The Mystery of Capital

By James Kwak

So the dust has settled on the Senate bill, and it remains studiously vague about capital requirements — no hard leverage cap, for example. This is what the administration wanted, for two reasons: first, they claim that regulators need ongoing flexibility to modify capital requirements; second, they claim that they need flexibility to negotiate a uniform international agreement.

There is one thing in there that is controversial enough to get the attention of the bank lobbyists: the Collins Amendment, which Mike Konczal has written about here. The main provision of the amendment is that whatever capital requirements apply to insured depositary institutions (banks), they also have to apply to systemically important financial institutions, including at the holding company level.

Sheila Bair of the FDIC is in favor of the amendment, on the argument that bank holding companies should not be able to evade capital requirements that are imposed on their subsidiary insured banks; she doesn’t want to regulate the depositary institutions but have all her work rendered irrelevant because the holding company collapses, triggering a mess of cross-guarantees.

This seems entirely unobjectionable, but as Konczal points out, the real threat to the banks is that it makes it harder for them to engage in financial engineering on the holding company level to evade capital requirements. According to the Wall Street Journal, not only the banks, but also the administration itself is planning to try to kill this amendment (at this point, in conference committee).

The administration’s argument, as mentioned above, is that these kinds of rules should be negotiated internationally, not set by Congress, which is overly political. But as Bloomberg pointed out earlier this week, international negotiations are nothing if not political. And as Konczal highlighted, the administration is also taking the banks’ side in the international arena.

The Collins Amendment wants to make basic capital requirements simpler, with the option of adding more complex requirements on top (“shall serve as a floor for any capital requirements the agency may require”). Opponents want regulators to have as much discretion as possible. I think it’s important to have a simple floor, because discretion and complexity are just a way of fooling ourselves into thinking we can measure something that is inherently unmeasurable.

A while back, Steve Randy Waldman weighed in on bank capital requirements. He goes much further and deeper than Simon and I did in our article about capital requirements. “Bank capital cannot be measured,” he says. His point is both practical and epistemological.

On the practical side, look at Lehman: it was well capitalized on paper right before it collapsed, and then a few days later it had negative equity of at least $20 billion. (And it wasn’t because of some fire sale, Waldman explains.)

Here’s the epistemological side (the part I like the most):

“Capital does not exist in the world. It is not accessible to the senses. When we claim a bank or any other firm has so much ‘capital’ we are modeling its assets and liabilities and contingent positions and coming up with a number. Unfortunately, there is not one uniquely ‘true’ model of bank capital. Even hewing to GAAP and all regulatory requirements, thousands of estimates and arbitrary choices must be made to compute the capital position of a modern bank. There is a broad, multidimensional ‘space’ of defensible models by which capital might be computed. When we ‘measure’ capital, we select a model and then compute. If we were to randomly select among potential models (even weighted by regulatory acceptability, so that a compliant model is much more likely than an iffy one), we would generate a probability distribution of capital values. That distribution would be very broad, so that for large, complex banks negative values would be moderately probable, as would the highly positive values that actually get reported. . . .  Given the heterogeneity of real-world arrangements, no ‘one-size-fits-all’ model can be legislated or regulated to ensure a consistent capital measure. We cannot have both free-form, ‘innovative’ banks and meaningful measures of regulatory capital.”

This is a point that I think is often lost. People talk about capital like levees to protect against a flood, but it’s like levees that you can’t see and measure, only guess at. Capital is probabilistic, so it’s only as dependable as your ability to assess those probabilities.

And, of course, with banks the errors always come out the same way — overstating capital:

“For a long-term shareholder of a large financial, optimistically shading the firm’s position increases both the earnings of the firm and the ‘option value’ of the firm in difficult times. It would be a massive failure of corporate governance if Jamie Dimon or Lloyd Blankfein did not fib a little to make their firms’ books seem a bit better than perhaps they are, within legal and regulatory tolerances.”

And here’s Waldman’s conclusion: “We need either to resimplify banks to make them amenable to the traditional approach, or come up with other approaches more capable of reigning in the brave new world of banking.”

Ultimately, capital requirements alone are not the answer. But as long as we’re going to base our banking regulation on them, we should make them as resistant to definition error and measurement error as possible.

58 thoughts on “The Mystery of Capital

  1. James, I would also emphasize another implicit point in the quote from Steve, namely that the permutation of accounting gimmicks, inconsistent accounting practices across borders, and tax treatments, can render, and does indeed render all the time, a highly evanescent snapshot of the capital condition of banks and their holding companies.

    The upcoming Kanjorski hearing represents another attempt to get at the accounting problem, but without some kind of international consistency (a very difficult goal to achieve) I think the threat to bank (and our) safety is even more alarming than the more conventional regulatory arbitrage that has so far achieved the greatest attention.

  2. Does this mean that the US Congress is effectively delegating the issue of capital requirements for banks into the hand of the Basel Committee? If so, is this not something that should be spelled out more clearly?

    Also are not the Senators and Congressmen aware of that it was primarily the Basel Committee inspired capital requirements, based on risks that served as growth hormones for the big banks to morph into the too-big-to-fail-banks, and which they all say they loathe?

    Also are not the Senators and Congressmen aware of that it was primarily the Basel Committee inspired capital requirements, based on risks that provided those yields that large bonuses are made of, and that they all say they loathe?

  3. James,

    Thanks for bringing up this point. The vast majority of commentary I’ve read–OK, truthfully, _all_ of it–approaches financial problems as fundamentally numerate. The numbers are the numbers, unless one lies. But one real issue here (not the only one, by any measure) is that financial objects like capital (as you point out), credit, and earnings are all in at least some ways functions of how we use words. I mean, the word “capital” in the context we’re talking about here means resources for paying back obligations; “credit” means how, in aggregate, borrowers and creditors believe that the borrowers can make good on their debts; and “earnings,” of course, means whatever positive number one can plausibly mark down to the bottom line.

    It seems to me the approaching finance quantitatively has tremendous strengths when the overall conditions are sound and stable. That is, when most information is reliable and most sources of information trustworthy. As trust breaks down (look at the TED spread), as credit becomes more expensive (read: as it gets more expensive to trust people b/c one can’t verify what they say), the quantitative approach becomes much less valuable. As you point out, we GIVE numbers to these phenomena–they’re not inherent. But the phenomena themselves are largely psychological (even the value of a concrete asset is psychological), and each time I think this through, I come back to the idea that the psychological phenomenon in play here is _trust_.

    So maybe we could usefully ask: What kinds of actions and rules would facilitate trust?

  4. If capital levels are probabilistic, perhaps we need something analogous to a Quantum Resonant Tunneling Diode. The probability wave function of the input electron is very wide (lots of uncertainty in the actual energy), but due to the action of resonant tunneling, the spread in the energy of the output is relatively very confined (much less uncertainty).

    It’s hard to see what a financial regulatory analog of the QRTD would look like, but I imagine it would involve some ensemble of regulatory models passed through successive “potential barriers” to achieve a resonance peak of desired narrowness.

    Or maybe not.

  5. Excellent comment. I’ve been saying for a couple of years that what has popped is not really the housing bubble, nor even the credit bubble, but the trust bubble. And as always when a bubble bursts, we all rush to the opposite extreme. Now, no one trusts anyone else, economically or politically, and no society can function without trust. So, asking what would build trust may be the fundamental principle that should guide decision making in the public arena.

  6. JRW: Thanks for the reply. The “trust bubble.” Exactly. I’m totally going to steal that.

    And further on that point, doesn’t this line of thought find substantial confirmation in the fact that the guys who invented economics thought of themselves as doing moral philosophy? I mean, it was all about how people treat one another en gross and how certain kinds of government actions caused ripples in the trust that is the bedrock of any and all markets.

  7. Cool idea. As I said, I bet it would work great when markets are stable. When not, I rather think that probabilistic analysis, no matter how sensitive or sophisticated, would break down as more and more factors (all of which cannot be modeled) become influential.

  8. The US is badly in need of adult supervision and behavioral modification. Not the much maligned people, the long suffering public which seeks only to go about its daily business creating wealth in the real economy in the face of mounting hardships, but rather the corrupt and irresponsible government, and the pampered princes of Wall Street, who are engaged primarily in wealth extraction and redistribution, primarily for themselves.

    Washington can pass all the reforms it wishes. But until it obtains the will and the regulators to enforce the laws, including the existing laws, it is all merely a show to placate the public and maintain a misplaced confidence in ‘extend and pretend’ sustained by self-serving neo-liberal economic mythology.

    Meanwhile, the financial sector is to be enriched by the translation of junk economics into international policy. Living in the short run is the financial sector¹s time frame ­ while distracting the attention of indebted populations from calculations that Wall Street understands quite well: the debts cannot be paid in the end.

    But they can be paid in the short run, with promises to pay someday ­ as if any economies ever have been able to grow by imposing austerity! It is all junk economics, of course. But it buys time for the bankers to pay themselves yet more bonuses this year. By the time the financial system collapses, they presumably will have put their money into hard assets.

    Bank lobbyists know that the financial game is over. They are playing for the short run. The financial sector’s aim is to take as much bailout money as it can and run, with large enough annual bonuses to lord it over the rest of society after the Clean Slate finally arrives.

    Less public spending on social programs will leave more bailout money to pay the banks for their exponentially rising bad debts that cannot possibly be paid in the end. It is inevitable that loans and bonds will default in the usual convulsion of bankruptcy.

  9. Let us be even more specific… what popped was “triple-A bubble”. The same way society cannot function without trust, neither can it function with blind trust… trust but verify… who said that?

  10. It is amazing how hard people try to obfuscate the reality of any given balance sheet. The assets or asset portions on the balance sheet of the subject entity involved are 100% the property of the subject entity. The subject entity has financed the assets with it’s liabilities and it’s permanent or semi permanent equity position. The subject entity owes 100 % of it’s liabilities outside of estimation accruals for incurred debts not yet billed.

    The idea of 8 % being capital allocated against an asset is simply silly. The idea of holding a reserve asset percentage of any subject asset as a liquid reserve to pay down liabilities exiting has no relation to the asset being reserved against. The reserve asset is general and is not assignable against a specific liability claim person. That may happen in specific transactions but that is contractural.

    What has long been happening is that esoteric tools using statistics have taken the place of the reality. The absolute reality of a financial balance sheet is that the claims on others be collectable in the ordinary course of the business. The make or break is loaning to be paid back or in other business applications collecting the credit you extend in the business.

    Does baloney explode under high heat? Do the tools now take the place of the facts themselves. The financial asset collapse of the last five years involve collapse of the art of lending. Ersatz assets like Synthetic CDO’s are proof of the decline of the art of lending. So much so, that the financial business changed to the science of grifting.

  11. Right, who is to provide “adult supervision”? Those naïve, gullible and innocent regulators that thought they could control the financial world with some capital requirements based on credit risk as assessed by some human fallible credit rating agencies? Come on, not even as babysitters!

  12. “We need either to resimplify banks to make them amenable to the traditional approach, or come up with other approaches more capable of reigning in the brave new world of banking.”

    So then how do we resimplify/reign in banks? Simple. Banks need to get back into the business of accurately pricing risk. To that end banks should be required to keep loans and other financial assets on their books. No more of this off-balance sheet B.S. That means if a financial institution has a reserve account at the Federal Reserve it should not be able to engage in most forms of securitization. Take away banks’ ability to move risk off their balance sheets and the incentive to fudge capital valuations goes with it. I suspect that without all this “innovation,” giving banks new and improved ways to hedge interest risk, credit risk, inflation risk, and every other kind of risk, measuring capital will become much easier. Hedging risk doesn’t make it go away; eventually someone has to bite the bullet and make a decision about how to price it. That someone should be the person with the most to loose. In other words, the banks.

  13. NKlein1553 “Banks need to get back into the business of accurately pricing risk”

    Absolutely… and in order to accurately price risk… regulators should not meddle with different capital requirements.

  14. Um, no. The whole point that Kwak and Waldman are making is that there are many ways “to accurately price risk,” and further, any one of them can generate an INFINITE number of accurate assessments. The issue therefore isn’t accuracy. Accuracy is a red herring here. The question is trustworthiness. Given that some sort of latitude is inevitable (and, under most circumstances, desirable), can parties to any given financial transaction trust one’s assessment of their situations. There many be many honest ways of pricing both capital reserves and risk, but there are many more dishonest ones. Government rules must therefore aim not to help ensure accuracy, but to facilitate and reward dealing in good faith.

  15. Financial Reforms ‘Cosmetic,’ Won’t Stop More Crises: Roubini

    Tuesday, 18 May 2010 – excerpt

    “We were on the verge of a great depression,” he said. “We needed the stimulus, or the outcome would have been ugly. Some countries can monetize fiscal deficits, others can’t.”

    The world is now faced with a choice between default or inflation, according to Roubini.

    “If the debt of governments becomes unsustainable, they won’t have the ability to prevent a deeper recession,” he said.

    He stopped short of predicting a double-dip recession, but if the sovereign debt issue is not addressed, it could be, in his words, “a huge problem.”

  16. Very true, and that builds on what J.Powers said. Verification, e.g. transparency, regulation, oversight, is needed to build trust. And those who oversee and regulate need to be the most transparent and trustworthy of all.

  17. Pricing risk in the granting of credit must occur when the loan is made. ( Or not made.) They call this area “fixed Income”. The product created is a loan of one stripe or another. After the loan is made, the product is in it’s aftermarket when it is sold. It is an Edsel or a Ferrari. Pricing the individual product in subsequent transactions is permanently tied to the risk associated with the product at it’s creation. After that it is haggling over the value of the carcass. Pawn shop business.

    Take a CDO consisting of the bottom tranches of 100 other CDO’s. Knowing this in very certain terms through personal knowledge of the CDO would have produced a heavily discounted note on top of cash flow yield at 100 % performance to produce a return weighted for risk. If every portion of all the tranches in the CDO received NO cash flow at a 92 % performance of cash flow from the original CDO … what is it worth? Nothing. The CDO should have been unsaleable at any price but a pittance. This bespeaks of buyers so stupid as to be beyond the wildest dreams of any grifter. Paying Ferrari prices for junk Edsel’s. Any grifter that can do that over and over is a consummate artist. Unless, of course, if the whole affair is a mass delusion. Still , a lot of money can be made stinging from outside mass delusions as John Paulson did.

  18. Mr. Roubini also wrote: May 13, 2010

    “I would go back to the kinds of restriction we had under Glass-Steagall when there was a full separation between commercial banks and investment banks.

    I worry that zero interest rates are leading to an asset bubble globally. I don’t think it’s going to burst for the time being, but give it two or three years.”

  19. Let me echo at least a couple of other responses. So long as many of the “banks” assets may be valued at an imaginary number, the entire idea of capital holdings becomes an effemeral exercise. Capital assets for the largest financial institutions is mythical until we have real valuation required under current accounting practices. At least then (if then is ever) they will have to assign a reasonable guess to the absurd derivatives that enable them to leverage ad infinitum. GAAP is now trash, let’s face it!!

  20. Trying to reform the system from within is wasted breath and energy. If someone hasn’t figured that out yet, they are gullible or rather slow to catch on. What more evidence is needed? Really.

    Have you read this opinion piece by Chuck Green? It’s amusing – sad, but amusing.

  21. But much of our economy is now based on duping people into paying Ferrari prices for junk Edsels. It’s not just finance where this happens. For example, we’re paying Ferrari prices for Edsel health care.

  22. “When in the Course of human events, it becomes necessary for one people to dissolve the political bands which have connected them with another, and to assume among the powers of the earth, the separate and equal station to which the Laws of Nature and of Nature’s God entitle them, a decent respect to the opinions of mankind requires that they should declare the causes which impel them to the separation.

    “We hold these truths to be self-evident, that all men are created equal, that they are endowed by their Creator with certain unalienable Rights, that among these are Life, Liberty and the pursuit of Happiness. –That to secure these rights, Governments are instituted among Men, deriving their just powers from the consent of the governed, –That whenever any Form of Government becomes destructive of these ends, it is the Right of the People to alter or to abolish it, and to institute new Government, laying its foundation on such principles and organizing its powers in such form, as to them shall seem most likely to effect their Safety and Happiness. Prudence, indeed, will dictate that Governments long established should not be changed for light and transient causes; and accordingly all experience hath shewn, that mankind are more disposed to suffer, while evils are sufferable, than to right themselves by abolishing the forms to which they are accustomed. But when a long train of abuses and usurpations, pursuing invariably the same Object evinces a design to reduce them under absolute Despotism, it is their right, it is their duty, to throw off such Government, and to provide new Guards for their future security.”

    – from The U.S. Declaration of Independence

    I wonder what percentage of our U.S. Senators and Representatives have even read the Declaration of Independence?

    It really IS time for a revolution and the end of this corrupt Corporate Plutocracy and Corporate Pollutocracy (e.g. BP).

  23. “Given that some sort of latitude is inevitable (and, under most circumstances, desirable), can parties to any given financial transaction trust one’s assessment of their situations.”

    But then how do we get the parties to trust each other? The best way, as I see it, is to properly align risk and reward. To do this banks should be forced to keep most of the risk on their books. If banks can move risk off their books through securitization no amount of government rule making will help. Bankers are always going to be ten steps ahead of regulators when it comes to finding ways around rules. But if banks have to keep the loans they make on their books, then they won’t have any incentive to look for loopholes.

  24. This country, with its institutions, belongs to the people who inhabit it. Whenever they shall grow weary of the existing Government, they can exercise their constitutional right of amending it or their revolutionary right to dismember or overthrow it.

    A. Lincoln

  25. This country, with its institutions, belongs to the people who inhabit it. Whenever they shall grow weary of the existing Government, they can exercise their constitutional right of amending it or their revolutionary right to dismember or overthrow it.

    A. Lincoln

  26. You know I am a strong Democrat, and someone who will vote Democrat 95% of the time. But I think if I hear from legitimate sources (that DOES NOT include the WSJ) even the slightest whisper that lily-livered, gutless, spineless slime Timothy Geithner and people of the President’s administration are trying to kill the Collins’s Amendment, then I am finished with Obama. If they try to stop the Collins Amendment I will not vote for Obama in 2012. PERIOD.

    And I think it’s something the administration better think over clearly in their mind because I am a very strong Democrat (I voted for Jerry Brown one year, if that gives you some idea) and I will not vote for Obama if I even here a whisper they are trying to stop the Collins Amendment.

    What does this then become when they work to kill the Collins Amendment??? It becomes a race to the bottom, the lowest common denominator of getting 50 zillion countries to agree to one capital requirement, and it becomes the lowest most sorry Blankfein anus-sucking requirement you could possibly imagine, with some country like Greece, or Mexico deciding what the capital requirement will be.

    And I strongly disagree with Steve Randy Waldman on this particular issue. I have to say I have never heard something so wishy-washy from Waldman, and I wonder if it was a Saturday night when he wrote that garbage. One reason why capital requirements have gotten messed up is because Asset Quality. Asset Quality has become the REAL PROBLEM here. Capital requirements don’t mean jack if your asset quality has been watered down to garbage. In fact it has been shown clearly many times over, with a consistent pattern, that of the 6 CAMELS indicators, earnings and Asset Quality show problems in solvency a long time before capital does. Assets show signs of trouble a full 6 months before capital does. Why?? Because banks can find new capital. The financial institutions can increase capital ratios many ways. Banks can lower assets by cutting back on lending or selling assets. It should be noted though, that capital ratios drop off dramatically roughly 1 year before bank failure, as investors foresee the possibility of default.

    And the argument of not setting a standard because capital ratios have gray areas is just DUMB_SS. COMPLETE DUMB_SS. If you don’t know when the flood will end, do you not measure the point where the river will flood????? Do you not put sandbags up because you don’t know when the rain will stop??? Do you not measure how much oil is leaking in the Gulf Of Mexico because “well, who cares, we don’t know the exact point the fish will die anyway and we should be sure Greece agrees the fish will die at the same time first”. I just wonder what world these people and the folks in the U.S. Treasury live in????

    I did a post on my blog about this, but I was borrowing largely from the work of researcher Yadav Gopalan at the St. Louis Federal Reserve. It also has some terrific graphs. You can read the original work at this link.

  27. That’s it! A dollar invested in an asset is a dollar invested in an asset no matter what its credit rating might be, and so that dollar or any dollar invested should be backed by exactly the same percentage of a dollar in capital requirement… and no phony risk-weights to blur the view.

    If an asset is perceived as more risky it will pay a higher yield than something perceived as safer, and that is the way how the market always cleared for risk… that is before these regulators from Basel came and thinking they knew it all confused the whole issue with some different capital requirements based on what some very few credit rating agencies said.

  28. Here’s the corrupt attorney-general Richard Olney in an 1892 letter to the corrupt Grover Cleveland:

    “The [Interstate Commerce] Commission . . . is, or can be made, of great use to the railroads. It satisfies the popular clamor for a government supervision of the railroads, at the same time that that supervision is almost entirely nominal. Further, the older such a commission gets to be, the more inclined it will be found to take the business and railroad view of things. It thus becomes a sort of barrier between the railroad corporations and the people… The part of wisdom is not to destroy the Commission, but to utilize it.”

    Just replace the word “railroads” with the word “banks” in the quote above, add a hundred years of refinement to corporate and government corruption, and our current predicament becomes clear. Where there is no honor in government or business, all regulation is a sham.

  29. Ted I agree with you about Steve Randy Waldman’s discussion of the notional quality of capital. I thought it was pretty weak and much too influenced by post-structuralist epistemology. Definitely late Saturday night thinking!

    Your focus on asset quality is very much more on point. And the dramatic effect of reduced levels of capital as a result of Basel II, with the tight correlation to the build up to crisis, is well documented in very graphic form by the OECD. Of course capital matters.

    A big problem is that capital evaluation has been allowed to be manipulated to the point of become a very unreliable guide to the soundness of an institution. Of course we have to set capital levels and we have to make them and capital reporting honest. AND they must be responsive to real assessments of asset quality.

    Unfortunately the mechanisms instituted once and after Basel focused almost exclusively on VAR and the IRB-based system have almost guaranteed that we wont have a clue what either the asset quality or capital levels really are. That was the lazy politician’s and regulator’s way out of real supervision and it overexcited the quants, which was asking for trouble.

  30. Not that I am proposing it but can you imagine what the trillions lost while searching for the AAA rated because these require lower capital requirements from the banks could have done to the world if capital requirements for banks had been set in terms of how lending fights climate change?

    The most important but still unasked and much less answered question about credit rating agencies is… What if there were 100% accurate, would the world benefit from following them into never-risk-land?

  31. Another Mystery

    May. 21, 2010

    “To hear economists talk, the Great Recession, which hurtled across the U.S. like a hurricane starting at the end of 2007, has passed. But on a human level, it often doesn’t feel that way. Jobs are scarce and unemployment – at 9.9 per cent – remains startlingly high after the massive layoffs of the past two years.

    On a trip to Buffalo last week, President Barack Obama acknowledged the disparity between the “fancy formulas” employed by economists and the lived experience of ordinary people. “If you’re still looking for a job, it’s still a recession,” he said. “If you can’t pay your bills or your mortgage, it’s still a recession. No matter what the economists say, it’s not a real recovery until people can feel it in their own lives.”

    “We haven’t seen long-term unemployment at this scale here in the U.S. going back 70 years. There’s no way to put lipstick on this particular pig – this is bad.”

  32. What continues to amaze me is the skirting of the real issue: JOBS. The government goes about its business of dealing with financial reform, health care reform, green energy when all the while more folks drop off the unemployment roles.

    The first order of business for this administration should have been the economy. They had an agenda in place and jumped into the priority list with their #1 issue – health care at a time when jobs should have been the focus.

    Of course financial reform is important but meanwhile the tax revenues at the federal and state level are falling off a cliff.

    If the federal deficit needed to expand for anything it should have been to assist in job creation. Meanwhile untold amounts of money have gone to bailout the banking sector. Had they allowed the breakup in the first place when the banks were at their weakest, waited on health care…we could have put the funds and energy into solving the unemployment problem.

    So many of the boom jobs are gone forever. We are a country of innovators. That is where our energy and resources should have been channeled. Where our focus should be now…jobs.

  33. Asset Quality. Ahhhh, Asset Quality. But who is there to judge quality in the first place? As Jerry J suggested above there is origination and everything after that is the after (or secondary) market.

    For a long time I have thought that the big commercial banks lost basic credit skills over the last 2 decades and replaced them with actuarial credit, i.e. credit at arms length as typified by the mortgage and credit card lenders and the rise of the rating agencies and that most scurrilous of all tools, the FICO. Of course the investment banks never had those skills to begin with.

    On a bad day, I can’t help but think that the banks may lack the personnel and the resolve to go back to genuine credit analysis. i.e. to judge asset quality (both risk and return) in the first instance.

    I read an article in The Economist about 12 or 15 months ago about sub-prime lenders in the U.K. They were actually doing quite well, thank you very much, because they were in the origination (not the trading) market, they did the basic grunt credit work, and they kept in touch with their clients as a regular practice, not just when things looked bad. They made money the old fashioned way – they earned it. I haven’t followed that particular story, but they were prospering then because they were finding all manner of generally good borrowers who were being turned away from the big banks.

    In sum, asset quality will not come from a spigot that is turned on by slapping some wrists, shaking a finger, and telling bankers to do things right for a change.

  34. Quality? Right… but what quality? The quality that repays loans… or the quality that creates jobs… or the quality that helps the environment… or any other quality?

    “For a long time I have thought that the big commercial banks lost basic credit skills over the last 2 decades and replaced them with actuarial credit” Yes and this is a tragedy and perhaps even more expensive than the financial crisis itself. I have protested that since 1997… to little avail.

  35. Well, poor credit skills leads to fatal losses in finance as we can all see. Superb credit skills are the most important factor in the business of loaning money. Secondary market acqusition of retail loans for securitization or for direct holdings adds layers of credit skills. It is 100 % collecting the agreed cash flows when the deal is made. If you collect the vig for the agreed time frames, including alternates, and collect back principle the business model is insured provided you maintain the proper spreads on borrowed capital.

    What has happened by not having good credit skills and judgement was fully predictable.

  36. Fifteen years ago, Phillip K. Howard discussed the underlying problems that blew out in the last five years in his ” The Death of Common Sense”. The obsession with process and uniformity to enable concentration of power. Here are some sentences on page 65. “Orthodoxy, not practicality,is the foundation of process . It’s demons are corruption and favorotism, but the creed this orthodoxy is a permanent uniformity”.The demons look to have done some fatal biting.

  37. Where is the Capital,and Jobs?______ US Fed.Outlays (Spending) FY 2011~est. $3.83tn // US Fed.Revenue (Receipts) FY 2011~est. $2.57tn. {(deficit of $1.26tn FY 2011)(FY 2010 deficit $1.6tn / FY 2009 deficit $1.4tn – note: incremental decrease from prior two years to present?)} These statistical predictions are built on, “Wishful Alchemy Thinking” from a page torn-out from an old discarded ,”Dictum Theorem Thesis scribed by Nostrodamous”,…pure hogwash! Fact: FY 2009 Outlays (all documented) for interest on debt budget was 5% ($187bn), whereas the US Debt was ~$12.1tn (1/3 US Public (IOU’s SSA/Trust Funds running surpluses) Debt~ $4.05tn & 2/3 Foreign (China/Japan/Asia/Arabs***/Europe,etc.) Debt~ $8.05tn)when the actual total debt due,and paid was ~$383bn.FY 2009 (talk about fudging the numbers)! Currently the true debt of the United States is at par with GDP~ @ $13.2tn (1:1)and growing fast. My projections put the US Debt FY 2013 @ (1.32:1),thats is $16.4tn US Debt vs $13.1tn (this number is conservative,and can move nicely if Europe expediates the proposed austerity plan – I myself am betting it will take time,and slow down the global picture of growth to moderate?)GDP? How can I say this? The US Dollar will reach parity with the Euro by late 2010/early2011 making America’s exports more expensive (hurts the global players which I care less about,period – lots of reasons & no time too explain?) but pegged to the Chinese Yaun,…our biggest trading partner. This will certainly help reduce our massive trade imbalance (China being the only reason for the entire world’s trading imbalnces – no surprises here) with China ,and others – adding money to our coffers only to be offset by our inflated dollar in other parts of the globe, which (looks worse as you go back in time,but I’m not trying to depress anyone) since 2007/(-$702bn.); 2008/(-$697bn.); 2009/ ($379bn.); 2010 ~est($423bn.) recorded Import/Export Trading Imbalances! Please note that China is our biggest trading partner that really has hurt the United States – they’ve devalued their currency deliberately, undermining the US Dollar competitiveness (US Global Partner’s are also behind this ruse,ie.)GM’s, WalMart’ Cat,Dell,…etc.?) for the last decade, making our dollar weak,and forcing our hand (terrible what they’ve done to the American worker,and consumer,absolutely pathetic. The tide has changed but only on par,…for now China’s manufacturing base will cost them(laugh with me ,please ,revenge is sweet), making the US more competitive, period! Perhaps,…maybe we can bring some of the “Five-Ten Million Exported American Jobs back home,…what ya say to that? What really can save the capital of America – that being both money, and human capital is stop spending $trillions on these useless wars! Important: $2.34Trillion already has be appropriated for FY 2010 & FY 2011 Total,…thats more than the entire US Federal Receipts for FY 2009 @ $2.105 Trillion. This is why we’ve got problems fighting the entire world’s wars on the US Taxpayers dime? Also, worth mentioning: Importing Oil will cost less,helping the trade imbalance,(unfortunately the cash strapped consumer will see just pennies) – the public will (even though the consumer accounts for 70% plus) never see it? President Obama will raise the “Gas Tax for Oil Co.’s”, thus the usual disinfectant “Trickle Down Theorem” kicks-in, but not like Reaganomic’s (slow as molasses) – but at Wall (politicians trying to catch a Rx lobbyist) Street’s “HFT” speed! PS. This is not “Rocket Science” but data from verified resources (at least through 12/2009) that I compiled? There is a cancer in our Government that has gotten so bad, that we, as a country ,are on the precipice of ruin – unless we demand reform. The European will do just the opposite as us regarding FINREG, and make it work. Notibly,so will the Chinese follow in their footsteps – we (the US) will be an afterthought in five/ten years when the next unfunded bailout implosion occurs. The lenders are fed up with the BS – the gig is over!

  38. Is ‘adult supervision’ supervision of adults, or supervision by adults or even maybe adults with super vision?

    Given that banksters appear to state that behavior, however terrible, was forced because others did it, how can SEC provide? After all they are busy with regulation priority porno duties?

    What a dog’s breakfast

  39. Where is the capital and jobs?

    Well maybe our Wall St. banks are shoveling all the cash they can loot into derivatives as higher profit investments than allocated to fund jobs?

    Still global derivatives values of $655,000,000,000,000.00 must almost be reaching maximum desired investment levels?

    Sorry guys, no capital available so jobs will have to wait for manana.

  40. If you want them off your books, because you do not want them on your books, then you should never have placed them on your books.

    Also the slicing and dicing of a mortgage should be prohibited and that should be one if the first part of the reforms.

    It should be a human right for a borrower to assume a compromise with a lender and fulfill that compromise to the same lender and not as know most often not even knowing who the current lender is (or lenders are) and having no access to “talk it over” if difficulties arise, as sometimes, naturally, happens.

    The base of any financial system that is stable and productive to society is built upon millions of financial commitments assumed and fulfilled by individuals and not tranched and sliced away into unaccountable anonymity.

  41. Sorry guys… since lending to those small businesses and entrepreneurs that create jobs require me to put of 8 percent of the bank equity that runs extremely scarce, you must understand I have to lend your deposits to those operations for which my regulator requires me to hold much less capital.

    Why do you not go to Basel and talk it over with those who decide on this type of issues here in the US?

  42. Great term, I love it too, but “trust bubble” is almost not just quite right.

    A “bubble” is when something gets overdone, like real estate prices. Trust per se didn’t get overdone here, greed did.

    The distinction we’re missing to make this solid is the distinction between trust-ed and trust-ing (the result of which interaction creates trust, or doesn’t).

    What we had, I would argue, was far more a failing of trustworthiness than of trusting. The IBs’ motivations, the ratings’ agencies’ complicity–you know the drill.

    Some people argue that we truly did have a bubble of trusting-ness: that too many people were too trusting. Hence the Ronald Reagan smokescreen of “trust but verify.”

    Hey if you have to verify, it ain’t trust. That was an actor’s double-talk, borrowed from a suspicious culture (Russia). What motivated a large chunk of those people was greed, not trust.

    But the bigger problem I think was trustworthiness. The financial engineers did such a great job of engineering markets and liquidity that they totally forgot about relationships, long-term perspectives, and obligations to humanity. (All of this encouraged by the way by the brand of economists who, like Reagan, were fond of spinning a variety of myths, like the only purpose of a business is to make money, or that markets are self-correcting–equally bogus).

    A bubble? Not really; more like the opposite–an exceedingly cynical nadir, not a zenith, of trustworthiness. Yes, too many were too trusting, but the initiating driver here and the bigger cause lay on the side of the untrustworthy.

  43. Good suggestion Per. I should go to Basel and have a holiday like those ‘hard-working’ banking apparatchiks.

  44. Paying Ferrari prices for Edsels is the foundation of our society today! We as taxpayers must be proud to pay Ferrari prices so that our infestment bankers can ride around in Ferraris!

    The alternative is Communism, gentlefolk! Communism!

  45. My thought was along these lines, except that I don’t think a diode is the right model. If you have an ensemble of possible starting points, and a set (or many sets) of transactions through which to filter those starting points, the best approach is to use Monte Carlo computational techniques to model the ensemble of outcomes. That’s what I want to see: the probability of failure (or the probability of solvency).

    You’re still, unfortunately, at the mercy of people over-valuing assets because it’s in their (financial) interest to do so, but if you had to use external measurements of asset values maybe we could get somewhere closer to a meaningful answer.

  46. An engaging discussion here, and I appreciate hearing all of the views expressed here. As a candidate for Congress in Illinois, I have a proposal for sweeping reforms that would meet most of the issues I hear raised here such as restoring trust and eliminating adverse incentives. You can read more about it on my campaign website:

    Briefly, I’ll just say that the program calls for establishing a Federal central bank with equal access to all to the electronic money transaction system – thus wrestling away control of that from the several banking cartels which control it now. It also calls for establishing a National Credit Union where all FDIC insured accounts would be moved. Home mortgages, revolving lines of credit and other assets would also be moved from the banks to the National Credit Union to offset the FDIC insured deposits and establish a central pool for all credit that does not involve project evaluations (which are ore appropriate for bond or equity issues).

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