Regulation 17g-5

Regulation 17g-5 should be striking fear into the heart of all European and American financial institutions. Yet not a whisper in the quality broadsheets. That is why this blog exists - can you afford not to be a follower?

Let me set the scene. Banks are simple in essence. They accept deposits, and use these to fund assets. Deposits are liabilities, and these must equal assets for the balance sheet to balance - that is, a bank can only lend what it has received. That's a gross simplification, but a useful heuristic for understanding the hyper-leveraged spaghetti credit-mess that banks have become entangled in. Let me explain.

Bearing in mind this simple asset/liability bank model, the Bank of England provides a useful graph of the 'funding gap' in its December 2009 Financial Stability Report:

(http://www.bankofengland.co.uk/publications/fsr/2009/fsrfull0906.pdf - p32)

The funding gap is is the simple difference between retail deposits on the one hand, and balance sheet assets on the other. The 'gap' must be filled by wholesale funding. That is to say, retail deposits make up only a portion of the liability side of the balance sheet and wholesale funding (money markets, pension funds, asset managers etc) must provide funding to fund the rest of the assets on the balance sheet; failing which, the bank is insolvent. Retail deposits became a progressively smaller portion of ballooning FIG balance sheets over the last decade of loose monetary policy. Wholesale funding, driven largely by the aggressive growth of securitisation markets, provided the balance.

The report only provides figures for the UK. The picture globally is similar, scaled up commensurately.

Crucially, central banks stepped in to plug the funding gap in the wake of the Great Contraction. In 2006, global ABS issuance was over $1.5trillion. In 2008, it was only $181bn - a huge fall-off. As a result, guarantee schemes saw c£134bn of Bank of England guaranteed debt issued by UK banks, and eur438bn across Europe supported by the European Central Bank. At the same time, UK banks lodged assets for which they could not find funds with the Bank of England, raising c£190bn in liquid funds (through the Special Liquidity Scheme). European banks raised an additional circa eur800bn. The numbers stack up alarmingly.

Those same central banks are now looking to normalise market operations and exit their positions. That means there is over 1.4 trillion of sovereign supported bank paper coming up for refinancing in the next 3 years. One of the reasons for the hasty exit is that sovereigns are running large budget deficits and gross national debt positions - central bank funding adds to the debt load, hence the political will to return banks to normal operations. Strong signs of economic recovery are providing impulsion. I will not recite the numbers since you can read about it in the pink pages every day - instead, let me return to Regulation 17g-5 and why it threatens to deliver a nuclear blast to the growing economic recovery.

Late last year, the Securities & Exchange Commission of the United States issued a release announcing changes to rule 17g-5 of the Securities Exchange Act 1934. The changes apply to asset backed transactions rated by a nationally recognised statistical rating organisation. In brief, the changes require the arranger of any rated asset backed deal (mortgage securitisations/RMBS, CMBS, ABS, covered bonds even) to publish on a password proteced website all information, written or oral, provided to the rating agencies retained. Other NRSO rating agencies will then be able to access the website. The aim appears to be break up the Moodys/S&P/Fitch oligopoly by giving other agencies access to data received by the big three.

In the words of one securitisation attorney, 'we may as well pack up our pens'.

Remember, the change requires all comms to be recorded - even phone calls - and logged on the website. Worse yet, it appears to capture so called Reg S deals if one of the big three is rating the trade - that is to say, even if the deal is a Dutch mortgage bond, arranged and issued by a Dutch bank, and sold to Dutch investors; if it's rated by one of the big three (as all ABS deals are in developed markets) it's caught. Yet further, it appears to capture covered bonds - the mainstay of European funding for financial institutions and a key propellor for the recovery. And to cap it all, it appears to apply to existing deals as much as new deals - no grandfathering relief for outstanding ABS deals. From June 2nd, they will be caught.

Aside from the extraordinary practical difficulty and risk of recording all comms of any kind with the big three, there is a vast question mark over what the other rating agencies will do with the website data. What would happen if they used such disclosures to take adverse ratings action?

All this is of fundamental significance. The funding gap makes one thing quite transparent: the secured financing markets are still on their knees with only a limited number of real money investors on hand to finance all those assets sitting on central bank balance sheets. The wall of money is simply not as big as the refinancing cliff. Despite all the rhetoric of requiring banks to exit central bank funding schemes, with no investor base to pick up the slack, central banks will only drive financial institutions into insolvency if they do deliver on the rhetoric.

At the same time, the SEC delivers a rabbit punch to the solar plexus of secured financing markets. It is difficult not to think that the left hand knows not what the right hand does. That will be no epiphany to market pundits. But it is no less alarming for it.

This is only the most extreme example of the tension that has been growing in credit markets since phase two of the crisis began. Regulatory overkill is in huge supply - uncertainty over hybrid capital, complex liquidity regulations obliging banks to term-out funding, endless initiatives to add questionable transparency to ABS through loan level diligence schemes - all these threaten to destroy the prospect of secured financing markets recovering; yet they must recover if the funding gap is to be plugged, or even partially plugged.

Sadly, shortly after stabilising the cardiac arrest, the surgeon has begun to remove the intravenous fiscal drip of central bank liquidity. At the same time, the nurse is punching the patient in the gut - as close to his febrile heart as he can. If the patient lapses into arrest again, the hospital should be sued for negligence.

Alas, the hospital may turn out to be utterly bankrupt. Creditors, beware.