The AAA-bomb… or how I brought down the Capitalist Empire

The memoirs of Carlos Molotov Pavlov a central planner who to avenge his loss of a cushy job in the Soviet entered the bank regulatory system in Basel and managed to create, seed and detonate an AAA-bomb in the heart of the capitalist Empire.

Chapter I: The fall of oil prices. How Pavlov lost his cushy job as a central planner in Kremlin

Chapter II: Pavlov’s theory. Since risks perceived as low carry a much larger destructive force than those risk that are perceived as higher, which by their sole nature make the investors more careful, what is needed is a method by which to enrich the leverage of low-risk investments.

Chapter III: The new soviet: Recurrent bank crisis despaired the world into handing over the full responsibility of bank regulations to an independent Basel Committee.

Chapter IV: Pavlov slips into Basel. A PhD in Quantitative Financial Analysis served as a Trojan horse.

Chapter V: Lucky break 1. The Basel Committee turned into a club of mutual admiration where all members shared one sole bedroom fantasy that of a world where no individual bank failed and no one had any interest in other issues… such as what is the whole purpose of the banks… like that of helping to generate decent jobs and sustainable growth.

Chapter VI: The collaborators 1. Global banks wanting to extend their reigns and searching for a system of regulations that would allow them to monitor credit from a long-distance so as to reduced the local competitive value of knowing your client and the feeling the firmness of his handshake.

Chapter VII: The collaborators 2. Finance ministers having the public debt "risk-weights" set at zero so that banks can lend to them without any capital requirements.

Chapter VIII: The difficulty. Keeping the focus on the individual banks so as not to raise suspicious of possible systemic crisis.

Chapter IX: Lucky break 2. The simultaneously ongoing process of reducing the individual citizens to being just credit scores which by means of risk discrimination allowed for the creation of many profitable niches of consumer debt financing and also numbed the general investor into accepting the truthfulness of any credit analysis.

Chapter X: The minimum capital requirements for banks. The design of a formula for bank equity based on a vague and limited definition of risk that allowed for an immense leverage for operations perceived as of a low risk.

Chapter XI: The credit rating agencies. The creation of an oligopoly in financial risk information that sooner or later had to result in the markets massively going where they should not go.

Chapter XII: Marketing. Empowering the credit rating agencies with the “If they are good enough for the Basel Committee they are good for you” which silenced all skeptical external directors.

Chapter XIII: The glorious June 26 2004… the AAA-bomb is armed!

Chapter XIV: Waiting. Seeing the leverages grow, the credit rating agencies place their AAA signs and the banks turning from lenders into mechanical spread optimizers.

Chapter XV: Lucky break 3. The generous provision of financially enriched uranium through the creation of economic disequilibrium between surplus and deficit countries.

Chapter XVI: Lucky break 4. The growing conviction that inflation, risks and volatility had all finally been conquered which allowed central banks to justify easy monetary policies.

Chapter XVII: Arming the bomb. How trillions of dollars were led by the AAA signs into the swamplands of badly awarded mortgages to the subprime sector.

Chapter XVIII: The blast. Huge! The first bank to fail from the badly awarded mortgages in California was a German bank that was not even involved in any mortgage lending in Germany.

Chapter XIX: The escape. Creating the cover up stories in order to convince the academia, media and politicians that the bomb had gone off because of a lack of regulations, economic disequilibrium, and easy monetary policies… anything except concoctions coming from the Basel Committee

Chapter XX: A close call. The Joker, in The Dark Knight said "You know, they're schemers. Schemers trying to control their worlds. I'm not a schemer. I try to show the schemers how pathetic their attempts to control things really are. So, when I say that … was nothing personal, you know that I'm telling the truth. It's the schemers that put you where you are. I just did what I do best. I took your little plan and I turned it on itself. Look what I did to this city with a few…" and no one heard the Joker thereafter saying “collateralized debt obligations”.

Chapter XXI: Lucky break 5. Conservative movements, many taken over by operators more interested in making money on conservatism, keep on having knee-jerk reactions against their traditional foes like Fannie Mae, and do not even notice the channeling of funds that the “risk-weights” cause.

Epilogue: The secondary effect of the AAA-bomb in a closed global confinement surpasses all expectations. Unemployment and misery. Significantly the Basel Committee is still in charge… while Carlos Molotov Pavlov awaits the AAA-Public-Debt-Bomb to explode. What a great future lies ahead for a central planner and his descendents.

Tentatively published in fall 2010 by the Voice and Noise Foundation

The credit-ratings-uranium enrichment process.

By allowing the banks to hold extremely little capital when lending or investing in what is officially considered as having no risk, like triple-A rated securities and infallible sovereigns, Basel bank regulations instruct and give the banks huge incentives to believe and follow what the credit ratings indicate immensely more when the ratings are good, than when they are bad.

In other words, the capital requirements for banks, serve as hallucinogens given to bankers in order to exaggerate their reactions to the signals the credit ratings emit.

Successfully increasing the destructive reach of the AAA-bomb

On April 28, 2004 in an Open Meeting at the SEC the Basel virus was further spread as the following was considered and approved:

"The Commission will consider whether to adopt rule amendments and new rules under the Securities Exchange Act of 1934 ("Exchange Act") that would establish two separate voluntary regulatory programs for the Commission to supervise broker-dealers and their affiliates on a consolidated basis.

One program would establish an alternative method to compute certain net capital charges for broker-dealers that are part of a holding company that manages risks on a group-wide basis and whose holding company consents to group-wide Commission supervision. The broker-dealer's holding company and its affiliates, if subject to Commission supervision, would be referred to as a "consolidated supervised entity" or "CSE." Under the alternative capital computation method, the broker-dealer would be allowed to compute certain market and credit risk capital charges using internal mathematical models. The CSE would be required to comply with rules regarding its group-wide internal risk management control system and would be required periodically to provide the Commission with consolidated computations of allowable capital and risk allowances (or other capital assessment) prepared in a form that is consistent with the Basel Standards. Commission supervision of the CSE would include recordkeeping, reporting, and examination requirements. The requirements would be modified for an entity with a principal regulator.

The other program would implement Section 17(i) of the Exchange Act, which created a new structure for consolidated supervision of holding companies of broker-dealers, or "investment bank holding companies" ("IBHCs") and their affiliates. Pursuant to the Exchange Act, an IBHC that meets certain, specified criteria may voluntarily register with the Commission as a supervised investment bank holding company ("SIBHC") and be subject to supervision on a group-wide basis. Registration as an SIBHC is limited to IBHCs that are not affiliated with certain types of banks and that have a substantial presence in the securities markets. The rules would provide an IBHC with an application process to become supervised by the Commission as an SIBHC, and would establish regulatory requirements for those SIBHCs. Commission supervision of an SIBHC would include recordkeeping, reporting and examination requirements. Further, the SIBHC also would be required to comply with rules regarding its group-wide internal risk management control system and would be required periodically to provide the Commission with consolidated computations of allowable capital and risk allowances (or other capital assessment) consistent with the Basel Standards."

You can hear more about that successful operation here:
Luckily, a serious nuisance, a warning by a Mr Leonard D Bole was ignored.

Could the Basel Committee be sued for malpractice?

The ruling it-shall-not-be-named-or-discussed fact is that if the Basel Committee had not implemented their “Minimum Capital Requirements for Banks”, based on what its members perceived as risk, which opened the door for the increase of financial leverage; and then with the “If they are good enough for the Basel Committee they must be good enough for you” empowered the credit rating agencies as the global risk-surveyors, other bad things might have happened, but never a financial crisis nearly as destructive as this.

Could therefore the Basel Committee be sued for malpractice? The mother of all class actions? Just for the sake of transparency? To stop it from digging the world further down in the hole they’ve been place by it?

Legal advisors consulted by Carlos Molotov Pavlow have told him..."don't you worry!"

Could Carlos Molotov Pavlov get on the list of the most wanted?

Forget it! They haven't even come around to start investigating the role of the Central bank governors and the heads of bank supervisory authorities in the Group of Ten (G10) that met on June 26 2004 and endorsed the publication of the International Convergence of Capital Measurement and Capital Standards: a Revised Framework.

We found 62.5/1 on a napkin

The following notes presumed to have been scribbled by Carlos Molotov Pavlov were recently found on a napkin:

“If a bank is allowed a limitless leverage as long as he lends to a sovereign rated AAA then that sovereign should be fairly predisposed to see our suggestions in a favorable light so let us start with that.”

“Then how much leverage could we suggest that a bank that lends to a corporation rated AAA or AA- could be authorized to have before the regulators choke? 70? too much? Ok let us suggest 62.5 to 1... that should do it”

They are leaving the rotten apple in the reform barrel

The recently proposed financial regulatory reform speaks about more stringent capital requirements but conserves the principle of “risk-based regulatory capital requirements” and so the New Foundation builds upon the most fundamental flaw of the current system.

Regulators have no business discriminating among risks since by doing so they alter the risks and make it more difficult for the normal risk allocation mechanism in the markets to function.

High risks could be negligible risks when managed by the appropriate agents while perceived low risks could be the most dangerous ones if the fall in the wrong hands.

And so it looks like Carlos Molotov Pavlov is still in control!

Pushing up the Empire's Gini coefficient

If Carlos Molotov Pavlov could somehow get himself into the regulatory authorities in charge of the insurance companies and there spread the regulatory paradigm concocted by the Basel Committee (with his assistance) then perhaps these regulators would nominate three health inspection agencies to rate the health of the insured; and require the insurance companies to put up more capital when they sell health insurance to someone with a low health rating; and letting them almost off the hook if the insured is deemed to be in tip top form.

This should guarantee such an increase in the Gini coefficient of the Empire that, according to what he was taught as a young revolutionary guard, he is convinced this would lead to a real revolution.

What a lunatic chaos! A true Joker´s joke!

Governments appoint financial regulators who use credit risk ratings issued by credit rating agencies to decide how much equity banks need to have, presumably so that the banks won´t fail and the governments will not have to bail them out... all while they must know that the rating agencies, when rating the risk of banks, explicitly measure the government´s willingness to bail out the bank. Which one is the chicken or the egg, the bank or the government? And the rating agency is he their guardian or the fox?

There are reports that “the Europeans banks are now net sellers of insurance against the chance of their own governments going into default – even though those same banks are implicitly backed by those governments”

For each day the markets become increasingly dependent on what the credit rating agencies opine. Look at how these Frankenstein monsters are now getting closer to rate down the governments, their own creators.

Partial schematics of the AAA-bomb

The double whammy!

The credit rating agencies have more direct and established relations with the debtors than what any individual anonymous investor in the market has and therefore, almost by definition, they will be much slower than the markets in conveying any bad news. This is something that the AAA-bomb takes advantage of as it produces a great aftershock. First the market prices in the new bad news, and then later come the downgrading that forces the bank to hold more equity and so down goes the market even more. What a blast!