The BubbleOmics Guide to Gaming Billions from Basel III
Stock-Markets / Credit Crisis 2010 Oct 02, 2010 - 05:13 AM GMTBy: Andrew_Butter
Good News, the draft new “Basel” rules from the Bank of International Settlements are just out and are approved subject to detail. So is this the start of a new beginning?
Banking Regulation is not exactly a subject that excites passion, although the reaction from “God’s Workers” was that the new rules might make it harder for them to perform their essential service to mankind (and thus more expensive). And thus the overview put out by the Central Bankers Club in Basel onto the Web, is a masterpiece of political correctness and restrained “gravitas” http://www.basel-iii-accord.com/.
Naturally no blame at all is assigned (or admitted) for any part of the recent spell of troubling events. As if those “events” that “we” are too polite to mention by name, had nothing to do with prevailing regulations at the time.
At one point in the internal Q&A, a question is asked:
“Is Basel III a brand new framework?”
Answer:
“Absolutely not; Basel III is Basel II plus the
lessons learned from the market crisis”.
Ah-ha…Basel II with bells on and lessons were learned!
Well that’s reassuring; but I’d love to know precisely what were the…“lessons learned”?
No clue is given about that. Perhaps the Basel Committee has a divine plan; or perhaps they didn’t want to upset anyone by pointing fingers; particularly if the fingers were to be pointed at central bankers?
There again, pointing fingers at central bankers is a mug’s game; for example, the history of The Bank of International Settlements, which was set up originally to process payments under the Treaty of Versailles, included a spell as a Nazi controlled finance house during World War Two, which is why Roosevelt wanted it shut-down after the war.
But even the mighty President-Who-Won-The-War had no luck pointing fingers in that direction, thus he was thwarted by the Machiavellian efforts of the current economic pin-up boy, none other than John Maynard Keynes.
And notwithstanding that a number of their “top-officials” at that time were convicted of war crimes, no one has ever accused “The Club” of financing construction of gas chambers…or more recently, helping to crash the world financial system.
There again, crashing a financial system is a different kettle of fish from, for example, crashing an aeroplane.
When you are figuring out how to make sure a plane doesn’t fall out of the sky (again), most people try and work out why the last one did that, and then they fix that problem. Perhaps everyone knows why the financial plane fell out of the sky, so the reasons can be quietly left unsaid?
But for the sake of those of us who are sadly not blessed with the supreme intellect of the Basel Committee, I thought I might briefly examine some of popular candidates for why the “plane” crashed, with a view to getting some perspective on whether “Version III” is likely to be any more reliable than “Version II”. And more to the point, to reveal clues on how to insert a virus and game it.
Option 1: Greenspan Did It.
According to legend, starting in late 2001, Alan Greenspan foolishly allowed the base rate in USA to stay low for too long, and that resulted in a wave of liquidity injected into “the system”.
Which meant that everyone had much too much credit, and so they all went a bit mad and used the money to buy expensive houses they could not afford, plus expensive toys from China and gas guzzling SUV’s that they could not afford either; and that caused a housing bubble, which inevitably, burst. As, sadly, bubbles tend to do, eventually.
Then anyone who had lent money into real estate, or borrowed money to “buy exposure” to that sector (i.e. bet), via the magic of securitisation (i.e. mortgage backed securities etc), or borrowed and bet on that exposure (collateralized debt obligations and credit default swaps), or borrowed and bet on the exposure on that exposure (synthetic collateralized debt obligation); regardless of their “vice”, they all ended up with a “problem” with their “liquidity”. In other words they couldn’t pay back the money that they had borrowed to place their bets.
Which is another way of saying that there was a “run” or the threat of one, and so, after no one believed Hank Paulson when he declared in July 2008 that, “The US Banking System is a Safe and Sound One”, governments and their agents (central banks) felt compelled to step in and provide the “liquidity” to “save the system”, and of course prove that “The US Banking System (and the World Banking System) is Indeed a Safe and Sound One”.
“Liquidity” in that context is the polite word for freshly printed dollar bills getting handed out to “deserving” members of society who are too big to be allowed to fail, like a mass injection of toilet paper after the patient gets the “runs”.
So, Boo-Ho, it was all Greenspan’s fault and he is a bad man, and if it hadn’t been for him there would not have been a credit crunch.
And the “solution”, presumably, would be to string him up so as to set an example?
Option 2: Perhaps it’s not that simple?
Sadly (for those who would like a simple explanation), and leaving aside whether the “trouble” that the bonus-bound shylocks got into, was one of liquidity (toilet paper is good for that), or solvency (which is a completely different affliction), from a technical standpoint, the “liquidity” that created the credit that created the bubble that created the credit crunch was never a result of the “spread” between short term interest rates and long term interest rates.
That spread used to be how the central banks “controlled” the economy, by increasing the spread between short and long-term money (the yield curve) they made it more profitable for banks to lend under the 3-6-3 Rule (borrow (short-term) at 3%, lend (long term) at 6%, and be on the golf course by three).
And if things got too hot, well they just hiked the rates. Simple really, like an accelerator pedal, except this time there was an unfortunate bit of “unintended acceleration”; which neither Mr. Greenspan nor his faithful apprentice Mr. Bernake noticed, until it was too late.
The “unintended acceleration” that caused the housing (and commercial real estate) bubble, was thanks to securitization, which from 2001 to 2007 supplied $15 trillion or so of debt (liquidity) into America (http://seekingalpha.com/article/181181-bens-right-fed-didn-t-cause-the-crunch-securitization-did).
That’s a lot of “liquidity”. By way of comparison the pointless adventures directed by Generalfeldmarschall Donald von Rumsfeld in Iraq and Afghanistan “only” (officially), cost about $1 trillion (so far); and depending on who you talk to, the response to the realization that US Banks were not quite as “safe and sound” as Hank Paulson said they were, didn’t cost the long-suffering US taxpayers (or more precisely, their children), more than $4 trillion (so far).
But as anyone who knows anything about securitization, knows, that game has got nothing to do with the base-rate.
The money there is (was) made on the spread between AAA “investment grade” securities, which did (and still do) attract a 20% risk weighting under Basel I and II, and US Treasuries which attract 0% risk weighting.
That was how the system was gamed, because if you could call a barrel full of toxic garbage, “AAA Quality”, and put some spurious valuation on it, that was money for nothing (and chicks for free).
Perhaps the solution that might save the world would be to mandate that all bankers should be on the golf course by three, like in the old days?
Option 3: Perhaps it was securitization?
Compared to the $15 trillion of money pumped into America via securitization, what Greenspan was doing, fiddling with the base rate, was, by comparison; a small and ultimately irrelevant side-show.
Evidenced by the fact that much to the surprise of Big Ben, when he cut the base rate down to zero so as to stimulate the dead donkey back to the dance floor, nothing (much) happened.
And so he was obliged to buy $1.25 trillion of securitized toxic garbage (paying we think “face” or thereabouts), to get the gambler-bankers off the hook and prevent a recreation of the famous “Domino Theory”.
The story he put about was, that was to “counter” the (temporary) loss of “liquidity” in the market. Another way of looking at that was no one wanted to buy that garbage anymore and they won’t want to for quite some time (that’s a solvency issue).
Time will tell whether Ben was handing out free lunches by paying much too much for what may eventually turn out to be a bunch of (almost worthless) assets, or whether he was just providing lubrication for a system that got “temporarily” constipated, which caused another part of the system to get the “runs”.
High finance is complicated isn’t it, one day it’s Imodium the next day its laxative, get that mixed-up and you can be in real trouble!
The test of that will be whether all that QE causes inflation if money isn’t pulled out of the system quick enough once “The Market” comes to its senses and starts to also pay face for all that toxic garbage that clogged up the pipes or whether it does not.
The way things are looking, with the howls of the dangers of “hyperinflation” that started eighteen months ago, almost a distant memory, it may be some time before anyone pays “face” for a lovingly crafted Goldman Special AAA rated collateralized debt obligation.
So don’t hold your breath.
Option 4: Perhaps Osama bin Laden did it?
One thing wrong with the “Bad-Evil-Man” theory that says Alan Greenspan (and his (allegedly) misogynist accomplices (Larry and Bob)) were the ones who caused the credit crunch; is by that logic, the inescapable conclusion you cannot avoid, is that actually, “it” was caused by Osama bin Laden.
How come?
Well Greenspan says that quite clearly in his book “The Age of Turbulence”, it’s all laid out in black and white in Chapter One.
He says that prior to 9/11 America was just coming out of a “mild recession” (after the Dot.com bust), which is another way of saying that he was poised to raise the base-rate. But after 9/11 he was in a state of panic about the economic health of America, and so he pushed the base rate down and down, to make sure that the effects of 9/11 would not cause a recession, (remember there was quite a lot of disruption for a while).
Really, I’m not joking, that’s what he says, read the book if you don’t believe me!
He also says (weirdly) that he thought the 9/11 attack was an attack on “free-markets and capitalism”. Reading between the lines (remember he wrote the book in 2006, not long after Mission Accomplished), he is “modestly” proud of the contribution that he personally made to help Win the Holy War on Terror; which goes to show that he understood even less about geopolitics than he understood about finance.
Personally I don’t believe that either Alan Greenspan or Osama bin Laden were responsible for the credit crunch. But it’s hard to know what the inscrutable gnomes of Basel think, or what they “learned” in their closed-door deliberations.
Although I suppose a clue might be that there is not a provision in the latest plan for someone to go off and carpet bomb some wretched peasants in places no one ever heard of, as a pre-emptive strike to protect the world financial system.
In case things get out of hand again.
Option 5: “They” should have known and DONE something!!
It’s a bit unclear about who “they” are, but the inescapable reality is that central bankers, who believed they controlled everything via their divine monetary “accelerator pedal”…lost control.
What really galls them, and that’s absolutely not something they want to talk about, is that they didn’t even notice what was going on. I recollect a speech that Ben made in 2007 at an economics conference in UK, waxing long and lyrical (and boring as hell), about the joys of “inflation targeting” and how the genius (of central bankers like him), was set to usher in a new era of Plentiful Prosperity in Paradise.
By the way, that’s nothing to do with PPIP, which was set to “unlock” the real “value” of the indisposed assets. But then, like a lot of the silly muddle-headed ideas in the War on Terror, quietly faded away (as predicted http://seekingalpha.com/article/134489-let-s-bury-ppip-before-it-starts-to-stink).
That’s also why in 2006, Alan Greenspan was strutting about, “modestly” taking “credit” (no pun intended), for the supreme vibrant health of the US economy, that was fuelled by consumers maxing out their credit cards and sucking equity out of their homes.
Some say Greenspan “should have” known and “done something”, like a financial commander-in-chief, delivering the foolish virgins from their foolishness.
Perhaps; but that wasn’t in his job description and the only tool he had was fiddling with the base rate.
Although perhaps the “solution” is to give the central banks and the “Basel Central Bankers’ Club” (much) more power, and then the world will be a safer place?
Maybe that’s the key? In that vein the Basel III plan has a whole section on, “Making global liquidity more robust”, so that next time, there will be plenty of what Tim Geithner called “fire fighters”, on hand to put out the fires.
What disturbs me is that so little is said about how the best way to put out fires caused by unintended acceleration, is not to start them in the first place.
Option 6: It was The Market
Here we go; this is what it says in Item 20 in the Basel III account on saving the world financial system (yet again):
The crisis vividly demonstrated that adequate liquidity is a prerequisite for financial stability. The drying up of liquidity at the level of financial institutions, countries and ultimately the global system caused the seizing up of credit provision and of financial flows.
Drying up of liquidity!!?
Err…well actually what happened was that no one wanted to pay zilch for what had been “valued” at $15 trillion dollars “worth” of toxic garbage which the moron bankers had bought with borrowed money, and later-on no one wanted to pay zilch for similar “instruments” created to pay for new police stations and riot control gear (so as to maintain the status-quo), in places like Greece.
What that “vividly demonstrates” is that if you take an almost dead donkey to the marketplace and it falls down dead in the middle of the street, and you discover (big surprise) that you can’t sell it for $15 trillion. And you might have to settle for something less than that, in fact you might have to pay someone to cart the carcass away so as the smell of the rotting corpse does not affect “confidence”.
Well you might just discover that the “liquidity” that you had been anticipating to pay back the money that you had borrowed to buy the almost dead donkey, might well have “dried up”.
Because everyone has figured out that the thing that’s gasping out its last AAA rated spasms in the dust, is either a dead donkey or a soon-to-be-dead donkey. And they don’t want to pay any money for it (or more important lend any money against it).
The “Basel” theory is apparently that the “market” went mad. Another way of looking at that is “the market” finally came to its senses.
The “market” for toxic garbage wasn’t much of a market anyway; it was a government granted concession fixed by the players to deliver an illusion of “liquidity” and “transparency” when in fact most of the transactions happened behind closed doors on the OTC (Over the Counter) “market” (http://seekingalpha.com/article/156361-armageddon-part-two-securitization-is-too-big-to-fail).
It wasn’t so much that the potential buyers in the market went mad (they call them the suckers), as that the realisation bubbled to the surface that the market was rigged.
Basel Version III says nothing substantive about that.
Option 7: Perhaps it was Basel II?
IF the Basel Committee is convinced (as they appear to be); that by “fixing” Basel II they will be able to make sure that there is not another financial meltdown any-time soon. THEN that sort of implies that there might have been something wrong with the previous version that needs to be fixed.
Or did I miss something?
OK I know that America was never very “hot” about Basel II, in a Q&A section from the latest briefing from Basel, we learn:
“It is true that the United States delayed Basel II, and we consider that something similar is likely under Basel III. But, Basel III is going to be implemented in the United States”.
It’s hard to read between the lines there, but perhaps they are saying that if America had embraced Basel II more enthusiastically then there would not have been a credit crunch?
That’s a possibility, and certainly, compared to Basel II the American financial regulations prior to the credit crunch were (and still are) a complete mess, that were more concerned about counter-terrorism, money laundering, the War on Drugs, and special perks for Members of Congress, than finance.
But regardless, most of the banks and financial entities that were involved in pumping up the bubbles that caused the credit crunch when they popped; were “compliant” with Basel II and many of the elements of Basel II were already incorporated into US financial regulation.
For example the idea of Risk Weighting, where if you are a Too Big To Fail AAA Bank, you can borrow (short term) a trillion dollars from the Fed discount window, paying 0.5% or so a year, and then lend that money to the government at 2.8% or so (these days) by buying a 10 Year Treasury and make a spread of 2.3%, i.e. $23 billion a year.
And how much of your own money do you need to put on the table to do that?
Well actually none, outside of usual campaign contributions and other types of “legal” kickbacks to keep your membership of the TBTF Club current; that’s because the risk weighting of your assets (10 Year Treasuries) is zero.
So, question for the budding MBA’s who will control our destiny, if you put zero money on the table and make $23 billion a year, what’s your Internal Rate of Return on the money you put down?
(Five Gold Stars for anyone who says, “Infinity” – wonder how they make those bonuses)?
Of course if you like you can instead use that money you can get hold of at 0.5% to buy some AAA investment grade synthetic collateralized debt obligations lovingly crafted by Goldman Sachs, in which case you will make a bigger spread, but the risk weighting will be 20%, so you will actually have to put some money down (i.e. you can probably “only” gear that deal at 33:1).
But there again, if those securities blow up, good old Uncle Ben will take them off your hands and pay you what you paid for them (face), so who cares?
What you don’t want to do under any circumstances, is lend any money to the “”deadbeats” on main street, or small businesses, because if you do that, your risk weighting will be 100% or more.
That’s unless you can hook up with a Payday Lender and get 400% a year, which is a pretty decent spread over the 0.5% you are paying to borrow the money (even bankers have to eat…right?)
That’s why the money that Ben handed over to the banks via the discount window, or paying “face” for $1.25 million “worth” of toxic garbage, hasn’t done much for the US economy in general.
That’s a similar scenario to Japan after their property bubble burst, since then you needed to have connections to get the super-cheap money, but most ordinary folk in Japan, if they want to borrow, go to a loan shark (and those guys got ways of making sure that you “honour your commitments”…like breaking your legs).
Those “Risk Weighting” parameters, which originated under Basel II, changed the face of banking.
What went out of the window was the idea that prudent bankers make loans (a) to people they know (b) operating businesses they understand (c) where they can reasonably expect that the collateral that is put up to secure the loan can be sold for more than the outstanding on the loan, some time in the future (if (horror) the borrower does not pay the loan back (with interest)).
That was the “old way” which attracts 100% and more risk weighting under Basel II.
Under the “New Banking World Order” (Basel II), that “risk” was “mitigated” by creating a daisy chain of complexity, where no one knows the people they are lending to, no one understands the business they are lending into, and no one gives a toss about how much they might be able to sell the dead donkeys that serve as collateral for the loans, some time in the future, if things go wrong.
That arrangement attracted a 20% risk weighting under Basel II, and so long as no one asks the question about what the collateral might as a minimum be worth in the future, well the music will keep playing, and the dancers will dance.
Meanwhile everyone is wondering why so many small American manufacturing companies who’s debt got marked at 100% risk weighting, got closed down and sold to multinationals.
Then the technology and expertise that had been accumulated over many years (and was written-down in the books to nothing), got bled out the back-door and re-created in tax-free zones in China as part of a “multinational” that could quite easily get its debt structured into something that could attract a 20% risk weighting.
That process has got nothing to do with low wages, the factory owners in the Chinese SEZ make a fortune, look at the companies in the S&P 500, fifty percent of their “declared” earnings are made on the back of sweat shops in China and elsewhere – outside of USA.
But it’s not the margin they pay over what they might pay workers in USA, it’s the tax-free money they make on the technology they transferred from America (or UK or wherever), and the tax-free money they make on the brand and the distribution chains they already set up (also valued at zero for the purpose of bleeding that asset out of USA).
That was one example of the great and honourable service that God’s Workers performed in America, by gaming Basel II.
Osama bin Laden had nothing on those guys.
How to game the New-Look Basel III
You don’t make real money in banking under the 3-6-3 Rule, that’s just a mugs game; how you make money in the New World Financial Order, is by creating situations of what are called in the business, “asymmetric information”.
Another word for that in plain English; is “ripping people off”. Like taking a dying donkey to the market place, shooting it up with speed until it’s jumping around, and then finding someone who is “dumber than you” to pay you the price normally reserved for pedigree racing donkeys.
That’s “asymmetric” information, because you know the donkey is dying, but you don’t let the sucker have access to the information where he might be able to figure that out.
But that’s not the end of the story, that’s just the beginning, then you create your own market-place where dead-donkeys can be “valued” mark-to-market. Do that and you have the beginnings of a bubble, and that’s where you can really make some money (just remember to jump off in time).
There are some mutterings in the grand new plan for Basel III about “forward-looking” valuations. In other words putting some thought as to what a dying donkey might sell for once it actually expires.
The G20 Leaders welcomed the FSF’s pro-cyclicality recommendations relating to accounting and called on accounting standard setters to work urgently with supervisors and regulators to improve standards on valuation.
I think that was a joke, wasn’t it?
In the old system the accountants were mandated to write down in the accounts the price that was paid for the donkey (Book Value), later on, thanks to the urging of IFRS and FASB they were told to use the price that you could sell the dying donkey today to someone dumber than you, in a non-transparent and rigged market-place where you were not obliged to tell the suckers everything they needed to know (mark-to-market).
One thing that the accountants and the rating agencies were not allowed to do was exercise any imagination about what might happen in the future, that would have “rocked the boat”.
That was something that the International Valuation Standards Committee (IVS) pointed out in July 2003 when they wrote to the “Basel Club” to say that the valuations that the accountants and auditors were using to work out the value of assets so that capital adequacy could be figured out (how much of your own money you have to put on the table to buy a Goldman-Special AAA rated collateralized debt obligation), were, quote; “Fundamentally Flawed and Bound To Be Misleading”.
Guess what? They were.
The general reaction to the outline for Basel III by the moron-bankers (well actually they are not morons, they just pretend to be when they need a bail out), was in general (according to the media reports that I have read), “One of Relief”.
That makes sense, the extra cost of the 7% Tier One Capital requirements and the changes in how Risk Weighting is calculated, can be passed on to those that are dumber than us, but Big Picture, the game didn’t change.
And what a relief, that there is no mention of employing International Valuation Standards to do the valuations of the assets. Instead we can rely on moron accountants, and spanked (moron) rating agencies.
All a “God’s Worker” can say about that is, “Yippee, let the games begin again”!!
By Andrew Butter
Twenty years doing market analysis and valuations for investors in the Middle East, USA, and Europe; currently writing a book about BubbleOmics. Andrew Butter is managing partner of ABMC, an investment advisory firm, based in Dubai ( hbutter@eim.ae ), that he setup in 1999, and is has been involved advising on large scale real estate investments, mainly in Dubai.
© 2010 Copyright Andrew Butter- All Rights Reserved
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