If the banks aren’t exposed to the risks, then who is?
The question springs to mind every time a bank proudly declares that it has passed the most recent mandatory stress test.
I have been jotting down and sharing my views on markets for well over thirty years and I can assure you that it takes a few days away from the coalface to escape the white noise of daily ups and downs – am I mixing my metaphors? – and occasionally to see the old forests replanted with new trees.
My thoughts were triggered from two sides. The one was a report that graduates are once again lining up to come into banking. Since 2008, when so many young bankers were positively fearful of admitting what they did for a living, and when it suddenly became “de rigeur” to study marine biology or environmental science and to try to rescue the planet, banking has not been the place to be. But now once again good old greed is good, owning rather than renting looks so much more attractive, and a Porsche or an Aston Martin ultimately remains sexier than a Nissan Leaf or a Tesla. Then I saw the quarterlies for some of the US banks which one by one knocked the cover off the ball and I receive reports that bonuses are on the up. And all I can think is “Yep, here we go again…”
The second trigger was a report on payments-in-kind (PIK). Last Monday the FT carried an article titled “Corporate debts mount as credit funds let borrowers defer payments”. The opening line was: “A growing list of companies have turned to their lenders at private credit funds for relief in recent months, seeking to conserve capital by delaying payments on their debt”.
Conserving capital? Why not call a spade a spade and admit that they can’t afford to pay the interest. In other words, they’re at risk of defaulting. But no, what they come up with is a PIK or payment in kind structure which has nothing to do with payment – it’s all about non-payment – and offers the borrower the escape hatch of capitalising the interest. Instead of being paid out, the interest is added to the debt pile, albeit with a more attractive spread. So the borrower who can’t afford to pay his interest promises to pay a higher rate on what he could not afford in the first place. The path to default is paved with PIK.
We saw this phenomenon before the outbreak of the Global Financial Crisis in 2007 although it was not until March of 2008 that the first of Wall Street’s two great pirate ships, Bear Stearns, ran aground then followed in September of the same year by Lehman Brothers. The Bear was caught just before it was smashed on the rocks by JP Morgan. Lehman was not so lucky. The GFC it has been argued, and not without good cause, was not an asset problem but one of liabilities. Please permit me to try to explain.
Banks have to hold capital reserves against loans or other forms of credit they hold on their balance sheets. These reserves have to be held in short term liquid assets, be that in cash or short term government securities which yield little. There is an appreciable opportunity cost to sitting on cash and near cash. But if the bank “invested” in an arms’ length investment vehicle, known then as a credit conduit, which held the loans there would be no need for the same level of capital reserves. If the assets in the fund were triple-A rated – of the highest credit quality – then the bank’s holding in the fund would also require little capital backing. The aim of the structured credit market was to take a bunch of low quality loans and to repackage them so as to make them triple-A. I spent my last years in mainstream banking in the middle of the structured credit space and I can, with absolute sincerity, affirm that this is entirely and quite legitimately possible. The problem was that, in the process, the embedded risk is shaken up so that in the end it is impossible for the outsider to be able to divine where the risks really are and where the bodies are buried.
Imagine a field in which 100 land mines have been dug into the ground. In an unstructured portfolio of loans, the landmines are evenly distributed and any one of them could blow up at any time. In a structured portfolio, such as one created in a Collateralized Loan Obligation or CLO, all the landmines are transferred to one corner of the field. The probability of being hurt in most of the field is much lower, yet in the designated corner much higher. Owning a share in the part of the field with no landmines is tantamount to being risk-free and buying a share in that trance of the portfolio can still pay a lot more than other putatively low-risk investments. The folks who buy a tranche in the spot where all the mines are located get paid a lot of money although in a low credit risk environment even their risk is manageable. Fact is that none of the investors care any longer who might default; they are playing a pure percentage game.
In late 2007, it became obvious that there was too much credit risk in the system but that nobody knew any longer who owned it and how much of it they owned. Banks could no longer assess how much risk was being carried by their counterparts and in deciding that discretion was the better part of valour opted to no longer lend to one another. Unable to borrow, the banks and their credit conduits had to begin to sell assets. But nobody else could borrow either.
There were only sellers and no buyers, and we all know what happens to a market when it ceases to be a market. The great near collapse of the financial system happened before the credit crisis had hit. Prices fell to well below fair value. The list of financial institutions that went to the wall is long and distinguished. Bear Stearns and Lehman Brothers were amongst them although in the UK it took down Northern Rock, Royal Bank of Scotland, Lloyds and HBOS. Others disappeared by takeover. Germany’s IKB went to the wall. Pretty much the entire Irish and Icelandic banking networks went belly up. The great remaining investment banks on Wall Street such as Goldman Sachs and Morgan Stanley were forced to take out banking licences in order to gain access to Federal Reserve emergency funding, known as the discount window.
So it was the inability of banks to borrow in order to fund their loan books that blew the bloody doors off. Those with the money to buy what was on fire-sale in the fullness of time made out like bandits. The credit conduits got blown away and now find themselves having been replaced by private debt funds, no longer owned by the banks but prodigiously borrowing from them. Peters’ First Law holds that credit risk is like energy; it can be converted but it cannot be destroyed. So, every time a bank proudly declares that it has passed the most recent mandatory stress test, one is left asking oneself: if the banks aren’t exposed to the risks, who is?
Over the past weekend, I happened to be exchanging notes with an American investor. He wrote: “I agree with your assessment about the banks however, why this time MAY be different is real estate has gone parabolic. …I did a study of my real estate holdings and they’ve gone up more than anything else. Including the left-for-dead office market. And that is up a stunning amount of money. So, in short, the rising asset values should provide credit support to the bank loans.”
There is a bon mot applied to the isle of Skye – for those not acquainted with Scottish geography, it is at the very top on the left – which states that if you can see the horizon it’s going to rain and if you can’t it is raining. One must beware of applying the same principle to real estate investing in that it’s either going to crash or it is crashing. But, at the same time, I can think of few sectors that can so quickly swing from boom to bust.
Commercial real estate has a very long and complicated lead time which means that it is prone to becoming overenthusiastic about its own prospects yet by the time a project has been planned, the land bought, planning permission received, the money raised, and the darned thing built, the outlook for medium to long term refinancing can have materially changed.
Some players in the sector have a greater ability than others to hold their breath and the recent troubles, especially in the office space space – does that make sense? – have offered great opportunities to those with cash to burn while those who were highly leveraged and who had to endure the high rates of interest and only modest demand have taken it on the chin.
I wrote back to the aforementioned American investor: “On the button! Doesn’t real estate that goes parabolic end up in a bubble? Been there, seen it, done it. This is where the smart investor follows Warren Buffett by selling when everybody else is buying and buying when everyone else is selling…”
And here another question arises. Do banking crises come before and lead to recessions or do recessions come before and lead to banking crises? There is of course no single answer to that question although, with ever more leverage being deployed and with private credit funds not being subjected to regulatory constraints such as capital reserve rules, we have yet to experience what might happen if, as and when there is a reversal of fortunes. One of the lessons of the Global Financial Crisis was that, when ample credit is available, defaults drop to negligible levels. When defaults are negligible, there will be no shortage of credit. One of the most egregious cases of a misjudgement of the credit cycle was that made by Chuck Prince, erstwhile Chairman and CEO of Citigroup. Tomorrow, we shall look at that.
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