Thursday, 24 April 2008 20:00

Banks, Brokers & Bullsh1t - v.3.1

This is part of my continuing diatribe on the state of the US and global banking system. As a backgrounder, and to get caught up on where I am coming from, see:

 

In my most recent post, I admitted to being disappointed in myself for allowing volatility drop my personal investment results below my internal 110% annualized return goal. This volatility stemmed from financials and the broad market rallying due to the "alleged and percieved mollification of systemic financial system failure". Now, I never believed we were at risk of systemic failure. That was just the fodder of tabloidal media outlets. Asset securitization and OTC counterparty credit risk management is on the verge of systemic failure, though, and these are significant portions of our financial system. I don't think these failures will bring the whole financial system down, just the portions that need it. We were, and still are, at risk of a correction where the excesses of the past will be shaken out and weaknesses in our system will break and then be eliminated, bringing down the players that were overly reliant on those weaknesses. Examples of these weak points are:

  • the lack of propert due diligence and credit risk management in the credit default swap markets,
  • the monoline cum multiline industry,
  • excessively leveraged structured products written on top of a real asset bubble, 
  • poorly underwritten, covenant none leveraged and high yield loans,
  • poorly underwritten consumer debt,
  • the peak passing and return to the trough of the most recent business profit cycle (banks and financial institutions in particular), 
  • the return to  mean of real asset prices.

 

A quick perusal of this weeks news and analysis pretty much reveals what I thought to be the case - this bear market sucker's rally will probably end in a deep downturn and entrance (continuation of) a prolonged bear market. These wide swings are the cause and source of the volatility that has now forced me to implement return robbing dampeners to quell these wide swings. I am also in a quandary. Should I allow the volatility to persist, for the aggregate risk adjusted return is still way above most other's efforts and alpha is being generated over both broad market and hedge fund indices, or should I spend the time and money to dampen both volatility and return to make everything look pretty and ease my own stomach? The answer really relies on who sees my returns and what kind of observers they happen to be. I think that too many investors are trying to mimic the steady fixed income-like and large cap returns that are the bread and butter of many institutions. The problem with that is that it actually reduces returns over the long run and introduces risk. I don't have time to get into this now, but it will definitely be on the table for a future blog posting.

Now, back to this week's events:

Thursday, 24 April 2008 20:00

Banks, Brokers & Bullsh1t: market update

  • From FT.com: Summarized by RGEMonitor.com - Citigroup is allowing private equity groups bidding for up to $12bn of its leveraged loans to cherry-pick from a wide range of assets with different prices and credit ratings. Deutsche Bank has been trying to sell parts of its €36bn ($56bn) portfolio in leveraged loans to private equity groups since August. Same for Credit Suisse and Goldman Sachs. But wait, it gets worse -the I banks provide vulture funds with financing to buy banks' distressed debt--> In its first leveraged loan sale, Deutsche lent the buyers $3 to $4 – at below market rates – for every $1 of credits they bought. The buyers paid full prices for the loan themselves, one buyer says.

    By selling the loans at full prices, Deutsche was able to avoid marking down its positions. The deal offers Deutsche additional protection because if the price of the loans drops, the buyers would have to put up more collateral, the loan buyer says. For the private equity firms, the key to the deal is the low-cost leverage, which gives them a chance to boost potential profits even though they paid a full price for the loans themselves. May I comment. The banks are trying to get $50 B of bad loans off of its balance sheet. So it makes $40 B of loans (under priced which should be market do market) to move these other bad loans that are guaranteed to drop in price. Are we supposed to believe that Deutsche Bank truly transferred risk from the balance sheet, or just transferred the assets? OK, I guess I'm just stupid and don't get it.

  • European banks biding time, mark to market losses will soon convert to operating and credit losses. Fitch sugar coats it: The issue of credit performance now becomes central to the outlook for leveraged  credit as medium‐term refinancing risk remains pervasive throughout the market. With banks arguing that any recovery in the primary market remains dependent on recovery in the secondary market, constituents have no choice other than to anxiously bide their time as financial system stresses continu  to be worked out and the inevitable contagion to the broader European economy approaches. Indeed, leveraged credit market constituents are left with little more than hope that outstanding credits continue to perform in time for an economic and credit market recovery that will provide the refinancing and exit options necessary to avoid widespread defaults. That hope may be justified as, ironically, the excess that accompanied the wind‐up in financial system leverage, particularly in regard to loose covenants and back‐ended debt maturity profiles, has insulated the leveraged credit market from the spike in defaults normally associated with a credit crisis.
  • Altman, whose Z score analysis I have used in this blog for the homebuilding industry chimes in on what happens when the excess liquidity from the non-traditional lenders dries up. I have state repeatedely that the historically low default rates will soon skyrocket, further distressing banks and the economy. Well,,, according to S&P/Res.recap blog: U.S. distressed debt ratio up sharply from less than 1% during past five months to 3% in August. The first sectors to succumb are the usual suspects: consumer products, retail/restaurants, and finance companies. Covenant "none" debt delay the inevitable defaulting through avoidance of technical triggers.
  • FT: Expect legal arbitrage rather than distress renegotiations with short-term oriented hedge funds; Geithner: Untangling complex web of OTC contracts in case of default like "unscrambling eggs"
  • Hu/Black; BofA: Distress renegotiations less likely with HF than with PE due to short-term focus. Also: these who buy credit protection in general bet on default, not restructuring. However: Physical bond settlement favors default because protection buyer receives face value (i.e. the underlying bond); cash settlement on the other hand includes substantial hair cut and protection buyer might be better off restructuring.
Thursday, 24 April 2008 20:00

Banks, Brokers & Bullsh1t - v.3.1

This is part of my continuing diatribe on the state of the US and global banking system. As a backgrounder, and to get caught up on where I am coming from, see:

 

In my most recent post, I admitted to being disappointed in myself for allowing volatility drop my personal investment results below my internal 110% annualized return goal. This volatility stemmed from financials and the broad market rallying due to the "alleged and percieved mollification of systemic financial system failure". Now, I never believed we were at risk of systemic failure. That was just the fodder of tabloidal media outlets. Asset securitization and OTC counterparty credit risk management is on the verge of systemic failure, though, and these are significant portions of our financial system. I don't think these failures will bring the whole financial system down, just the portions that need it. We were, and still are, at risk of a correction where the excesses of the past will be shaken out and weaknesses in our system will break and then be eliminated, bringing down the players that were overly reliant on those weaknesses. Examples of these weak points are:

  • the lack of propert due diligence and credit risk management in the credit default swap markets,
  • the monoline cum multiline industry,
  • excessively leveraged structured products written on top of a real asset bubble, 
  • poorly underwritten, covenant none leveraged and high yield loans,
  • poorly underwritten consumer debt,
  • the peak passing and return to the trough of the most recent business profit cycle (banks and financial institutions in particular), 
  • the return to  mean of real asset prices.

 

A quick perusal of this weeks news and analysis pretty much reveals what I thought to be the case - this bear market sucker's rally will probably end in a deep downturn and entrance (continuation of) a prolonged bear market. These wide swings are the cause and source of the volatility that has now forced me to implement return robbing dampeners to quell these wide swings. I am also in a quandary. Should I allow the volatility to persist, for the aggregate risk adjusted return is still way above most other's efforts and alpha is being generated over both broad market and hedge fund indices, or should I spend the time and money to dampen both volatility and return to make everything look pretty and ease my own stomach? The answer really relies on who sees my returns and what kind of observers they happen to be. I think that too many investors are trying to mimic the steady fixed income-like and large cap returns that are the bread and butter of many institutions. The problem with that is that it actually reduces returns over the long run and introduces risk. I don't have time to get into this now, but it will definitely be on the table for a future blog posting.

Now, back to this week's events:

Thursday, 24 April 2008 20:00

Banks, Brokers & Bullsh1t: market update

  • From FT.com: Summarized by RGEMonitor.com - Citigroup is allowing private equity groups bidding for up to $12bn of its leveraged loans to cherry-pick from a wide range of assets with different prices and credit ratings. Deutsche Bank has been trying to sell parts of its €36bn ($56bn) portfolio in leveraged loans to private equity groups since August. Same for Credit Suisse and Goldman Sachs. But wait, it gets worse -the I banks provide vulture funds with financing to buy banks' distressed debt--> In its first leveraged loan sale, Deutsche lent the buyers $3 to $4 – at below market rates – for every $1 of credits they bought. The buyers paid full prices for the loan themselves, one buyer says.

    By selling the loans at full prices, Deutsche was able to avoid marking down its positions. The deal offers Deutsche additional protection because if the price of the loans drops, the buyers would have to put up more collateral, the loan buyer says. For the private equity firms, the key to the deal is the low-cost leverage, which gives them a chance to boost potential profits even though they paid a full price for the loans themselves. May I comment. The banks are trying to get $50 B of bad loans off of its balance sheet. So it makes $40 B of loans (under priced which should be market do market) to move these other bad loans that are guaranteed to drop in price. Are we supposed to believe that Deutsche Bank truly transferred risk from the balance sheet, or just transferred the assets? OK, I guess I'm just stupid and don't get it.

  • European banks biding time, mark to market losses will soon convert to operating and credit losses. Fitch sugar coats it: The issue of credit performance now becomes central to the outlook for leveraged  credit as medium‐term refinancing risk remains pervasive throughout the market. With banks arguing that any recovery in the primary market remains dependent on recovery in the secondary market, constituents have no choice other than to anxiously bide their time as financial system stresses continu  to be worked out and the inevitable contagion to the broader European economy approaches. Indeed, leveraged credit market constituents are left with little more than hope that outstanding credits continue to perform in time for an economic and credit market recovery that will provide the refinancing and exit options necessary to avoid widespread defaults. That hope may be justified as, ironically, the excess that accompanied the wind‐up in financial system leverage, particularly in regard to loose covenants and back‐ended debt maturity profiles, has insulated the leveraged credit market from the spike in defaults normally associated with a credit crisis.
  • Altman, whose Z score analysis I have used in this blog for the homebuilding industry chimes in on what happens when the excess liquidity from the non-traditional lenders dries up. I have state repeatedely that the historically low default rates will soon skyrocket, further distressing banks and the economy. Well,,, according to S&P/Res.recap blog: U.S. distressed debt ratio up sharply from less than 1% during past five months to 3% in August. The first sectors to succumb are the usual suspects: consumer products, retail/restaurants, and finance companies. Covenant "none" debt delay the inevitable defaulting through avoidance of technical triggers.
  • FT: Expect legal arbitrage rather than distress renegotiations with short-term oriented hedge funds; Geithner: Untangling complex web of OTC contracts in case of default like "unscrambling eggs"
  • Hu/Black; BofA: Distress renegotiations less likely with HF than with PE due to short-term focus. Also: these who buy credit protection in general bet on default, not restructuring. However: Physical bond settlement favors default because protection buyer receives face value (i.e. the underlying bond); cash settlement on the other hand includes substantial hair cut and protection buyer might be better off restructuring.

I've been promising to give an illustration of the shenanigans being played by the commercial and investment bank's for some time now, but I've been quite busy working on my entrepeneurial pursuits and paperwork. It is unfortunate that I have to call it "entrepeneurial pursuits" instead of just stating what it is, but the regulatory powers that be don't think you can handle it. I will coddle stuff together from email discussion, news clips and my prop models to hopefully explain why I'm still so bearish on the banking sector.

From WSJ.com

In recent months, the financial crisis sparked by subprime-mortgage problems has jolted banks and sent Libor sharply upward. The growing suspicions about Libor's veracity suggest that banks' troubles could be worse than they're willing to admit.

The concern: Some banks don't want to report the high rates they're paying for short-term loans because they don't want to tip off the market that they're desperate for cash. The Libor system depends on banks to tell the truth about their borrowing rates. Fibbing by banks could mean that millions of borrowers around the world are paying artificially low rates on their loans. That's good for borrowers, but could be very bad for the banks and other financial institutions that lend to them...

...

The global financial crisis that began last summer has made it more difficult for banks to package and sell all kinds of loans as securities, as well as to issue bonds and short-term IOUs to investors. Increasingly, banks have turned to the interbank market to borrow cash. But their mounting losses on mortgage securities and other investments have raised fears that a major institution could go bust. That's made banks increasingly wary of lending to one another.

[chart]

Such jitters have made many banks unwilling to extend loans to each other for more than one week. As a result, the rates they quote for loans of three months or more are often speculative, because there's little to no actual lending for that time period, brokers say. "It amounts to an average best guess," says Don Smith, an economist at ICAP, the London broker of interbank loans and derivatives.

These bank problems are proving costly to other kinds of borrowers around the world. One way to measure the rough cost is by comparing the three-month Libor rate with an interest rate that doesn't reflect worries about banks' financial health -- such as the yield on a three-month Treasury bill, which is backed by the U.S. government. The gap between the two stood at 1.58 percentage points Tuesday, and has averaged 1.39 percentage points since the crisis began in August. In the five years before the financial crisis started, it averaged only 0.28 percentage points.

Citigroup's Mr. Peng believes banks could be understating even those abnormally high Libor rates. He notes that the Federal Reserve recently auctioned off $50 billion in one-month loans to banks for an average annualized interest rate of 2.82% -- 0.1 percentage point higher than the comparable Libor rate. Because banks put up securities as collateral for the Fed loans, they should get them for a lower rate than Libor, which is riskier because it involves no collateral. By comparing Libor with that indicator and others -- such as the rate on three-month bank deposits known as the Eurodollar rate -- Mr. Peng estimates Libor may be understated by 0.2 to 0.3 percentage points...

... In a report published in March by the Bank for International Settlements, economists Jacob Gyntelberg and Philip Wooldridge raised concerns that banks might report incorrect rate information. The report said that banks might have an incentive to provide false rates to profit from derivatives transactions. The report said that although the practice of throwing out the lowest and highest groups of quotes is likely to curb manipulation, Libor rates can still "be manipulated if contributor banks collude or if a sufficient number change their behaviour."

I've been promising to give an illustration of the shenanigans being played by the commercial and investment bank's for some time now, but I've been quite busy working on my entrepeneurial pursuits and paperwork. It is unfortunate that I have to call it "entrepeneurial pursuits" instead of just stating what it is, but the regulatory powers that be don't think you can handle it. I will coddle stuff together from email discussion, news clips and my prop models to hopefully explain why I'm still so bearish on the banking sector.

From WSJ.com

In recent months, the financial crisis sparked by subprime-mortgage problems has jolted banks and sent Libor sharply upward. The growing suspicions about Libor's veracity suggest that banks' troubles could be worse than they're willing to admit.

The concern: Some banks don't want to report the high rates they're paying for short-term loans because they don't want to tip off the market that they're desperate for cash. The Libor system depends on banks to tell the truth about their borrowing rates. Fibbing by banks could mean that millions of borrowers around the world are paying artificially low rates on their loans. That's good for borrowers, but could be very bad for the banks and other financial institutions that lend to them...

...

The global financial crisis that began last summer has made it more difficult for banks to package and sell all kinds of loans as securities, as well as to issue bonds and short-term IOUs to investors. Increasingly, banks have turned to the interbank market to borrow cash. But their mounting losses on mortgage securities and other investments have raised fears that a major institution could go bust. That's made banks increasingly wary of lending to one another.

[chart]

Such jitters have made many banks unwilling to extend loans to each other for more than one week. As a result, the rates they quote for loans of three months or more are often speculative, because there's little to no actual lending for that time period, brokers say. "It amounts to an average best guess," says Don Smith, an economist at ICAP, the London broker of interbank loans and derivatives.

These bank problems are proving costly to other kinds of borrowers around the world. One way to measure the rough cost is by comparing the three-month Libor rate with an interest rate that doesn't reflect worries about banks' financial health -- such as the yield on a three-month Treasury bill, which is backed by the U.S. government. The gap between the two stood at 1.58 percentage points Tuesday, and has averaged 1.39 percentage points since the crisis began in August. In the five years before the financial crisis started, it averaged only 0.28 percentage points.

Citigroup's Mr. Peng believes banks could be understating even those abnormally high Libor rates. He notes that the Federal Reserve recently auctioned off $50 billion in one-month loans to banks for an average annualized interest rate of 2.82% -- 0.1 percentage point higher than the comparable Libor rate. Because banks put up securities as collateral for the Fed loans, they should get them for a lower rate than Libor, which is riskier because it involves no collateral. By comparing Libor with that indicator and others -- such as the rate on three-month bank deposits known as the Eurodollar rate -- Mr. Peng estimates Libor may be understated by 0.2 to 0.3 percentage points...

... In a report published in March by the Bank for International Settlements, economists Jacob Gyntelberg and Philip Wooldridge raised concerns that banks might report incorrect rate information. The report said that banks might have an incentive to provide false rates to profit from derivatives transactions. The report said that although the practice of throwing out the lowest and highest groups of quotes is likely to curb manipulation, Libor rates can still "be manipulated if contributor banks collude or if a sufficient number change their behaviour."

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