Synthetic Danger, Again
In “The Big Short” Michael Lewis was able to elegantly explain just how "a security so opaque and complex that it would remain forever misunderstood by investors and rating agencies: the synthetic subprime mortgage bond-backed CDO, or collateralized debt obligation" is created. It takes him less than a page. However, the thicket of financial products does get a bit more complicated from there.
For example, as many toxic mortgages as there were to package together for speculators to make side bets on, Lewis pointed out,
when Mike Burry bought a credit default swap based on a Long Beach Savings subprime-backed bond, he enabled Goldman Sachs to create another bond identical to the original in every respect but one: There were no actual home loans or home buyers. Only the gains and losses from the side bet on the bonds were real.
Yes, synthetic CDOs were born out of the collective imagination of Wall Street. Now, there’s a new synthetic something to put on your radar: Synthetic securitization in the form of capital relief for banks.
The latest Grant’s Interest Rate Observer calls our attention to the latest bit of financial razzle-dazzle to make banks risky again. What annoys bankers in the world of Basel regulations is the requirement to hold reserves in differing percentages against different types of loans and investments. Loans to governments, no matter how financially dodgy, require no reserves. Loans to people, companies, construction mean plenty must be set aside, making doing those loans in some cases unprofitable.
The whole idea of capital relief, as the name would imply, is to lower the amount of equity required and increase leverage. What’s a banker to do when a pension or hedge fund rep stops by and offers to unlock some of his or her bank’s idle capital?
Euromoney.com reported in 2016 that Nordea sold “a 5% first-loss transfer [which] saw risk-weighting on the portfolio fall from around 45% to 7%, giving a 30 basis points benefit to tier-1 equity.”
What’s synthetic about this securitization is that no assets are transferred. The buyer, in exchange for being paid an interest rate on the total amount of loss covered, doesn’t take possession of the loans and therefore, “it doesn’t interfere with the businesses and client relationships,” Nordea’s Jonas Backlund told Euromoney. “The benefit is you still face the client, who does not even notice the risk has been sold,” echoed Jorge de Vries.
Grant’s cites a Deutsche Bank A. G. report estimating the amount of capital relief transactions in Euroland increased from €20 billion in 2013 to €94 billion in 2016. However, when Grant’s attempted to quiz regulators, here, in Canada, and across the pond, about which banks are exposed and are guarantors good for their side of the deals, regulators were silent.
Perhaps, it’s as George Passaris told Euromoney, “The term synthetic creates negative connotations among politicians and regulators, because it sounds complex,” he says. “In synthetics there’s a lack of understanding [in the European Parliament] of the differences between a balance-sheet securitization and arbitrage deals.”
Return on equity is the name of the game and thus regulations forcing increases in bank equity were the mothers of invention. Funds providing capital relief “are betting that the regulators are underestimating the quality of the loans, therefore overestimating the need for capital,” writes Grant’s.
However, that’s not the only bet the synthetic securitization sellers are making. Grant’s believes the riskiest bet is “that a decade’s worth of interest-rate suppression has not distorted Europe’s economy, destroyed its bond market and corrupted its credit culture.”
Here in the U.S. Fannie Mae and Freddie Mac engage in capital relief. Grant’s explains,
As of June 30, 2018, according to the Federal Housing Finance Agency, the duo transferred $81 billion worth of credit risk on $2.5 trillion of unpaid principal balance, and they had covered another $278 billion worth of credit risk on $1.1 trillion of unpaid principal through primary mortgage insurance.
Counterparty risk is what comes to mind when considering capital relief. Back in the 2008 crash, AIG had provided the financially engineered backstop and Eurozone banks depended on AIG’s AAA rating. When the huge insurer and financial alchemist teetered on the edge of bankruptcy, Europe’s banks were joined with AIG on the ledge.
Grant’s Evan Lorenz writes,
All the more reason for Eurozone banks to hope that the multitude of counterparties backing capital-relief trades--whoever they are, and however much they are on the hook for--will prove more reliable in the next crisis than AIG did in the last one.
Investors in Europe’s banks have already given their opinion. The Euro STOXX Banks Index today trades at 60 percent of book value compared to 156 percent of book at the end of 2007. U.S. banks in the S&P 500 trade at 125 percent of book.
Jim Grant often says, “knowledge in finance is cyclical, not cumulative.” Remembering past financial folly, DoubleLine Capital’s Jeffrey Gundlach told Grant’s, “Are synthetic securitization not kindred spirits with synthetic CDO-squareds?”
The extraordinary book “Finance and Philosophy: Why We’re Always Surprised” includes a chapter entitled “Usually a Banking Crisis Somewhere.” Author Alex J. Pollock counts 263 banking crisis in the 100 years from 1901 to 2000. That’s 2.63 crisis per year, and these events have continued mightily since 2000.
“Add uncertainty, fundamental illiquidity, and smallness of capital, and what have you got?” Pollock asks rhetorically. “Usually a banking crisis somewhere.”
Michael Lewis, call your office.
