BIS Finds Out that the Old Dogmas Don't Apply Anymore in its Annual Report

Tuesday, June 30, 2009

Wishing that the Bank for International Settlements (BIS) had issued its annual report 2009 a day earlier - when Vienna drowned in torrential rain - I nevertheless attempt to provide readers with an executive summary that the central bank of central banks has omitted in its version.
This leads me to the first conclusion that world finance must have become really complicated when not even several dozen BIS economists with months of preparation time can sum up 250 pages of data and events. Please recline your chair and hang around as this annual report from what should be the highest-ranking group in the know unwittingly delivers ironies rat-tat-tat like an AK-47 in the loose hands of a kid soldier in one of these African countries we only know about because their soil holds rare elements needed to make your iPhone.
Starting with a stark notice that even the BIS profit declined from SDR 544.7 million to SDR 446.1 million (FRN660 million) YOY we are told that in a world once dominated by the Markowitz' model of portfolio diversification not even the BIS with a portfolio supposedly filled with assets (or just papers?) from all over the world was able to outperform markets.
If you read some sarcasm into this, you are right. After all there are enough bloggers who had warned about the current global crisis as many as 5 years early. Check my blogroll in the sidebar.
Sarcasm is the mildest form I can call my lines following below. Or was it just plain ignorance of warning voices that lead the authors of this annual report to start off with a question?
How could this happen? No one thought that the financial system could collapse.
Maybe they had better looked at the irresponsible monetary policy of the Federal Reserve in this millennium that did not create a society of house owners but a universe of debtors who have sunk below the water line called negative equity.
And how about reading other stuff than the Bubble Street Journal (WSJ) or other lamestream media? Simple "Go ogle" searches on various topics and reading their very own statistics could have alerted them to such fundamental changes like the USA morphing from the biggest creditor (until Nixon closed the gold window) to the biggest debtor in 3 decades that managed to stuff its unbacked FRNs down the throat of more or less all other nations under the disguise that these unbacked greenbacks were a "reserve currency."
As I am already so enraged I refer you to pages 2 to 10 of Alice in Wonderland, sorry, I meant the BIS annual report.
I have only one explanation for their explanations: One does not bite the hand that feeds one. I bow my head in honour of former World Bank chief economist Joseph Stiglitz who overcame this rule in order to set the record straight with his books. The same applies to former economic hitman John Perkins who tells in 2 books how he was contracted to draw unrealistic growth scenarios for developing countries, to be used by US banks and companies as a reason to indebt such nations while reimporting the loans by handing out contracts to US firms, greasing the local elite's hands on the way.
You don't really have to read these 9 pages if you have been following this blog on a post-by-post basis since April 2005.
You can also skip page 11, containing such wisdom like:
Commentators cautioned about the deterioration of credit standards, especially in the issuance of mortgages. And they warned about the risks that come with rapid financial innovation.
Do they allude to the blogosphere or did I just drink too much vin du pays this sunny afternoon?
Page 12 shines a light on the true problem for the first time:
Monetary policymakers’ only available instrument was the short-term interest rate, and there was a broad consensus that this tool would be ineffective against the alleged threat.
How many SDRs does one get paid for such enlightenment - after the world's investors were pared of half their savings in 2008, according to Blackstone?
As the BIS writers begin mind games whether more regulation - currently a hot issue in the EU especially stressed by German chancellor Angela Merkel - could have helped avoid the mess we currently live in, I humbly remind everybody that in a truly free market it is every investors own occupation to do his due diligence on prospected investments. There has never been a free lunch.
Before you get tired; the BIS is good at drawing tables of events that truly simplify recollecting what lead to the biggest financial/economic crisis in mankind's written history.

TABLE: Most important events leading to the current crisis. Source: BIS Annual Report. (Click all graphs for a larger image)
If you did not replicate Robinson Crusoe's life on an isolated island you can also skip pages 16 and 17. But the following timeline of key events from 2007 to mid 2009 is a useful guide for future historians.
  • 9 August Problems in mortgage and credit markets spill over into interbank money markets when issuers of asset-backed commercial paper encounter problems rolling over outstanding volumes, and large investment funds freeze redemptions, citing an inability to value their holdings.
  • 12 December Central banks from five major currency areas announce coordinated measures designed to address pressures in short-term funding markets, including the establishment of US dollar swap lines.
  • 16 March JPMorgan Chase agrees to purchase Bear Stearns in a transaction facilitated by the US authorities.
  • 4 June Moody’s and Standard & Poor’s take negative rating actions on monoline insurers MBIA and Ambac, reigniting fears about valuation losses on securities insured by these companies.
  • 13 July The US authorities announce plans for backstop measures supporting two US mortgage finance agencies (Fannie Mae and Freddie Mac), including purchases of agency stock.
  • 15 July The US Securities and Exchange Commission (SEC) issues an order restricting “naked short selling”.
  • 7 September Fannie Mae and Freddie Mac are taken into government conservatorship.
  • 15 September Lehman Brothers Holdings Inc files for Chapter 11 bankruptcy protection.
  • 16 September Reserve Primary, a large US money market fund, “breaks the buck”, triggering large volumes of fund redemptions; the US government steps in to support insurance company AIG (and is forced to repeatedly increase and restructure that rescue package over the following months).
  • 18 September Coordinated central bank measures address the squeeze in US dollar funding with $160 billion in new or expanded swap lines; the UK authorities prohibit short selling of financial shares.
  • 19 September The US Treasury announces a temporary guarantee of money market funds; the SEC announces a ban on short sales in financial shares; early details emerge of a $700 billion US Treasury proposal to remove troubled assets from bank balance sheets (the Troubled Asset Relief Program, TARP).
  • 25 September The authorities take control of Washington Mutual, the largest US thrift institution, with some $300 billion in assets.
  • 29 September UK mortgage lender Bradford & Bingley is nationalised; banking and insurance company Fortis receives a capital injection from three European governments; German commercial property lender Hypo Real Estate secures a government-facilitated credit line; troubled US bank Wachovia is taken over; the proposed TARP is rejected by the US House of Representatives.
  • 30 September Financial group Dexia receives a government capital injection; the Irish government announces a guarantee safeguarding all deposits, covered bonds and senior and subordinated debt of six Irish banks; other governments take similar initiatives over the following weeks.
  • 3 October The US Congress approves the revised TARP plan.
  • 8 October Major central banks undertake a coordinated round of policy rate cuts; the UK authorities announce a comprehensive support package, including capital injections for UK-incorporated banks.
  • 13 October Major central banks jointly announce the provision of unlimited amounts of US dollar funds to ease tensions in money markets; euro area governments pledge system-wide bank recapitalisations; reports say that the US Treasury plans to invest $125 billion to buy stakes in nine major banks.
  • 28 October Hungary secures a $25 billion support package from the IMF and other multilateral institutions aimed at stemming growing capital outflows and easing related currency pressures.
  • 29 October To counter the protracted global squeeze in US dollar funding, the US Federal Reserve agrees swap lines with the monetary authorities in Brazil, Korea, Mexico and Singapore.
  • 15 November The G20 countries pledge joint efforts to enhance cooperation, restore global growth and reform the world’s financial systems.
  • 25 November The US Federal Reserve creates a $200 billion facility to extend loans against securitisations backed by consumer and small business loans; in addition, it allots up to $500 billion for purchases of bonds and mortgage-backed securities issued by US housing agencies.
  • 16 January The Irish authorities seize control of Anglo Irish Bank; replicating an approach taken in the case of Citigroup in November, the US authorities agree to support Bank of America through a preferred equity stake and guarantees for a pool of troubled assets.
  • 19 January As part of a broad-based financial rescue package, the UK authorities increase their existing stake in Royal Bank of Scotland. Similar measures by other national authorities follow over the next few days.
  • 10 February The US authorities present plans for new comprehensive measures in support of the financial sector, including a Public-Private Investment Program (PPIP) of up to $1 trillion to purchase troubled assets.
  • 10 February G7 Finance Ministers and central bank Governors reaffirm their commitment to use the full range of policy tools to support growth and employment and strengthen the financial sector.
  • 5 March The Bank of England launches a programme, worth about $100 billion, aimed at outright purchases of private sector assets and government bonds over a three-month period.
  • 18 March The US Federal Reserve announces plans for purchases of up to $300 billion of longer-term Treasury securities over a period of six months and increases the maximum amounts for planned purchases of US agency-related securities.
  • 23 March The US Treasury provides details on the PPIP proposed in February.
  • 2 April The communiqué issued at the G20 summit pledges joint efforts by governments to restore confidence and growth, including measures to strengthen the financial system.
  • 6 April The US Federal Open Market Committee authorises new temporary reciprocal foreign currency liquidity swap lines with the Bank of England, ECB, Bank of Japan and Swiss National Bank.
  • 24 April The US Federal Reserve releases details on the stress tests conducted to assess the financial soundness of the 19 largest US financial institutions, declaring that most banks currently have capital levels well in excess of the amount required for them to remain well capitalised.
  • 7 May The ECB’s Governing Council decides in principle that the Eurosystem will purchase euro-denominated covered bonds; the US authorities publish the results of their stress tests and identify 10 banks with an overall capital shortfall of $75 billion, to be covered chiefly through additions to common equity.
Sources: Bank of England; Federal Reserve Board; Bloomberg; Financial Times; The Wall Street Journal.
If you need more detail, read a longer version of these key events thru page 36, multi-colored graphics included.
Page 37 headlines "The financial sector under stress" but I presume readers of alternative media have grappled already long ago that the world's central banks were not digitizing all these fresh trillions just for fun. Correctly stating that we saw a level of unprecedented policy intervention (by central banks, I assume) since the onset of
a full-fledged crisis that reached historic proportions.
Looking into the future the BIS arrives at the aha-conclusion that further developments will depend on the dynamics of both financial institutions and the macro economy:
Over the medium term, the health of financial firms will depend on the interplay between their response to losses and the dynamics of the macroeconomy. The feedbacks between the two become particularly strong when the capital cushions of financial firms are depleted. In the first stage of the crisis, capital raised from private investors met the cost of writedowns on securities portfolios. In subsequent stages, private capital had to be supplemented on a large scale by public sector resources to address mounting losses on institutions’ loan books driven by rapidly deteriorating macroeconomic conditions. The pace and shape of recovery will be critically linked to the ability of financial firms to manage their leverage and capital positions in a challenging environment without unduly restricting the flow of credit to the economy.
From a longer-term perspective, the crisis carries important messages for the structure and stability of the financial system. The events of the past two years highlighted how strong the interdependencies between financial system components can become. Market participants and also, arguably, prudential authorities underestimated the complementarities in the roles of different actors along the securitisation chain, the close interlinkages among financial markets and institutions, and the interplay between asset market and funding liquidity.
Things get more interesting on page 40 again.
TABLE: So far bank losses seem to have peaked in the 2nd half of 2008. But all unofficial talk that reaches my ears focuses on the BIG whoppers still ahead of us. Especially corporate inter-linkages between banks and insurers may prove to be the major problems as accounting at insurers allows to hide losses much longer than on balance sheets of banks. And don't forget the yet unsolved $700 TRILLION problem of over-the-counter (OTC) derivatives. Search that figure yourself in the BIS report. Last time I checked it was "only" $600 TRILLION.
Here Some Color Before You Doze Away
Realizing that this blog post is in imminent danger to resemble the boring (but very readable) layout of the BIS original, here comes some color concerning the investment banking sector, whose limitless greed for ever larger bonuses for its employees is IMHO the root of all the problems we face today.

GRAPH: These charts are self-explaining and are in line with bankers bonuses over the past years. I notice that a decline in private risk securitization is now being substituted with more government debt business. As all other underwriting sectors have gone from boom to bust in the hands of pinstriped investment bankers I think this may forebode soon-to-happen disasters with public debt, i.e. the default of sovereigns. Check out this post about the pending risk of defaulting nations/fiat currencies.
Hedge Funds Going To Where They Came From: Nothing Left
Sorry for having water boarded you with too much black ink for the past couple of screens. You don't need to read page 48 and onwards to find out that 2008 was the year where the guys in front of an array of Bloomberg screens literally jumped out of the window together with most markets they had been betting on in the years before.

GRAPH: No need to say much here. Hedge funds were only riding the wave of markets and disappeared at the same velocity with which the markets of their choice went down. To be fair: Policy interventions limiting trading the short side did not leave them much room for survival in what turned out to be one of the worst years for all kinds of markets.
The last decade was not only marked by leveraging equity to the max (most institutions went down or were bailed out once leverage exceeded a level of 30, meaning banks, funds and all other players with access to easy money (thank you Alan Greenspan, thank you Jean-Claude Trichet, thank you Ben Bernanke) were playing with 30 times as much money as they actually had in the till.
A World Full of Debt Slaves
As if turning the better part into debt slaves by pushing mortgages on more or less everybody who could make it to a bank's office unaided was not enough banks were looking for still more business (and bonuses!) Saturated home markets left them only one choice: Expanding into new territories, kind of a financial recolonization of formerly dependent territories.

GRAPH: Having grazed off domestic markets, engulfing them in the highest debt levels of history, banks set the sail and started lending all over the world. Of course it is always easy to have the winnining lottery numbers on a Monday; but how the hell is it possible that a generation of whiz kids excelling in constructing sophisticated Excel sheets completely missed out on the unbending fact that growth has its limitations and every excess ends in a mutual cannibalization of market share?
Becoming a little tired to reprint the BIS explanations about the obvious mega-problems in the financial sector one is happy that after 55 pages the BIS begins to focus on what matters most: Financial crashes have always been the precursor of extended economic downturns.
Think South Sea Bubble, think France before the revolution in 1789, think Vienna stock exchange in the 70s of the 19th century (then the biggest stock market in the world) and then again in the late 1980s after Jim Rogers kissed it awake from a century long slumber.
When the easy money begins to dry up, so does the real economy (that is where all other people except bankers make their money!)

GRAPH: The real economy followed the downturn in the financial sector with a delay of about one year, proving again an old market rule that stock markets discount the future at a range between 12 and 18 months.
I absolutely disagree with this charts low showings of inflation. Inflation indexes are governments tools to keep the wages of public employees and the pensions of retirees as low as possible. This is not a science but simply a sophisticated way of lying in the face of the public.
Finally, Some Sort of Summary
Oh, on page 72 I find out I criticized the BIS for not coming up with some sort of executive briefing. Well, the black ink proves me wrong. Here we go:
The global financial crisis has led to an unprecedented recession accentuated by rapid declines in trade volumes, large employment cuts and a massive loss of confidence. How deep and prolonged the downturn will be is uncertain. In the industrial countries, there are some signs that the rapid pace of decline in spending witnessed since the fourth quarter of 2008 has started to ease. But a strong, sustained recovery in those countries could be difficult given attempts by households and financial firms to repair their balance sheets.
Nevertheless, substantial fiscal stimulus and exceptional monetary easing in many countries should help bring the recent contraction to an end. The policymakers’ task in the near term will be to ensure a sustained recovery. In the medium term, however, it will be to ensure that policies are adjusted sufficiently to maintain the stability of long-term inflation expectations.
Feeling that many readers will never have scrolled to this piece, I relieve the busy bee readers with another BIS conclusion beginning on page 136. Get this last dose of what I would not exactly call mythic wisdom of central bankers but a statement every economic and financial observer will agree with. In short: We need an instant reform but there are sooo many obstacles. Here's the longer BIS version:
We have no choice but to take up the challenge of first repairing and then reforming the international financial system, all the while cushioning the impact of the crisis on individuals’ ability to live productive lives. Efforts so far have fully engaged fiscal, monetary and prudential and regulatory authorities for nearly two years. The public resources devoted to economic stimulus and financial rescue have been staggering, approaching 5% of world GDP – more than anyone would have imagined even a year ago.
Recovery will come at some point, but there are major risks. First and foremost, policies must aid adjustment, not hinder it. That means moving away from leverage-led growth in industrial economies and export-led growth in emerging market economies. It means repairing the financial system quickly, persevering until the job of restructuring is complete. It means putting policy on a sustainable path by reducing spending and raising taxes as soon as stable growth returns. And it means the exit of central banks from the intermediation business as soon as financial institutions settle on their new business models and financial markets resume normal operations.
In the long term, addressing the broad failures revealed by the crisis and building a more resilient financial system require that we identify and mitigate systemic risk in all its guises. That, in turn, means organising financial instruments, markets and institutions into a robust system that will be closer to fail-safe than the one we have now: for instruments, a system that rates their safety, limits their availability and provides warnings about their suitability and risks; for markets, encouraging trading through central counterparties (CCPs) and exchanges, making clear the dangers of transacting elsewhere; and for
institutions, the comprehensive application of enhanced prudential standards combined with a system-wide perspective, beginning with the application of something like a systemic capital charge (SCC) and a countercyclical capital
charge (CCC).
Successfully promoting financial stability requires that everyone contribute. Monetary policymakers must take better account of asset price and credit booms. Fiscal policymakers must ensure that their own actions are consistent with medium-term fiscal discipline and long-term sustainability. And regulators and supervisors must adopt a macroprudential perspective, worrying at least as much about the stability of the system as a whole as they do about the viability of an individual institution. An encompassing policy framework with observable objectives and implementable tools is at an unfortunately
early stage of development. But the suggestions made here and elsewhere are a start. The work will have to be coordinated internationally. In particular, institutions with expertise in the field – including the Basel-based standard-setting committees and the Financial Stability Board – will need to play a leading role in making such a framework operational. This is going to be a long and complex task, but we have no choice. It has to be done.
As in most of my past 600+ posts I disagree with this official attitude that has landedus where we are. It would be maybe of help if all insiders REALLY read David Ricardo and Adam Smith and then follow these centuries old guide lines for free markets. My two cents can be found here and will be extended in the future.


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