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The FT's Alphaville has recently run some pieces about how regulatory capital arbitrage is possible under Basel III. These make the point that this activity is most certainly happening. The title is "Back to the BISTRO", a reference to some famous JP Morgan deals of the late 90s. I remember at the time trying to work out how these BISTRO deals worked, and it took a while to realise that they were an arbitrage based on moving assets from the banking to the trading book and buying protection from a non-bank.

These days the arbitrage is not banking v trading book, but the transfer of sufficient risk to the non-bank sector to convince regulators that "significant risk" has been transferred. It's a more sophistictaed version of form over substance, but form over substance is what it is.

This one will run and run: in the same way that it is worth the while of big firms to pay expensive advisors to minimise tax, so big banks can afford to pay for ways of freeing up regulatory capital.]]> http://www.robinhoodfinance.com/blog/index.php?entry=entry120103-180430
A few points which I think will be relevant in 2012:

-Banks will struggle to fund themselves, particularly in the medium and longer brackets. The FT's Lex said on 2nd Jan what we have been saying for some time: get over the prejudice about securitisation; apart from the bonkers structures (CDO squared, US subprime etc.) this asset class has performed amazingly well since 2007. And the more covered bonds a bank issues, the worse the risk for the unsecured creditors. Securitisation has many benefits!

-The shadow banking sector will increse its influence. This is an inevitable consequence of tighter regulation and increased solvency requirements: hedge funds, private equity and money funds are either unregulated, or regulated much less tightly than banks. One development which would benefit many parties would be bundling credits to loan-starved corporates and distributing them via (properly regulated) funds to income-starved investors.

-Banks will no longer be able to hold off selling assets as they come under increasing presssure to improve solvency ratios. The shadow banking sector will be a big buyer. Funds will be set up for this purpose.

-There will be various attempts at regulatory arbitrage, for example along the lines of RBS's Project Isobel (it's not clear what risk has been transferred in this UK property deal, but it is clear that RBS is "smoothing" losses, i.e. spreading the pain over time. At a price). Another potential structure is where a non-bank posts cash collateral for the equity piece of a portfolio of assets. The bank in turn pays an amount equal to this expected loss plus a profit, and saves a chunk of capital. This is a classic form over substance structure, and regulators will no doubt be onto it.]]> http://www.robinhoodfinance.com/blog/index.php?entry=entry111206-090346
So the finance minister of a major country effectively holds his job at the whim of three unaccountable private sector organisations whose business it is to express opinions (for that is what they are) and which opinions have been at times badly wrong. Remember Asia in 1997 and the AAA subprime bonds in more recent years.

Politicians are in part to blame for this nonsense: they have hardwired ratings as a substitute for thinking and analysing into the financial system under the Basel rules. But we really need to get away from a slavish adherence to what these three not-exactly-oracular organisations opine. That needs both more agencies and a return to thinking for ourselves.

By the way, we are talking about the difference between "minimal" and "very low" credit risk as we go from Aaa to Aa in Moody's ratings, so not exactly a disaster scenario:
Aaa Obligations rated Aaa are judged to be of the highest quality, with minimal credit risk.
Aa Obligations rated Aa are judged to be of high quality and are subject to very low credit risk.]]> http://www.robinhoodfinance.com/blog/index.php?entry=entry111125-105809
"With most credit investors expecting the worst in Europe and with sovereign spreads going through the roof it seems that ABS securities, senior in particular, continue to be a safe haven of relative stability."

How the tables are turned! It was just three years ago that I was introduced by an old friend to a firm which advises pension funds and insurance companies. I patiently made the case for AAA consumer-asset backed bonds (aggregate default rate 0.07% throughout the crunch, as we now know)-diversification, higher yield, safe home for funds etc. Oh, and they were available for 60% of face value due to bulk sales by Lemming & Co.

This analysis was dismissed out of hand-politely whist I was present, then in quite derogotary terms once I had left the room, according to my friend. Perhaps their advice was to buy EU government bonds. Who knows?

The fact remains that, then as now, consumer ABS represents a good, safe asset. The investor gets this, and the bank gets much-needed term funding. And the economy benefits. Apart from that, there's no upside!]]> http://www.robinhoodfinance.com/blog/index.php?entry=entry111121-173720 http://www.robinhoodfinance.com/blog/in ... 230-105742

The thesis is that property has been shown many times to be poor security-big lumpy things whose value can fluctuate wildly, and which do not produce sufficient cashflow to repay loans (sale or refinancing is invariably necessary). Short-term, self liquidating assets such as trade finance are a far better bet.

I have in more recent times had discussions with various Islamic banks, some with a UK presence and some without. One common theme is the desire for "safe" property-based assets and suspicion of "risky" short-term assets, even when the latter are backed by rated (Takaful) insurance.

I have come across Islamic institutions which have a large part of their balance sheets invested in commodity murabaha yielding half a per cent or so with, presumably, at best A or BBB rated counterparties, but who are unwilling to take the "risk" of assets with a similar level of risk but ten times the profit. And some of these banks desperately need to increase profits.

In addition, one of the tenets of Islamic banking is mutuality and benefit to society. Compare here putting money into a building and facilitating trade and commerce.

Once again we're in the realm of the psychological rather than the logical: property is seen as the "safe" option internally. Senior management needs to change its views. There is upside for everyone.]]> http://www.robinhoodfinance.com/blog/index.php?entry=entry111109-155956
The first was by Ben Chu in The Independent. Mr Chu lays into securitisation with gusto: "Credit rating agencies, rather than blowing the whistle on this malpractice, had continued to label these toxic securities as AAA rated. Investors, gulled by the stellar ratings, kept on snaffling them up. Then, in 2007, the party stopped. Investors finally realised they had bought junk, began to experience huge losses on their securities, and the market collapsed." And so on. OK, it's an opinion piece, but you get the picture.

The second was in the FT by the excellent Tracy Alloway. She reports on the AFME's submission to the EU about Solvency II. The nub of the argument is that Solvency II is over-egging the capital requirements for assets which have performed very well indeed throughout the crunch, e.g. "Those backed by European home mortgages, about 70 per cent of the region’s securitisation market, for instance, have a cumulative default rate of just 0.07 per cent".

The point of securitisation is to get money from where it is to where it is needed, e.g. from insurance companies or funds to people trying to buy houses, or businesses which desperately need funding to grow and create jobs. Of course securitisation can be abused, just like many useful tools: my bread knife is very useful for cutting bread, but I could stab someone with it; in which case the Ben Chus of this world would no doubt seek an international ban on all bread knives.]]> http://www.robinhoodfinance.com/blog/index.php?entry=entry111019-115709
On the other side, there seems to be a large unofficial/unregulated lending sector, which UBS estimates for China as a whole could be as high as $627 billion or 10% of gross domestic product. Part of the attraction of this unofficial market to depositors is that official interest rates are so low. But the lack of regulation is causing big problems.

Back in Europe, banks are being asked to put up increasing amounts of real equity, and are currently engaged in a stand-off with the regulators. The banks are more or less saying "back off, or there'll be no lending to get the economy going again".

In both China and Europe banks are not lending to SMEs. Europe doesn't have much of an alternative to bank deposits, but there is real demand from SMEs for funding. One solution is to set up rated, regulated funds which invest in, say, trade receivables. That gives the depositor a better rate of return and gets cash to the SMEs to get the economy moving.]]> http://www.robinhoodfinance.com/blog/index.php?entry=entry111012-144714
Unfortunately for the faithful, highly remunerated managers have about as much power to overcome market forces as the Wizard of Oz.

From the FT:
"In a blow to highly paid stock-pickers, funds that buy shares and use short sales to hedge their positions have delivered the same returns as the S&P 500 index, including dividends, in the first nine months of the year, a loss of 8.7 per cent".

And managers who had been successful in the past got it badly wrong:
"John Paulson’s flagship Advantage fund is now down 47 per cent for the year after losing a further 19.3 per cent in September". Mr Paulson called the subprime crisis right, but he looks to have made a pig's ear of it recently.

I recently attended a fundraiser at my son's school. In one game people have to predict (i.e. guess) whether heads or tails will come up. One boy won by predicting correctly five times in a row. He turned a stake of £1 into £33 in minutes. No doubt the true believers will be queueing up to entrust him with their millions!]]> http://www.robinhoodfinance.com/blog/index.php?entry=entry111001-094005
What S&P call Consumer (RMBS, structured covered bonds, and consumer ABS) had a cumulative default rate for all asset classes of 0.06%. That puts them in the safe asset category as far as any rational observer can see. But remember that these very assets were trading at 60 or less only a couple of years ago!

That was the effect of hysteria rather than cool analysis, another side of which is the persistent and false view that ABS is mad, bad and dangerous to know. In fact the opposite is the case-banks badly need longer term funding and risk management, and consumer ABS offers a valuable tool to help achieve this.]]> http://www.robinhoodfinance.com/blog/index.php?entry=entry110927-084024 http://www.robinhoodfinance.com/blog/in ... 005-101826
http://www.robinhoodfinance.com/blog/in ... 112-095327

The European market is pretty much dead, and issuance into the US is still driven by the amazingly high savings on the EUR/USD spot-forward swap. On 15th September, issuing at USD Libor and swapping to EUR would give EUR Libor MINUS 68 in 1 month and MINUS 93 in 3 months. What happens to conduits as and when this arbitrage goes away was not discussed.

Some of the usual ex-post justifications for ABCP were given: they are easier to analyse than a whole bank (better stop making short-term deposits, then); and money market funds can distinguish between a bank and its conduit (but one bank mentioned to me that they had set up a new conduit not long ago, only for it to prove just about useless following a downgrade of the bank-no linkage there, then!)

I put to several attendees the question whether, if faced with a blank sheet of paper, they would invent CP conduits. None would, of course, and in private one senior ABCP person agreed that their conduit served no useful purpose and would not be missed if closed, "but then I'd be out of a job".]]>