A bad habit November 20, 2013 at 9:33 pm
The claims that senior bankers have been using dangerous drugs are shocking, but the evidence appears irrefutable. Yes, cov-lite loans are growing:
This is going to have a nasty come down…
Category / Credit
The claims that senior bankers have been using dangerous drugs are shocking, but the evidence appears irrefutable. Yes, cov-lite loans are growing:
This is going to have a nasty come down…
Peter Lee in Euromoney points out that while dealers’ bond inventory has been going down, the big funds have got bigger.
Liquidity is drying up across the bond markets. Regulations designed to curtail banks’ leverage have had the unintended consequence of also sharply reducing their ability and willingness to make markets in corporate and even government debt.
Felix Salmon picks up the story and reposts this chart from Citi as evidence:
As the title hints, what is at stake here is the declining ability of the markets to absorb risk. Twenty years ago, dealers would make ‘risk’ prices for big blocks, committing their balance sheets to take on customer blocks in exchange for a return. That’s rare now, and become rarer. Dealer inventory has declined too as it becomes more costly in capital to hold. The net result is not just a market with wider spreads and less certainty of execution; it is also one that is becoming more and more vulnerable to even mild selling from the two buy-side leviathans, Pimco and Blackrock. It is no one’s interest that these firms are now so big that they cannot change their positions meaningfully without causing market disruption.
From Goldman’s Jesse Edgerton, via FT alphaville:
In the current iBoxx US investment grade index, for example, about 15% of bonds in the index trade less than once a month, and only about 65% trade on any given day. Even fewer bonds trade multiple times per day in substantial sizes. Thus prices and yields for a large fraction of the bonds that are aggregated into published indices must be estimated by the providers of the index data each day.
Unfortunately, it appears that the procedures used to estimate these prices do not incorporate all information available on each day, because future movements in bond indices are easily forecastable well into the future. To illustrate, we regress daily changes from 2010 to present in the Bank of America-Merrill Lynch BBB index yield on contemporaneous and lagged daily changes in 5-year Treasury rates and daily changes in spreads on the 5-yr CDX index of corporate default swaps, a more liquid credit market instrument… Although information reflected in Treasury yields is incorporated into the index quickly, information in CDX spreads is incorporated very slowly. A 1 bp increase in the CDX spread accompanies only a 0.1 bp increase in the BBB index yield on the same day, but it predicts an increase of another 0.3 bps on the following day and further increases up to three weeks later.
This is more important than I have space for, really, so just a few hints:
Bloomberg reproduces the following chart of Moody’s ratings of major banks with and without government support.
You could read this at face value: the claim would then be that an unsupported BofA and Citi are junk. But really, is this credible? The BB+ one year default rate averages, depending on period, somewhere around 1 – 1.5%. A fair credit spread, without liquidity premiums or other compensation, and assuming a Lehman-type 25% recovery would therefore be at least 1%, with the actual credit spread being bigger than that.
This does not seem credible to me. The PDs are high; the spreads are high; perhaps it is the stand alone ratings that don’t make sense?
Lehman Brothers Holdings Inc said on Wednesday it plans to distribute about $14.2 billion to creditors early next month… [this] will increase total distributions to about $47.2 billion, with two-thirds going to third parties.
The company has said it hopes to distribute more than $65 billion, on average about 21 cents on the dollar for allowed claims…
Following the distribution, holders of senior unsecured claims against the parent company will have received about 14.8 cents on the dollar on their claims
So, five years on, more or less, we are up to 15% recovery, with 20% in sight. Hmmm.
It seems that JPMorgan’s travails have become a spectator sport, to be enjoyed with a snack of your choice. I am only half way through the senate report, let along the appendices, so I won’t add to the (already comprehensive) guides to the action‡.
Instead I want to focus on four key issues which emerge from this debacle.
It will be interesting to see if the Senate can keep up the (encouragingly bipartisan) momentum here. One is uncomfortably aware that a confrontation may be brewing with politicians and public on one side, and the big banks, the OCC, and perhaps the FED on the other. If it really does pan out that way, the legitimacy of current regulatory arrangements may not survive the fall-out.
*The reference is to an extraordinary radio interview that Paul Roy, ex-head of equities at Merrill, gave about the old days on the London Stock Exchange, in which he claimed his equity traders used to enjoy a glass of madeira, or perhaps champagne, as a mid-afternoon pick-me-up. O Tempora, O Mores.
‡See also here and here. One delicate point, by the way, which I have not seen anyone really pick up on, is what ‘lag’ means in the transcripts. It seems to mean the time between general economic improvements affecting the HY vs. the IG indices, but it could also mean the difference between it affecting the spread of the components vs. the index itself. Given that JP’s opponents where hedging mostly using the components, JP was very exposed to the index/components basis.
§See the recent speech from Stefan Ingves here. Ingves says that “Major [Basel Committee] projects currently under way include: … completing the review of the trading book capital requirements. This entails an evaluation of the design of the market risk regulatory regime as well as weaknesses in risk measurement under the framework’s internal models based and standardised approaches.”
There has been a blog-fight between Bloomberg, whose editorial suggested that large US banks enjoy an 80 bps funding subsidy from the tax payer, and Matt Levine, who came to, well, a lower number. Now, I don’t really have a dog in this fight, but I was amused to note that SIFMA, a trade association, quoting the IMF, came to a 20bps subsidy.
Let’s assume that the subsidy is indeed 20 bps, and moreover that that 20 applies just to non-deposit funding. We will take JPMorgan, as that seems to be the paradigmatic example. JP has roughly speaking $2.4T of assets, funded by $1.2T of deposits, $200B of shareholder’s funds, and $1T of debt (quite a bit of it short term). So suppose JP enjoys a 20bps subsidy on that $1T*. That comes to $2B. Two billion dollars. To put this number in context, JPM’s last dividend payment was roughly $1.1B (30 cents a share last quarter to 3.8B shares). So the annual state subsidy JP gets, using trade association numbers, covers 40% of what JP gives shareholders. Um. I don’t know about you, but if this is even vaguely plausible, then the US taxpayer could legitimately be quite peeved about it‡.
*Obviously the 20 is a blended number; it won’t apply equally to all maturities of debt, nor equally to secured vs. unsecured funding.
‡For an earlier discussion of the UK taxpayer, see here.
Mortgage backed securities began with pass throughs; these were simply bundles of mortgages in security form. The PT did what it said on the can, passing through payments on the underlying mortgages to the security owner, perhaps after a servicing fee has been taken. Only later did trenching come to the MBS market.
Now, it seems, pass throughs are coming to the corporate loan market. In particular, some European banks are trying to develop a repo market in corporate loan PTs. Nothing has, I understand, been done yet but the ambition is there.
Perhaps some of the lessons of the CDO market have been learned: certainly a PT with full transparency over the underlying loans is simpler than a tranche of a high grade CDO, especially a managed one. But nevertheless this is shadow banking, and one might worry about the procyclicality of haircuts.
Today is a dark day.
His grief is for PAF2, an innovative regulatory arbitrage ahem I mean risk transfer deal whereby CS had their bonus pool write protection on a mezz tranche of derivatives receivables to get CVA capital relief. Or not. This deal probably wouldn’t have worked in most jurisdictions, and even in Switzerland it seems that its days are numbered. As IFRE tells us:
Credit Suisse may be forced to scrap or, at the very least, radically restructure [the deal]
The problem is that CS had to get protection on the senior to get relief, and no one really wanted to write that for what CS wanted to pay, so CS had to reduce the liquidity risk of the senior CDS by agreeing that if there was ever a payment on the senior, they would lend the counterparty the money to make it. So if the world goes to hell and CS lose a lot of money on counterparty credit risk – really* a lot of money – then they make a claim on the senior CDS which CS’s counterparty pays with money they have just borrowed from CS**. Um. Is that risk transfer?
As Matt says, Basel says no. Hence the problem.
Now, unlike Matt, I’m not sad, because this deal should never have worked. Regulatory arb that finds a clever way to transfer risk at the right price in order to exploit mis-designed rules is fair enough; reg arb that purports to transfer risk but doesn’t seems to me to be basically an arb not of the rules but of the regulator’s understanding of the trade. Unless, that is, they understood it but didn’t see the problem, in which case we have a bigger issue.
*Matt seems convinced that the senior attachment point was so high there was practically zero risk in the senior; I haven’t seen the trade details so I don’t know, but I will say that wrong way and concentrated sovereign risks can be significant in derivatives receivable securitisation structures, so one would want to be rather careful about the modelling before asserting something like that.
**And which, it appears, they can ‘pay back’ – in a very loose sense – by assigning the CDS back to CS.
How large sea creatures should avoid trying to optimize their capital requirements
First, regulatory capital optimization under the post-crisis rules was a critical motivation:
Two of the recent Basel Accords, commonly referred to as “Basel II.5” and “Basel III,” alter the RWA calculation for JPMorgan and other banking organizations. As the new standards become effective over a phase-in period, certain assets held by banking organizations such as JPMorgan will generally be assigned a higher risk-weighting than they are under the current standards; in practical terms, this means JPMorgan will be required to either increase the amount of capital it holds or reduce its RWA… In 2011, JPMorgan was engaged in a Firm-wide effort to reduce RWA in anticipation of the effectiveness of Basel III. The Synthetic Credit Portfolio was a significant consumer of RWA, and the traders therefore worked at various points in 2011 to attempt to reduce its RWA.
The initial position was long protection to hedge against the naturally long credit position in the CIO bond portfolio:
In the fourth quarter of 2011, the Synthetic Credit Portfolio was in an overall short risk posture
The combination of capital optimisation and trying to add jump-to-default protection to the short credit spread position did not help. In particular, rather than paying out, they funded the JTD protection by selling protection on the IG9s:
the traders began to discuss adding high-yield short positions in order to better prepare the Synthetic Credit Portfolio for a future default. The traders, in late January, also added to their long positions, including in the IG-9 index (and related tranches). These long positions generated premiums, and (among other things) would help to fund high-yield short positions
So what they had was an IG9 5 year short (short credit), high yield short (short credit but specifically long JTD protection) funded by an IG9 10 year long. The net position turned long credit, but they were well positioned against a shortish recession.
The firm’s main problem at this point was that two goals were in conflict. On one hand their position was so large (if unnoticed by regulators) that they would get crushed if they tried to leave too fast: on other other, they needed to leave to reduce capital. The solution, of course, was to try to change how capital was calculated.
the concern that an unwind of positions to reduce RWA would be in tension with “defending” the position. The executive therefore informed the trader (among other things) that CIO would have to “win on the methodology” in order to reduce RWA.
JPM were so big in the IG9s they could not do more — or significantly less. They had to contemplate taking yet more basis risk to balance the portfolio:
[The only option]… was to increase his long exposure in on-the-run investment-grade instruments, such as IG-17 and IG-18,… Beginning on March 19 and continuing through March 23, the trader added significant long positions to the Synthetic Credit Portfolio. These … included additions to the 5-year IG-17 long position (a notional increase of approximately $8 billion), the 5-year IG-18 long position (a notional increase of approximately $14 billion), and several corresponding iTraxx series, most notably the 5-year-S16 ($12 billion) and the 5-year-S17 ($6 billion).
This did not help the RWA usage of the portfolio: all of that basis risk is expensive in an IRC model. As the trader said, this is what kills me. They mis-marked it too, of course, for some definition of mis-marked, because it is impossible for traders to mark something that size accurately. But the real lesson is that JPM did not navigate between the Scylla of upcoming capital requirements and the Charybdis of close out costs very well. What is interesting is that without the RWA motivation, this probably would not have happened.
Bloomberg has an interesting story on the Danish FSA’s pursuit of mis-stated financials at banks:
Denmark’s financial regulator is warning the country’s banks that an understatement of lending risks won’t be tolerated as it embarks on a hunt to catch what it’s dubbed “backdoor” capital dilution.
The Financial Supervisory Authority will review internal rating models that determine how much capital a lender sets aside to ensure banks don’t find a way around stricter standards. While banks may fulfill capital requirements on paper, recent failures suggest risk weights don’t always reflect reality, leaving buffers too small to absorb losses… When Denmark’s housing bubble burst more than four years ago, it revealed widespread capital shortfalls that have since led to the demise of more than a dozen regional lenders. Toender Bank A/S, the most recent insolvency, followed a reported three- fold increase in profit in the first half and a solvency ratio – - a measure of financial strength — of 17.3 percent at the end of June. Yet an inspection last month by the FSA revealed bad loans almost 10 times as big as those reported by the bank, wiping out its equity.
Bloomberg loses a few marks here for not being precise: the capital requirements are fine, but the capital available to meet them is bigger than it should be because the bank has not taken enough provisions and thus has over-stated its earnings. What is interesting is that when the Danish FSA tightened their standards on impairments, impairment charges doubled at one large (and well-regarded) bank, Nordea. Presumably the impact elsewhere was similar. This kind of solid, boring policing of lending is very important, so kudos to the Danish FSA for doing it. One does wonder what Toender’s auditors were doing though…
FT alphaville had this as their chart of the day:
Now, there is a lot going on here including deleveraging, corporate cash hoarding, bank use of collateral (reducing the assets available in bankruptcy to support senior debt holders), increasing mortgage quality, and changes in bank resolution & regulation. Still, it’s an interesting chart.
Four telling graphs, from a great presentation by Citi’s Matt King (HT FT Alphaville).
First, the importance of the repo market:
Second, the growing importance of collateralized borrowing (and the decline of the interbank market):
Third, the trend towards the use of ‘safe’ collateral:
Fourth, where the bad stuff ends up:
So… what do we have? It’s hard for a bank to borrow unsecured. It’s hard for it to borrow secured in the private market unless they have the best collateral. But, riding to the rescue (kinda), is the ECB, where you can pledge some of that dodgy collateral. This state of affairs is not sustainable in the long term, though; we need to do something to get banks to trust each other again.
I’m a little busy trying to finish something, so here are three terse items from my ‘read, and want to blog about’ list for the week so far:
The immediate impact … would be a significant but arbitrary increase in pension scheme liabilities. If these proposals go ahead, funded pension schemes will undoubtedly have to adopt higher funding levels and shorter periods over which they have to make up any deficits… If schemes are forced to adopt ultra-cautious funding models, they will need to disinvest from equities, which would be highly damaging for European financial markets… None of this will offer meaningful protection to fund members – on the contrary, it will undermine the very existence of the remaining defined benefit schemes.
If we’re talking about the banking system, here, we’re talking about a world in which banks simply cease to trust each other at all, and the answer to all interbank credit [extension] questions is “no”. The only way for banks to lend to each other is to either go through some central counterparty, hub-and-spoke style, or else to retreat to the world of repo, where banking prowess counts for nothing and all that matters is collateral quality.
Clearly a fundamental job of banks is to lend, including to each other: to make credit judgements and to put money on the line based on those. We need to find a way to restore bank confidence in each other (not least because smaller amounts of unsecured debt in a bank’s capital structure gives less of a cushion protecting depositors in resolution).
From BCBS 228, Basel III counterparty credit risk – Frequently asked questions :
How should purchased credit derivative protection against a banking book exposure that is subject to the double default framework or the substitution approach be treated in the context of the CVA capital charge?
Purchased credit derivative protection against a banking book exposure that is subject to the double default framework or the substitution approach and where the banking book exposure itself is not subject to the CVA charge, will also not enter the CVA charge. This purchased credit derivative protection may not be recognised as hedge for any other exposure.
So, let’s get this right. You have a banking booking position, oh say some RMBS, just to pick a random example. You buy CDS on it from oh, say MBIA. MBIA’s credit spread goes to the moon during a crisis, but there is no CVA charge just because it is in the banking book? (There will be a higher default risk charge, of course, but that isn’t the point.) Interesting…
There’s a problem in corporate swaps. It’s this.
Three banks that spoke to Risk for this article all claimed to be assuming there would be no exemption. They also said rival dealers are doing the opposite.
You might say ‘of course they would say that’. But there is a problem here, and it isn’t going to be resolved any time soon.
Via Alea, I found an interesting article in Euromoney about a presentation by JPMorgan’s Michael Ridley. He was discussing the parlous state of secondary bond market liquidity in Europe is one of the most worrying by-products of the region’s bank-funding crisis. Primary volumes in the first quarter were excellent, but secondary volumes remain low. Apparently bonds are often cheaper in the primary market than in the secondary market, and the challenging market liquidity situation is not improving.
The volume figures quoted in the article are rather scary:
Explaining that the US bank traded 5,000 names last year, Ridley noted that of the top 1,000 bonds, just eight traded more than three times a day. Twenty-six traded twice a day, 134 once a day and 832 traded just three times a week. Ridley added that 145,000 bonds on the bank’s books did not trade at all in 2011.
If you buy a corporate bond in the primary market, you should plan on a worst case holding period of ‘until maturity’.
Lisa Pollack has a long and good post on FT Alphaville which can be summarized thusly:
So, Mr. Regulator, given you had full reporting of JPMorgan’s synthetic credit trades in the DTCC warehouse, and it was blatantly obvious from that that they had a whale of a position, why didn’t you do anything about it?
When Magellan emerged from the strait that bears his name into the Pacific ocean, he thought that he was only a few days sailing from Portugal and home. Good try, but no cigar. A similar navigational issue seems to be plaguing folks over last night’s $2B JPMorgan loss. Here are some things we can, and cannot conclude from this ‘egregious’ loss.
Update. FT alphaville makes a similar point about the difficulty of identifying a ‘good’ hedge here.
According to Bloomberg, The largest U.S. banks, including JPMorgan Chase & Co. (JPM) and Goldman Sachs Group Inc. (GS), told the Federal Reserve that a limit on their credit exposure is unnecessary and “fundamentally flawed.”
They are of course wrong. The FED’s single counterparty credit limit (10 percent of capital for credit risk between a company considered systemically important and any counterparty when each has more than $500 billion in total assets) is a sensible move to address interconnectedness. Why is it that few challenge the proposition that the derivatives market – where exposures are typically collateralised every day – is too interconnected, but when it comes to direct interbank credit, no one cares that one SIFI owes another billions?