During the Financial Crisis Inquiry Commission's second panel of the day, I got a real treat: an introduction to Kyle Bass. He's a managing partner at Hayman Advisors. He's also, by far, the smartest person I've heard testify all day. And that includes the CEOs of four of the most major banks. His testimony is worth noting.I also managed to catch Mr. Bass on an interview with CNBC this morning. That video is included at the end of this post. His written testimony before the commission can be found here (.pdf).
I just wanted to excerpt a few parts, however, because it's so valuable. He's highly concerned about leverage, as am I. I've said before that leverage was the reason why we had a crisis. Bass explains:
A fundamental tenet of the US banking system is leverage. Using current regulatory guidelines, banks are deemed "well capitalized" with 6% Tier 1 capital and "adequately capitalized" with 4% Tier 1 capital based upon risk weighted assets (as an aside, the concept of risk weighted assets should also be reviewed). This in turn means a well capitalized bank is levered 16X to its Tier 1 capital (much more to its tangible common equity) and an adequately capitalized bank is 25X levered to its Tier 1 capital. How many prudent individuals or institutions can possibly manage a portfolio of assets that is 25X levered? Again, unfortunately, the answer has turned out to be not many. Of the 170 banks that have failed during this crisis, the average loss to the FDIC is well over 25% of assets, or more importantly 6 times their minimum levels of regulatory equity. Depository institutions like Citibank were able to parlay their deposits into large levered bets in the derivatives marketplace. In fact, at fiscal year‐end 2007, Citigroup was 68.4X levered to its tangible common equity, including off‐balance sheet exposures. According to the following table, real leverage at the institutions in question got completely out of hand:
(click on chart for a legible version)
I couldn't agree more with Bass on this one. Even if you ignore the final row above and just look at "Gross Leverage to Tangible Common Equity," those are clearly dangerous levels. Look at Citi. It was leveraged 68.4%. That means for every $68.4 dollars it had at risk, it had $1 of cushion. Put another way, if its assets incurred just 3% losses, it will have eaten through its capital, twice.
Realize: this guy is a private sector financial advisor who managed to make these calculations based on public filings. If he could do it, what was preventing the regulators like the Federal Reserve from doing so? And if regulators knew leverage was at such ludicrous levels, why were they so comfortable? Was there no conceivable scenario where Citi could suffer, say, 2% losses and blow through all of its capital?
In fact, in responding to questions today before the commission, Bass explains that he also calculated that, even if the housing prices just remained flat -- not declining -- for several years, the loses to some mortgage securities created by Wall Street would be catastrophic. He brought these concerns to Bear Sterns prior to its failure. Its bankers were unimpressed. Then he talked to a Federal Reserve official -- one of the guys who want more regulatory power to oversee systemic risk. He also dismissed it. The Fed explained its economists believed that home prices would continue to rise, because economic indicators were good. Sure, Bass was only one data point, but his argument was compelling.
Here's another amazing excerpt about Fannie and Freddie, which he spends a few pages of his testimony on:
Fannie and Freddie used the most leverage of any institution that issued mortgages or held mortgage backed bonds. At one point in 2007, Fannie was over 95X levered to its statutory minimum capital with just 18 basis points set aside for losses. That's right, 18 one hundredths of one percent set aside for potential losses. They must not be able to put humpty dumpty back together again.
If you have the time and interest, I'd strongly suggest you look at all of Bass' testimony. It's enlightening stuff. He also addresses derivatives reform and several other topics. I'm more impressed by his understanding of finance, economics and global markets than pretty much anyone I've ever heard on CNBC. Here's that video: