March 29, 2010 In a gesture that was symbolic of the business-endorsed reforms of the Progressive era, William Jennings Bryan hailed the passage of the Federal Reserve Act in 1913 as a "triumph for the people." His response provided a measure of the intellectual achievements of reformers in the Progressive period. Of longer cultural significance, it also illustrated how completely the idea of "reform" had become incorporated within the new political boundaries established in Bryan's own lifetime. The reformers of the Progressive era fit snugly within these boundaries -- in Bryan's case, without his even knowing it. Meanwhile, the idea of substantial democratic influence over the structure of the nation's financial system, a principle that had been the operative objective of the greenbackers, quietly passed out of American political dialogue. It has remained there ever since. Democratic Promise: The Populist Movement in America At most three dozen members of the House and Senate genuinely understand monetary policy. The system is designed that way. Constituents will come to their representative's office and say, "The Fed is closing our plants, it's crushing our farmers," and he'll say, "That's terrible, I'm with you." Then he'll take to the floor of the House and denounce the Federal Reserve in the most flamboyant language. Well, the Fed understands that part of its role in the system is to be the public scapegoat occasionally for doing things politicians would get un-elected if they did. Most members of Congress are quite unconscious of how they play out these charades. As soon as the Fed changes course and a recession begins to subside, the Congress falls silent and nothing has been changed. They haven't reformed the Fed. They haven't democratized it. They haven't pursued any of the questions their constituents wanted pursued. Until the next recession when they make the same speech again. I don't think our political leaders are going to see their way out, frankly, by reading my books, or Larry's, or by listening to our speeches. The only way you can educate them is to begin humbly in places like this by convincing average people that they're perfectly capable of taking this stuff on if they trust their own common sense and values and have the guts to assert them. If enough people begin to do that, you'll then have a voice that can speak to the system with the logic of truth. William Greider Democratic Money: A Populist Perspective Some of you are wondering where and how we find these little gems from the history of American finance, like the quotations above by Larry Goodwyn and William Greider about the nature of the populist movement and of political power in America. The answer is that IRA co-founder Christopher Whalen is finally writing a book. The working title is "Inflated: Money, Debt and the American Dream" and deals with the evolution of the politics of money in the two centuries of our nation's existence. God willing, the book will be out in the Fall published by John Wiley & Sons. This week in The Institutional Risk Analyst, we feature a comment from our friend Achim DĂĽbel on the legislation proposed by Rep. Scott Garret (R-NJ) to create a covered bond market in the US. DĂĽbel is an independent, international mortgage finance consultant and founder of Finpolconsult, a financial sector think-tank based in Berlin/Germany. He has authored several European mortgage market studies in the past 15 years and was member of the EU Commissions Mortgage Funding Expert Group in 2006. He has been continuously working on US housing finance system issues for the past 10 years. Achim recently consulted on the creation of covered bond laws in Turkey and Uruguay. Before we go to our feature, we have to take notice of the IPO last week by First Interstate Banc System (FIBK), a $7 billion asset bank holding company from Billings, MT. FIBK has evolved since 1968 from a single bank in Sheridan, Wyoming to operating 72 branches and over 100 ATMs in Montana, Wyoming, and South Dakota. And yes, FIBK does sport the old First Interstate brand which almost disappeared more than a decade ago with the merger of the CA bank that once bore that name.
Source: FDIC/The IRA Bank Monitor While FIBK shows some stress on ROE, overall it shows stress well-below industry levels. Indeed, all of the Bank Stress Index results for this subject are exemplary and indicate below-average financial stress compared with the current nose bleed average stress levels in the industry. Notice that the average ROE score for the entire US banking industry in Q4 2009 was so high that the average maxed out at 100, the highest score on our index. This is two orders of magnitude above the benchmark year (1995=1), which happens to be where FIBK's stress score is today. That's good. FIBK had almost 7% bank level tangible common equity to tangible assets at year-end 2009. The bank had 71bp of defaults in Q4 2009, half a standard deviation below the average charge-off rate for its peers. Kudos to Jim Cramer for showcasing FIBK last week. Of note to the rest of our friends at CNBC, and also at Bloomberg, etc., FIBK shows that it is possible to run a really profitable commercial bank without a trading or investment banking operation. Most of the bank's risk-based stress, which we illustrate in The IRA Bank Monitor using a classical measure known as Economic Capital, is on the treasury side followed by lending, with zero risk weight from trading since there is no trading! In fact, the risk-adjusted return on capital or RAROC for FIBK at the end of 2009 was 57%. Love it. The ratio of Economic Capital ("EC") to Tier One Risk Based Capital for FIBK is just 0.38:1, meaning that the IRA Bank Monitor says that FIBK has much more -- almost 3x to be specific -- capital than risk. JPMorgan Chase (JPM), by comparison, has a ratio of EC to Tier One Risk Based Capital of 4.7:1, meaning the computer wants to see 4x more capital than JPM has today to cover the risks taken by the world's biggest OTC derivative dealer bank. Of the $540 billion in EC calculated by The IRA Bank Monitor, more than half is attributable to JPM's trading operations including OTC derivatives. The bank units of JPM had a RAROC of just 0.2% at the end of 2009, suggesting that JPM is not generating sufficient returns given the risks taken by the bank. All we can say to FIBK CEO Lyle R. Knight and his team is keep up the good work. US covered bond legislation - Where is the promised change? Covered bonds are a proven and useful tool for supporting mortgage finance in Europe - and the Congress is right to be considering legislation to start such a market the US. But the bill introduced by Congressman Scott Garrett (R-NJ) in the House needs to be changed if it is to restore investor trust and provide needed new liquidity to real estate markets. Covered bonds work when they are simple, conservative and transparent. These principles, and not the interests of bankers or intermediaries, should drive legislative design. Covered bond laws often come from crises. The deep German real estate and banking crisis of the 1890s helped create the Pfandbriefe. The bankruptcy in the 1990s of the Credit Foncier de France, Europe's oldest mortgage bank founded in 1852 led to the Obligations Foncieres. The new laws always required very secure cover assets (high quality real estate or state guarantees) and conservative lending practices. The simple, yet clearly defined design of covered bonds limits the number of counterparties involved and keeps issuers accountable. As a result, covered bonds became attractive for generations of European investors and required no external ratings until very recently. There are varying types of European covered bonds, and they performed very differently last year. Denmark's Realkreditobligationer, a pass-through bond basically unchanged since 1850, survived the financial crisis without tapping government support. More common portfolio covered bonds require regular rolling over because of the mismatch in maturity between the cover assets and the bond; many of these ran into trouble last year. Governments and ratings agencies are taking notice. Covered bonds weren't exempt in Europe from the liberalization trend of the past decades. Issuers tried take a free ride on the existing simple and accepted bond products, introducing loans secured by movable assets or securities as cover assets. However, such departures from the basic concept of the bonds were occasional and did not alter the character of backing by either high-quality real estate or state guarantees. The key point to make in all successful covered bond programs such as Denmark is that the interests of the borrower and the investor who ultimately holds the loan, not of the banker that makes the loan and issues the bond, must be paramount. The current US proposal sponsored by Rep. Garrett, in contrast, seems to disregard many lessons learned from the financial crisis in the US proper. Garrett's proposal seems to ignore the bias for conservativeness needed to build investor trust when a new product is launched. In fact, the current covered bond proposal before the US Congress seems designed to solve a wide range of pressing asset refinancing problems facing banks, not to create a market that will last decades or centuries to come. This follows a pattern of US financial history over the past century, my friend Chris Whalen argues, where the immediate wants and needs of the banks have been put ahead of the long-term interests of consumers and investors. For example, the Garrett bill allows for an unusual menu of eligible collateral in the covered bond pool, including securities that may introduce legal and agency (rating) risk, financial assets not backed by real estate or public guarantees, and short-term assets that can be perfectly financed by deposits. Even home equity loans, a symbol of irresponsible lending practices, have found their way into the Garrett bill. The present bill leaves lending standards - for real estate and other purposes - up to the primary regulator's discretion and even allows ex-post inclusions of financial assets underwritten under historic standards. It ignores the importance of low loan-to-value ratios and specific real estate valuation standards. Clear standards have featured prominently in European legislation; they are particularly relevant for a jurisdiction recovering from the financial fallout of large residential and commercial real estate price cycles. Moreover, the proposed transparency requirements over the cover pool assets fall behind established US standards. And the absence of a clear definition of the basic asset-liability management principles renders market and liquidity risk exposure of issuer and cover pool an unknown. These issues, seemingly, are left de-facto to the discretion of his primary regulator. Precisely those aspects of bonds that proved problematic last year are encouraged or ignored by the Garrett legislation; the best practices of the Danish balance principle are unnoticed. A potentially unlimited range of counterparties involved in derivative and insurance protection of the cover translates into an ambiguous credit support structure that can vary from issuer to issuer, and is hard to analyze for investors. Bonds issued under the bill, in fact, will be closer in character to so-called 'structured' covered bonds, bonds that were created as arbitrage products in Europe allowing for lower precision of design, than to general statutory covered bonds. These hybrid bonds faced even greater problems through the crisis. Because of loosened standards on asset eligibility, risk management and counterparty selection, high amounts of overcollateralization will be required by the market to render the product suggested by the Garrett proposal palatable for investors. These loser standards promise to highly subordinate bank depositors and unsecured bondholders on the bank balance sheet, and also raise the likelihood that insufficient funding liquidity will be available to a trustee appointed in insolvency. The result is an increased reliance on, and adverse selection of, public insurers of first and last resort, i.e. the Federal Deposit Insurance Corporation and the Federal Reserve System. This reliance on federal backstops comes even though an explicit role for the Federal Reserve System in liquidity provision, such as present in the case of Fannie Mae and Freddie Mac, has been avoided until now. A bond with such an unusually high level of implicit government support will still be only mildly attractive for large, too-big-to-fail US banks who can save issuance costs by relying on unsecured bonds. However, it will be very attractive for mid-sized banks that currently face strict market discipline through the threat of FDIC intervention, including possible clawbacks of securitized or pledged assets, and by implication high unsecured and even occasionally secured funding costs. In its current version, the Garret proposal in effect promises to just extend even further the life preserver of implicit federal guarantees for the US financial system. The US would be better off with a bill that tries to truly lay the foundations for a new private bank bond market, a "gold standard" for financing retail and commercial mortgages that is based on high-quality assets and restoring private market discipline in a vital sector of the economy, namely real estate finance. Legacy problems with shaky assets of all colors of bank balance sheets should be solved via bad banks and/or bank insolvency and restructuring, not in legislation that seeks to create an entirely new secondary market for selling bank mortgages to investors. Questions? Comments? info@institutionalriskanalytics.com About IRA Products and Services IRA offers advanced analytics for risk surveillance and investment research via subscription products such as the IRA Bank Monitor for Professionals covering the US banking industry and the IRA Corporate Monitor covering public companies. For a trial subscription or an on-line demonstration, please register here. IRA Advisory Services including our channel research and diligence support services are available to qualified clients.For more information, please contact our offices. IRA for Consumers IRA provides consumers easy to buy online reports to independently check on their banks via our How's My Bank? system. IRA on Web 2.0 For updates during the week please follow IRA www.twitter.com/IRABankMonitor. The Institutional Risk Analyst is published by Lord, Whalen LLC (LW) and may not be reproduced, disseminated, or distributed, in part or in whole, by any means, outside of the recipient's organization without express written authorization from LW. It is a violation of federal copyright law to reproduce all or part of this publication or its contents by any means. This material does not constitute a solicitation for the purchase or sale of any securities or investments. The opinions expressed herein are based on publicly available information and are considered reliable. However, LW makes NO WARRANTIES OR REPRESENTATIONS OF ANY SORT with respect to this report. Any person using this material does so solely at their own risk and LW and/or its employees shall be under no liability whatsoever in any respect thereof. (c) Institutional Risk Analyst http://institutionalriskanalytics.com
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