Category: off balance sheet

Credit contraction has only just begun

A few weeks ago we presented “Unwinding Planet Leverage” at the Spring CMRE dinner (http://www.cmre.org/) where I would say many were concerned about the ongoing credit fiasco. On the other hand, after countless capital raises, reassurances from commercial and investment bankers and the Bear Stearns rescue several months ago, sentiment has swung into bullish territory. Time after time I hear the same response from investors, “the Fed will not allow another large bank or investment bank to fail” or “I’m buying stocks since the Fed has things under control”. Oh really?

Today the Financial Times did a piece about potential accounting changes to off balance sheet entities created by our transparent bankers. Evidently, FASB wants to remove all conduits, SIVs, VIEs and any other form of off balance sheet activities consequently returning roughly $5 trillion to bank balance sheets – ouch!

Accounting changes could force US banks to take thousands of billions of dollars back on to their balance sheets in the coming months in a move that is likely to curb further their lending and could push them into new capital raisings, analysts have warned.

Analysts at Citigroup said a planned tightening of the rules regarding off-balance sheet vehicles would force banks to reconsider arrangements and could result in up to $5,000bn of assets coming back on to the books.

The off-balance sheet vehicles have been used by financial institutions to keep some assets off their balance sheets, thereby avoiding the need to hold regulatory capital against them.

Birgit Specht, head of securitisation analysis at Citigroup, said: “We think it is very likely that these vehicles will come back on balance sheet. “This will not affect liquidity because they are funded, but it will affect debt-to-equity ratios [at banks] and so significantly impact banks’ ability to lend.

In the past I’ve discussed leverage at various financial institutions which in some cases actually increased since the credit crisis began last Spring. For example, since the Bear Stearns funeral Citigroup actually increased their leverage from 18-1 to 19-1 while Lehman and Morgan Stanley shifted more of their level 2 assets to level 3. Adding additional pressure to an already strained banking system, the SEC will hear proposals regarding new credit rating systems, specifically asset backed securities.

The U.S. Securities and Exchange Commission may recommend this week that Moody’s Investors Service, Standard & Poor’s and Fitch Ratings include a new designation to the scale created by John Moody in 1909. The changes may force investors to reassess the way they gauge the risk of securities backed by mortgages, student and auto loans and credit cards, said one of the people, who declined to be named before the announcement. The action could force banks to add capital to guard against losses or curb lending.

To be considered “well-capitalized” under U.S. regulations, banks are required to hold five times as much capital against corporate debt than they are for commercial or residential mortgage-backed securities rated AAA and AA by S&P, Fitch
Ratings and Moody’s.

Should the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corp. order banks to hold more capital, investors in asset-backed securities may balk at buying, making mortgages more expensive, said American Bankers association executive director Wayne Abernathy.

Finally, the Bank of International Settlements is out with a warning on the global credit crisis implying a potential depression from the massive credit contraction.

In its latest quarterly report, the body points out that the Great Depression of the 1930s was not foreseen and that commentators on the financial turmoil, instigated by the US sub-prime mortgage crisis, may not have grasped the level of exposure that lies at its heart.

According to the BIS, complex credit instruments, a strong appetite for risk, rising levels of household debt and long-term imbalances in the world currency system, all form part of the loose monetarist policy that could result in another Great Depression.

The report points out that between March and May of this year, interbank lending continued to show signs of extreme stress and that this could be set to continue well into the future. It also raises concerns about the Chinese economy and questions whether China may be repeating mistakes made by Japan, with its so called bubble economy of the late 1980s.

My Comments: As planet leverage continues to unwind expect numerous rounds of toxic financing as regulators pressure banks and investment banks to raise more capital, diluting shareholders away in the process. Concurrently, regulatory pressure from the Fed will require banks and investment banks to meet margin calls as posted collateral via temporary lending facilities decline in value. Finally, our banking system will move closer to Japan circa 1991-1993.

Paulson to the bat phone

Returning from New York this past weekend I opened the Wall Street Journal on Monday to discover yet one more chapter in the structured finance shell game. Evidently Treasury Secretary Henry Paulson picked up the bat phone to several of the largest US banks, begging them to work together in order to facilitate an orderly unwind of numerous off balance sheet structured investment vehicles (SIVs). The proposed Super SIV will try to float one year capital notes with proceeds earmarked for the purchase of SIV assets originally created by Citigroup. Thus Citi avoids two problems, an increase in reserve requirements from assets returning to their balance sheet and ongoing reputational risk.

At this point, the rational investor is throwing up his hands, and why not?

“I have never seen Treasury play this kind of role,” said John Makin, a visiting scholar with the conservative American Enterprise Institute in Washington and a principal with hedge fund Caxton Associates LLC. The banks made “riskier investments that didn’t work out. They should now put it back on their balance sheet.”

Paulson and Co have their hands full lately as trust and confidence in structured finance have been waning. Apprehension and/or the inability to mark securities to market have sent a shock wave through the credit markets. More recently we witnessed the following acts of desperation:

  • Increased injections of liquidity by the Fed
  • Broadening the collateral accepted (to include asset-backed commercial paper) and terms (from 7 to 30 days) of the repo market
  • 100 basis point cut (two separate actions) in the discount rate and 50 basis points to fed funds
  • Encouraging use of the discount window (formerly stigmatized) because banks no longer trust collateral being posted when lending to each other
  • Proposed Super SIV whereby roughly 20% of the total SIV market is re-tranched

Clearly the credit markets are faced with unprecedented circumstances due to countless players and massive leverage. Unlike LTCM which required a NY Fed bailout, the credit markets today have grown incredibly opaque while derivative exposure has gone parabolic.

It’s obvious the SIV assets won’t be priced at market rates because there’s not much of a market to begin with (and why the super SIV exists in the first place). But where exactly do they get priced? To whose benefit? And by which standard?

Unlike the Bernanke induced rally two months ago, Paulson seems to be striking out in spades. The banking index is probing 52 week lows while Citigroup has dropped over 6% in 3 days.

This latest scheme, to which the ex-Goldman Treasury Secretary gives his blessing, attempts to put off the structured finance day of reckoning even further. Could the Super-duper SIV create the inevitable mark-to-market across most aspects of the securitization world leading to a run on the bank? Note to Hank: Beware the law of unintended consequences.

From off balance sheet to on

Since the ABS commercial paper market locked up several weeks back the guilty have slowly disclosed some of their off balance sheet conduits. Today news from down under as the largest bank in the country, National Australia Bank, moved $4.9 billion of funding back on to their balance sheet.

“The banks are not totally immune and the credit shakeout is bound to have some effect on them,” said Hans Kunnen, who helps manage the equivalent of $117 billion at Colonial First State Global Asset Management in Sydney. “They have to take appropriate action when circumstances become extreme, but have big enough balances sheets to absorb most of the pain.”

My comments: Mr Kunnen makes the statement about large enough balance sheets but it appears the Reserve Bank of Australia has already hit the panic button. Both Australia and Europe have experienced uncontrollable spikes in overnight lending rates since the credit revulsion began. In fact, Libor surged today as apprehension among lending institutions becomes the norm. The confidence game is waning as most players have no idea what the real balance sheets entail.

Banking’s perfect storm

Returning from the long holiday weekend bulls continue to bank on several rate cuts by Mr. Bernanke while George Bush relieves a segment of subprime borrowers. More and more we witness “portfolio managers” recommending banks based on above average earnings or low price to book. Like the housing bulls several years ago we believe the ‘analysis” is flawed on several fronts:

1) Banks hold over $1.27 trillion in asset backed securities on their balance sheet, mostly mortgage related. Recent collateral repricings caused by tighter lending standards and ongoing foreclosures will create mark to market problems intermediate term. For example, due to national house price declines thus far and 2008 projections one could make the case for a 15% haircut to present valuations.

2) LBO debt exposure is roughly $300 billion, most of which has already declined by 10-12% due to the recent credit crunch. As deals get restructured and or cancelled write downs could approach $40-50 billion.

3) Banks are potentially on the hook for several hundred billion in asset backed commercial paper conduits which remain “off balance sheet” until something breaks. Accounting rules don’t require banks to separately record anything related to the risk that they will have to loan the entities money to keep them functioning during a markets crisis. Several bailouts both here and abroad have already been announced over the past few weeks. Today in the WSJ Citigroup reluctantly disclosed some of these off balance sheet conduits known as SIVs:

Conduits and SIVs are entities that banks use to issue commercial paper, which are usually highly rated, short-term notes that offer investors a safe-haven investment with a yield slightly above certificates of deposit or government debt. Banks use the money to purchase longer-term investments such as corporate receivables, auto loans, credit-card debt or mortgages. The two kinds of vehicles are closely related, although SIVs can also issue longer-dated notes, can use leverage and have tended to have greater exposure to mortgage debt.

Banks affiliated with the vehicles typically agree to provide a so-called liquidity backstop — an assurance the vehicles’ IOUs will be repaid when they come due even if they can’t be resold, or rolled over — for all the paper in a conduit. For SIVs, three to five banks typically offer a liquidity backstop, but only for a portion of the vehicles’ assets.

Those liquidity backstops have become important because gun-shy investors are in some cases refusing to buy commercial paper. That could force banks to ride to the rescue if it happened to one of their affiliated conduits or SIVs.

These conduits are substantial in some cases. Take Citigroup, the nation’s largest bank as measured by market value and assets. Its latest financial results showed that it administers off-balance-sheet, conduit vehicles used to issue commercial paper that have assets of about $77 billion.

My comments: In a U.S. banking industry with $857 billion in equity, roughly $1.75 trillion dollars of securitized real estate loans, LBO debt and off (soon to be on) balance sheet ABS commercial paper exist, certainly not an insignificant number. The threat to the banking system might not present itself in the amount of questionable loans it currently holds, rather in the number of good loans that might later prove vulnerable as weak holders of loan obligations in other sectors of the economy liquidate these loans. Even in a highly leveraged society in which the risk is widely dispersed, the unwinding process can quickly escalate. Housing bulls learned a lesson; will the bank buyers take notice?

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