causes me to wonder - as many other people are - about how one might go about slicing up the population of TBTF's to achieve this in a way that does not trigger unwanted side effects to the remainder of the economy in the process.
Over the years IRA has piled up mountains of data on banks and I've designed tools to support all manner of what-if modeling for acquisitions and divestitures. Some of these tools were used to confirm that the objectives of the Move Your Money initiative would indeed be positive contributors to the economy before we committed to donating our support to this cause. The tenets of building solutions strategies that are stable and achievable are central to my own comfort zone going all the way back to my Cold War days as a strategic military analyst. These cautions apply even more so when it comes to turning screws on the nuclear devices of finance, the TBTFs.
So the thought hit me that it might be interesting to ponder the stoichiometry - the math behind the chemistry - of the TBTF rebalancing issue. Butchering mastodon into chewable portions along logical lines turns out to be a rather complex process of avoiding unintended consequences. It's clear that doing careful impact analysis on things like regional competitiveness and market share up and down the national to local strata of the economy is critical. We do not want "machete-scale" TBTF action at the high end to cause undue damage to other parts of the banking and finance system.
For instance, parametrically slicing any one of the big banks is probably a combination of separating lines of business, dividing operating geographies and in some cases further dividing share within over dominated specific markets. The appropriate sizes and lines of business combinations are in turn driven by the landscape of incumbent competitors, large and small as well as healthy and stressed, within the affected sub-markets. Because we still do want to improve economic system efficiency not degrade it, there remains an overarching need to preserve whatever economies of scale and technology leverage have been gained from these big banks' combined corporate learning curves.
While the populist thinking is to send these banks to the gallows, that's not necessarily the safest or even achievable approach to furthering long run U.S. economic stability. Note that one does not necessarily need to legally slice up the institution to accomplish many of these risk management objectives. In fact, in some cases, it might be strategically counter-productive, causing a disastrous series of "knee jerk" responses further destabilizing the system. What's important to consider here is what's in the best "national interest".
As the nation ponders bank reform, I suggest that opening a line of discussion about a series of stringent rules imposed on banks that are either over a certain size or if they engage in certain combinations of lines of business. Such a discussion would say that they must set up set up certain new "walls" between segments of their business and run them as silos might be enough to bring some aspects of net risk to GDP per institution into better alignment. In other aspects of the process, forcing the creation of true arms length separations might be more appropriate.
I also believe that both government and banking need to be exploring this, if not together, then certainly in parallel. TBTF banks can make it proactive corporate policy to set up internal controls so that no single silo within their business can generate a "bail out" triggering risk. Banks within a certain exposure class can do the right thing and elect to disclose more transparent data so their combined systemic risk exposures can be tracked by both regulators and markets to emphasize promoting - as opposed to hiding - earlier warning and avoidance of future broad crisis conditions. Just like we did with things like Sarbanes-Oxley give them a fixed number of years to change, instruct the regulators to track the changes and adjust the regulations during that period to take advantage of what's learned during the process, then make the resulting more stable rules mandatory. Anyone who resists the tide? That's what liquidation is for. Now you've got a true carrot and stick enforcement strategy with a specific and actionable set of objectives. Better mouse trap.
Only in this way can government once again begin to operate as a guiding hand instead of a slapping one. If we don't do this we're going to break something. This is industrial engineering on a grand scale no less far reaching other great things in America's history. It cannot be done by the seat of one's pants or the smell of one's nose. But it can be done.
Investment Banking and California's Municipal Bonds
California State Treasurer Bill Lockyer is a man with a lot of questions. On March 29, 2010 his office sent letters to Bank of America Merrill Lynch, Barclays, Citigroup, Goldman Sachs, JP Morgan and Morgan Stanley asking about their Credit Default Swap practices. In his letter, he expressed worries that these firms - who are hired to market California's General Obligation (GO) bonds and also sell many other municipal debt issuances across the United States -- also participate in the credit default swap (CDS) business of betting against these bonds.
Mr. Lockyer notes that the State of California has never defaulted on its' obligations, he asked each bank to explain why they both sell for the State on one hand and bet against the State with the other. Responses were due back by April 12, 2010 and the State of California posted all of the responses on the Treasurer's website at this URL http://www.treasurer.ca.gov/cds/index.asp.
Why is there a market in California defaults? Basically an opportunity for arbitrage - what I like to call a mathematical gap between reality and financial modeling - exists. In an article published by Bloomberg News on April 19 on L.A. Unified's latest bond issuance, they note that California has "the lowest-rated U.S. state, is ranked Baa1 by Moody's, three steps above non-investment grade, and A- by S&P, four levels above." Bookies call this the "spread" and so does Wall Street.
The language of the banks responses to California are steeped in the murky language of finance but translated into English the banks say the answer is because there's money to be made playing both sides of the street. In the finance business it's acceptable for institutions to happily take fees and commissions both on the "sell side" as they market California's debt to primary buyers and on the "buy side" making markets - that means promoting business - for people betting against that debt using, among other things, CDS. Of the banks asked, the response by Goldman Sachs was the most direct.
They explained that working both sides is fine and dandy because a "Chinese Wall" separates the two sides of their activities. The message is that California - or any municipality - is a client only of the sell-side. California is not a client of the buy-side on the other side of the "Chinese Wall. That's some other "client" in need of insurance because the rating agencies say your State isn't a risk free investment. In effect, they take the business position that the job of a Wall Street middleman is to make as much for the house from both business channels. The other banks admit they do this too though the demeanor of their letters seem somewhat less ebullient probably remembering that there's money to be made on the sell side.
The letters tell California State Treasurer Lockyer that CDS is actually a good thing because someone buying insurance on the predicted mathematical default probability somehow means they are creating a bigger market to buy more of it. Huh? That's what the letters say. The common theme says because someone buying California GO bonds can also buys CDS protection they can lever up and buy more GO bonds. They've hedged their position against California defaulting on its' debts even though it never has. Remembering that their sell-side services business is also lucrative, they also say that California's bonds are among the most desirable on the planet. This brings up two questions. One, are you sure that Chinese Wall is sound proof? And two, why do you need default insurance on bonds that don't default again?
Citigroup, one of California's staunchest sellers of tax-exempt municipal issuances, did note with what I felt was a hint of sympathetic frustration in their response that they thought the buy-side hype about California's so called modeled default spreads has been overblown and at times out of control. Insurance is about selling perceived risk even if that perception is purely mathematical. So maybe we need to ask if, just as people wonder if some ratings were pushed up to help sell certain types of now toxic securities, might there also be a need to see if we need to weed out systemic pressures to push risk spreads on CDS arbitrage?
If your head isn't hurting too badly yet read on. It gets weirder.
On February 17, 2009, President Barack Obama signed the American Recovery and Reinvestment (ARR) Act. Part of this stimulus package created something called the Build America Bonds program known in finance circles as BAB's. Most municipal bonds are tax-exempt financial instruments. BAB's aren't. They are federally subsidized taxable bonds sharing some of the characteristics of corporate bonds.
BAB's opened a door for taxable bond investors, who had previously not been as active in this area, to become active speculating on municipals. In case you haven't figured it out by now the finance universe consists of micro-communities that get along about as well as the bi-polar opposites of the U.S. middle-class, Progressives and Tea Partiers. Taxable bond investors are used to working with corporate bonds. Unlike sovereign debt, corporations carry tangible default risks and corporate bond investors live by the motto that it's prudent to take on insurance to hedge their positions. So what happens when these people come to play in the municipal bonds sector?
Their deeply ingrained habits about the "investment tripod" of position, hedge and financing will begin to alter the market for municipal bonds. Corporate bond CDS spreads are based on the perceived problems of the company. Anything and everything imaginable is fair game for arguing what the spread should be. And these folks can be a mite jittery. Can Municipal BAB's be any less risky than a heavily government subsidized entity like General Motors? And so California's legendary polar politics, budget woes and legislative gridlock become the shrapnel far outweighing the payment history tapes.
Reading their letters, all of the respondents noted that they weren't quite sure what this means. Alignments of unsteadiness like that are significant in finance. BAB's are new, a very recent invention on the Obama Administration's watch. All of them were careful to assure California that this won't affect demand for the State's General Obligation bonds. But the letters also said the CDS desks of these institutions fully intend to continue to make markets from this new source of transaction clients interested in purchasing CDS insurance on things like BAB's. They also indicated the possibility that the CDS' written on these BAB's may result in an uptick in both rational and irrational analysis of municipal issuer default quality. That could make all municipal bonds harder to sell. Given that the credo of charge what the market will bear is almost irresistible to Wall Street, one needs to ask if the law of unintended consequences just manufactured another future systemic challenge to deal with.
One additional note, the statutory issuance window for BAB's ends in January, 2011. However, other federally subsidized taxable bond programs such as the Qualified School Construction Bond (QSCB) program authorized under the very recent Hiring Incentives to Restore Employment Act also exist. So it's not like these things are going to disappear. Per the Bloomberg article mentioned earlier, QSCB's trade more thinly than BAB's so the pressure to help them liquefy is even stronger.
My point is that finance is never quite as simple as calling for solutions one can make with a machete. Bill Lockyer's stack of letters deserves a broader reading. They are a canvas to learn a little more about the perturbations we make to the very complex system that is the U.S. economy.
Thanks to Tom Petruno from the L.A. Times for pointing me at the letters.
Mr. Lockyer notes that the State of California has never defaulted on its' obligations, he asked each bank to explain why they both sell for the State on one hand and bet against the State with the other. Responses were due back by April 12, 2010 and the State of California posted all of the responses on the Treasurer's website at this URL http://www.treasurer.ca.gov/cds/index.asp.
Why is there a market in California defaults? Basically an opportunity for arbitrage - what I like to call a mathematical gap between reality and financial modeling - exists. In an article published by Bloomberg News on April 19 on L.A. Unified's latest bond issuance, they note that California has "the lowest-rated U.S. state, is ranked Baa1 by Moody's, three steps above non-investment grade, and A- by S&P, four levels above." Bookies call this the "spread" and so does Wall Street.
The language of the banks responses to California are steeped in the murky language of finance but translated into English the banks say the answer is because there's money to be made playing both sides of the street. In the finance business it's acceptable for institutions to happily take fees and commissions both on the "sell side" as they market California's debt to primary buyers and on the "buy side" making markets - that means promoting business - for people betting against that debt using, among other things, CDS. Of the banks asked, the response by Goldman Sachs was the most direct.
They explained that working both sides is fine and dandy because a "Chinese Wall" separates the two sides of their activities. The message is that California - or any municipality - is a client only of the sell-side. California is not a client of the buy-side on the other side of the "Chinese Wall. That's some other "client" in need of insurance because the rating agencies say your State isn't a risk free investment. In effect, they take the business position that the job of a Wall Street middleman is to make as much for the house from both business channels. The other banks admit they do this too though the demeanor of their letters seem somewhat less ebullient probably remembering that there's money to be made on the sell side.
The letters tell California State Treasurer Lockyer that CDS is actually a good thing because someone buying insurance on the predicted mathematical default probability somehow means they are creating a bigger market to buy more of it. Huh? That's what the letters say. The common theme says because someone buying California GO bonds can also buys CDS protection they can lever up and buy more GO bonds. They've hedged their position against California defaulting on its' debts even though it never has. Remembering that their sell-side services business is also lucrative, they also say that California's bonds are among the most desirable on the planet. This brings up two questions. One, are you sure that Chinese Wall is sound proof? And two, why do you need default insurance on bonds that don't default again?
Citigroup, one of California's staunchest sellers of tax-exempt municipal issuances, did note with what I felt was a hint of sympathetic frustration in their response that they thought the buy-side hype about California's so called modeled default spreads has been overblown and at times out of control. Insurance is about selling perceived risk even if that perception is purely mathematical. So maybe we need to ask if, just as people wonder if some ratings were pushed up to help sell certain types of now toxic securities, might there also be a need to see if we need to weed out systemic pressures to push risk spreads on CDS arbitrage?
If your head isn't hurting too badly yet read on. It gets weirder.
On February 17, 2009, President Barack Obama signed the American Recovery and Reinvestment (ARR) Act. Part of this stimulus package created something called the Build America Bonds program known in finance circles as BAB's. Most municipal bonds are tax-exempt financial instruments. BAB's aren't. They are federally subsidized taxable bonds sharing some of the characteristics of corporate bonds.
BAB's opened a door for taxable bond investors, who had previously not been as active in this area, to become active speculating on municipals. In case you haven't figured it out by now the finance universe consists of micro-communities that get along about as well as the bi-polar opposites of the U.S. middle-class, Progressives and Tea Partiers. Taxable bond investors are used to working with corporate bonds. Unlike sovereign debt, corporations carry tangible default risks and corporate bond investors live by the motto that it's prudent to take on insurance to hedge their positions. So what happens when these people come to play in the municipal bonds sector?
Their deeply ingrained habits about the "investment tripod" of position, hedge and financing will begin to alter the market for municipal bonds. Corporate bond CDS spreads are based on the perceived problems of the company. Anything and everything imaginable is fair game for arguing what the spread should be. And these folks can be a mite jittery. Can Municipal BAB's be any less risky than a heavily government subsidized entity like General Motors? And so California's legendary polar politics, budget woes and legislative gridlock become the shrapnel far outweighing the payment history tapes.
Reading their letters, all of the respondents noted that they weren't quite sure what this means. Alignments of unsteadiness like that are significant in finance. BAB's are new, a very recent invention on the Obama Administration's watch. All of them were careful to assure California that this won't affect demand for the State's General Obligation bonds. But the letters also said the CDS desks of these institutions fully intend to continue to make markets from this new source of transaction clients interested in purchasing CDS insurance on things like BAB's. They also indicated the possibility that the CDS' written on these BAB's may result in an uptick in both rational and irrational analysis of municipal issuer default quality. That could make all municipal bonds harder to sell. Given that the credo of charge what the market will bear is almost irresistible to Wall Street, one needs to ask if the law of unintended consequences just manufactured another future systemic challenge to deal with.
One additional note, the statutory issuance window for BAB's ends in January, 2011. However, other federally subsidized taxable bond programs such as the Qualified School Construction Bond (QSCB) program authorized under the very recent Hiring Incentives to Restore Employment Act also exist. So it's not like these things are going to disappear. Per the Bloomberg article mentioned earlier, QSCB's trade more thinly than BAB's so the pressure to help them liquefy is even stronger.
My point is that finance is never quite as simple as calling for solutions one can make with a machete. Bill Lockyer's stack of letters deserves a broader reading. They are a canvas to learn a little more about the perturbations we make to the very complex system that is the U.S. economy.
Thanks to Tom Petruno from the L.A. Times for pointing me at the letters.
Off Balance Sheet Derivatives: Show Me the Money!
It's always good to have something to ruminate on over the weekend. With bank reform being the "trill thrill" of the week, what's this derivative thing? And more important, who's got how much in play at the casinos? So print this out and ponder it with your buddies while watching that ball game.
Remember, this is all about life inside the Matrix. "It'll feel ... a little weird." Derivatives are made up transactions. Two people, each of whom thinks he or she has the brass to out model the other, agree to bet on what will happen to an arbitrary amount of money. The winner of the bet gets the difference in the outcome. The winnings or losses are leverage that helps the bank participate in more betting both on-balance sheet real investments - they call that improving liquidity - or, if they like the trader/analyst team that did it, authorization from the risk and compliance officers to do more innovating.
They call the imaginary bet the "notional balance". Because it's not real money auditors won't let you book it on a balance sheet and that's why it's tracked as an off-balance sheet line item. For you aficionados, please see form RC-L of the Call Reports. To get the bigger picture, IRA sums these amounts across the individual FDIC Certificate (CERT) units of a bank holding company (BHC) and runs a variety of calculations on these numbers. One of my personal favorite measures is the ratio of the OBS notional balance versus the balance sheet assets of just the operating bank portion of the BHC. This figure gives you an idea of how much leverage derivative activity within the bank contributes to ongoing business operations.
There's one final thing to note before flashing the stash. These families of instruments were originally meant to be back office activities that served primarily to offset market risks against things like interest rate or currency exchange rate fluctuations. In many cases they still are. This aspect of derivatives is what people mean when they say they serve a financially useful function. Many of the banks listed below can and do use derivatives for these purposes. It's the appropriateness of innovating leverage for leverage sake that accelerates systemic speculation we need to assess as we reform.
Ok here goes. What ya'll make of these?
Top 50 Banks Reporting Off Balance Sheet Derivatives Notional Balances to the FDIC as of 4Q2009(amounts in $ millions)Source: IRA Bank Monitor/FDIC
Remember, this is all about life inside the Matrix. "It'll feel ... a little weird." Derivatives are made up transactions. Two people, each of whom thinks he or she has the brass to out model the other, agree to bet on what will happen to an arbitrary amount of money. The winner of the bet gets the difference in the outcome. The winnings or losses are leverage that helps the bank participate in more betting both on-balance sheet real investments - they call that improving liquidity - or, if they like the trader/analyst team that did it, authorization from the risk and compliance officers to do more innovating.
They call the imaginary bet the "notional balance". Because it's not real money auditors won't let you book it on a balance sheet and that's why it's tracked as an off-balance sheet line item. For you aficionados, please see form RC-L of the Call Reports. To get the bigger picture, IRA sums these amounts across the individual FDIC Certificate (CERT) units of a bank holding company (BHC) and runs a variety of calculations on these numbers. One of my personal favorite measures is the ratio of the OBS notional balance versus the balance sheet assets of just the operating bank portion of the BHC. This figure gives you an idea of how much leverage derivative activity within the bank contributes to ongoing business operations.
There's one final thing to note before flashing the stash. These families of instruments were originally meant to be back office activities that served primarily to offset market risks against things like interest rate or currency exchange rate fluctuations. In many cases they still are. This aspect of derivatives is what people mean when they say they serve a financially useful function. Many of the banks listed below can and do use derivatives for these purposes. It's the appropriateness of innovating leverage for leverage sake that accelerates systemic speculation we need to assess as we reform.
Ok here goes. What ya'll make of these?
Top 50 Banks Reporting Off Balance Sheet Derivatives Notional Balances to the FDIC as of 4Q2009(amounts in $ millions)Source: IRA Bank Monitor/FDIC
| Off Balance Sheet Derivatives Notional Balance, per CALL/TFR | "Bank-Only" Assets, per CALL/TFR | Ratio of OBSDIR to CALL/TFR Assets | |
| JPMORGAN CHASE & CO. | $78,608,811 | $1,729,229 | 45.5 |
| BANK OF AMERICA CORPORATION | $44,470,772 | $1,674,099 | 26.6 |
| GOLDMAN SACHS GROUP, INC., THE | $41,597,107 | $91,050 | 456.9 |
| CITIGROUP INC. | $37,982,426 | $1,278,882 | 29.7 |
| WELLS FARGO & COMPANY | $4,193,794 | $1,187,315 | 3.5 |
| HSBC HOLDINGS PLC | $2,934,372 | $169,142 | 17.3 |
| BANK OF NEW YORK MELLON CORPORATION, THE | $1,326,055 | $178,254 | 7.4 |
| STATE STREET CORPORATION | $644,678 | $153,779 | 4.2 |
| PNC FINANCIAL SERVICES GROUP, INC., THE | $294,358 | $275,877 | 1.1 |
| SUNTRUST BANKS, INC. | $237,963 | $164,341 | 1.4 |
| NORTHERN TRUST CORPORATION | $182,241 | $83,456 | 2.2 |
| REGIONS FINANCIAL CORPORATION | $115,590 | $138,007 | 0.8 |
| KEYCORP | $100,180 | $90,195 | 1.1 |
| U.S. BANCORP | $93,875 | $282,169 | 0.3 |
| TORONTO-DOMINION BANK, THE | $86,133 | $150,102 | 0.6 |
| BB&T CORPORATION | $68,275 | $162,061 | 0.4 |
| FIFTH THIRD BANCORP | $65,733 | $112,736 | 0.6 |
| UK FINANCIAL INVESTMENTS LIMITED | $57,936 | $149,385 | 0.4 |
| CAPITAL ONE FINANCIAL CORPORATION | $48,629 | $165,351 | 0.3 |
| MORGAN STANLEY | $41,467 | $66,159 | 0.6 |
| MITSUBISHI UFJ FINANCIAL GROUP, INC. | $40,394 | $90,357 | 0.4 |
| HUNTINGTON BANCSHARES INCORPORATED | $27,219 | $51,111 | 0.5 |
| GMAC INC. | $25,915 | $55,303 | 0.5 |
| DEUTSCHE BANK AKTIENGESELLSCHAFT | $21,994 | $46,644 | 0.5 |
| BOK FINANCIAL CORPORATION | $21,053 | $25,966 | 0.8 |
| COMERICA INCORPORATED | $20,339 | $59,161 | 0.3 |
| BANK OF MONTREAL | $18,347 | $44,661 | 0.4 |
| ALLIED IRISH BANKS, P.L.C. | $17,609 | $68,768 | 0.3 |
| MARSHALL & ILSLEY CORPORATION | $17,380 | $58,361 | 0.3 |
| FIRST HORIZON NATIONAL CORPORATION | $17,379 | $25,842 | 0.7 |
| METLIFE, INC. | $15,907 | $14,107 | 1.1 |
| ZIONS BANCORPORATION | $14,781 | $52,336 | 0.3 |
| BANCO BILBAO VIZCAYA ARGENTARIA, S.A. | $14,703 | $70,131 | 0.2 |
| BNP PARIBAS | $11,472 | $73,706 | 0.2 |
| BARCLAYS PLC | $10,182 | $12,614 | 0.8 |
| PACIFIC COAST BANKERS' BANCSHARES | $6,442 | $616 | 10.5 |
| PRIVATEBANCORP, INC. | $5,863 | $12,101 | 0.5 |
| UBS AG | $5,188 | $30,174 | 0.2 |
| CIT GROUP INC. | $5,017 | $9,146 | 0.5 |
| BANCO SANTANDER, S.A. | $3,562 | $80,431 | 0.0 |
| ASSOCIATED BANC-CORP | $3,352 | $22,582 | 0.1 |
| SYNOVUS FINANCIAL CORP. | $3,306 | $34,539 | 0.1 |
| ROYAL BANK OF CANADA | $3,074 | $27,667 | 0.1 |
| LAURITZEN CORPORATION | $3,070 | $15,785 | 0.2 |
| POPULAR, INC. | $2,769 | $34,136 | 0.1 |
| CULLEN/FROST BANKERS, INC. | $2,499 | $16,344 | 0.2 |
| CITY NATIONAL CORPORATION | $2,082 | $20,749 | 0.1 |
| FIRSTMERIT CORPORATION | $1,931 | $10,522 | 0.2 |
| SOUTH FINANCIAL GROUP, INC., THE | $1,929 | $11,876 | 0.2 |
| CITIZENS REPUBLIC BANCORP, INC. | $1,889 | $11,820 | 0.2 |
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