Deus Ex Macchiato

The two first introduce Limited Purpose Banking, or LPB. They then write, in How to take moral hazard out of banking:

Mutual funds are, effectively, small banks, with a 100 per cent capital requirement under all circumstances. Thus, LPB delivers what many advocate – small banks with more capital. Will this work? It has. Unlike so much of the financial system, the mutual fund industry came through this crisis unscathed. True, the Primary Reserve Fund broke the buck by investing in Lehman and had to be bailed out. But under LPB only cash mutual funds (invested solely in cash) would never lose investors’ principal. The first line of all other funds’ prospectuses would state: “This fund is risky and can break the buck.”

(The full FT article is here.)

Um, no. First, mutual funds don’t have a 100% capital requirement: they have a 0% one. All their funding is debt. This makes them highly risk averse: at the first sign of trouble, they sell, exacerbating liquidity problems in the short term note and CP markets. Using short term notes to fund longer term risk taking is a recipe for disaster. Instead we do at least know that historically using insured retail deposits to fund loans is relatively sound, provided that capital requirements are high enough. Splitting originating loans from taking the risk on them doesn’t work as there is no alignment of interests: splitting deposit taking from risk taking doesn’t work either due thanks to mismatch in the term of funding.

Turning now to Felix Salmon, we find:

if investors think that huge losses are coming around the corner, or that a bank is incapable of making sustainable profits over the long term, then no amount of capital today is likely to reassure them that a bank is safe.

This is not true. Some amount of capital will certainly reassure them: an amount equal to the plausible worst case losses, plus a bit, say. OK, that might be quite a bit more than 2% core tier 1 ratio permitted under Basel, but that’s fine.

stock-market investors don’t necessarily reward well-capitalized banks and punish those with only thin layers of equity — in fact the opposite is true much of the time.

Duh, as Homer would say. High leverage = high returns in the good times = high equity price. Of course the equity markets reward high leverage most of the time: most of the time, high leverage is fine. It’s just that when it isn’t, the costs are enormous. No, I wish I had a better recipe than the universal bank under high capital requirements, but I don’t, and I don’t think anyone else has either. Unless of course you know different.

Posted in: Commercial Paper, Liquidity and liquidity risk, Regulation by David /
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The conventional explanation for the decline in the ABCP market is that structured finance is on the slide, perhaps for good. There is another reading, though. It could be that the structured finance isn’t dead – after all Morgan Stanley got a CMBS deal done recently – it could be that maturity transformation is dead. Northern Crock didn’t fail because of structured finance, it failed because of funding. Of course the reality is not so clear-cut, but if there is even a grain of truth in this musing, securitisations with little or no liquidity risk and well understood collateral will continue to be executed even as other parts of the structured finance market fail.

Posted in: ABS, Commercial Paper, Liquidity and liquidity risk, Securitisation and Tranching by David /
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In the financial markets there is nothing really new. Some vaguely good news:

• The ABCP market has expanded a little, for the first time since August 2007;
• The 3m swap spread has come in a little; and
• Despite all the talk, a major monoline has not yet defaulted or even lost its AAA.

Meanwhile the realignment is continuing:

• The VIX is up;
• Shares are broadly down although they are still bizarrely high compared with bond spreads;
• Corporate defaults are expected to rise according to Citi and JPM and the iTraxx is a little wider;
• The rerating and downgrading of CDO tranches continues; and
• The tightening of the ABX over Christmas was temporary.

Posted in: ABS, Commercial Paper, Economic Theory, Markets by David /
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Naked Capitalism makes a very good point about the (relative) lack of a catastrophe in the ABCP market recently:

Many mortgage-related ABCP issuers have gone to a lender of last resort, namely the Federal Home Loan Banks, which have extended $163 billion of loans to them.

(The FHLBs are commonly thought of as equivalent to U.S. government risk, although they do not have an explicit government guarantee.) NC then references a Bloomberg article, quoting

Countrywide Financial Corp., Washington Mutual Inc., Hudson City Bancorp Inc. and hundreds of other lenders borrowed a record $163 billion from the 12 Federal Home Loan Banks in August and September as interest rates on asset-backed commercial paper rose as high as 5.6 percent. The government-sponsored companies were able to make loans at about 4.9 percent, saving the private banks about $1 billion in annual interest.

To meet the sudden demand, the institutions sold $143 billion of short-term debt in August and September, according to the FHLBs’ Office of Finance. The sales pushed outstanding debt up 21 percent to a record $1.15 trillion, an amount that may become a burden to U.S. taxpayers because almost half comes due before 2009.

[...]

The home loan banks “were the only game in town for a lot of borrowers,” said Jim Vogel, head of agency debt research at FTN Financial a securities firm in Memphis, Tennessee. They are “like an old watch your grandfather left you years ago, and you pull it out of the drawer and find it’s the only timepiece you have.”

This is really scary. The FHLBs are lightly regulated (laws tightening the regulatory framework around them are currently stalled in the Senate), were one of them to fail or come close to failure, there would be enormous pressure for a government bail-out, yet their risk management practices are hardly likely to be in the same category as a Goldman Sachs. Avoiding a market crisis this way may just be storing up trouble for the future. Gangway, gangway, I want to get off this particular boat.

Posted in: ABS, Commercial Paper by David /
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The importance of my earlier question about how the MLEC will price the assets it is going to purchase is highlighted by an article in the FT today:

[It has emerged that] Axon Financial, a SIV linked with the US hedge fund TPG-Axon, had taken losses of $110m on sales of $3bn of its investments.

Very crudely scaling from $110m on $3b to Citi’s $100b in conduit assets gives us a loss of $3b. So we know a real mark to liquidation would really really hurt. The market is so illiquid at the moment that it’s hard to be sure until you try to sell of course. So it should be no surprise to learn that many banks have not yet marked their conduit assets down:

One banker said last week: “The banks have varied enormously in terms of how much they have marked down their books – of course there are some that want to avoid the big write-downs.”

The MLEC then looks like an attempt at creating a new vehicle the banks can claim is arms length and which they can use to justify valuations which might not really be liquidation levels. That helps in turn helps the banks other conduits and the value of their on-balance sheet ABS. If you tell people it’s worth par often enough, loudly enough, maybe it will be…

Posted in: ABS, Commercial Paper, Fair Value, SIVs and Conduits, Writedown by David /
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…and some of them are even more rare than buyers in the ABCP market. That however, may be about to change.

The proposal apparently (the details are sketchy) is for a group of banks to set up a mega-SIV. This new vehicle will acquire the mortgage assets now held by some existing SIVs and conduits. The range of participants is unclear – Citi, with over $100B in conduits, is apparently leading the deal structuring, with JPMorgan interested in selling the new paper. The basic idea is that having a vehicle with a more diverse range of assets will avert the need for many banks to sell their existing conduit assets causing a crash in the RMBS market. Things are not exactly going well there as it is, as you can see from the recent price action on the ABX Home Equity BBBs (this graph is for the 07-2s):

(Graph from Markit via Calculated Risk. This is pretty good on the ABX if you need some background.)

The credit enhancement for the new vehicle hasn’t been made public thus far: one structure might be for all the contributing banks be jointly and severally liable for some bottom tranche, followed by a layer of seller-specific credit enhancement. The proposal is apparently to be dubbed M-LEC, for master liquidity enhancement conduit.

In this context it occurs to me to wonder why holding assets off balance sheet in conduits have such a preferential capital treatment compared with on balance sheet credit enhancement. To see this, consider the following two trades: 1. A bank sells a diverse $500M portfolio of assets into a conduit, retains a $10M seller’s interest, funds by issueing three month ABCP, and writes a back-up liquidity line; 2. A bank holds the assets on balance sheet and buys a three month credit derivative on losses in excess of $10M, rolling it as it expires.

In both cases the bank is exposed to losses between 0 and $10M but not above. In 1., it has to fund the assets if the ABCP market is disrupted, whereas in 2. it knows that it has to fund the assets in all conditions and hence can lock in term funding. Therefore arguably 2. is less risky than 1., and certainly not riskier. But you can guess which situation has the higher regulatory capital, can’t you?

Update. The plan is now out. Or, at least, the intention to come up with a plan that may lead to the MLEC is out. I wonder how they are going to value the assets the MLEC will wave in…

Posted in: Art, Commercial Paper, SIVs and Conduits by David /
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Today the Bank of England said it will lend £10B to commercial banks in an emergency three-month auction and widen the range of securities it accepts as collateral to include mortgage backed securities. That should bring the 3 month swap spread in. The question is, why have they caved in to the banks after holding the line admirably until now? Some possibilities, the first three none too savoury:

• The political clamour over Northern Rock could not be ignored and the Bank was worried that someone like Alliance and Leicester or HBOS might be next.
• The Bank knows that another player is in serious trouble.
• The knock-on effects of the high cost of Libor-referenced funds in the real economy are becoming too large.
• The rate the Bank is charging for this extra liquidity is sufficiently high that it provides appropriate liquidity yet makes anybody imprudent enough to need it pay through the nose. This wouldn’t be too bad but one wonders why at least some of this £10B was not provided earlier.

I agree with Nils Pratley that this is not a resigning matter for Mervyn King – the Bank has played a reasonable hand. But we do need understand what their thinking is. The performance today will be interesting.

Update. King is blaming the Market Abuse Directive for preventing him lending to Northern Rock covertly, and the takeover code for stopping him organising a quick-but-effective sale. This is fascinating if it’s true.

Posted in: ABS, Commercial Paper, Credit, Liquidity and liquidity risk by David /
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The BBC doth protest too much. First:

Shares in one of the UK’s largest mortgage lenders, Northern Rock, have fallen 32% after it had to ask the Bank of England for emergency funding.

The next paragraph however:

But experts say it does not mean Northern Rock, which has £113bn in assets, is in danger of going bust.

Liquidity risk has nothing to do with solvency. You can go bust with £113B in assets and £1 in liabilities if you can’t find the cash to pay the liability and it is due today. If you have to go to the Bank of England as Lender of Last Resort because, well, it is a last resort, then you are in danger. And it is no surprise that an institution whose business model was based on originating mortgages then securitising them has a funding crisis. What is more surprising is the number of Corporal Joneses going around crying ‘don’t panic’. Panic seems entirely appropriate. Unless you are naked long CDS protection on mortgage banks, of course, or long gamma on the stock…

Remember, if it looks like a duck, smells like a duck and quacks like a duck, it is probably a duck. Similarly if it looks like a liquidity crisis, smells like a liquidity crisis and the central bank acts like it is a liquidity crisis, then it’s probably a liquidity crisis.

Posted in: Commercial Paper, Liquidity and liquidity risk by David /
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From today’s FT:

Continued high overnight interest rates forced the Bank of England to offer £4.4bn additional cash to commercial banks on Thursday morning, in an effort to normalise the money markets.

A decent sized conduit or SIV is £5B so the bank’s extra liquidity is less than one conduit’s worth. Is anyone else surprised how relatively small the bank’s offer is? Personally I think they are doing an excellent job in not rescuing the imprudent, but I wonder if £4B is significantly different from zero.

Posted in: Commercial Paper, Liquidity and liquidity risk, SIVs and Conduits by David /
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The term ‘money market’ is pretty unhelpful in current conditions. There isn’t one. There is a short term Libor market, which is decidedly interesting at the moment, and a short term govy market, which is awash with liquidity at least in some currencies. These two markets have decoupled.

The FT, reporting on a speech by Axel Weber, president of the Bundesbank, says:

[...] the tools that modern central banks possess to address liquidity problems can only directly address such runs inside the traditional banking sector, and do not directly touch the non-bank financial sector, which has been hardest hit by the current credit crisis.

Mr Weber’s analysis highlights the dilemma facing central banks, which cannot channel funds directly to the non-bank financial sector, and may therefore have to resort to easing monetary policy instead.

Once the Libor market disassociates from the govy market, there isn’t much that a central bank can do. They control financial operations in the govy market, and they can inject extra liquidity there via accepting a broader range of collateral at the window, cutting rates, or whatever. But they have no power over the Libor market. They can hope that if the differential between the two markets becomes large enough banks will step in, borrow from the central bank, and lend into the Libor market, but they can’t force that to happen.

Weber claims that the current situation is like a run on a bank, but one effecting conduits and SIVs rather than banks per se. In that these vehicles are suffering a liquidity squeeze that they are vulnerable to due to mismatched funding, I’d agree. But Weber says this “is a total over-reaction”. I’m not so sure. If you can get Libor plus 100 for lending a AAA Libor-based funder cash (because cash is really scarce and you have it) why wouldn’t you?

Posted in: Commercial Paper, Liquidity and liquidity risk, Markets, SIVs and Conduits by David /
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Today’s FT discusses the current problems for SIVs and conduits and identifies two main ones:

They have been hurt as funding in short-term debt markets has seized up.

Simultaneously, the values in the kinds of assets they hold have fallen as investors deserted all asset-backed bonds in repsonse to fears of contagion from the US subprime mortgage markets.

Now the killer punch:

Analysts at Moody’s said during an investor call on Tuesday that the funding problem was by far the most serious for most vehicles.

“The ongoing liquidity crisis has deepened and broadened since . . . July,” said Paul Kerlogue, senior credit officer for SIVs at the agency.

“Vehicles that fund [by means of] the issuance of commercial paper have found financing either impossible or achievable only at exorbitant levels.”

There are three ways out of this. Default; pay up for CP at current levels and hope you don’t run out of cash to pay spread before the ABCP crisis ends; or deleverage. Your asset quality effects which of these alternatives are available to you but it doesn’t change your exposure: even if your assets and capital structure mean that your debt should still be AAA, you nevertheless still have a problem. And it is going to get worse, at least for a while. There are tens of billions of dollars of ABCP due to expire in the next ten days, and even more falls off next month. Some of that will be financed in the short term via backup CP lines with banks, but that will just force the 3m swap spread out further and the ABCP market is likely to become even more arid. The key to understanding the current crisis is the liquidity market.

Posted in: Commercial Paper, Liquidity and liquidity risk, Markets, SIVs and Conduits by David /
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