future valuations of too-big-to-fail banks

[SharperDingaan]

Dwy000: Agreed re the credit risk inclusion in Basel II & III, but they were baby steps.

 

The gaming around credit related regulatory capital needs regulation, & it needs to go the risk drivers. You mentioned that not all sovereign risk is the same, & that a bankrupt bank shouldn't be able to write-up its equity. We would add that bad asset repo's over period ends should be excluded, most securitizations should be treated as recourse, and all (OTC & market) net derivative exposure should carry a capital requirement based on the counterparty's capital ratio (published monthly by Basel).

 

If you did this now, it would instantly shut down Euroland. You would also kneecap the unregulated hedge fund industry - as any time the hedge fund industry is a counterparty, a Basel regulated bank would have to hold capital against it. Were Basel to make the capital requirement on a hedge fund counterparty higher than a bank, Basel would force the unregulated hedge fund industry into the regulated bank world. Big, bad, & ugly - but largely enevitable.

 

Basel is a phazed-in approach for a reason. Protagonists may be able to resist change today, but at some point their bargaining power will weaken - & the noose will tighten. Basel IV as version 1, version 2, etc.

 

SD 

 

   

 

   

   

[dwy000]

Sharper - agree on most of your point.

 

For hedge funds, I'm not sure it would change much (they already are charged higher capital as they need to be internally rated just like the banks - although depends on what they're rated).  Virtually all derivative trading with hedge funds (and interbank) is done on a fully or over-collateralized basis and Basel II capital weightings net out cash/treasury collateral so the risk and capital there is much reduced.  Interestingly the bank losses on hedge funds have been minimal since the lessons learned from Long Term Capital (LTCP refused to post upfront collateral) and held up very well during the market meltdown.

 

My personal concern on the trading side is more due to the rehypothecation of the collateral as proven out by MF Global.

 

I still contend that investing in banks is a black box and you should focus on management not assets.  You'll never know what youre getting so better to bet on the jockey than the horse.

[Rabbitisrich]

There is a provision that attaches a CVA capital charge to counterparties based upon a CDS derived change of expected loss. That looks a little procyclical to me as well, but I guess it depends on how you view the CDS market (there doesn't appear to be a liquidity or volume check). It also provides a major incentive to put everything through clearinghouses, although red flags should go up any time the market "craves" a risk-free pivot. This time it was the financial guarantors and NRSROs, but credulousness on a global financial scale is creepy wherever it is applied.

[vinod1]

 

The banking system today has not been reformed.  That doesn't mean the banking system isn't healing or the consumer isn't healing.  Nothing of the sort.  But what it means is that these major bankers are waiting for the music to start again.  People hated the music from 1930-1980.  But today's banker and consumer can't wait to hit the dance floor again.

 

I am with Klarman on this one.  Unlike GD, the GR has not been a good teacher.

 

I do not think we would be able to say if the banking system has been reformed until after another 10-20 years. I can give some anecdotal evidence that it is more likely that enough changes have been made to make the financial system pretty robust

 

1. Where I work, we are spending just under $200 million for Basel 2 compliance. This amount is not to shore up capital but to strengthen the control and risk management systems and to ensure that the data we report is accurate. Company is absolutely fanatical about making sure that there are 2-3 levels of checks and balances along the whole chain. This is pervasive across multiple dimensions in the type of data we look at, the risk models we use, etc. Always the concern is what can go wrong? We built a castle, we have a moat, we filled the moat with dangerous reptiles yet it seems it is not sufficient. We are populating the perimeter with fire breathing dragons.

 

We are in close contact with regulators and they are being fanatical about putting all the right controls.

 

2. I recently moved to a new house and when I tried to order cable, they did a credit check, and not satisfied they wanted the lease agreement. When I sent them the lease, they found a minor error in the lease agreement and asked me to correct the lease agreement before they process the order! I have very good credit history but the Cable company wanted to make sure that the lease agreement is corrected.

 

We have come a long way from no doc loans of $500K to a legal team scrutiny of a cable order with a a monthly bill that is around $150!

 

3. I took a loan on a car just to get my wife's credit history built up. It is a joint loan from a credit union in which I had a bank account for 17 years. The has my direct deposit of my salary for the last 14 years and cash on hand in the checking account has averaged twice the car loan for many years. Yet it took me heck of lot of documentation just to get the loan approved. I had to talk 4-5 times with the loan officer before the loan got approved.

 

This leads me to believe that people have probable gone to the other extreme. Dexia and MF Global seem to point otherwise but I think those are much different and do not reflect what is going on in the broader financial world.

 

Vinod

[Rabbitisrich]

Vinod, do risk management teams improve the culture of a company despite optimism regarding collateral and capacity, or does optimism induce management to reap profits in spite of risk management teams? At almost every major institution related to the crisis, some mid-level people spotted risks. Paulson even recruited a Bear Stearns executive to oversee the construction of his swaps!

 

Unless the automated risk management controls buffer optimism and exuberance, they simply work until they really don't. The more faith people put into the an automated procedure--a few people have already noted sovereign risk-asset weightings--the crazier the downside.

 

Basel III, in its current form, should make people bullish on the NRSRO system.

 

[treasurehunt]

why higher x? I think big banks will become more like utility companies in the future?

 

Is it unreasonable for a utility-like business to have a P/E of 12-13? Here's a list of all the utilities in the S&P 500 that have positive earnings and their P/Es according to Yahoo.

 

AEE: 13.98

AEP: 10.30

CNP: 5.90

CMS: 13.54

ED: 15.84

CEG: 19.43

D: 19.22

DTE: 12.31

DUK: 15.09

EIX: 13.15

ETR: 8.90

EQT: 17.34

EXC: 11.83

FE: 17.62

TEG: 15.27

NEE: 15.71

AGL: 15.52

NI: 20.06

NU: 14.85

NRG: 15.71

OKE: 26.68

POM: 16.10

PCG: 15.24

PNW: 14.91

PPL: 10.86

PGN: 20.74

PEG: 11.07

QEP: 15.10

SCG: 14.29

SRE: 9.36

SO: 18.06

TE: 14.05

WEC: 14.31

XEL: 15.06

 

A large number have P/Es in the 13-16 range. This may go down somewhat in a higher interest rate environment, I assume. Still, a P/E of 13 seems reasonable.

 

This article has a chart of historical P/Es since 1993 that indicates that 13 is on the lower end of P/Es for utilities: http://seekingalpha.com/article/288627-a-look-at-historical-sector-p-e-ratios. But you can certainly argue that post-1993 is not a good reference period.

[vinod1]

Vinod, do risk management teams improve the culture of a company despite optimism regarding collateral and capacity, or does optimism induce management to reap profits in spite of risk management teams? At almost every major institution related to the crisis, some mid-level people spotted risks. Paulson even recruited a Bear Stearns executive to oversee the construction of his swaps!

 

Unless the automated risk management controls buffer optimism and exuberance, they simply work until they really don't. The more faith people put into the an automated procedure--a few people have already noted sovereign risk-asset weightings--the crazier the downside.

 

Basel III, in its current form, should make people bullish on the NRSRO system.

 

Do not disagree at all. I do not have much faith in automated systems for risk management. My point is more around the intensity and focus that is being put on risk management. Previously focus used to be on growth, now it is all about risk. I am saying optimism is in retreat at least anecdotally.

 

Taleb had a very good article called "The black swan of Cairo" http://www.fooledbyrandomness.com/ForeignAffairs.pdf.

 

Vinod