As much as I like to think I have a reasonably active imagination, it never ceases to amaze me how a bad situation can easily become worse.
Readers probably know the European authorities have been stunningly late to wake up to the fact that EU banks are undercapitalized, apparently being the only ones to believe their PR exercise known as a stress test. The banks’ options would seem to be limited. One is to raise more equity, which is kinda difficult now since no one is terribly keen about banks in general, and the ones in most need of more capital are the least attractive. Second is to let existing loans roll off. The authorities don’t like that idea, since less lending will increase downward economic pressures. And since bank CEO pay is correlated with size of institution, the banksters aren’t too keen about that either. Third is to cut pay to help accelerate earning their way out. You can guess how likely that is to happen. Last is to suffer state-assisted recapitalization, which under EU rules, would be a draconian exercise.
But never fear, the financiers have an “innovative” way around this problem. And this innovation is a remarkably destructive idea. From the Financial Times:
Banks are striking deals with private equity groups, hedge funds and insurance companies in an effort to preserve their precious regulatory capital.
A growing number of investors is moving to provide beleaguered lenders with special targeted transactions to help them share their risks – for lucrative fees – through a fast developing class of “regulatory capital relief” funds.
Interest in such vehicles comes as banks, particularly those in Europe, scramble to develop new funding tools and identify ways of protecting capital, as they grapple with the prospect of sovereign defaults, forced recapitalisations and new Basel III rules.
The schemes typically involve writing partial guarantees for the assets sitting on banks’ balance sheets through bespoke securitisations, meaning insurance companies or funds absorb the losses on the riskiest portions of banks’ loans.
Such transactions allow banks greatly to decrease the amount of money they must hold in reserve as a backstop for potential losses in their lending books.
David Peacock, co-head of corporate credit at the Cheyne Capital hedge fund in London, which has been striking such deals with banks since 2004, says: “This is a means of capital raising which has been used over a number of years, but the need now is much more acute than it has ever been before.
The Japanese had an interesting attitude toward regulation, which is that they’d tolerate all sorts of things on small scale, but reserved the right to stop any activity cold if it got big enough to warrant scrutiny and they concluded they didn’t like it. Here, the “difference in degree is a difference in kind” logic is even more operative.
Regulatory capital relief is a gimmick that never should have been tolerated in the first place. The lesson of the crisis just past is that the biggest cause was the widespread selling of underpriced insurance by financial firms that were already highly geared. Eurobanks and US investment banks hedged AAA rated CDOs with credit default swaps where the guarantee failed or similarly bought AAA tranches that were synthetic (meaning made of CDS) where the protection writer failed to perform. This is a basic risk management error, called wrong way risk: buying a hedge from a counterparty that it pretty likely to be impaired if the bad event you are worried about comes to pass.
Any regulator that tolerated regulatory capital relief is an idiot. Banks rarely get trouble in isolation; the pattern more often is that multiple banks have fallen victim to the same bad exposures or economic risks. A lot of hedge funds were pummeled in the crisis and quite a few liquidated. Quite a few insurance companies suffered as well. So some, perhaps many, of these guarantees are likely to prove worthless if they are ever put to the test.
And its impact on a larger scale is even worse. The biggest failing of our financial system is its tight coupling. In tightly coupled systems, there are not enough firebreaks and events propagate across the system unchecked. It’s like a badly designed electrical system, where a lightening bolt hitting a single transformer will take down the entire East Coast.
One of the dangers of tightly coupled systems is that actions that are intended to reduce risk actually increase them. We discussed on the blog risk reduction efforts in the pre-Lehman phase of the crisis that made matters worse. For instance, efforts in January 2008 by Congress to use Fannie and Freddie to help deal with the mortgage crisis led Fannie and Freddie spreads to blow out, setting off a chain of events that led to the collapse of Bear Stearns.
The most important thing that needed to happen in the crisis and didn’t was reducing the tight coupling of the system. The stymied Bank of England effort to separate retail from wholesale/investment banks would have been a step in the right direction.
This regulatory capital relief effort gimmick is a massive step in the wrong direction. It enmeshes other financial players into the already-too-tightly connected grid of major financial firms, particularly the big dealer banks at the core of the global debt/over the counter trading markets. It has the effect of enlarging the “too big to fail” complex, so that if any large player gets in trouble, the damage done by its unraveling are greater and even more difficult to analyze in advance. And it creates more points of failure. Recall how the downgrading of comparatively small monolines led to losses at banks as they had to write down the instruments they guaranteed. If key providers of regulatory capital relief were to come into doubt, banks considered to be adequately capitalized would also come up short.
The very fact that this device will apparently be tolerated on a large scale is proof that the officialdom is completely unwilling to stand up to continued banking industry looting and will allow schemes almost certain to create the need for even bigger bailouts to be foisted on ordinary citizens. This is neofeudalism wrapped in the mantle of modern financial technology. I can only hope things blow up quickly enough that the authorities who cast a blind eye on these practices are held to account.
21 comments
Comments are closed.
Yves,
You’re right if the reg cap relief is transferring leverage from banks to the funds. Actually it doesn’t, because all these trades are fully funded if structured right, and if the funds lose money, it’s not borrowed money but capital. That’s why they ask for equity returns on these…
Very different from buying CDs from aig under CSa when aig was aaa rated and claiming relief on that
Cheers
That may have been true of the older trades, when this was a small scale activity and only a few discerning hedgies were willing to play ball. But with liquidity scarce in the Euromarkets and so many banks now scrambling for capital, I’m willing to bet not.
Recall what happened with the CDO. Most people forget that CLOs are CDOs too, just not resecuritizations like ABS CDOs. Even though they got whacked in the crisis (AAA tranches went from 100 to in the 80s), they were not a total fail.
The CDOs as resecuritizations were always riskier. This is a similar transfer of what amounts to lower tranche risk. And over time, the structures got riskier and the assets in them got riskier.
And being collateralized (“secured”) isn’t as comforting as it might be either. Recall that the reason JPM withheld cash and other collateral from Lehman (which was the blow that sent Lehman under) was they realized some of the collateral JPM had sent them was garbage. And this wasn’t new, the story that recounted it made clear that Lehman had been sending stuff its employees called “goat poo” to JPM for a while. If Lehman could snooker JPM for months, what chance to you think European insurers have? Remember, AIG was WIDELY considered to be the smartest, most ruthless, most risk savvy insurer in the world (I’ve met AIG people, they were much brighter bulbs than the folks at other insurers). Yet hey failed due not just to the holding company risk (not as tightly controlled due to its contractual independence, but Cassano was scared of Greenberg, so de facto control was probably better than the formal controls) AND their secured lending blowup (which was clearly under Greenberg’s purview). AIG’s blowup pretty much proves the case that any insurer willing to play on the wild side is at risk of being screwed. And insurer are MUCH deeper pockets in aggregate than hedgies.
Yves, you do know Timmy is there “helping” them in their folly, don’t you. He is teaching Lie, Extend and Pretend 101.
To reduce the nominal risk associated with a particular asset class, does Mr Eurobanker call Chayne Captial who securitizes the risk associated with the asset class and finds a counterparty who by buying “bespoke securitizations” guarantees a specific value for the asset class? Under Basel II/III asset class values determine the amount of money lenders must hold in reserve.
What’s see the difference between regulatory capital relief (RCR)and CDS? OTC and securitization hanging out on the corner again. Can I buy RCR on your RCR?
It’s a Ponzi Scheme based on natural resources, especially oil, that is now collapsing. The banksters are suppressing oil demand through austerity to mitigate the effects of peak oil. This will buy them time to unload even more of their bad debt onto tax payers.
When the smoke clears it will be tax payers on the bottom of the pile crushed by a mountain of sovereign debt that will be made good by privatizing the common weal and slashing social programs. The looting is in a final frenzy now that peak oil is here.
I purchased a bicycle recently and am prepared to peddle my way into the future. This is very different than what was promised years ago.
Rocket car, rocket car, wherefore art thou?
This analysis is exactly right. The idea that banking idiocy can be overcome by adding capital is simply exponential stupidity. We need to stop banking idiocy, which means an end to credit default swaps. There isn’t enough capital in the universe by absorb the risk of these nuclear weapons.
Ha! Too me, its like creating a time portal…into many futures…picking the pockets of promises and events unknown…to gain realized reward today!
Skippy…600Tish futures / possibility’s[?]…outcomes predetermined…straight in to my account…ROFLOL…
As long as they are allowed to continue to loot the system and get away with the loot, so long will they continue.
The only way to stop this is to disallow looting and to make sure those bankers cannot get away with the loot. This requires the spirit of the rule of law to be readjusted to get closer to real justice as perceived by the great majority of people. The laws have been perverted over the past many years and do not reflect anymore real tangible justice but are bent to benefit the few at the expense of the many.
but but but… the criminals write the laws. It’s the new American Justice System, and it’s just downright bully.
The financeers need to hire some biologists, who will instruct them on biodiversity and exploiting ecological niches. Expansion into ever larger networks is a loser. There is an old Wall-Street saying: a tree doesn’t grow to heaven.
A very good analysis. I would add that the EU leaders are trying to squeeze every drop out of every leveraged euro in order to avoid having to go back to national parliaments to explain that this is going to cost a couple of trillion and in order to avoid having to ask the ECB to start intervening in various shapes and forms, FED style.
A consequence of the euro states thusly getting increasingly pregnant with each others debt is that it probably will become impossible to unwind the whole thing, making a full-blown federal pool of euro debt the next unavoidable step.
Looks like a balance sheet gimmick. The balance sheet of the bank seems less risky and the risk is seemingly transfered to someone else. For a real fee, of course, in exchange for a promise to pay.
It the risk-taker cannot honour the pledge for some reason, the bank still fails. Unless, of course, you bail out the risk-taker, i.e. a hedge-fund or whatever.
Going back four or five years, Gretchen Morgenstern (!) said in passing that the crisis stemmed from the willingness of regulators to count insurance policies as capital. It would be so easy to simply exclude insurance policies from the regulatory definition of capital. In contrast, it will be almost impossible for regulatory examiners in the field to evaluate partial guaranties via bespoke securitizations, each of them custom made, highly individualized, one-offs. A bank might want such “guaranties” for its own protection. Why would sovereigns accept such schemes in lieu of what I might call real capital, tangible net equity? Why would sovereigns accept such schemes in lieu of a capital cushion against loss that would protect them–the sovereigns–from having to bail out banks? Because the sovereigns don’t have the money to do it themselves (recapitalize the banks, bail them out?) Because the banks can’t raise capital in any othe way? For ideological reasons, like avoiding nationalization of banks, or not constraining their animal spirits, or because private-public partnerships are fashionable?
One of the solutions to problems for capitalism, is to move the problem around, as not to affect the capitalist. So, the gimmickry and then the lying about the gimmick, is part of the process of denying that there are major structural problems with capitalism. Today, we call it propaganda or public relations. Marx called it false consciousness. What is truly amazing, is that capitalism manages so far to work around its self imposed structural problems and come up with solutions that extend its money making and profit taking for a long enough period, a secular business cycle or two, that we all go back to our day to day lives and and live off the fat of the land and not worry about things too much.
Will it be different this time? Will the cascading crisis from America to Europe and now from Greece to the entire Eurozone and from the Zone to America and then? S America, East Asia? How bad can it get? Even if the world’s politicians come to their senses and start to tax all of the mountains of cash piling up in the form of corporate profits, private capital will just make even greater returns. Even if taxes reach confiscatory levels of 90%, the profit making machine of capitalism will outrun the governments, by absorbing the money spent on the masses in the form of government contracts only they are large enough to handle. There is no way to stop the gimmickry from being instituted short of force. One solution is a gradual reconstruction of a new social order within the one that is functioning now. Capitalism grew up side by side, within feudal kingdoms and bishoprics. There is no reason why a more stable economics can’t grow up side by side with capitalism.
Yves,
This is an incredibly important post. Thanks for highlighting the development.
The entire CDS market needs to be shut down, liquidity be damned. It didn’t exist before 1990 and we lived just fine w/o it. These hedge funds are unregulated insurance companies. Who knows if they have adequate loss reserves provisioned? If this practice is to continue, and I think it shouldn’t, then CDSs must be brought under the umbrella of national and international insurance regulation and their issuers treated by the same rules as life insurance companies, for example.
I can’t believe we are seeing the “yeah it’s toxic waste, but if it melts down we’ve got it insured, so effectively it’s AAA” game being trotted out to rescue Europe. That’s like getting in trouble with a loan shark and deciding to deal heroin to get the money to pay them off. Come to think of it, we’ve seen that move before: John DeLorean. And think how well that worked out for him.
Phichibe
The other side of the coin it seems is that this move allows bank to avoid mandatory clearing rules for CDS, thereby saving margin that they would otherwise have to post to a CCP.
Euro crisis solution methodology http://www.independent.ie/multimedia/archive/00963/cartoon_i_963487t.jpg
Meanwhile, at the ECB http://www.cartoonstock.com/newscartoons/cartoonview.asp?catref=bron1904
There’s always the old magic hat trick http://www.forexillo.com/wp-content/uploads/2011/08/Cartoon-Trichet-790759-8th-aug-ecb-intervenes.jpg
Diagrams of neofeudalism, in increasing order of complexity
The basics http://1.bp.blogspot.com/_ZyG_6AwOlh4/S0dfdcQuFeI/AAAAAAAAARY/AFFMButx3V0/s320/Feudal+heirarchy.jpg.png
Extending the metaphor a bit further http://i2.crtcdn1.net/images/asset/906/622/50/f29587_260x195.jpg
A more complex model (my favorite!) http://theintelhub.com/wp-content/uploads/2011/05/neofeudalism.png
There are no fixes only cons.
There are no fixes, only cons
That’s true, but the tragedy is that people’s pensions belong to this “con”, or “fictitious capital” (paper claims on wealth in the form of stocks, bonds, interest and rents).
The latter is now in excess of the total available surplus value, plus available loot from third world countries.