Thursday, April 28, 2016

So You Think You Can ... Run a Bank?

You’re probably not alone in thinking you could have done a better job running one of the banks.  

Now you can see if that’s true, thanks to the Banking Simulator, a creative, educational tool designed by PF2 team member Joe Pimbley.  Like a flight simulator for pilots, it will give you a chance to hone your skills in simulated, but realistic, market conditions and risk scenarios.

Bank managers and executives use models for VaR, loss distributions, economic and regulatory capital, to help with decision-making, but of course those cannot capture the human element of a manager’s decision-making process during a downturn or in reaction to a “black swan” event.
Click on the slideshow for detailed instructions
In the Banking Simulator, you'll be playing the part of the bank CEO or CFO; you'll have to make many quarterly decisions and contend with several risks to keep your bank afloat in whatever situations we throw at you... including bank runs. You decide on the level of debt and equity to issue, and the amount of risky assets to acquire. You also decide the strength of your risk management.

You must make quarterly decisions to: 
  • buy and sell risky assets
  • issue deposits
  • issue, redeem, and repurchase debt
  • issue and repurchase equity
  • pay dividends  

The simulator will show you your bank’s net income and stock price at the end of every quarter. You'll be encouraged to monitor and manage your asset-to-debt and reserve ratios, and you'll need to buffer against asset-liability or maturity mismatches.

Can you run a profitable bank, and at the same time maintain your reserve ratio, satisfy regulatory stress tests? 

Take your chances.  Let's see how resilient you can be, under changing market conditions.  Will you survive a run on the bank?

Monday, April 25, 2016

Rogue Bonds

We received a couple of calls late last week about the securitization structure (or catastrophe or "cat" bond) deal that Credit Suisse is preparing.

We haven't seen the deal docs, but from what we understand and have read, the concept is interesting:

Credit Suisse would free up some capital by insuring itself (by way of the bond sale) against certain operational risks, like fraudulent transactions, trade processing errors, regulatory or compliance shortcomings ... or the all-important concern of rogue trading, which caused JPMorgan and SocGen a pretty penny (just look up London Whale or Jérôme Kerviel).

We understand that CS would issue a two-tranche securitization, reportedly backed by a 700 million franc policy from Zurich Insurance Group.  Zurich would retain the first 10% of the risk, with the senior notes being sold off by way of a Bermuda vehicle.  From the reports we've seen, the senior notes would attach at losses of $3.6 billion and detach at losses of $4.3 bn. It's not immediately clear to us whether Credit Suisse would stomach losses above $4.3 billion, but that would seem unlikely ... we assume there's more to it than is publicly known at this time. 

Operational Risk, or What Credit Suisse Will

There are some serious questions.

It would seem Credit Suisse would have a massive informational advantage over the other side: they would know their operational strengths and weaknesses better than anybody else.   That's okay, as long as it's well understood.  

But the real questions start when there is a loss, 

Can one always put a value on the operational portion of the cost, easily separating out all of the factors?   Suppose for example that a loss is magnified as the market turns against a bank while it was slowly extricating itself from a large, unauthorized trade -- as happened in the case of JPM's London Whale?  Is that additional writedown the fault of the bank or the operational shortcoming?  How much of the supposedly unauthorized trade would have been "okay" and how much was "unauthorized"?  One issue here is that the party that knows best if probably Credit Suisse ... but it may often be a conflicted party, benefiting directly or indirectly through the decisions in makes in quantifying the losses.  

Next, the category of operational risk can be difficult to define, and items may fall in the grey zone. Might CS, knowing it has insurance, be more likely to categorize the marginal loss as operational?

And might it change Credit Suisse's approach to fixing up an issue to the extent it knows of certain insurance providers' interests or exposure?  At worst, knowing that they're insured, might they be less particular about buffering against the risk?  Could that create an adverse incentive from a cultural perspective? 

Banks might not need a second invitation!

If this all goes wrong ... we're insured!  Double down!  Lock and load!

Thursday, April 14, 2016

Goldies Sampling, and the Silver Settlement

This week has brought with it some significant disclosure on some of the forms of pre-crisis misconduct at the banks, and the first settlement of post-crisis alleged manipulation of the silver markets.

Allegations into silver and gold markets manipulation are among a string of claims made against the big banks for post-crisis benchmark manipulation -- the other well-known cases being the three exchange rate and interest rate manipulation allegations: LIBOR, FX, and ISDAFIX, the last of which survived a motion to dismiss, just two weeks ago.

Deutsche Bank has settled with the class In re: London Silver Fixing Ltd., Antitrust Litigation, 1:14-md-02573, U.S. District Court, Southern District of New York (Manhattan), but those terms have not been disclosed.

Statistical Sampling Techniques ... Gone Wrong

But the Goldman Sachs settlement (a headline settlement amount of $5.06 billion) for what the Justice Department calls "serious misconduct," provides some real insight into the artful approach taken to mortgage sampling for residential mortgage-backed securities (RMBS).

Imagine you wanted to get an idea of the quality of teachers at a school you're considering for your kids.  The school chooses a sample of 100 teachers, removes the 90 worst ones, and presents to you the 10 most credible, as if they were randomly selected to fairly represent the whole group of teachers.

Well that's pretty much what several of the big banks did.  They sampled the mortgage loans under consideration for inclusion in RMBS transactions.  They kicked out some (or perhaps all) of the non-compliant ones in the sample, and then they presented the cleaned-sample as if it represented the entire pool.  

Among the problems was that the samples were not very big.  So if half of the loans are non-complaint (say 50 out of 100), and you sample only ten percent (say 10 out of a 100) ... and then you kick out 5 from those 10, well, there are still 45 non-compliant loans (half of the unsampled 90 loans) going into the pool!

We wrote about this revelation/absurdity back in 2011, just after the Financial Crisis Inquiry Commission released documents showing this incredible pattern.  (You can read our report here, or below.)

The language in Monday's Statement of Facts is additive, and confirms some of the worst suspicions that come from documents provide by Clayton to the FCIC.  Here are some choice snippets: 
"Even when the percentage of loans graded as EV3s and dropped by Goldman from the due diligence samples indicated that the unsampled portions of the pools likely contained additional loans with credit exceptions, Goldman typically did not increase the size of the sample or review the unsampled portions of the pools to identify and eliminate any additional loans with credit exceptions."
"The Mortgage Capital Committee also asked “How do we know that we caught everything?” In response to that question, the Goldman due diligence employee who oversaw the due diligence for one pool of loans purchased from SunTrust Mortgage wrote “we don’t[,] it was sampled w[ith] max at 20%- the drops were a result of timing not systemic issues with SunTrust.” Another Goldman due diligence employee who oversaw the review of a pool of Countrywide loans that Goldman had purchased on March 29, 2006 responded to the same question: “Depends on what you mean by everything? Because of the limited sampling on CW 10-15% we don’t catch everything and the way they [Countrywide] deliver the files we have little chance to upsize. This trade had issues with aged loans and we tried to get pay histories and were told they would not provide them.” In response to the Mortgage Capital Committee’s question “Are these results systemic,” the same employee wrote: “Every trade varies, but typically CW have a very high credit 3 drops on the first review of DD 60% and then clear the docs, so one can assume that the files we are not reviewing would have the same issues.”"
"In April 2006, the Mortgage Capital Committee received a memorandum with a highlevel summary of Goldman’s due diligence results in connection with a proposed Alt-A RMBS offering. The memorandum included aggregate due diligence results for three Countrywide loan pools that Goldman had purchased on March 30, 2006 and indicated that 34.38 percent of the loans in the proposed offering had been drawn from certain of those Countrywide loan pools. The memorandum reflected that Goldman had conducted credit and compliance due diligence on a total of 15.44 percent of the loans in the three March 30 Countrywide pools. ... The memorandum also stated that Goldman had dropped a total of 6.07 percent of the loans in the three Countrywide pools (not the samples) for credit or compliance reasons. Across the three Countrywide pools, Goldman dropped nearly 40 percent of the loans in the credit and compliance due diligence samples for credit and compliance reasons. The memorandum referred to this as an “exceptional drop amount” and stated that “in the case of [Countrywide], an unusually high drop rate for missing or deficient documents resulted in an above average total drop percentage (approximately 33% of the credit drops were due to missing appraisals).” Contemporaneous records reflect that Goldman closed on six Countrywide loan pools on March 29 and 30, 2006, and that Countrywide was struggling with staffing and workload issues that affected its ability to deliver missing documents requested by Goldman for the loans in those six pools."
"Although Goldman dropped 25 percent of the loans in the due diligence sample because they were graded as EV3s, including all the loans graded as EV3s for unreasonable stated income, which comprised at least 2.5 percent of the loans in the due diligence sample, Goldman did not review the portion of the pool not sampled for credit or compliance due diligence, which comprised approximately 70 percent of the total pool, to determine whether there were similar exceptions in the unsampled portion. Goldman subsequently securitized thousands of loans from this pool into one GSAMP transaction. The Mortgage Capital Committee approved the issuance of this offering."

Our report from 2011 can be viewed here:

For an update on the current status of alleged benchmark-rigging antitrust cases, see Alison Frankel's blog, here.

Monday, April 4, 2016

Sydney, Australia

We're thrilled to have launched an office Australia, and to welcome Chris Coleman-Fenn to the team.

Chris is a math whiz, and we look forward to entertaining blogs coming out of him in the near future.

If you're in Australia, give us a shout.  ~ PF2