econgineers

The “bad bank” idea is gone. And in it’s place the government will provide default insurance to the banking industry.  So what will this change?

First, we need to define well two different sources of risk, which are often confused for each other, Credit Risk and Counterparty Risk:

Credit Risk is the risk that someone who owes you money in the form of a debt, loan or bond will fail to pay you (defaults on their debt). When a bank gives a loan, provides a mortgage or buys a bond from any entity (a person or company), they gain Credit Risk to that entity.

Counterparty Risk is the risk that the Counterparty in a transaction will fail to honour their side of the deal. This risk can occur at the point the transaction is done, or at any point while the transaction is “live”. This risk can relate to a simple asset purchase, where the risk would be that you pay your money, but never receive the asset. It can also relate to a complicated derivative transaction, such as an option purchase, where you pay for something upfront, but expect to receive money back conditional upon a certain event happening (stock prices going up, fx rates going down, a company defaulting). Here the risk is that when the event happens, the counterparty does not pay you.

Banks are able to hedge their Credit risk to large corporate exposures through the Credit Default Swap market. However this then gives them a new Counterparty risk around the hedging transaction. This Counterparty risk is very difficult to get rid of. If you hedge the Counterparty risk with another market player, you then have a new Counterparty risk exposure which you need to hedge. This is a viscous circle which is impossible to completely solve, and very expensive to minimize.
Counterparty risk was mostly overlooked for many years, with the classic derivative pricing models having as a base criterion “assume no counterparty risk exists”. The collapse of Bear Stearns, Lehman Brothers, et alia, exposed this to be false in a way that shocked the markets to their core.

Banks are NOT able to hedge either their Credit or Counterparty exposure to small corporations, nor to individuals. The Credit Default Swap market for such small entities simply does not exist. These exposures tend to be small individually, but on aggregate can make up a large percentage of the banks overall exposure and revenue.

This brings us to the government’s plan of providing loan insurance to banks. The intention is that banks will quantify their exposure to individual people, as well as small and medium size businesses. They will then estimate default probabilities for each of these, and purchase insurance from the government to get rid of the Credit Risk.

The Government will then become the new counterparty. Theoretically, the Government is always risk-free, and therefore Counterparty risk does not exist. This is open to dispute, however we will leave this can of worms alone for now.

So this plan, in essence, will remove both Credit Risk and Counterparty Risk from the banks, for a price. The big question mark is the calculation of this price.

All the information about the credit quality for small businesses and individuals lies with the lenders (banks). The Government does not have this information, nor the knowledge and expertise to price this debt well. They will have to rely on the banks “honesty” to ensure that the deal is done at a fair price.

If the premium is priced correctly, then the overall fees received by the Government should be completely cover any potential future losses. In fact, due to gains made from aggregation of risk (the fundamental principal of insurance) they should make a small profit.

On the other hand, if the premium is priced too low, then the taxpayer will again end up out of pocket for billions.

In conclusion, the idea is fundamentally sound. However, all eyes will be on how the scheme is priced, as this will be the key for success.

by Andrea Graves and William Durham
18.01.2009

You may also want to read:
Robert Preston’s Blog: A bank insurer, not a toxic bank
BBC News: Brown urges banks to ‘come clean’

Articles, Discussion counterparty risk, credit risk, Government, insurance, insurer, toxic bank

“Ministers are understood to be considering creating a state-owned “bad bank” as part of government plans to stimulate the UK economy.
It would accept “toxic assets” – risky loans on many banks’ balance sheets – easing the pain of the credit crunch.”

We are all in agreement that we prefer a government that acts and tries to find solutions than one that sits back and does nothing while the economy collapses.
However, we should discuss and analyse the plan of action before jumping to conclusions.

We are all aware of the gangrene that banks have in their balance-sheet, toxic-loans that are still being hidden in “for sale books”, amongst other accounting tricks and manoeuvres. And just like gangrene, banks should cut their losses before it spreads. Some will be left standing and alive, while others may lose a leg, an arm, or even their lives in the process.
That is what gangrene does when you leave it rotting inside you.
Like a fatherly figure the government, although with best intentions, is offering to hold the gangrene on behalf of the banks. Like a transplant, to cut the gangrene out from banks and insert it in the state.

No matter who holds it, it is still gangrene!

It is naïve to think that healthy tissue won’t get contaminated by it, or that healthy debt won’t get contaminated by the toxic debt.
Default probabilities are normally computed by correlation matrix, meaning that when assets belong to corporations from the same sector, geographical region, and credit rating they are likely to suffer the same macro-economic influences and therefore likely to hold some type of correlation between them. This methodology is used to estimate probabilities of default, and ultimately how we calculate credit spreads.
Credit Ratings are not instantaneous, nor efficient, they may take months to get updated by credit agencies, and sometime may not reflect the real financial situation of the company (i.e. Lehman Brothers that only in September 2008 had its credit rate cut by Moody’s from A2 to a B3, which is not that bad for a bank that is about to open bankruptcy).

Besides these inefficiencies and time-lags, recovery rates also are not calculated correctly. Most models assume that recovery rates are dependent on the seniority of debt or collateral and do not respond to systematic factors, therefore they do not attract risk-premia and are considered independent of probability of default.

There are three main variables when estimating credit risk:
Expected default frequency (or probability of default), exposure (or risk) and loss given default (which is one minus recovery rate).

We denote,
EL – Expected Loss
EDF – Expected Default Frequency or PD (Probability or Default)
LGD – Loss Given Default
RR – Recovery Rate
R100 – Exposure (i.e. DV100
where,
LGD = 1-RR
EL = R100 * EDF * LGD = R100 * PD * (1-RR)

The recovery rate is a key variable to price and estimate credit risk. One would assume that accurate models are in place to estimate and forecast recovery rates.

However, most literature and academic work has been focused on developing models to estimate accurately the probabilities of default: reduced form (exogenous) and structural (endogenous), i.e. Merton Model, Moody’s KMV.

Over the last eight years more studies have appeared focused on RR estimation and relationship between RR and PD.
Frye (2000a and 2000b), Jarrow (2001), Hu and Perraudin (2002), Jokivuolle and Peura (2003), Carey and Gordy (2003), Bakshi et al. (2001), Altman, Brady, Resti and Sironi (2001 and 2004), and Acharya, Bharath and Srinivasan (2003).
Moreover, evidence from many countries, in recent years suggests that collateral values and recovery rates can be volatile and tend to go down just when the number of defaults goes up in economic downturns
Schleifer and Vishny (1992), Altman (2001), Hamilton, Gupton and Berthault (2001).

These new and more realistic models which estimate RR, are not being used by banks to price their assets yet. Therefore, in reality the toxic-debt hiding in their books is even worse than they actually have assumed or estimated it to be. Banks of course are aware of this and do not intend or wish to implement the changes necessary to price correctly their assets, as this would cause them to take bigger reserves for the positions they hold. Given that they are short of cash, reporting such a huge loss (based on methodology choice) wouldn’t be in their best interest. Instead it is easier to justify to regulators that the methods utilised are benchmark methods, and therefore they must be accurate.

It has been since the very start pure misconduct; lending even when the borrower could not possibly pay the loan back (mortgages that at times were over 10 times people’s income), and now turning a blind eye to the mispricing of their toxic-assets.

Taking the toxic-assets out of banks and moving it to a state owned bank, won’t free up any significant amount of cash (or reserves) to be lent back into the economy. It is somewhat optimistic to think that would be the case. Banks have already chosen carefully the most appropriate ways to report all toxic-assets priced at par (or close to it) by either using accountancy, regulatory or legal manoeuvres that enable them to lawfully declare these debt at much higher prices than they are actually worth, without breaching any compliance or regulatory guidelines.
Hence, Lehman, Goldman Sachs, Barclays and others were considered to have a much higher credit rating than they actually deserved. Most banks real finances are disguised under so many layers that revealing the truth is almost mission impossible.

Instead the government might like to consider simplifying and tightening the financial sector’s regulations, increase legal penalties for negligence or misconduct, and propose a “qualified certification” scheme to control and monitor professionals within the banking system.

by Andrea Graves
16.Jan.2008

Articles, Discussion bad bank, credit, credit crisis, credit cruch, credit spreads, Government, probability of default, recovery rates

How does it matter if money is cheap nowadays, if nobody has access to it?
Money is simply not available.
Banks have stopped lending to individuals and corporations.

Although there are clear indications from the Bank of England that further cuts to the bank rate might be ahead, however how will that feed into the real economy if loans are simply nonexistent?

What is the solution?

Nobody has the right answer yet, and like most problems it might not have only one plausible solution. In order to move forward towards an acceptable solution we may analyse the following:

- Government giving more guarantees to banks, so that banks feel less exposed to the credit and counterparty risk.
If the government would give more guarantees to banks, this could lead into a new problem: long and prolonged subsidy of the financial sector, creating a dependency on state backing. The moment that the economy would show signs of recovery the government would find it hard to retrieve these guarantees, as it is likely to cause an immediate reaction by banks which wouldn’t be keen to lend without them.

- Government lends money directly to corporations and individuals, cutting the middle man (banks).
By lending directly, the government would invariably increase the competition for building societies, credit cards, and banks. It would force some lenders to participate in the market to protect their market share.

- Corporations and individuals find funding externally (i.e. in the form of foreign investment).
Finding funding externally is a bit of a challenge for individuals, but might be possible for medium and big corporations, that in many cases are linked in one way or another to other countries, activities and industries.

The truth is that none of the propositions above is ideal, nor what one would have wished for our economy, as in one way or another we are being bailed out of trouble by either the state (tax payer’s money) or by external investors. In some situations we need to find the least detrimental solution, and this is one of them. The cost of doing nothing and taking the “conservative” approach of not bailing the economy out of trouble would most likely result in a much higher price later.

However, the worst possible outcome is to carry on backing banks, giving out guarantees, and extracting the toxic-loans the banks have in their balance sheets.

It would be no solution to the economy to continue acting like a loving parent puppet in the hands of a spoiled and manipulative child.

So what is the solution then?

Stick and carrot.

Do not bail the banks. Natural selection needs to happen (within the financial sector), the strongest shall survive and the weakest should perish, giving their place to the next in the chain.
This would guarantee skilled, hard working and efficient banks carry on, without compromising the quality of the services offered to the public. Getting rid of failing banks is not a bad idea. Most of them are failing due to their own lack of business judgement and excessive risk taking. To keep them, could be dangerous in the long term. It might corrupt healthy institutions by disseminating inefficient, negligent, and irresponsible practises. And although such professional conduct has proven to not work, it has been overlooked through a lack of consequences. This might instigate a sense of impunity, and give little incentive to honest, hard working institutions to keep their professional code.

It is true that corporations and business are at stake, and these do need some kind of support, as they are the ones that provide employment to the real economy. A rescue plan should have been targetted at this layer of the economy, by offering financial support through these difficult times. The government is trying to act on this, with fiscal policy (i.e. VAT cut) and BOE monetary policy (bank rate cuts). However, banks are unable to pass on the cuts in interest rates to the real economy; banks are simply in no place to lend money. They don’t have it. Most banks do not have the money available to lend it out and the ones that do might not want to lend it while asset prices will carry on falling. So although the government bailed banks so that they could carry on facilitating business in the real economy, this is simply not happening. There is not much that the government can do about it, without direct interventionist policies. So how can the government increase availability of cash? Well, tackle it from a different angle. If they would make available funds through an alternative route, such as building societies, this would challenge lenders into participating by threatening part of their market share. It would also accelerate the “clean-up” process that the financial sector is going through, as only the positive cash balance banks would be able to participate in the lender’s market.
Additionally, increasing the market share of these smaller players, would greatly improve competitiveness in the financial sector. This is especially important given the recent trend of consolidation amongst the large banks, which seems destined to create a banking oligopoly, with all the market distortions which that brings.

by Andrea Graves
12.01.2009

Articles, Discussion Availability of Money, BOE, Cash, Central Bank, Economy, Government

Robert Peston’s Blog Review

Robert Peston mentions “that the sum of consumer and corporate borrowing in the UK is equivalent to something like 240% of our annual economic output in the UK, while US household and business debt is closer to 300% of that country’s GDP.”
He appears to have a rather dim view on this matter, furthermore a hint of condemnation. This only shows part of the picture however, and we need more information to get the full idea of where we stand on the international stage.
1) What are the equivalent levels for our peers? What would the % debt levels be for other major economies such as Italy, Spain, France, Germany and Japan?
2) What about savings? Someone has lent all this money, which means that they have the savings to support it. Did this come from internal investors or external?
These additional pieces of information are critical to understanding the debt effect on the countries FX rate, GDP and standard of living, by telling us whether the country as a whole is in deficit, and by how much. They also change the optimal economic policies for fixing the problem, (which should always be the focus).

He follows by saying “In cash money, that’s about $45,000bn – or one of those big numbers that induces vertigo. Which is quite a burden, and – as far as I can tell – a record-breaking mountain of debt for us to pay off. The alarming and important point is that if deflation were to set in, if prices were to fall, the real burden of that debt would increase – thus prolonging and exacerbating the severe recessions that appear to be taking hold in both the US and the UK.
That’s why the US Federal Reserve has set its policy interest rate as so close to bupkes or zero as makes no difference.”
The logical extension of this is that; if deflation increases the real burden of debt, then inflation decreases it. Therefore, one could expect the CBs to review their inflation targets in the near future, as they might be more accepting of new levels of inflation, and intending to inflate their way out of debt. Given that the real IR for both US and UK is currently negative (i.e., IR – Inflation < 0), this seems to be a policy which they are in favour of.
However, this brings us back to the question of who lent the money in the first place?
If the money mostly came from internal investors, then inflation cuts two ways, as the investor ends up getting back less (in real terms) then their original investment. In the end, this is little different from simply writing off a portion of the debt. This is hardly a fair outcome for people who have saved responsibly while others were gorging themselves on debt to fuel artificially high demand.
If the money came from external investors, their investment loss would act as a positive net transfer of wealth into the domestic economy, and is therefore beneficial.

What are some alternatives to this? One is to accept that we had debt-fuelled high demand for a long time, that it is time to tighten our belts, stop spending and pay off (over a long, long period of time) our debt (the conservative party argument).

However, this is likely to result in (at best) a long period of sustained poor growth, high unemployment, and low standard of living. And this can end up becoming a vicious cycle; as the economy is producing less, there is less money to service debt. This results in less money being invested for the future, resulting in the economy producing less. A further, and very real, danger of this policy is the unemployment hysteresis effect. This is that when unemployment goes up sharply, and stays elevated for a long period of time (more than a couple of years), a significant portion of the unemployed forget skills, loss motivation and can become unemployable. This results in a decreased GDP growth for the rest of their working lives (maybe 25 years). And this is the reason why the BOE and FED have been taking drastic monetary and fiscal steps to stimulate demand, because the cost of doing so (although high) is still less than the cost of not doing so.

How do we fix this mess? The short term policy is to stimulate demand, which will also stimulate inflation. Not only would it help by devaluing domestic debt as it would, in the first instance, generate a boost in retail and industrial activity income and have as a knock-on effect the generation of more jobs (so long as their operating costs do not increase at the same rate as inflation). In order to generate a long-lasting growth to the economy, inflation would need to be controlled such that these effects do not back-fire, it will be a delicate balancing act of getting perfect timing of when to inflate the economy and when to control inflation. Ways to achieve this exist, such as stimulating specific industries, i.e. services, research, development, technology and education, industries that use little raw materials, processes, installations, transport, fuel, commodities, etc. These industries main resource is labour. They tend not to adjust wages at the same rate that their income varies. This will unfortunately mean that in the short term people’s cost of living will continue to suffer, as wages continue to not keep up with inflation. However this should stop unemployment rising to far or too fast, and allow for sustainable growth in the future. In the long term, this will create more dynamic labour markets in these industries, which will raise wages (and standard of living), and refuel inflation.

Andrea Graves and William Durham
10.01.2009

Articles, Discussion BOE, Central Bank, deflation, FED, Inflation, IR, Policy, UK, US