Busted: Bankers and The Global Economy

February 25, 2008

FDIC and Careless Banking Risk

Filed under: banking, credit, government, investment, money, security — Tags: , , , , , , , , , , , — digitaleconomy @ 12:00 pm

A year ago, the global financial system was still highly liquid. Bank profits were at all-time highs. Downgrades of triple-A-rated CDOs were virtually unheard of. SIVs, mono-line insurers, municipal bond auctions, and mortgage-backed securities weren’t making the daily headlines that they are now. Everyone thought the world was “peachy keen”.

bair_sheila.jpgThe FDIC holds that the systematic breakdown in lending standards in a large segment of the U.S. mortgage market came from the bankers themselves. The FDIC considers the importance of new legislation and regulation to put a stop to abusive and irresponsible mortgage lending practices.” This statement today indicates that abusive and irresponsible mortgage practices are still in vogue. FDIC Chairman Sheila Bair stated, “We’ll need significant reforms to restore confidence in the integrity of financial markets.” First, she cited a “lack of transparency” in reference to structured finance. Bankers created new investment vehicles with unknown consequences that could not be easily resolved. In fact, the consequences of these back room deals could take years to unravel. Ms. Bair also cites “a pervasive, over-reliance on ratings and quantitative methods, as a substitute for good judgment and traditional credit discipline.”

Essentially, when bankers received a rating, they looked no further and were only concerned with the perceived profit from the transaction. Ms. Bair intimated that collateral in most of these transactions was a real issue.

If you want to analyze a rated corporate bond, for example, you can go to the SEC website and get financial statements and a wealth of reports about the borrowing corporation. If the bond is actively traded, you can check out the latest secondary market prices and volumes in the Wall Street Journal or on your Bloomberg. On the other hand, suppose you want to analyze a CDO. You might ask for a standard spreadsheet of loan-level data. But you would probably find this unavailable, even for a potential investor. And even a basic summary about the underlying collateral may not have been given due diligence or independent validation, and is unavailable to the general public.

This is the dark ages, foolish thinking that bankers bought into according to the FDIC. Information was not available on banking instruments and investors did not seek that information. They simply snapped up the investment based on the perceived ratings value and the perception of profit. Banks even assumed that they had no risk exposure because of the bond rating that the instrument had received.

The FDIC doesn’t have any hard solutions for the mess that bankers have created, suggesting that incentives are needed to make bankers follow the rules and supply collateral information rather than relying on ratings. U.S. banking regulatory agencies have agreed not to release any bank from responsibility until a complete study and review is done to provide a clean bill of health.

Sheila Bair says that this is progress. What do you think?

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