Fiduciary responsibility

Rightly, I think, we've focused heavily on the role of the regulators in this financial crisis, pointing to their considerable failures.

An unlikely ally now comes in the form of Kenneth Clarke MP who, in the Independent on Sunday today has harsh words for the tripartite system of regulation between the Bank of England, the Treasury and the Financial Services Authority, which took away the Bank's supervisory powers.

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Another day, another admission

Typically, the journos miss the point, although this article is by Richard Spencer - a China hack, not a financial specialist. However, because Howard Davies, former head of the Financial Services Authority, is speaking in Peking – no doubt after flying out first class and being put up in a five star hotel – his views are reported by Spencer, who focuses on Davies's comments about Iceland.

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Totally unaccountable

Rather than taking the responsibility of commanding a ship, clearly it is better to be an anonymous banker on an international committee making the rules if you mess up. That way, not a hair on your head is disturbed and you glide effortlessly on, safe in your anonymity as your monthly salary cheques continue to flow.

And there is not a single politician , journalist or commentator prepared to do a thing about it. Thus are we betrayed.

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Something of an enigma

Members of Parliament are often referred to by the generic name "lawmakers", especially by news agencies such as Reuters. You would have thought, therefore, that they and the political classes would be interested in how the laws of this land were made.

You might also think, with some justice, that they would be interested in the philosophy of regulation, and whether their laws actually work. Since, in theory at least, they make the laws, they do have a professional interest in the subject. Strangely, though, this does not seem to be the case.

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We need an inquiry

Six days ago, I wrote on this blog these words:

The financial crisis in which we are presently engulfed was a "disaster waiting to happen". This is the final chapter in an inevitable, but wholly avoidable disaster that involves primarily a complete breakdown in the structure of our law, and its enforcement. In short, what we are experiencing is a major regulatory failure, possibly the most serious and expensive in the history of mankind.

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An "Enron" speech

Mr David Cameron has delivered a speech, heralding "The Conservative plan for a responsible economy". Parts of it are good – some of it is very good, very good indeed. However, good or bad, in 4,956 words, there are two words missing: "European Union". Nowhere in this wide-ranging speech can those two words be found.

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The man who knows?

Normally, after "deep immersion" in a controversial subject, some clarity begins to emerge and the arguments begin to settle. However, several weeks into the deep crisis phase of this financial nightmare, the issues are no clearer. If anything, they seem even more obscure, with crucial aspects entirely unresolved.

In many respects, this should not be surprising. Not only are we reaching into the depths of banking theory which, frankly, very few people understand – or ever will - we have the overlay of highly complex regulatory systems framed at national, regional and global levels, together with national and international politics and, of course, the drama of the events themselves.

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Cracks beginning to show?

Headline reports from the Paris "summit" – this one of the 15 eurozone members plus Gordon Brown and "hangers on" like Barroso – speak of "a plan to confront the financial crisis which will involve hundreds of billions of dollars of new initiatives to head off a feared 'meltdown'".

Thus we hear of Sarkozy saying that governments would "buy into banks to boost their finances and guarantee inter-bank lending." "The EU,” we are also told, "will ask the United States to help organise an international summit to reform the global finance system."

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They’ve known it all along!

As we previewed last night, we have discovered cast iron evidence that the EU commission has known for at least a year that there have been disastrous "shortcomings" in its system of financial regulation. This system include the measures for the application of the "mark to market" rules which lie at the heart of the current banking crisis.

The commission has also known that changes to the system were urgently needed to prevent a repeat of the "market turmoil" of the summer of 2007. Yet, despite a massive effort to produce new rules, it has only just been able to deliver drafts of these vitally needed changes.

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The blind will not see

You really have to give it to Charles Moore in his column today. He has really excelled himself – in his blind, vapid, malign stupidity. It transcends all his previous efforts and stands as a towering monument to the blindness of our political classes (of which he is a fully paid-up member).

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Smoking gun II

This blog has discovered incontrovertible evidence that the EU commission has known for at least a year that there have been disastrous "shortcomings" in its system of financial regulation. These include the measures for the application of the "mark to market" rules which lie at the heart of the current banking crisis.

The commission has also known that changes to the system were urgently needed to prevent a repeat of the "market turmoil" of the summer of 2007. Yet, despite a massive effort to produce new rules, it has only just been able to deliver drafts of these vitally needed changes.

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The driver quits the train

The real experts in the business seem to be saying that the thing to watch as this crisis unfolds is the inter-bank lending. It is, after all, the seizure of the credit market that is at the heart of the problem.

In this context, an index that, if we were honest, very few of us knew much about even a few days ago, suddenly assumes crucial importance – that is the Libor (London interbank offered rate).

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Hic sunt dracones

This is not good. In fact, it is double-plus ungood. The situation is seriously unravelling. Little Gordie's EU-approved rescue plan is about to come unstuck.

This might explain why he has written to "EU leaders" to urge them to follow Britain in guaranteeing inter-bank loans, proposing a "European-wide funding plan" to help ease the financial crisis.

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Children at play

A day after the government had announced its bank rescue plan, the Taxpayers' Alliance (TPA) has come up with a report, trailed on its website, telling it what it should have done.

Rightly – although a bit late coming after the event – the Alliance suggests as its very first item that the government should consider, "Suspending mark to market rules that cannot function effectively in the absence of a liquid market for many key assets." Helpfully, it also supports its argument by telling us that had these rules been in place during the 1980s, all ten of the largest US banks would have become insolvent.

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A fascinating insight

Jon Moulton, managing partner of Alchemy - the private equity company – has written a piece for The Daily Telegraph on the financial crisis. His opening thesis is that the banking rescue package "seems to be probably too little and very definitely too late", but the fascinating part of his article is where he asks, in respect of the banking crisis: "Who was guilty of inaction?"

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It ain't working … yet

If the point of yesterday’s "rescue" was to ease liquidity in the banking sector, it has not had any discernible effect on the all-important Libor (London inter-bank offered rate). According to Bloomberg, the Libor dollar rate has jumped to the highest level in the year and the credit is staying frozen.

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The politics of denial

An overnight communication from a trusted source - very close to the "horse's mouth" – put the final pieces into place.

It confirmed beyond any doubt that the UK's bank rescue plan was not a unilateral action but – as we had suspected – part of a carefully structured and co-ordinated plan devised at Ecofin, building on the foundations laid at the "summit" in Paris on Saturday.

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God help us!

No wonder we are in such trouble. It is more than a week since David Cameron stood in front of his audience in Birmingham and declared that one of the main problems in the financial crisis was "a new international accounting regulation called 'marking to market' [which] automatically downgrades the value of banks."

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Oh shit!

"We face extreme danger. Unless there is immediate intervention on every front by all the major powers acting in concert, we risk a disintegration of global finance within days. Nobody will be spared, unless they own gold bars."

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The story so far ...

In what has been a roller-coaster and exhausting week, we've got to a position where we've got part of the story – not the whole story, which is far more complicated – but enough of it to make sense.

Through this blog, in no less than 20 posts since Saturday week last – listed here (with links in chronological order), when we cranked up our coverage of the financial crisis, some of the story gradually emerged.

Now ...

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Which begs the question; How long can the Euro survive this storm and if the Euro goes does the EU go too?

"Economics – so some claim – is a science. Banking is not. It is more of a black art, and the two should never be confused."

Economics is not even vaguely a science. The idea is ridiculous, though one that is widely spread by its more arrogant practitioners, and the waves of little MBA-droids who seem to think that their MBA coursework is holy writ, graven on tablets of stone.

The most damaging sort of theoretical economists are the mathematicians manque, who think that writing a lot of equations is some sort of proof of their intellectual wonderfulness. Real mathematicians avert their eyes in horror from the complete lack of rigour.

The most damaging part of this ridiculous idea, and the one most responsible for the current problems, is the idea that all financial market movements are a random walk based on some variation of a Gaussian probability distribution. Over the last deade or so, use of these random walks has moved beyond simple derivatives - puts and calls on forex rates, or share prices, for example - to being used for credit pricing.

In particular, via these daft 'Value at Risk' models, they have been enshrined in bank regulation via the Basel agreements.

The MBA-droids like to stick with the Gaussian distribution because it is analytically tractable - i.e., it is relatively easy to differentiate, and generally chop and change, and produce variations on a theme. The end product of all this is usually something based on the probability of an event happening at the far end of the bell curve. This is interpreted as either the price of credit insurance, or "an event this extreme will only happen once every 500 years".

The trouble is, financial market movements are not distributed according to a Gaussian distribution; they display far higher kurtosis : extreme events happen much more often than a simple Gaussian would lead you to expect. We're in one now ...

Banking used to be a black art, in that it was all about the exercise of individual judgment, at all levels of a bank, in lots of different banks. In recent years, that individual judgment has been subordinated to the diktats of an intellectual monoculture based on these idiotic economists' ideas. The very basis of a random walk - the net effect of a large number of independent random variables - has been replaced with a large number of droids marching in line, leading to our current state.

Bring back the black art, say I. It was not perfect, but it was much better than the monoculture.

With regard to your EU thesis, Richard, even without the EU, we would probably have been dragged into the whole damn fool over-regulated Basel business. But I am sure you are right that EU inertia will make it much harder to drag ourselves out again.

I was, of course, being deliberately provocative suggesting that economics was a science ... bit like sociology really ...

And I am sure you're right about Basel 2. It most certainly would have been adopted with or without the EU. British were lead players in getting the standards into place. But you have exactly defined the position. Now we are in a mess, the EU involvement makes it very difficult for us to get out of it.

That is the real story.

Hey, HarryR, That was a superb rant. Thank you. I really enjoyed it. You and I share an astonishingly similar view here [Prejudice? Ed. NO. JA.]. Excellent.

Q: "What about those outliers?"
A: "No problem at all. We just ignore them."

The mark of such 'scientists' is that for them tractability always trumps reality if the two conflict, otherwise they've got nothing to show.

I haven't seen it stated like that before but your comment on the existence of this monoculture is well worth noting. It sharpens things in the mind's eye very very nicely.

Well said.

P.S. You might add that their notation is phcking ugly too.

I'd suggest a similar thing has happened in our judicial system. Juries, while imperfect, nevertheless provided a flexible organic response to the cases before them so bad laws could be circumscribed by precedent to limit their damage. Now the judiciary take it on themselves to mindlessly follow directives from on high, even to the extent of doing Wrong in the name of the law.

Ah, some Mandelbrot fans perhaps? http://www.sciam.com/article.cfm?id=mul ... all-street

Harry R.

I second John a superb rant.

But that is only part of the problem, as although the mathmatics were horribly flawed, it was the greed culture that happily overlooked any warnings. Those products were able to generate such fantastic upfront fees, that all common sense was thrown out of the window, in the desire for bonus'. There have been and are plenty of mkts that are invariably illiquid, which could have been used to test those risk models, but they would have shown up the flaws, that was not what the bankers wanted to hear.

Plus there are also the well known risks attached to Daisy Chain mkts, but if the OTC derivative mkt, was not a Daisy Chain mkt, the lawyers would not have received any fees...Everywhere you go in this saga, self interest trumped, common sense.

As to Mark to Market.....removeing it will not be the panacea that those who advocate it, think it will be. The biggest problem out there, is the lack of trust between counterparties, due to not knowing one anothers financial health, removeing Mark to Market will only worsen that situation. Though if it was the solution, Dr North is absolutely right the EU's sclerotic decision making process, would make it all far worse.

Somehow the Toxic deals have to be taken off the banks book, or garanteed, then the system will unfreeze, which is what the TARP plan is intending to do, though removeing Mark to Market might undo that gain......but on removeing the Toxin, the EU/Europe is silent.

I think one has to distinguish between past and present, and between causation and perpetuation, as this crisis moves to a new phase. The causes of the crisis are now well documented but the bulk of the original toxic debt - the worst of it - has already been written off.

The current problem, as I see it, is that the market has over-reacted (as they tend to do) and the current debt, relying on the mark-to-market system and the Basel II risk assessment model, is now chronically and artifically under-valued. Thus, the market is undergoing a massive liquidity crisis, which is clogging up the system.

Injecting relatively small amounts of fresh liquidity into the market is hardly going to have an effect, when the sclerosis affects assets worth many times more. That is where the logjam arises and, until that is sorted out, we are not going to see much movement.

Any idea where the switch from Mark-to-Model to Mark-to-Market originated and with whom?

Somebody suggested today (in a Norwegian news site) that it was the banks themselves that lobbied for the switch.

Having manipulated models for years in order to award themselves record bonuses they could see the writing on the wall and pushed for Mark-to-Market in order to bring it all crashing down at breakneck speed with the expectation of government bailouts. Once the bailouts are in place the cycle can begin again.

Why preside over a gradually worsening situation over many years (without bonuses of course) when you can clear the decks with one fell swoop and start again?

Any thoughts?

I think HarryR has got part of the story in his comment.

viewtopic.php?p=72599#p72599

The "industry" was split down the middle. The "old guard" hated the idea but the wizz-kids and the tranzies went for it. I got an e-mail from a very learned professor yesterday saying that the accountants opposed it almost to a man, but caved in under great pressure, for the sake of "international harmonisation".

It seems that this was one of those obsessions which worms its way into the system every now and again and, once lodged, is impossible to remove - a bit like herpes.

for those of us who are not au-fait with accounting terms, can someone explain , in laymans terms , what "mark to market" is, and how it differs from "mark to model"?


( perhaps an EU Ref glossary might not go amiss? )

great work by the way on covering the financial crisis - you sure are linking the strands together that no MSM outlet is doing - with the exception of Booker in the Telegraph.

(which is why my first port of call for my news fix is always this blog...)

Mark to market ...

http://en.wikipedia.org/wiki/Mark-to-market

Mark to model (also known as Enron accounting)

http://www.amex.com/servlet/AmexFnDicti ... tleid=3916

As a general rule, I tend to assume readers will google any terms with which they are not familiar. I really don't want to clutter up posts, as they tend to do in the MSM, by treating their readers like morons (even if some of them are) and explaining every technical term, each and every time it is mentioned in a new story.

Mark To Market: What can I buy/sell the position for now, though often ignores the fact that the price for 10 will be widely different or even unobtainable for 10,000 or so, i.e. liquidity/depth of market is ignored. Also, for many positions held by banks/funds, these are customised legal agreements between two or more parties (OTC = over the counter, as in not off the shelf) and their is no reason to suppose any other party would be similarly inclined.

Mark To Model: The price output from a mathematical model, possibly an order of magnitude more sophisticated than implied by HarryR on Sun Oct 05, 2008 7:40 am, which in theory has as input the current state of the market and typically assumes that the market will absorb a buy/sell order of any size without affecting the price.

For a broader viewpoint see perhaps half a dozen articles at http://globaleconomicanalysis.blogspot.com/ or http://market-ticker.denninger.net/

This current siuation and the twelve steps leading up to it were largely predicted in February 2008 by Nouriel Roubini http://www.rgemonitor.com/redir.php?sid ... cid=244929