The Institutional Risk Analyst: Fear & Loathing in Credit Land

One of the most skilled risk professionals we know, reacting to our comment this week in Washington & Wall Street about incredibly low US�bank loan default rates, provides the following color commentary on the state of affairs in the credit markets. He confirms our view that the use of derivatives in consumer lending may be�distorting key data elements�which are part of bank regulatory disclosure.

"The liquidity in the system is obscene, as companies issue junk bonds to pay equity holders 'dividends'..."

"Regulators are clueless, as money-center banks push debt 'off their balance sheets' in the form of CDOs, and lend hedge funds the money to buy the very same CDO's, only to have the regulators give the banks beneficial treatment (and subsequent reduction of capital) under Basel Accord rules..."�

"The consumer is mortgaged to the hilt... We don't need to touch on the housing market...."

"Emerging market debt spreads are so low that Mexico is priced as a less risky credit than quality US corporates..."

"The ratings agencies are in cahoots with the finance boys," says the banker.� We find his view confirmed by the painfully slow movement of the ratings monopolies in downgrading sectors such as autos, banks�and real estate.

And the fact of which we are constantly reminded: "The current wiz-kids have never been through a real bear market... I tell you, this is the first time as a risk manager that I am a bit frightened."� Ditto.�

Intolerable Disclosure

Meanwhile in Washington, bank regulators are engaged in trench warfare with their constituent banks over efforts to increase the amount of disclosure over CDOs and other derivative structures, among other things.�Regulators have been struggling for years to catch up with "off balance sheet" transactions for the purpose of�tracking risk data such as�shared national credits.� We hear from participants in these discussions that the banks are increasingly sensitive to regulatory disclosures and that efforts to increase disclosure over CDOs are considered particularly offensive.�

The Federal Financial Institutions Examination Council (FFIEC) has approved revisions to the bank reporting requirements for the Reports of Condition and Income or "Call Report" that will be phased in over the next two years. Many of the commenters to the new disclosure rules used technical issues to obtain a delay in new or revised data items that were originally to be included in the proposal.�

A few banks have even begun to appreciate that the FDIC, which is the main data gatherer for�US regulators,�will eventually shed the opaque legacy format for disseminating regulatory filings, allowing investors and analysts to directly access "as filed" data via real time machine-to-machine ("M2M") transfers.�

The FFIEC's proposal also includes revisions to the officer and director signature requirements. In response to concerns expressed by commenters about these revisions, the agencies are not proceeding with the proposal to require that the directors who sign the Call Report be members of the bank's audit committee. The existing language of the directors' attestation statement will not be substantively revised, according to the FFIEC.

The agency backed-off regarding increased attestation requirements for bank officers.� The CFO's attestation statement would not assert that the chief financial officer is responsible for establishing and maintaining adequate internal control over financial reporting, as had been proposed.

Says the FFIEC: "Consistent with longstanding agency policies, a general statement that the bank's board of directors and senior management are responsible for establishing and maintaining an effective system of internal control, including controls over the Call Report, would precede the attestations. The revised signature and attestation requirements will take effect September 30, 2006."

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