Who’s responsible for the risk?

The life of a banking system analyst can be lonely indeed. One tends to both offend and support all various interests at different times. I’ve been accused on MB of being a supporter of both Karl Marx and Ayn Rand whilst being a rent seeker for the non-Mega Bank Australian ADIs.

I can honestly say I’m not a follower of any particular economic theory or have a barrow to push for any particular vested interest. I simply analyse how the financial system works with a view to identifying weaknesses and strengths. I’m not aligned to the dogma that is associated with every movement whether economic or otherwise. Movements to become popular dumb down their messages to simplistic bites that can be drummed into many but with the necessary detail and true meaning lost in order to advance a simple but often dangerous meme.

Dumb downed messages may allow the masses to develop a chant, but they can become very dangerous as they are easily twisted to support almost any human or organisational behaviour.

Modern Monetary Theory seems to chant that borrowings of a central government in its own fiscal currency do not matter as the government can always print to repay the debt. In a single sentence that statement can sound like quite a sensible proposition. However, when I try and work through the rhetoric and dogma that is MMT, that single proposition is used to support all types of illogical chants. One thrown at me on MB was that offshore borrowing by Mega Bank in a foreign currency is about term not funding, as it actually does not raise any net funds. Give me a break!

Speaking as a banker who has raised funds offshore for banks and for my own finance business, I can assure readers that its about funding not just for the organisation but also the country.  As for the last few years foreign investors have been buying Commonwealth debt which has resulted in significantly increasing deposits and reducing Mega Bank’s need for increasing its own offshore funding this is not a trivial matter.

There is another meme that seems to abound that if an organisation raises funds offshore in a foreign currency and swaps back to $A, then that is equivalent to borrowing directly in to $A. It’s not.

Money is still owed in a foreign currency and must be repaid in that currency. The borrower however, has created a derivative where a party agrees to pay or receive the difference FX rate between $A and the foreign currency. The derivative creates risk for the swap counter parties but does not change the underlying debt transaction. In cases where the debt is never repaid but just continually rolled over (as the majority of Mega bank debt), I’d argue that creating the swap, which also needs to be continually rolled over, is an unnecessary risk transaction that distorts the FX rate but does not eliminate the underlying FX obligation for the borrower or for the country.

 

To melt or not to melt

A special piece of dogma is the slow melt of the Australian housing market which seems to be entrenched on this site as the likely future outcome. However, this proposition is never supported with any deductive logic. A slow melt is a massive assumption that Australia’s younger generations are happy to purchase expensive housing with little hope of future capital gains to offset the added debt costs.

What’s even worse of course is the assumption that these generations should pay a large share of the costs of the over leveraging the country has taken on. The biggest losers of a sudden resetting of housing prices will be those that have both created the over leveraging and have benefitted from it. These Australians should pay for their excesses and not rally around an argument that paying the price of the past should be shared as that’s somehow good for the economy. Its as bad as banksters arguments that they should be paid excessively because they’re job creators.

However, the biggest false meme in financial risk management is that history or past performance can be relied upon to as a guide to manage future risk. Sounds reasonable as a general rule but like all dogma, such propositions can and are twisted for highly dangerous consequences.

Recently I had the distressing experience to be the first on the scene at a car accident with a double fatality.  The accident occurred right outside my property, somewhere on the NSW’s coast. It was a single car accident on a sunning afternoon with speed playing no part. A very bizarre situation that at first seemed to defy explanation for such an accident by a driver that had driven the same road many many times in similar circumstances.

I had a great deal of time to analyse the situation waiting for the services in this remote part of the coastal Australia. When you see a situation in its raw state without the disruption that occurs when help arrives, you can learn a lot. Rather than the accident being freakish, it was apparent that the many small things conspired to be in place so that the young girl who tragically died may as well have had a loaded gun with a hair trigger pointed at her head simply waiting for the bump that would set it off. There is no blame in my assessment rather its was a stark reminder to look at everything when you are putting someone who is totally reliant on your actions for their health and well-being and not simply rely on the premise that if something has not happened then its unlikely to happen.

Generationally, I believe we have the same responsibility to our children and all descendants to protect them from our actions when they are fully reliant on the situation we leave for them. That’s the simple explanation of why I continue to expose the weaknesses in the Australian financial system. Its not about predicting whether disaster will occur or not, its about whether the risk is acceptable or not, for not only the current set of adults but future generations.

 

An idea is a dangerous thing

This brings me to a piece of research that I think is excellent but analagous to  the use of models within Australia’s Mega bank:  The Formula That Killed Wall Street’? The Gaussian Copula and the Material Cultures of Modelling”  (link goes to a PDF download) by Donald MacKenzie and Taylor Spears

Its well worth a read and you don’t have to understand the math to understand the issues and risks it exposes. In Australia, perhaps we could substitute “Local Councils” for “Wall Street”

In short, certain models were used by investment banks and rating agencies to determine the risk and to manage CDOs (collaterised debt obligations). Because these models were fundamentally flawed, particularly in relation to asset backed security (ABS) CDOs, massive losses occurred within the holders of the securities generated. These losses were critical in triggering the GFC.

Let’s look at the authors description of their research.

 The paper draws upon this history to examine the articulation between two distinct, cross-cutting forms of social patterning in financial markets: organizations such as banks; and what we call ‘evaluation cultures’, which are shared sets of material practices, preferences and beliefs found in multiple organizations. The history of Gaussian copula models throws light on this articulation,

The authors research is focused not on the technical aspects of the models but why were they used, why they were used when flaws were widely understood and why were they adopted across the market?

I have a great deal of experience in ABS structuring and understand the risks and how they are put together. When I first saw a proposal for an ABS CDO, it was obvious to me, that the correlation assumptions of the underlying collateral were faulty and based on a corporate debt model without regard for the underlying mortgage loans. My view was of no consequence as rating agencies used the models and AAA rated securities were created in the hundreds of billions for the unsuspecting investors, and here’s why.

 As well as being partially embedded in communication amongst banks and hedge funds, the Gaussian copula also played a pivotal role in a crucial organizational process: determining traders’ bonuses. The critical issue here was how and when profit should be ‘booked’. My interviewees reported a universal desire amongst traders for the profits on a credit derivatives deal (most of which lasted for between five and ten years) to be recognized in their entirety as soon as the deal was done – as ‘day-one P&L’ – and so to boost that year’s bonus as much as possible.

The researchers discovery above is pivotal in organizations adopting what may be legitimate algorithyms in an illegitimate manner no matter what the consequences. The model allows traders to book a total calculated profit today, but the model also provides the legitimacy of good risk assessment, an astounding situation when the faults were well know. The whole game was simply based on the hope that the blow up doesn’t happen on the traders watch and damn the consequences for those caught with the risk.

 The result of the embedding of Gaussian copula models in governance via ratings was the large-scale ‘gaming’ of them and of the other models employed by the ratings agencies. The crisis was caused not by ‘model dopes’, but by creative, resourceful, well-informed and reflexive actors quite consciously exploiting the role of models in governance. ‘[T]he whole market is rating-agency-driven at some level’,

 Is this a unique situation? No! besides the fact that Gaussian copula models are still be used, just ask the London whale, Australia has its own version of model gaming which may have devastating consequences for the innocent.

As I’ve posted on previously, Mega Bank uses IRB models to determine risk weighted assets and therefore capital. These models use probability of default (PD) of loans based on historical performance as a primary driver in determining the risk weighted assets. In relation to mortgages these models are used to justify very low levels of capital, less than 2%, with devastating future consequences.

Any decent quant would realise that basing PD on historical performance in a rising house price market or over a period which is not long enough to cover different economic circumstances is invalid. This makes no difference, Basel II rules give legitimacy to the methods and low capital requirements allows for higher returns on capital and the ability to write more loans, ensuring the bankers are rewarded today. The similarity of the situation with the misuse of Gaussian copula models should not be missed.

I see it as my responsibility to at least highlight the risks in the system that should be obvious to an independent analysis. Its whether anything will be done before the fall out is heaped on the innocent is the question.

 

 

Comments

    • Who? Those responsible for the risk have already collected their huge salaries and bonuses. It will be the taxpayer who will be held responsible for the risk and the savers who will be punished with low interest rates.

    • The Australian citizenry is indulging in intercourse – as back-passage receivers.

      Denise Brailey made it very clear before the Senate inquiry: agents have gamed the finance system, to the great cost of both borrowers and banks.

      And I scoff at ‘Slow Melt’. As each prop to high land prices is removed the golden palaces erected thereon look more and more unsound. There is enough uncertainty out there to give FHB’s pause. And a pause is all we need to prompt a correction.

      Don’t Buy Now!

  1. Modern Monetary Theory seems to chant that borrowings of a central government in its own fiscal currency do not matter as the government can always print to repay the debt.

    I think MMT’s point is when there is spare capacity in the economy, additional spending from ANY source will not cause inflation. Also, Govt. is issuer of the currency – not a user.

    “No sane individual with power to issue his own money and credit would ever dream of financing either his business or social enterprise by borrowing money and credit from someone else. Much less would he ever borrow at interest to the point of bankruptcy and then starve for want of buying power which he had the power to create”.

    Comment 1

    • jrb that is a very simplistic assumption. it presumes you can 100% accurately target your stimulus at only unused resources and that you can then target 100% correctly where the money will flow after it is first used. (I agree we are talking stimulus from any source – it doesn’t have to be Govt)
      However, oprincipally around here, and what Deep T is objecting to (I think) is the false presumption that the govt can print without creating further debt. Again it is ‘possible’ theoretically but impossible practically. You need to get your stimulus out into the resources you want used and back before it can be used anywhere else at all.

      In any case Deep T’s point is the reliance by some on stupid dogma and incorrect assumptions.

      • P.S. My last comment was aimed at minimising our differences here in Deep T’s post. It’s a great post and undeserving of a petty argument breaking out. I should have just shut the hell up!
        Cheers 🙂

  2. Nice work. The insights of someone with first hand experience are appreciated.

    One thing that might improve public debate and policy making is a general expectation that those who are highly trained and have well developed skills in analysis and communication, participate in public debate rather than wash their hands of any responsibility.

    The banks, finance companies and regulators are full of such people and the more that speak up the better. It is well time that every govertment department hosted an open policy discussion forum -on their websites – the RBA would be a good place to start followed by ASIC and the ACCC and APRA. It would at least remove the excuse that issues were not drawn to their attention.

    I am not talking about divulging confidential information – simply participate in public debate and bring the knowledge and experience of the insider.

  3. “reflexive actors quite consciously exploiting the role of models in governance”.
    This is a breathtaking statement Deep T. With a culture like this, how much longer can your industry possibly survive in its present form?

    • How much longer?

      I don’t know but significant change will happen as the exploitation becomes public.

      I also do not think I made the point well enough. Models that are used for governance should never be used as the basis to recognise income. That is just and invitation to fraud and exploitation

  4. For as long as I can remember, except for a small period in 1990s where the economy had capacity the RBA has been leaning on property prices. If they cut rates and let them go crazy then we may have had a chance to oversupply the market. Now it is too late. The massive demand for labour through the mining industry and the government overspend has soaked up any potential capacity to build houses and RBA is again leaning on prices through comparatively tight MP. Hard to see a sudden correction in a market that feels under-supplied with a labour shortage.

    • I think the serious labour shortages only exist in the resource sector – which only employs around 3% of the labour force.

      And the way it’s looking at present, that may not last all that much longer.

    • There is plenty of capacity in NSW just no demand at the prices being asked. Relax controls and fees on green and brownfields sites and construction will take off as they struggle to meet demand for new lower cost houses.

      The rest of the market will then follow.

  5. I’ve just finished reading Michaels Lewis’s excellent book The Big Short which details the stupidity of the underlying assumption in the USA Sub Prime market that housing defaults would have very low correlation – after five or six years, even the traders who knwongly hoodwinked the rating agencies started to believe their own crap and bet accordingly. Net result GFC.

    I now read that you’re telling me Australian Banks also assume low correlation in housing defaults!!! And again bet accordingly.

    Re the USA Rating Agencies I am dimayed they were allowed to get away with their stupidity, and somehow remain in business and are busily rating.

    Again, it appears the RBA or APRA is asleep at the wheel if they allow that stupid assumption into official risk calculations for Australian Banks.

    Or perhaps they are not asleep – given the MB article yesterday and RBA’s manipulation of house price data, they may be aware of their pasy folly and are desperately trying to keep that ballon full.

    Run for the hills….

  6. Gaussian copula models sound like the latest “innovation” cooked up and peddled by financial alchemists who have convinced investors that somehow, magically, this time is different, and that somehow, magically, this time lead indeed can be turned into gold.

    And while these schemes never work out for the investor, they nevertheless can be quite profitable for the alchemist.

  7. “Basel II rules give legitimacy to the methods and low capital requirements allows for higher returns on capital and the ability to write more loans, ensuring the bankers are rewarded today.”

    Amazing how the banks CEOs are against Basel III where, I believe, the capital requirements will increase to 2.5%. I guess from a banker’s perspective they have to increase their capital by a quarter to go from 2% to 2.5%.

    The current financial turmoil is a perfect opportunity for the Australian regulators to show that Australia is truly different by raising the capital requirements. I’m surprised that there has not been more talk along the lines of ‘we are doing this (increasing capital requirements) to ensure that what happened in Europe and US does not happen here’.

    • If you have regulators hell bent on deregulation and granting regulatory forebearance, does the nominal capital requirement have any significance at all? The regulators have so many potential tricks up their sleeve when it comes to capital requirements that it seems to me that the nominal figure is all but meaningless. The devil is in the details.

      A great case study of this can be found in the Savings & Loan crisis in the United States during the 1980s, detailed in this FDIC study:

      http://www.fdic.gov/bank/historical/history/167_188.pdf

  8. A special piece of dogma is the slow melt of the Australian housing market which seems to be entrenched on this site as the likely future outcome. However, this proposition is never supported with any deductive logic. A slow melt is a massive assumption that Australia’s younger generations are happy to purchase expensive housing with little hope of future capital gains to offset the added debt costs.

    Well, anecdotal samples that we saw do not support the proposition that the younger generation(s) use logical thinking when they decide to load-up mortgage debts to buy another IPs or upgrade their house. I agree with you that this is still big assumption but still valid IMHO, due to the fact that most people are not logical in making such housing decision.

    • Agree Deo, and I’m wondering exactly what Deep T’s point is in that statement – that it will reach a sudden critical mass at some point and collapse in a heap? Or something else?

      A few years ago, I was expecting a sharp crash but such a thing has not eventuated thus far.

      • I would say your assertion is pretty much that.

        i had to read the entire thing a second time, I too said to myself ‘what question is he asking to be pondered here?’

        My guess would be the final paragraph…

        ‘Its whether anything will be done before the fall out is heaped on the innocent is the question.’

        I too suggest the ‘slow melt’ hypothesis here is overblown. We had a large chunk of 1% MoM falls, and that’s beyond slow melt in my eyes.

        Bearing in mind, this country as deployed every means possible, including the wasting of a century high ToT to offer any resistance.

        If immense exertion combined with good fortune provides a slow melt, the removal of one pillar of resistance can easily trigger off a horrendous chain of events considering how risk exposed we are.

        My view is perhaps Deep T sees the crash as now inevitable, offers the advice to get out now, because innocent victims will be in abundance. Don’t feel you have to ‘man up’ and take the bullet for anyone, an honourable fall would be misguided.

        Perhaps with even a bit of Freddy Nietzsche nihilism thrown in…. enjoy the decline….

        • No problems with that RP – it’s just that I think it pretty obvious that the market can remain irrational for a very, very long time.

          • Lefty, in my case it is measured in multi-decades! You might be able to put a proposition that in my case it might be me that is irrational 🙂

            Re house prices every time they look like falling this is accompanied by falling retail and employment which causes everyone, MB included, to call for radical and swift lowering of already negative RAT rates.

            Under this scenario the big fall we all hoped for will not happen until the whole scheme can go on no longer.
            Again I’ve been waiting decades

            We are in no danger of house prices falling because someone in power decided to do the right thing!

  9. Deep T, I hear what you are saying, it is appreciated. Going against head in the sand memes is a real challenge. I find your perception and balance important in my own assessment in what is going on. Please keep it up as long as you can but do look after yourself as well.

  10. Thanks for this great article.

    Two questions.

    “In relation to mortgages these models are used to justify very low levels of capital, less than 2%, with devastating future consequences.”

    What size move would wipe this captial out?

    “Funding”

    It seems that everyone should know what the term “funding” means (sounds so simple right?) but I suspect it is not a simple thing.

    What does “funding” actually mean in practise, in terms of the size and nature of the requirements to be met?

  11. DT

    The point you make in terms of currency risk on offshore borrowings being hedged by derivatives, I assume these derivatives cover not only the principal but the interest paid to the investors who have invested in our mortgage pool.

    If mortgages go out 25 years the interest alone is a massive number, how do the counter parties to these derivative contracts secure the obligations to cover exchange risk over such long dated mortgage risk?

    If I enter an obligation through the options market here in Australia I am required to cover that risk with security pledged to the Options Clearing House.

    I read with concern that Australian Banks have OTC derivatives with a notional face value of $15 trillion, who are the counter parties to these contracts are Australian Banks guaranteeing the currency risk to offshore investors?

    • Mitch

      Your questions point to a huge mine field. The counter party margin calls that will be required if mortgage collateral deteriorates and rating downgrades occur will be massive.

      We should not be in this position with such risks which are continually denied and yet a housing market poised on the brink

      • What bank did you work at where they called FX swaps “derivatives”? It isa vanilla function in all the banks I worked at.

        I don’t feel like picking an argument, but I see this misconception stated more and more and it is incorrect,as perpetuated above.

        The buy and sell legs of FX swaps are very simply a spot transaction and a future dated reverse flow adjusted for the interest rate differential.

        There is minimal currency movement risk on the nominal amount once a swap deal is booked, just on the interest delta, but it is also negligible relative to the nominal amounts involved.

        I don’t dispute your point on the overall risk of borrowing offshore, but this too is somewhat misleading:

        “There is another meme that seems to abound that if an organisation raises funds offshore in a foreign currency and swaps back to $A, then that is equivalent to borrowing directly in to $A. It’s not.”

        If the borrowings are hedged via swaps then it is equivalent in terms of cost because the swap rate excatly adjusts the cheaper off shore borrowing back to the cost of borrowing in equivalent AUD rates.

        Of course there is credit risk and balance of payments risks, but if swaps are used there is minimal FX risk.

        • I dont disagree with you but for the full risk exposure we must look at the total borrowing book over multiple refinancings at varying pricing and over a long period.

    • In late June 2011, RBA Assistant Governor Guy Debelle said the following in his Address to the Conference on Systemic Risk, Basel III, Financial Stability and Regulation –

      “The solvency of any bank first and foremost is a function of the quality and value of its assets. This is, of course, true of any entity, but it is particularly true for banks because of the implications asset quality has for liquidity and because of the leveraged nature of financial institutions.

      The crux of my argument today is this: if I am a creditor of a bank, my due diligence should be spent mostly on assessing the asset side of the bank’s balance sheet in determining whether or not I will get repaid in full.”

      http://www.rba.gov.au/speeches/2011/sp-ag-280611.html

      Debelle went on to admit that Australian banks’ reliance on funding from overseas does represent a foreign exchange risk. However, he argued that there is nothing to worry about, because our banks’ foreign currency exposure is “fully hedged” –

      “If a liquidity issue were to arise around this funding, it is of critical importance that the foreign-currency denominated funding is fully hedged into Australian dollars, which indeed it is.”

      In supposed proof of this claim, Debelle referred (in his speech’s footnote #9) to a paper that appeared in the RBA Bulletin, December 2009. When you look up that (old, clearly out-of-date at time of Debelle’s speech) paper, the authors did not say what Debelle claimed –

      “Summary – The 2009 survey of foreign currency exposure indicates that Australian institutions remain well hedged against the risk of sharp movements in the exchange rate. Australia’s foreign currency debt liabilities are essentially fully hedged into Australian dollars using derivative instruments…”

      Not exactly the categoric affirmation that Debelle would have his audience believe.

      Importantly, the data referenced in that old paper was sourced via an ABS survey – that is, it relied on the banks honestly reporting their true positions (!?!). And, the data was only current to 31 March 2009 – more than two years prior to Debelle’s speech.

      Finally, the included Table 2 showing the banks’ admitted “Gross Outstanding Foreign Exchange Derivative Positions By counterparty, notional value”, actually evidenced a net Long position of some $288 billion (@ 31 March 2009).

      So, we had the RBA claiming our banks are safe from foreign exchange risk because they are “fully hedged” using derivatives, and citing in evidence a 2+ year old paper that used data acquired via a survey of the banks, one which actually showed the banks’ being net Long foreign currency to the tune of $288 billion at that long-since-past time.

      I’m convinced. Our banking system is safe as houses.

      Nothing to see here. Move along now.

      • Thanks Op8 very informative.

        Someone set me straight please. Theory would suggest that borrowing in Foreign currency and covering the risk ought be a zero sum game unless the transactions are done at different times. If this isn’t the case there ought to be quite a few smart fellos making billions every few days!
        I can borrow USD for my business but if I try to cover the risk the interest rate differentials negate any advantage. The only way I can really profit is to do something ‘smart’. I borrow the USD and hope I can cover later at some stage when the exchange rate has moved at least temporarily in my direction.

        Am I not sufficiently sophisticated?

        • No you are correct, see my reply above.

          There is no interest advantage if fully hedged, if not hedged you have full currency risk which is far greater than the minimal yield advantage, but the carry trade is still alive and well

          FX swap points are the difference between the interest rates of the two currency pairs for whichever duration is being hedged. There is no arb, the bank that makes the swap price manages mostly interest rate risk.

    • Hi Moderator – it seems an old problem of my comments going straight into your Spam folder has recurred … could you check please?

      Mod: was too long, cleared it, thanks for headsup.

  12. “It’s whether anything will be done before the fall out is heaped on the innocent is the question.” The answer is likely to be , No. How can it be any different! You, we, they all know of the embedded risks, but it’s too big now; too established to ‘melt’ the edifice. Fingers crossed, and lets hope it goes bad on the next watch, as you note, is about as certain an action that we can expect.As usual, Deep T (does your real surname start with an S?!),top post.

  13. Good post.
    The only problem I had was with

    “Generationally, I believe we have the same responsibility to our children and all descendants to protect them from our actions when they are fully reliant on the situation we leave for them.”

    Human behaviour does not generally follow the course of protecting the unborn (with some Green exceptions).

    I spent 16 months in Saudi Arabia in the 80s. The one (and virtually the only) thing that impressed me about the place was how honest merchants were. No prizes for why.
    By contrast, I haven’t seen any one-handed bankers around here recently…

  14. “My view was of no consequence as rating agencies used the models and AAA rated securities were created in the hundreds of billions for the unsuspecting investors, and here’s why.

    Not in Australia so much: US assets, London banks the originators and hedgies and European banks ended up being

    ” These models use probability of default (PD) of loans based on historical performance as a primary driver in determining the risk weighted assets. In relation to mortgages these models are used to justify very low levels of capital, less than 2%, with devastating future consequences.”

    interesting to see the Fitch headline that 97% of RMBS retain their AAA status after 35% falls in house prices. I realise the pet shop galahs in here will fall off their perches about how you can’t trust rating agencies , but the result is not an outcome reliant on any mathematical models: its simply collateral value, less price fall, less liabilities and you still end up with a AAA rated structure, (which has some equity ) the really interesting stat would be what fall would be necessary to wipe out the equity in the tranches

    • …97% of RMBS retain their AAA status after 35% falls in house prices….

      It’s stuff like this that leads me to believe that the finance sector is an even bigger house of cards now than it was back in 2007.

      The financial house of cards has been propped up, and in fact whole new wings of rooms added onto it, by deregulation and the granting deregulatory forbearance. What was needed—-cleaning up the asset side of the banks’ balance sheets—-has been postponed until the whole thing eventually comes crashing down.

      The FDIC published a paper which delineates the lessons which can be learned from the 1980s S&L crisis:

      **quote**
      The regulatory lessons of the S&L disaster are many. First and foremost is the need for strong and effective supervision of insured depository institutions, particularly if they are given new or expanded powers or are experiencing rapid growth. Second, this can be accomplished only if the industry does not have too much influence over its regulators and if the regulators have the ability to hire, train, and retain qualified staff. In this regard, the bank regulatory agencies need to remain politically independent. Third, the regulators need adequate financial resources. Although the Federal Home Loan Bank System was too close to the industry it regulated during the early years of the crisis and its policies greatly contributed to the problem, the Bank Board had been given far too few resources to supervise effectively an industry that was allowed vast new powers. Fourth, the S&L crisis highlights the importance of promptly closing insolvent, insured financial institutions in order to minimize
      potential losses to the deposit insurance fund and to ensure a more efficient financial marketplace. Finally, resolution of failing financial institutions requires that the deposit insurance fund be strongly capitalized with real reserves, not just federal guarantees.

      http://www.fdic.gov/bank/historical/history/167_188.pdf

      **end of quote**

      But were any of these lessons learned, much less heeded? Each day it’s becoming more apparent that they were not. Instead, in the wake of the GFC, regulators and policy-makers have responded exactly as they did in the early 1980s. As the FDIC paper succinctly highlights it, “Government Response to Early Crisis: Deregulation.”

      People should be afraid. Very afraid.

  15. For readers who find the MacKenzie, Spears paper, “The Formula That Killed Wall Street” hard going, I think this speech by Andy Haldane, “Tails of the unexpected” is kinda on the same theme.
    http://www.bankofengland.co.uk/publications/Pages/speeches/2012/582.aspx

    He uses analogy of a pile of sand. It’s more or less stable until “a small addition of risk – a single sub-prime grain of sand – [is] sufficient to cause the whole edifice to collapse in an uncontrolled cascade”.

  16. Truly wonderful post DT

    Re the front loading to generate profits for bonuses it’s not as if there were not previous lessons in this which, if learned, would have protected us somewhat. The rise and fall of Enron 1991 to 98 was chock full of this rubbish. I remember they did a deal on some North Sea gas associated assets,maybe a pipeline and reserves. There were many imponderables in the likely outcome of the investment. The whole 20 year income stream was booked into the current year…the mind boggles at what the discount rate used might have been. In this way everyone got their bonuses. The fall of Enron was characterised and caused by the preponderance of such deals.

    But we learned nothing then and I doubt we’ll learn anything now.

  17. A lot of good points here, although – and I do agree with it – the part that discuss generational responsibility is mostly a set of ethical statements…

    Also agree with the “past performance” analysis, and although I am sympathetic with the idea that this is as good as it gets in term of prediction capacity, I think the main issue is not the way we calculate risk; but rather the assumption that these calculations are accurate or sufficient for risk taking exercises. This is what is creating systemic risks. Although basel tries to limit these risks by increasing the capital requirements; it is both too small an answer and open to many flaws (such as off balance sheet products).

    The point is that it does not matter how we “predict” how the pile of sand will crumble or under what circumstances, we should just simply agree to limit the size of that pile of sands.

    Ironically, of course, the worst part is that the models currently use tend to predict the occurrence of exceptional events every 50, 100, 1000 years and justify this on past performance. But it seems “adverse” banking crisis have been a lot more frequent of late! Not only does relying on the past does not work, but when past events occur, we certainly don’t learn any of the lessons.

  18. As a young person I am constantly dismayed when people my age take out massive mortgages because “that’s part of growing up”. It is almost a mainstream cultural expectation that to be considered successful you have to “own” your own home, renting doesn’t cut it. If it means a 400-700k mortgage then so be it. It’s a game I will not be participating in, but I will feel for friends that have, if the risks do materialise.