JC Flowers, the Private Equity house based in New York, has agreed to pay GBP50m for a 49% stake in a Joint Venture with Kent Reliance Building Society (KRBS).

Does JC Flowers see KRBS as a major business opportunity? Hardly, because KRBS has only one branch and 45 employees. So it is definitely not in the multi-billion dollar league in which JC Flowers normally plays.

No, JC Flowers has done this deal for one reason only – to get cheap, fast access to a banking license. Whilst the “Grumpy Old Men” (Peston’s name for the group of banking industry veterans who have clubbed together to form a company to buy bank branches which the big4 are being forced to sell) are applying for a license from scratch (although with special dispensation from the UK Financial Services Authority which allows the group to bid for banking assets at the same time – so the outcome of the license application is pretty clear), JC Flowers has bypassed this.

A UK banking license is a valuable commodity. Under EU legislation, banks are now able to “passport” the licenses throughout the EU, obviating the need to apply for a license in each member state. So the moment the JC Flowers / KRBS deal is closed, JC Flowers is able to use this vehicle to provide banking services throughout the EU.

Should banking licenses be available in this manner? Or should there be a requirement that any significant change in shareholders or executive officers triggers a review of the license, and possibly a requirement to repeat (a subset of) the application process, forcing would-be bidders to think very carefully?

For sure the banking regulator can revoke a license, but this is a very serious and very public course of action, and exposes the regulator to unwanted public scrutiny of its approach. Refusing to grant a license initially, or postponing this until further requirements are fulfilled, is much easier.

Here at Vox Sapiens, we have concerns that there is a route to bypass the hoops that must be jumped through to obtain a banking license, thereby increasing the risk of problems in the banking industry. And we know what havoc these can cause.

The European Union parliament will vote next week on new legislation to curb bankers’ bonuses. The rules on bonuses are included within a larger proposal on capital requirements. According to the Financial Times, ‘lawmakers and EU officials welcomed the agreement and said it should help to reduce the “bonus culture” in the banking sector.’

Well here at Vox Sapiens, at risk of repeating ourselves (see Bankers’ bonuses – wrong target) we think the bonus culture should be increased, not reduced. This is because a properly designed bonus structure should align a banking employee’s goals with those of the employer. The problem is not one of a bonus culture, it is one of misalignment.

First, let’s consider where we find the most extreme bonus cultures. Is it in banking? Absolutely not. Instead, take a look at the “little man in the street” (or “little woman” – for reasons of brevity I will use only the masculine henceforth, but references to males should be read as equally applicable to females) that the authorities believe they are protecting by reducing his liability to bail out banks. Let us assume that this “little man” is self employed. So this “little man” generates business, performs some services, and receives payment. The business therefore generates a profit. How much of this profit is attributable to the “little man”? Well clearly, in the case of a sole trader, 100%. And for the vast majority of small limited liability businesses, also 100%.

Now let’s think about bankers. Typically around 50% of a bank’s profits are paid out to employees.

So where is the bonus culture strongest? Actually in the hundreds of thousands of “little men.”

So all this hot air about the banking bonus culture is completely wrong.

What is wrong, is the misalignment – paying bonuses from non-existent profits (not possible in the “little man” scenario), and/or developing bonus calculation mechanisms that reward employees for taking risks where the employee’s downside does not balance his upside (possible to a degree for the “little man” although the typical downside might be bankruptcy, which is far worse than being fired).

There will continue to be a clash while politicians and mandarins continue to pander to barely-informed populist agendas and rail against the bonus culture per se, rather than work on a serious framework to induce alignment between risk-based performance and reward.

The US Senate has started to debate the Financial Reform bill. This bill proposes the most sweeping changes to US (and, therefore, global) financial markets regulatory practices since the Great Depression of the 1930s.

So one might think this an extremely important bill, right? So all the Senators have read it? Dream on!

The bill presented to the Senate is 1,300 pages long. How many people will read all of it? And even those few souls who do manage to read all the way through, will they really digest it, thoroughly, all of it? Of course they won’t.

So here we have what is possibly the most important piece of legislation relating to financial services for decades, and nobody fully understands it. Isn’t that frightening?

Perhaps in clauses hundreds of pages apart there are disparities that will keep lawyers employed for years.

In addition to its length, another problem is the breadth of the subject matter. Whilst all of the bill relates to financial markets in the broadest sense of the word, there are sections that are barely related to each other. A key risk here is that concessions and watering-down will be agreed in one section in order to gain support for a completely unrelated section. So, for example, the agreement to the derivatives section might affect regulation of deposits, or comments on naked insurance might impact international wire safeguards. These are just possible examples, the Vox Sapiens team hasn’t read the bill.

The US has an opportunity to show real leadership to the world here. It should cut the bill up into smaller sections that allow proper understanding of the consequences of each clause.

As Tolstoy said: “There is no greatness where there is not simplicity.” Is there greatness in this bill?

Let us hope that debating this bill doesn’t encourage many Senators to snore so that others can fleece us.

The Icelandic Special Investigation Committee (SIC) yesterday (April 12th, 2010) delivered its report on the collapse of the three main banks in Iceland. It makes shocking reading.

It can be downloaded here.

At Vox Sapiens, our initial vision was of a couple Escher’s masterpieces.

“Ascending and Descending” depicts a monastery where half the monks are forever walking upstairs and half are forever walking downstairs.

“Waterfall” depicts a perpetual motion machine in which water runs forever downhill.

The business empires of the owners of the three large Icelandic banks – Landsbanki, Glitnir and Kaupthing – allegedly demonstrate similar features.

The banks’ owners are alleged to have borrowed money from their own banks, and to have used some of this money to buy shares in the banks, resulting in an increase in the share price. The SIC refers to this as “weak equity” and it grew to represent more than 25% of the banks’ capital base.

These shares were also used as collateral against loans, further leveraging the banks’ positions.

And the growth of the banks was out of all proportion when compared to the Icelandic economy and the ability of its officers to supervise the banks.

In seven years the banks grew to twenty times their size until their debt issuance exceeded the GDP of Iceland and grossly distorted the requirement for foreign currency reserves. The writedown in the value of the banks’ loans in 2008 was the equivalent of five years GDP.

At the same time, a country of only 320 000 people was not able to provide a sufficiently large and experienced banking oversight regime to handle three large banks.

Finally, there appears to have been insufficiently long arms when lending contracts were established. Not only were loans provided to the banks’ owners, but also to the owners’ other businesses. These other businesses also pledged icelandic shares when borrowing from foreign banks. As the icelandic share prices fell, the icelandic businesses had to repay the foreign banks, and the icelandic banks stepped in to replace this debt, further leveraging the icelandic economy. The SIC summary presentation at the press conference states that “these investment companies had an abnormally easy access to loans in the banks in the capacity of their ownership and influence within them.”

A sorry state indeed.

Note: These images are available for commercial reuse.
Ascending and Descending search
Waterfall search

They can be obtained from:
Waterfall: http://picasaweb.google.com/lh/photo/36X8UHueP5H6pycVt_JBEA and
Ascending and Descending: http://picasaweb.google.com/lh/photo/gwkazaD_DWA9EyY3W0LyfA

The recent financial crisis was exacerbated by several failures, one of which was poor risk management by banks. Previous attempts to coerce management into being more responsible have failed. How about this approach?

In principle, fining companies for risk management failures is not very effective. A fine is a one-off that can be explained as such and the magnitude is of minor importance because financial accounts can be presented excluding the effects of the fine.

However, an alternative approach would be that the capital adequecy requirements of companies are affected by the results of risk management failures. The Basel requirements calculation could be modified to include factors to compensate for poor risk management (evidenced either through the identification of weaknesses during an audit or through the manifestation of a failure).

By forcing banks with poor risk management to hold more capital, this introduces a market adjustment and puts such banks at a competitive disadvantage, thereby encouraging better risk management.

Furthermore, this approach would embody the “prevention is better than cure” principle by improving risk management before banks got into serious difficulties rather than adopting some of the ring-fencing techniques (such as the currently fashionable contingent capital approaches) to prevent contagion and systemic failures.

There would be some pre-requisites for this approach, including:

• improvements in regulatory competence – the failure of the regulators being another reason for the magnitude of the financial crisis
• clear guidelines for assessing the severity of risks to make sure that the capital surcharge penalty was appropriate for the crime
• detailed modelling to ensure that banks cannot game the rules and continue to allow weaknesses because fixing them costs more than the cost of holding the additional capital

So how does this proposal differ from (UK Financial Services Authority Chairman) Lord Turner’s capital surcharge for risky banks proposal?

Well firstly, I should say that the approaches can work together. In fact, they should work together.

The emphasis of the UK regulator’s proposal is a bank’s strategy – additional capital is required in order to engage in risky activities. What Lord Turner’s approach does not cover is banks’ capabilities to manage the risks in these activities. In effect it assumes that all banks are equally competent at risk management.

However, this is clearly not the case.

So the Vox Sapiens proposal suggests that risk management competence is also measured and used to compute an appropriate capital requirement.

During the last few days many of the large Investment Banks have announced staff bonuses. And in many cases these have been at, or near, record levels. This has led to public outcrys.

As a response, some governments have announced special taxes on these bonuses. And the triumverate of governments, central banks, and financial services industry regulators have all railed against the bonuses.

But why are the bonuses so high? Who should be the real target of the outrage?

Well unless you are a shareholder in one of these Investment Banks, it should not be the bankers. Bankers’ bonuses are just a transfer of wealth from Investment Bank owners (shareholders) to employees (bankers). Other than a miniscule drip-down effect introduced by higher earnings and dividends, there is no impact on the economy. And like all employees, all that the bankers are doing is getting as much out of their employers as they can do. This behaviour affects the average man in the street far more when sports stars do it (leading to higher and higher prices for admission tickets and replica kits) than when bankers do it.

But what allows bankers to demand such hefty bonuses? Extraordinarily high bank profits.

Just a year after virtual doomsday, and a blood-splattered Wall Street, Investment Banks are making hefty profits again. Why?

Because making profits in the last few months has been easier than taking candy from a baby.

Firstly, interest rates have been kept exceptionally low – near-zero in many developed economies. As a result, banks have been able to borrow costless money. And have banks suffered the same credit squeeze as other business? Not the big ones, not on your life. They have had money thrown at them in order to prime the pumps of the world’s economies (a task in which they failed, but that’s the subject of another post).

And secondly, banks have been handed “get out of jail free” cards on their bets that went wrong. Banks have been able to sell their toxic assets at prices higher than they could get in the market (i.e. more than they are worth, the difference in price being risk-free profit).

And who have been responsible for creating these über-benign conditions? Our good friends the governments, central banks and regulators.

No wonder they are so keen to keep the attention on the bankers’ bonuses – it deflects attention from the banking profits that they have helped create – the real transfer of wealth from the average Joe to the large Investment Bank. Joe Taxpayer forks out to support the banking system, and in return finds the recovering banking system taking more money. Do you think Joe Taxpayer might get a wee bit angry if he realized? So better that he didn’t, eh?

So McClatchy Newspapers has discovered that in late 2007 some analysts at Moody’s Investors Service were “downsized” for expressing concerns about the accuracy of the ratings being applied to some of the CDOs (collateralised debt obligations), especially those comprising MBSes (mortgage backed securities).

The news group alleges that Moody’s shuffled its internal employees, sidelining and/or firing those that were raising red flags and replacing them by structured finance specialists, in order to continue to provide the high ratings needed by the Investment Banks that were assembling the CDOs (see this story). The allegations are supported by quotes attributable to several former employees.

If true, the allegations reveal a deep weakness in the debt valuation process.

The story ends with the comment:

The ratings agencies were under no legal obligation since technically their job is only to give an opinion, protected as free speech, in the form of ratings.

Experts such as Columbia University’s [finance expert, John] Coffee think that Congress must impose some legal liability on credit rating agencies. Otherwise, they’ll remain “just one more conflicted gatekeeper,” and the process of pooling loans — essential to the flow of credit — will remain paralyzed and economic recovery restrained,” Coffee said.

As somebody involved in the equity valuation process, I find this absence of responsibility quite shocking.

In the equity valuation process, an analogous process to debt ratings would be VDD, or vendor due diligence. VDDs are employed to reduce disruption to a Seller’s business. For example, if a Parent company wishes to sell one of its business units (the “Target”), then every potential Buyer would wish to dispatch its own team of analysts to perform (buy-side) due diligence on the Target’s finances, including interviewing management representatives from the Parent and Target.

The VDD approach means that only one team of due diligence analysts is encamped at the Target, preparing a due diligence report. The Parent company contracts the due diligence provider, and pays for the work, and often attempts to suppress any negative commentary about Target business. However, when the transaction is completed, the vendor due diligence report is assigned to the successful Buyer, and the due diligence service provider assumes a duty of care to the Buyer.

This approach focuses the due diligence service provider’s mind on preparing an objective and factual report when confronted by the Parent company management’s intimidation.

This is very different to the “under no legal obligation since technically their job is only to give an opinion” scenario in which the debt rating agencies work.

Isn’t it time that the users of debt ratings demanded that the ratings agencies become more accountable for their “opinions?”

An annuity is a contract between you and an insurance company whereby the insurance company will pay you a certain amount of money, on a periodic basis, for a specified period. For example, you might pay an insurance company ten thousand dollars and in return you will receive 100 dollars a month for 10 years.

Typically an annuity will be the basis for a pension, but this need not be the case. And some annuities are structured to provide tax benefits, this being the case especially for pension annuities.

Annuities, at a high level, can be divided into two categories: immediate annuities and deferred annuities.

An immediate annuity almost always involves a lump sum payment and the “distribution phase” begins as soon as you have made this payment.

A deferred annuity almost always involves an “accumulation phase” where you make periodic payments to create a capital sum which is later used to provide the payments to you during the distribution phase.

The distribution phase might be a fixed term or it might be until the end of your life (or, in the case of a joint annuity, until the later of the end of your life or the end of your spouse’s life).

The payouts during the distribution phase are a combination of a return of the capital that was used to establish the annuity plus additional money earned by investing the capital sum. For distribution phases that run until the end of your life, the payout amount also depends upon your life expectancy. The inclusion of the return of the initial capital is what makes the returns appear particularly high – especially for lower life expectancies.

The investment component of the payout can be either fixed or variable. Fixed returns are either guaranteed by the annuity provider or a result of investing in products with fixed returns, such as bonds. Variable returns are typical achived by investing in stocks.