Big banks turned in a pretty stellar first quarter. All but one beat profits expectations. But as I told you last week, I'm now out of these stocks completely.
Do you want the truth about what shape banks are in right now? Sure you can handle it?
I'm sorry; I can't tell you the truth.
Regulators can't tell you the truth.
And the Federal Reserve won't tell you the truth.
No one can tell you the truth. That's because banks don't tell the truth. And neither does the Federal Reserve.
You won't know the truth… until the next meltdown (which, by the way, is coming). Because in an acceptable kind of way, it's hidden from regulators by banks themselves – with the aiding and abetting winks and nods of central banks.
Of course, to the untrained eye, it's all a matter of unintended consequences that result from trying to regulate and safeguard the world's agonizingly complex financial systems.
That's what they want you to believe. It's not the truth.
The truth is, the next meltdown will be no accident, either…
Twenty-five years back, a complex regime was set up by central bankers (gee, who do you think they work for?) to establish ostensibly "self-regulatory" standards that everyone thought would safeguard banking systems better.
Instead, what they did in phases was undermine simple, prudent safeguards and accounting standards to unleash big banks' extraordinary risk appetites to fatten their bottom lines and bonus pools.
I'm talking about The Basel Accords.
Stop – don't get turned off and assume that this is some boring explanation of an esoteric subject that you don't care about because you can't see how it affects you.
You'd better believe it affects you. Plus, it's simple to get. So, when you're reading stuff buried in the back pages of financial newspapers about this – and it's out there right now – you'll understand it and… get sick.
But don't blame me.
The Basel Committee on Banking Supervision was formed in 1974 in Basel, Switzerland, under the auspices of the Bank for International Settlements (BIS). The BIS is nothing more than a collection of central bankers acting like they're the central banks' central bank.
They aren't. They don't have any money. They just write a lot of rules and regulations that they call "standards," that they expect banks, regulators, and legislators in countries with banks to implement.
Hmm. I guess that covers the entire world.
Back in 1988 the Basel Committee came up with the first Basel Accord, commonly called "Basel I."
It was fairly straightforward at only 30 pages long. It had a lot to do with mandating prudent capital reserve requirements – the safety net banks set aside against loans and liabilities. The Committee wanted to raise reserves to make banks safer.
Gee, what a good idea. That's because it was supposed to look like a good idea.
But, ask yourself, why would central banks who work for banks want to crimp their lending and profit-making ability by making them hold aside more reserves, which they can't then use to make loans (and profits)?
(And no, central banks don't work for governments. They partner with governments, to back them when they need government's unlimited power to backstop central banks' supposed unlimited power… to backstop banks when they get in trouble)
The "unintended consequence" (rubbish!) of one of these little changes actually changed banking forever.
Gee, I wonder who benefitted there?
Under the new rules of how to measure the risk of bank assets, and what reserves to set aside against those risk categories, the Committee decided that holding a 30-year mortgage was risky, because (duh!) you are holding it for 30 years. But mortgage-backed securities, because they could be traded instantly – supposedly – weren't as risky. So banks would only have to set aside a tiny amount against those "less risky assets."
Now, bankers aren't stupid. They all packaged the mortgages they held into mortgage-backed securities and got to reduce their reserve requirements. Sweet!
You see where this is going, right? You should, because we went there.
Securitization exploded, and now you know why.
Then it got better… for banks, that is.
Basel II came out in 2004. It was "tougher" than Basel I – and boy, was that ever tough on the poor banks. Basel II required still higher reserve requirements. But surprise, surprise, trade-offs would soften them.
Gee, I wonder who would benefit from those trade-offs?
The European Union wanted foreign subsidiaries of American investment banks to follow Basel II, and they wanted their parent holding companies to be regulated. In a grand compromise, the Securities and Exchange Commission made a deal with big American investment banks. The SEC got the right to monitor and regulate the "bank holding companies" that owned the big investment banks in return for letting the investment banks determine how much capital they needed to set aside to meet capital reserve requirements. The E.U. went along.
What happened was that the old "net capital" rule in place for broker-dealers since 1975 – a calculation that requires broker-dealers to use set "haircuts" to discount the value of assets they hold to account for their true liquidation value if they have to be sold – was pushed aside for the big investment banks.
In its place, the banks were given the right to determine how much capital they needed to hold as a cushion against potential losses by calculating the value of their assets using their own internal models.
The result was catastrophic.
Under the old net-capital rules, broker-dealers' leverage ratios got as high as 12 times their capital. But under the new arrangement, leverage soared as high as 40-to-1.
Investment banks used internal models to reduce the capital they needed to set aside. They then passed along that freed-up capital to their BHC parents, who applied more leverage to that capital.
In the end, they all collapsed. All of them.
Bear Stearns went first, then Lehman Bros., then Merrill Lynch. And then on a Sunday in 2008, Goldman Sachs and Morgan Stanley ran to the Fed to beg to become commercial banks so they could feed at the Fed's discount window and its other liquidity troughs.
And this is where we still are.
Only it's worse now.
Okay, so if you've read this far, we might as well dissect this all the way.
You want the truth about where banks are now and how they're lying? I'll give it to you in my next article and you will need an airsick bag… trust me.
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About the Author
Shah Gilani boasts a financial pedigree unlike any other. He ran his first hedge fund in 1982 from his seat on the floor of the Chicago Board of Options Exchange. When options on the Standard & Poor's 100 began trading on March 11, 1983, Shah worked in "the pit" as a market maker.
He helped develop what has become known as the Volatility Index (VIX) - to this day one of the most widely used indicators worldwide. After leaving Chicago to run the futures and options division of the British banking giant Lloyd's TSB, Shah moved up to Roosevelt & Cross Inc., an old-line New York boutique firm. There he originated and ran a packaged fixed-income trading desk, and established that company's "listed" and OTC trading desks.
Shah founded a second hedge fund in 1999, which he ran until 2003.
Shah's vast network of contacts includes the biggest players on Wall Street and in international finance. These contacts give him the real story - when others only get what the investment banks want them to see.
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