The Bankers Bonus - Financial News Blog

Dragon lands

2010-08-15T11:58:00.000-07:00

Those who know me, know well my love of China. Here is a first hand insight from a fine journalist:

http://www.creditwritedowns.com/2010/08/whither-china.html

Take Off

2010-07-28T15:06:00.000-07:00

It has been an eyewateringly happy week for holders of financial institution equity. Bank stocks soared. There are two key reasons for the volte face in sentiment towards the sector. First, and most important, the Basel Committee has greatly watered down the content of Basel III, the latest incarnation of the international accord to regulate prudential capital in the FIG sector. No longer will minority interests be deductions (cue Barclays take-off), no longer will deferred tax credits be ineligible capital (cue Jap banks soaring), and no longer will the net stable funding regimen be implemented as originally planned. The NSFR threatened to require banks in Europe to raise 3 trillion euros before its implementation, which was planned for [tbc]. Removing this vast debt raising pressure from the sector has vastly alleviated its funding needs, and means that there is now a fair prospect of the wall of investor money being mobilised to meet the still hefty refinancing cliff that loom.

The second fillip to the sector, less widely reported, is that covered bonds have been included in banks' eligible 'liquidity buffer', albeit as 'level 2' assets with a 40% concentration cap. Assuming HM Treasury does not - perversely - prosecute its formerly announced position of precluding them, this is a major boost to the banks ability to raise secured funds in the covered bond mart by cementing the position of the bank buying base. Covered bonds will be a big feature of the issuance landscape in H2.

There remain ominous threats on the horizon, however. The pending debt refinancing needs across the eurozone are still disarming, and the competition from sovereigns seeking funds from the same investor base will be significant. The position of eurozone sovereigns themselves also remains parlous. Even after several years of austerity, the Greek debt load will still exceed 150% of GDP, and the interest burden alone on that debt will exhaust much of the domestic financial resources of Greece. How long will the Greek punters bear the turns of the rackscrews?

2010-07-26T14:27:00.000-07:00

It’s relatively stale news now - a couple of weeks old - but I haven’t seen any journalistic coverage, so it seemed worth a short blog.

Standard & Poors has circulated a consultation paper that touches on their counterparty support criteria. One of the key principles of these new criteria is that for a structured finance rating to achieve AAA, all counterparties providing substantial direct support to the deal must have a minimum rating of AA.

Innocuous and defensible on the face of it. However, swap providers and cash account providers provide direct support to such deals, and these are integral features of virtually all structured finance transactions. So the entire universe of ABS rated by Standard & Poors is in the crosshairs of this policy amendment. Furthermore, the number of banks with a AA rating is in fact relatively small. None of the big UK clearing banks has such a strong rating. Barclays, which came out best in the European stress test outcomes, is rated AA minus. The impact of the proposed ratings policy change is therefore very substantial.

S&P estimates that adoption of the new criteria would see them downgrade approximately 35% of the structured finance transactions that they rate. This is a seismic change. The demoted bonds may no longer be eligible in many investors hands, and would attract higher capital costs in bank investor hands. There is no reason to believe that Standard & Poors will backpedal from this position – they seem intent on devaluing the AAA brand in the structured finance arena (and presumably acquitting themself of some embarrassing exposures down the road). Expect much hand-wringing in the near future, therefore, from the financial sector as the pain of this proposal becomes clearer and closer.

Of course, the entire securitisation market has virtually been shut down in the US by the passing of the Dodd-Frank bill. This unexpectedly stripped rating agencies of their exemption from expert opinion liability in public bond offers. The SEC has repealed the offending provision until the year end, but come 2011, there is yet another reason for the ABS market to falter. The regulatory and policy overload is steadily killing the market. There may be a surge in second-half issuance as issuers look to sneak in under the wire of Dodd-Frank and Europe’s version of 17g5 - but the shape of ABS in 2011 is otherwise looking very uncertain. Welcome to policy, Keystone Cops style.

PCS Redux - Potomoac bonds

2010-07-16T14:44:00.000-07:00

The PCS story broke in the pink press at the end of last month (“European banks take steps to free up loan pool”, 28 June 2010). According to the article “The biggest European banks are seeking to revive the struggling wholesale finance market with a new type of enhanced securitised product”. Apparently the chief executives of 10 of Europe’s biggest banks have been in regular dialogue for over a year now to revive the securitisation markets. Sadly, the PCS initiative seems to have been the output – and you know my views on that. Perhaps it’s because CEO’s sit at ten thousand feet, so may not be best placed to diagnose the market’s ills, nor indeed remedy them? I talked to the head of funding at one of the bank’s named in the FT article, and he disavowed all involvement in the soi-disant Potomac Group named in the article. What the article does not report, is that the board of AFME, to whom the PCS was submitted several weeks ago, derided it for the misguided folly it is, effectively kyboshing the initiative.

In other news, my contacts at the FSA are growing increasingly twitchy at the looming debt mountain that stretches its shadow across the Anglo-saxon banking world. Reserve plans are being drawn up for further central bank collateralised funding in the event that we endure another liquidity drought in the capital markets.

The backlog of debt refinancing is beginning to pile up with the recent moratorium in FIG issuance, although prime names broke the hiatus a couple of weeks ago. That will be a theme to come. Lower rated credits, building societies in particular I would suggest, are going to find it’s no fun funding in the medium term. It’s going to be a big H2 for bank debt issuance – and if it’s not, expect some outsized problems - with a depleted policy arsenal to fight them with.

Poorly Considered Scheme

2010-06-02T13:38:00.000-07:00

The pink pages caught up with 17g-5 today; but the world has caught up with the vast debt-load I wrote of in that article well before the regulatory nuke struck home. In fact, as it was, the SEC gave non-US issues a stay of execution on 17g-5 until 2 December - and the weight of sovereign debt in Greece spoke for itself in the meantime...

Let us assume for now that the exceptional policy stimulus from the ECB overpowers the macroeconomic fault-lines, and finance marts resume some kind of normalcy in the near future. What else does the future hold for secured financing?

One prospect on the horizon, designed to kick-start the moribund secured funding markets, is the Prime Collateralised Securities initiative. This is another financial scoop for the Bankers Bonus - you will read of it in the broadsheets some weeks hence. The project is the brainchild of certain CEO's of European banks - it is effectively a kitemarking initative, a gold label for certain securitisations intended to facilitate investment. It aims to provide assurances as to the quality of the collateral securing the loan. The architects of PCS cherish heady ambitions for the scheme - they believe the PCS kitemark will foster transparency, quality, simplicity and liquidity. Who could argue against such an endeavour?

Sadly, the scheme is likely to have the reverse effect. It is typical of the policy responses that have dominated secured funding in its naivety. The simplistic narrative feeding such projects is that transparency and complexity caused the credit contraction, and that addressing these must therefore revive the market. In truth, PCS is just another layer of bureacracy that real money investors do not need nor want and which will only act as a drag on the fragile recovery in ABS markets. The PCS sponsors propose a European secretariat be appointed to monitor eligibility for the PCS kitemark (and here we begin to discern some less savourable motivations behind the scheme - wresting control, undermining the London and Dutch hubs where secured financing - and investing - is most active). The eligibility criteria are very poorly considered, and would preclude virtually all assets. Issuers would be hampered, not assisted, and a two-tier market is inevitable, causing serious liquidity problems. Nor is it clear how the secretariat would be funded, or to whom it would answer. The whole thrust of the proposal runs counter to the CRD2 principles of investors acting in a sophisticated way to evaluate collateral and credit risk off the back of detailed asset data, instead offering some kind of short-cut that makes over-reliance on ratings look positively sage.

The bald truth is that transparency and quality are not crimping European ABS markets. Instead, the uncertain regulatory landscape (exacerbated by misguided industry-led initiatives such as this), and the evisceration of the leveraged AAA investor base are the key reasons for the market rupture. And yet, recent volatility notwithstanding, the ABS market has begun to find its feet again. The core real-money investor base has returned. In the first four months of 2010, over 19 European securitisations have been executed (11 public transactions and at least eight private transactions) leading to an issuance amount of over €26 bln equivalent. In addition, there are at least ten more public transactions in the near term pipeline, although these are now not likely to surface until Q3.

Crucially, this is progress made in spite of the minatory storm clouds of regulation that have been gathering. It has been market-led, responding to issuer and investor demands. The market was out of control - but in the crisis, the market has begun to heal itself wisely. It will gall the high pundits of capitalism's fall to hear a banker plead that the market be allowed to mend itself - but in reality, that is the only route to rebuilding the secured funding lines. Regulation to prevent over-zealous expansion of credit is a necessary response to the crisis - but politically motivated, ill-informed interference in the ABS landscape is misconceived. The funding gap must be plugged, and secured funding provides the only semblance of a hope to plug the gap; failing which, we will see a re-run of the Lehman debacle. Regulators should temper their zeal.

Liquidity is the key to reviving the ABS space. There is no reason, despite the claim, to believe the PCS will improve liquidity. It is an empty aspiration. Something concrete is needed to improve liquidity - UCITs eligibility, inclusion in liquidity buffers, capital treatment for trading positions or such like. These things could improve liquidity. But a naive kitemark selling the pipe-dream of simplicity in a region where regulations, bankruptcy rules, lending models and asset classes differ so widely, will not.

Let me leave you with some concrete facts about European securitisation in place of the child-like story that passes for wisdom in the wake of the great credit contraction. Despite the narrative, European ABS and RMBS has performed extremely well to date, especially if one eliminates CDOs and CMBS from the picture (which the market has itself eliminated for these very reasons). According to Fitch, only 3% of EMEA Prime RMBS tranches rated AAA between 2005 and 2007 have been subsequently downgraded as compared to over 80% of non-agency US Prime RMBS rated AAA in the same period that were subsequently downgraded. The differences are similar even further down the ratings scale where only 10% of the BBBs of EMEA Prime RMBS have been downgraded as compared to 98% of BBB non-agency US Prime RMBS has been downgraded. European ABS is a bargain.

Secured funding will return since the logic of collateralising debt is too self-evident for the market to misprice and disregard in the longer term. The seemingly unending layers of regulation and policy overlay, however, are seriously threatening the timing of the recovery, and with it, the prospects of an orderly refinancing of the looming debt mountain. This will feed into further macro-economic distress, and very likely overpower the monetary stimuli. It will be a rocky road to recovery.

Regulation 17g-5

2010-04-07T14:40:00.000-07:00

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.

Solvency II

2010-03-19T13:23:00.000-07:00

As regards the welter of regulatory reforms that are afoot in the world of financial capital and liquidity, little press ink has been spilled on the new Solvency II regime. Solvency II will set out new, strengthened EU-wide requirements on capital adequacy and risk management for insurers with a view to reducing the likelihood of an insurer failing. Dull stuff, you may think.

In its current draft, however, it threatens to toss a grenade in an abstruse but highly lucrative niche of FIG funding - German registered bonds.

German insurance companies are a key buyer of bonds that are constituted in registered form, as opposed to bearer bonds. Bearer bonds are technically transferable through delivery of the bond itself. In practice, such bonds are locked in a vault with a custodian and interests in the bearer bond are transferred electronically through Euroclear and Clearstream. Registered bonds, in contrast, are constituted so that ownership is transferred through entries on a central register. In practice, therefore, little distinguishes the bearer bonds from registered bonds, although certain legal and tax consequences spin on the difference.

By virtue of a local accounting idiosyncracy, German insurance companies enjoy an economic advantage by investing in registered bonds. Under German GAAP, the bonds may be accounted for at amortised cost - whereas bearer bonds are normally marked-to-market, putting volatility into the profit and loss statement.

The loss of this accounting perq would be significant. There are over 500 insurance and pension funds in Germany with about eur540bn to invest in fixed income, of which eur300bn is invested in registered notes. It's a big industry.

So although the grenade is sitting on the draft statute books ticking away, it's unlikely that you'll see it detonate over the pink pages any time soon. That kind of financial clout at the heart of the EU is a powerful lobby. Expect the Solvency II threat to fizzle out before it becomes a mainstream newstory. But if it doesn't.....you read it here first.

In defence of bankers - big bankers

2010-03-15T13:10:00.000-07:00

The Fleet Street commentariat is foaming at the jaw lambasting and lampooning all things banking. Even the venerable Financial Times regularly features critical comment deriding this blogger's chosen profession. I might not be doing God's work, I think, as I read this invective. But I am doing something useful. Let me recapitulate - for it is no time to capitulate.

Depositors rely on banks to park their cash and provide a return. On the faith that not every depositor requires its funds at the same time - which in normal market conditions is the case - banks use depositors' cash to help consumers and businesses invest. They provide international payment systems facilitating 730 million payments a day. They provide services to individuals and companies to manage financial risk. They help governments finance their expenditure. And so on. These are important fiscal services with real societal value. The fulcrum of this business model is confidence. Where risk is properly managed, confidence is maintained and banks are able to provide these services to promote economic growth and the prosperity of nations.

2008 saw a catastrophic rupture of this business model. Almost half of the increase in economic value contributed by banks in the UK (wages and gross profits) from 2001 to 2007 was blown in short measure through the extraordinary fiscal measures taken by the Bank of England in the last two years (source: Financial Times Monday 15 March, pace John Cassidy). This was not, however, some grand scheme cooked up by the soi disant masters of the universe to steal taxpayers' coin for a generation to come. And it was not the work of the average common-or-garden banker fresh out of school with the opportunity of social mobility ahead of him or her. There was a great deal of ingenuity invested in circumventing prudential governance, but it was - in my experience at least - done with rigorous intellectual effort (within the white-swan logic that informed it) and honesty; not as a dubious scam to enrichen the incumbents. There were sharp practices, and there were extraordinary errors of judgement. Politicians, clergy and multi-millionaire footballers are all human alike. But it is the politics of envy to tar banks - and bankers - with one dark brush. Banks are ultimate meritocracies, places where nought but commitment and ability determine success. The best banks - Goldman Sachs and Barclays - rely on enfranchising the best qualities in their people, in a co-operative team oriented endeavour to manage risk but maximise returns. The work they do is valuable work that confers real social benefit. Mistakes were made. But let us not throw the baby out with the bathwater and over-regulate the City - and its talent pool - out of existence; or out of the country, at any rate.

Consider a multinational pharmaceutical. It borrows from a bank. It also taps capital markets for diverse funding (capital markets remained open when loan markets shut down). It raises debt and equity in multiple global locations. It manufactures and sells, buys raw materials and trades cross border. Its purpose is to produce medicine that benefits human kind. Only a bank can provide the fiscal services to meet the needs just articulated. And only an integrated global bank can do so effectively.

Banks enable consumers to buy homes and other assets, and small businessess that require debt to grow. Banks provide services to enable pension funds to meet their pension liabilities. Banks can assume risk and distribute it more widely. Only global banks can provide liquidity to large sovereign nations. Asian, European and Middle Eastern buyers of sovereign debt require banks to intermediate their capital to invest in, for example, US and European sovereign debt. Without this facility, the cost of borrowing rises and higher taxes or lower public spending ensues. Followed by lower economic growth.

So let's not hang the bankers out to dry. It may seem obtuse, but England would be poorer yet without its financial capital. Those outside the rareified universe of investment banking will beg to differ. Whether we let them win the argument remains to be seen.

Weird Coca

2010-03-14T16:16:00.000-07:00

One of my favourite FT columnists, Jennifer Hughes, penned an article on the latest CoCa bond development recently. Coca or CoCo bonds are contingent capital bonds that flip to equity when a given solvency trigger has been breached. Regulators (Adair Turner) and central bankers (Paul Tucker) have been pushing their development recently as countercyclical capital instruments - although the regulator has not formally approved any such bonds. LLoyds made the debut in this new instrument class by issuing £7.5bn of enhanced capital notes at the end of last year. They convert if Lloyds breaches 5% of core tier one regulatory capital.

The latest development that Jennifer writes about is the launch of a senior contingent note by Rabobank, the AAA rated Dutch financial institution. The solvency trigger is a 5% equity capital trigger, rather than a regulatory capital switch, giving more certainty to investors. Regulatory capital is under intense scrutiny, and subject to change as prudential policy evolves.

The Rabobank paper writes down by 75% upon a breach, suggesting it may be viewed as lower tier two paper (where recovery values on default are typically 25%).

Notably, the Lloyds bond was a tender exchange for paper that Lloyds is forbidden from paying the discretionary coupon on (one of the costs of sovereign ownership). Lloyds bondholders arguably had little choice but to accept the tender. The Rabobank paper is a straightforward public offer, without such handcuffs. Which is where things begin to puzzle.

Jennifer writes: "The bonds are particularly notable because Rabobank, a triple A-rated institution, did the deal from a position of strength, rather than the weakness that has characterised many bank hybrid deals through the crisis."

Rumoured pricing is a 6-7% coupon. Rabobank is an amply capitalised, highly regarded financial credit. The question one has to ask is, why would such a credit fork out such an astronomical sum for capital it does not, it claims, require?

Favourable commentators may buy it is a black-swan policy - insurance against extreme tail risk. Less generous pundits may speculate that something is rotten in the state of Denmark. Could a ratings action be lurking in the shadows?