People always say Follow the Money. You might do better to Follow the Risk.
Risk is the pollution created by the process of making money. So where you find people making one you will surely find them hiding the other. You’ll find both at the banks.
Banks have managed to convince the regulatory authorities – their regulatory authorities, and I use the word ‘their’ advisedly – to convinced them to count the creation and storing of risk as part of the banks contribution to the nation’s GDP. I wrote about how our governments count risk creation and storage of as part of the bank’s GVA (Gross Value Added) in What the Banks Contribute to GDP. Our government’s reasoning is that risk is an unavoidable by-product of the financial industry so the industry should get credit for dealing with the stuff. But imagine counting the creation and storage of radioactive waste as part of the value added of the nuclear industry? Would it not seem perverse to celebrate increases in the amount of waste being stored and see it as evidence of what a wonderful industry it was, rather than ask why they produced so much in the first place? Would it not seem odd to talk glowingly (sorry) of the increases in radiation levels being stored, and reward the industry accordingly, rather than ask if there might not be a safer, less radioactive way of generating power? It seems to me this is the situation we are in with banking.
I wrote extensively about Banks and Risk in Propaganda Wars: Our Version – Risk Weighted Lies and its follow up Propaganda Wars: Our Version – Balance Sheet Instabilities. What I did not considered in those articles is that managing and hiding risk is as critical to shrinking a bank as it is to growing it.
Ever since we all woke up to banks being too big to fail, there has been talk of banks having to shrink or de-leverage their balance sheets. The question was, and is, how? Banks don’t like the idea of shrinking so by and larger those that weren’t forced to haven’t. They have chosen instead to shrink their risk not their size.
There are several ways for a bank to reduce its risk of failing. In simple terms it’s all about the ratio of the capital base to the loans that base supports. So a bank can either increase the base of capital (Often referred to as its Regulatory Capital – the amount of capital regulators say it must have relative to the size of its loan book) or shrink the size of the business. If the bank opts for increasing the capital base it can raise extra capital to increase the buffer of cash it has by withholding profits, which means paying lower dividends and lower bonuses (unpopular with investors and bankers respectively), or it can issue new stock (unpopular with investors again). An alternative to raising more money is to shrink the size of the loan book which is supported by the capital base. This is done either by making fewer new loans or selling old ones. Selling loans can be done either by selling a ‘book’ of loans or an entire business unit or subsidiary.
The problem with making fewer loans is that it might make the bank a little safer but it starves the rest of the economy of credit. The problem with selling stuff is it makes you a smaller player and you may not get the price you hoped for making you poorer as well.
The plans [European] banks submitted to regulators in January 2012 suggest that the shedding of bank assets will play a small part in reaching the target ratio….The EBA’s first assessment shows that banks intend to cover 96% of their original shortfalls by direct capital measures,…
Which means the European banks will be damned if they are going to slim down and become smaller than their US competitors and prefer instead to raise money by any and all means. For those interested a more detailed look reveals,
Planned capital measures thus account for 77% of the overall effort, and comprise new capital and reserves (26%), conversion of hybrids and issuance of convertible bonds (28%), and retained earnings (16%), while the remaining 23% rely on RWA reductions, notably on internal model changes pre-agreed with regulators (9%) and on the shedding of assets (10%), comprising planned RWA cuts of €39 billion in loan portfolios and some €73 billion through asset sales.
That was January before more bad debts surfaced (lots of them in Spain) and more severe economic contraction across Europe was admitted.
My guess is that raising new cash from selling stock and issuing convertible bonds has reached its limit. Selling loan books and businesses can be slow and loss making. Many of the major banks created their own ‘bad banks’ which is just a holding company for unwanted, toxic and non-performing loans and business units, whose job is to gradually sell them off. The ‘bad bank is still owned by the parent bank but the bad loans are not directly on the banks own books looking all ugly and frightening. Citi set up a bad bank called Citi Holdings. Commerzbank did the same. According to an article at Risk.net (Basel 2.5 prompts flurry of asset sales…) , Citi’s bad bank has been a roaring success selling its old tat to willing buyers,
… assets and businesses, which totalled $827 billion during the first quarter of 2008, had shrunk by 65% to reach $289 billion by the third quarter of 2011
Not to be outdone,
Since 2007, European banks have reduced their credit market assets by around 53%, down from a total of approximately €852 billion, it says. However, this leaves a rump of around €397 billion of exposure across the market….
These are pretty big numbers. The question, of course, is not who sold but who bought and with what money? I’ll come back to this.
But first that other component of the banks’ plans, ‘RWA reductions’. They are always a worry. RWA is Risk Weighted Assets – and reducing them means fiddling about with the assumptions and variables in the bank’s own computer model until it spits out the desired answer, which in this case is to show how an asset (loan) is less risky than a regulator thought. Being less risky means less capital has to be held against it. Holding less capital means the bank can claim to have reduced its risk without either selling anything or having to rise any more money. You just have to have your computer find that you weren’t as risky as everyone thought you were. Like magic but with added ‘science’.
And this is has been a growth industry inside the banks for the last two years at least. Don’t take my word for it, from an FT article from Oct. 2011 called “Banks turn to financial alchemy…”
Jamie Dimon, JPMorgan’s chief executive, said last week that he intended to “manage the hell out of RWA” to reach the higher levels.
But even this has its limits. According to the same article, the regulator told JPMorgan it was ‘managing’ a little too aggressively and must stop, when it did, the bank’s RWAs suddenly ballooned by $44 billion.
So what is a bank to do? Well the answer is as simple as it is worrying – just sell the risk. Get rid of it. You don’t have to sell any actual assets. You don’t have to raise capital. You don’t even have to argue with regulators about risk levels. You just sell the stuff to someone. Like having barrels of waste that are leaking and costing you a fortune. You just get a bloke to take it off your hands. And this option, which so far has been small, is now a growth industry. It is called Regulatory Capital Relief trading.
Regulatory Capital Relief
As always the essence is simple, the details massively complicated. Any trade, any loan carries a risk. Generally the riskier the more lucrative. You buy something that gives you a great return, generally it does so because it is risky. You buy the risk along with the return. So when you have to clean up a bank and the obvious solution is to sell the risky stuff, you are also selling the potentially lucrative stuff. This is fine if it is stuff that has already gone bust and shows no sign of recovery. But what about stuff which hasn’t imploded yet, but has a fair old risk that it might, or stuff that has imploded but shows signs that it might recover (with the help of refinancing from the central bank’s super-low loans)? It hurts a banker to have to sell such stuff.
The answer is to somehow separate the risk from the return, sell one, keep the other. A bit like selling the shadow but keeping the object. You would think they were inseparable. But not in banker world. What banks have done is go back to where modern banking was born – securitization. If you want to refresh your understanding of securitization I wrote a series all about it called Securitization – The Undead Heart of the Shadow Banking System parts 1, 2, and 3.
Securitization took unique and therefore unsellable loans (mortgages) and by the now infamous process of slicing and dicing them, and then recombining and pooling all those slices of loans in to standard units, the unique mortgages were transmuted in to a kind of currency. Think of a mortgage as a unique coin. You’ll never be able to get anyone to accept as payment a pocketful of random coins. But melt them down and pour the metal in to a new and standard coin and bingo, you have currency. That is what securitization did for mortgages and other loans. It turned debt into money. Now what they are doing is turning risk in to money. Securitized risk is being sold to investors in return for money/capital.
The bank gets to keep the asset – doesn’t have to sell it for a loss and doesn’t shrink the bank, but get’s rid of the risk. The buyer takes on the risk in return for a fee. It’s a kind of insurance. For those of you thinking it sounds like a CDS (Credit Default Swap) you’re right. What we are talking about is re-securitizing the risk from a pile of securities, by creating a derivative bet on that risk. Confused? I think that is the point. Banks and the financial industry in general like sentences that pack as many acronyms as possible in to sentences which purport to explain clearly but are intended to do the opposite.
So let’s look again and disentangle the notion.
Although Securities are bundles of loans, each security itself and the risk it contains, is different from others securities. Each is unique. You can see where this is going. The obvious answer is to slice and dice the risk in the securities, re-securitizing them, to make a new ‘product’ which contain slices of the over all risk of a bunch of securities. Having done this you then sell that newly securitized risk. Selling the risk means the buyer gets an ‘insurance’ fee in return for paying an agreed amount of any future loss on the underlying securities. Remember the buyer is not buying the underlying securities, only the risk they contain. This is called a Derivative. Like all financial ‘innovation’ it sounds great until you start asking questions.
The benefit to the bank is that the ‘asset’ in this case a security made of mortgages is suddenly a lot less risky – at least less risky for the bank. So when the regulator comes calling the bank can show a loan book that has a lot less risk attached to it. Less risk means having to hold less capital against it. Having to raise or hold less capital saves billions for the banks and makes them ‘safer’ as far as the regulators, governments, central banks and ‘I’ll swallow anything you tell me to’ journalists are concerned. The bank has decreased its risk … allegedly.
The benefit for the buyer/insurer is obvious – the fee.
First question – how does this work for the bank’s finances? The bank had a security which was supposed to bring in an income stream. It went bad and didn’t. But rather than sell the asset the bank wants to keep it, but not the risk of it loosing even more value and income. So the bank now wants to pay a fee to an insurer for that insurer to pay a slice of any future losses. To understand how this can possibly be profitable you have to figure in the policy of Central banks keeping interest rates at next-to-zero.
When banks create or buy mortgages they do not go the their pile of deposits to find the money. They create the loan electronically and then borrow the capital necessary to cover the loan. The important bit is that they borrow the money. However the banks don’t borrow the money for the same length of time that they loan it out. The banks lend it out for 25-30 years but borrow what they need to cover that loan for only a couple of years at a time. Thus they have to roll the loan over regularly, every couple of years, for the life of the loan.The reason – it is cheaper to borrow someones money for a short while than it is for a long while.
Thus the banks have lots of loans and securities which they funded back when the loan was made at the interest rate of the time. Let’s say they loaned the money out at 5% but borrowed from the central banks or from other banks at 3%. They were making 2% on the deal. Now the security goes bad. That doesn’t mean every loan in that security stops paying. A security is ‘non-performing’ if enough of its loans stop paying so that it no longer covers the cost of the money the bank is borrowing to cover it . The losses destroy that 2% advantage. The security was supposed to return 5% but now it is returning only 3%. And 3% is what the bank is paying to borrow the money to finance the loan. The bank is making no money at all. And because it has to hold capital against this loan the whole deal is costing it.
BUT then along comes the central bank which says we will now loan you money at 0.25%. The bank can now re-finance its loan cutting its borrowing from 3% to 0.25%. So now the security which is only bringing in 3% is suddenly profitable again because what the bank is paying for its loan has just gone down from 3% to 0.25%. In fact the security can be counted as ‘performing’ again, even though it is as rotten now as it was two sentences ago.
The important point is that although there is still only 3% coming in, it now costs only 0.25% to finance it. And the difference is the banks profit out of which it can now, finally, afford to pay the fee for the Insurer to take on a portion of the risk of any further, future losses.
The idea behind the strategy is that we sell loss protection against parts of a bank’s investment book, usually, that protects them against unexpected losses…[A]s a result of buying protection against these unexpected losses they’re able to go back to their regulator and say, ‘I’ve protected myself against the risk of loss on this particular part of my portfolio,’ and if the regulator signs off, then they can hold less capital against that part of the portfolio…
Which, in turn, means the banks can now issue glowing press releases about how it is turning round, reducing risk, and returning to profitability, while the politicians and regulators can enjoy their own great sound bites about how successful their policies have been at healing the financial system and saving the banks. This is the miracle of ZIRP (Zero percent Interest Rate Policy). We pay the cost of the policy and suffer as it erodes our savings and pensions but can feel good knowing the banks are making money again on rotten ‘assets’.
Of course the risk hasn’t gone. It’s just moved. And in moving it has accrued more interest around itself making it even more costly to eventually pay it down. In that sense the total amount of cost and risk in the system as a whole has gone up not down. The best that can be said is that the risk has been spread more widely, reducing its concentration inside the banks by putting it elsewhere. Which doesn’t sound nearly as heroic and sadly isn’t true either.
The fact is, as this FT article from July 2012 makes plain,
…the structure only makes sense if it pushes the risk on the tranche outside of the banking regulation net. If another bank held the tranche, they’d have the same issue that the original bank had in terms of regulatory capital cost. (my emphasis)
And there you have it. The risk has not gone away at all it has simply been put where the regulators don’t look. Genius. Don’t diffuse the bomb just put it under the stairs. Now supporters will say -‘Such wilful ignorance. We are insurers who know how to deal with risk, who understand it and can contain it’. Yeah – like AIG and all the other ‘insurers’ who folded in 2009 who had given us the exact same blather before collapsing then begging for bail out cash.
Where has the risk gone?
It hasn’t. The risk is being bought by Hedge Funds, old established and newly set up, by Asset Managers and Money Funds, and some is even being bought by the big Insurance companies and Pension Funds.
First thing supporters will say is that there are strict rules in place about who can own Hedge Funds. Banks can only own three percent of a hedge fund, so transferring the risk to Hedge funds really does take it out of the banks. To a point yes. But banks like Hedge funds. They are lucrative. Banks are more tied to Hedge funds than the 3% rule would suggest. Since the bank crisis began the ETF (Exchange Traded Fund) revolution has taken off. I wrote about and explained ETFs in ETFs The next Accident waiting to happen? Part One and Two .
Banks are very often the owners, creators and market makers for ETFs. And one type of ETF they have a lot of money and risk tied up in is … Hedge Fund ETFs. Goldman Sachs runs a large one. This fund doesn’t own Hedge fund shares but tracks their value using yet more derivatives. The point is that the bank sells its risk on securities to a hedge fund. But it then runs an ETF which is tied to that Hedge fund, and others who have done risk deals with other banks, and therefore is tracking, in part, the risk the banks claim to have ‘got rid of’. The banks are exposed to the risk only now one removed. Is being one removed better? Maybe, maybe not. Is standing one away from a bomb better than actually sitting on it? Probably but you’ll still be looking for your legs. If the risk goes bad, the Hedge fund pays on first or very close to first loss, its takes the hit, its shares dip. As its shares dip so does the value of the Hedge fund ETF which is tied to the bank.
But it’s not all Hedge Funds is it? Some of the bank’s risk has been sold to Asset managers. True – Like Blackrock for example. But this doesn’t really help because there are no special restrictions on how much of an Asset Manager or Money Fund a bank can own . And let’s remember that several such funds had to be bailed out when they collapsed in 07-09. You can see a list of who owns Blackrock here. The list includes State Street, Barclays and JPMorgan Chase. The same goes for Pension funds and Insurers.
So the situation is that the banks are selling their risk to all the institutions they invest in, part own and do other business with including loaning money to. According to David Peacock, who is co-head of corporate credit at Cheyne Capital hedge fund in London, quoted in an FT article from October 2011 entitled ‘Banks share risk with Investors’,
“There is a huge amount of interest now.”
Axa Investment Managers has launched a closed-end fund that will provide junior protection on banks’ loan portfolios. The investment arm of the French insurance group has already raised €80m and is aiming to increase that to €150m by January next year. Axa has previously done deals with some of Europe’s biggest banks.
So the banks are crippled by bad debts and the risk of more losses on them. The other financial institutions are suffering because of the very low interest rates which are saving the banks. Low interest rates means no one can make money because the rates and therefore returns are so low. So what do they do? They turn to the banks looking for something lucrative …and find it in the form of the risky loans which crippled the banks in the first place and which necessitated the ZIRP which is what is killing everyone else. The other institutions take the risk because the banks pay them. The banks do so because it removes the risk from their shoulders and from the preying eyes of regulators. The risk, however, is NOT gone it is just out of regulatory sight and mind.
The risk has in fact gone up because there is now interest to be paid for protecting it. But who cares. The Funds insuring it are making fees. Let’s take the example of the Pension funds who are insuring some of this stuff. Wasn’t one of the reasons for ‘saving’ the banks that if we didn’t the Pension funds would collapse and take our pensions with them? Yet now we have those same Pension funds taking on the risks we ‘saved’ the banks from. Genius.
When the risk blows up next time we won’t have to bail the banks to save our pensions we’ll be able to bail out the Pension funds directly.
All this has been about Europe. Earlier in this article – back when you were younger – I said, regarding who was buying up risky assets, that I’d come back to that. It turns out that major buyers of European bank risky assets are American Banks. Why? Because the Basel 2.5 and 3 rules which have tightened the screw on European Banks and increased how much capital they must hold against risky assets have not been applied to American banks. The US government has called the rules Anti-American and has held them up. So for the moment American banks can buy European risky assets without having to worry about holding extra capital against them.
In the article at Risk.net an article called Basel 2.5 prompts flurry of asset sales,
When a bank such as Natixis was selling its portfolio, some US banks went directly to the selling banks, and told them ‘We can buy your book at a more aggressive level, because we don’t have the cost of capital’,” says the head of credit trading at one European bank. Natixis announced the sale of an €8.6 billion credit derivatives portfolio in July 2010,…
It turned out Morgan Stanley was the main buyer. Getting risky assets for a low enough price to make them lucrative. So European risk is piling up in American banks. When tighter capital rules do come to American banks those assets will no longer be lucrative for the Americn banks just as they ceased to be for the European banks from whom they bought them, and there will be a blossoming of Regulatory trades in America. In the short term, however, the US banks have a temporary advantage and there are profits to made. This is regulatory arbitrage at its naked best. More bonuses I suspect.
Believe it or not the picture I have painted here is hugely simplified. And that itself is part of the problem. Just as with Securitization and its CDS insurance, back the first time round, the labyrinthine complications of Regulatory Capital Relief are already growing. People are insuring stuff they do not understand and will not be able to cover in the event of another serious crisis. How can I, an outsider, possibly pass such judgment on professionals whose business it is? Well they didn’t understand it the first time and judging by their actions, haven’t learnt much since.
Banks are selling and insurers are buying risk on bundles of securities. It all looks great from a distance – banks reduce risk is all the headline writers bother with. But underneath, the insurers are buying bundles not knowing if the risks on the inside are all nicely spread, different and therefore insurable or if they are all tightly correlated and therefore a ticking time bomb.
One last point – a general one but an important one. Whoever buys the risk from the banks, no matter what claims are made for how separate they are from the banks and how much this removes the risk from the banks, ask yourself where these other people got the money to buy the risk from? The fact is 98% of all the money in the world is credit backed bank created money. No one is insuring bank risk or buying risky assets with sovereign backed money. They are buying it with credit backed money – credit that at some point was created by and loaned from a bank. Somewhere back along the chain a bank counts that loan as an asset and has a risk attached to it. That one simple fact means that it doesn’t really matter who ‘buys’ a bank’s risk. Ultimately it is still tied to a bank and the banking system. The risk never ever goes away until the loan it is part of is paid down. The risk from the bad loans that are still crippling our banking and financial system have not been removed or dealt with in any way other than to move them from the regulatory spot light to a darker corner where they can fester un-noticed. They will not be dealt with until the loans are paid down or written off. The losses must be cleared from the system and will be – by bankruptcy or bail outs. In the mean time all this insurance is, at best, moving the mines around the mine field.
The take home message from all this? The risk has not gone. It is simply being moved from the banks where it is regulated to other places where it is not. Once again the regulators are behind.
Because there is now more interest to pay on the risk, it has grown.
Where is it now? Some is piling up in American banks. Much more is being bought up by Hedge funds and Asset Managers. How much will depend on how big this trade gets. It is early days but I suspect Basel 2.5 and 3 will make it a bigger and bigger trade over the next few years. In the next crisis, no matter what its immediate cause, I would look for some of the big names among those involved in this trade to be casualties. So even if it is a European sovereign default, if a bank goes over, the ripples will now spread quickly to those helping the banks with their Regualtory Capital Relief.