Naked Capitalism: Clueless Bank Regulators

Banks Resorting to Old Tricks to Reduce Capital Levels

Wow, did I miss it? Didn’t we have a crisis just a bit over four years ago? And wasn’t one of the big drivers the fact that banks were overlevered and took on too much risk?

Well, not only do we seem to be rerunning that playbook, banks are using strategies right under regulators’s eyes last time around to create phony capital. Worse, are pulling the exact same tricks they did last time around. On top of that, regulators seem to be doing nothing to stop it.

As the New York Times reports (hat tip Scott):

Banks have been shedding risky assets to show regulators that they are not as vulnerable as they were during the financial crisis. In some cases, however, the assets don’t actually move — the bank just shifts the risk to another institution.

This trading sleight of hand has been around Wall Street for a while. But as regulators press for banks to be safer, demand for these maneuvers — known as capital relief trades or regulatory capital trades — has been growing, especially in Europe.

Yes, sports fans. Eurobanks, who are so large relative to GDP that their governments can’t credibly backstop the banking system (and that list includes pretty much every county in Europe, including Germany) are getting equity booster shots from hedge funds and pension funds:

Rather than selling the assets, potentially at a loss, the banks transfer a slice of the risk associated with the assets, usually loans. The buyers are typically hedge funds, whose investors are often pensions that manage the life savings of schoolteachers and city workers. The buyers agree to cover a percentage of losses on these assets for a fee, sometimes 15 percent a year or more.

The loans then look less worrisome — at least to the bank and its regulator. As a result, the bank does not need to hold as much capital, potentially improving profitability.

This is ridiculous. How many hedge funds were forced to shut down in the crisis? Answer: a not trivial number, including ones managed by Goldman, the supposed ne plus ultra of that business. And are these regulators kicking the tires of hedge funds to see how good this equity really is? No way would hedgies stand for that kind of scrutiny. And in any event, it would be pretty meaningless, given the speed with which a hedge fund can change its risk exposures.

This is another version of the fantasy we had last time around, that risks could be sliced, diced, price, and distributed efficiently. But moving risk around does not eliminate it. And why should investors other than bank equity and bond holders bear risk? If you are going to start disaggregating a bank balance sheet, why have a bank at all? All you do is create more tight coupling across the financial system. As we’ve been warning for years (following Richard Bookstaber) the first job in reducing systemic risk is reducing tight coupling, aka interconnectedness. Any other risk reduction action is likely to make matter worse if you don’t do that first. Even Timothy Geithner in 2007 understood that well. From a March speech:

A third issue relates to the dynamics of failure and the infrastructure that supports these markets. The dramatic growth in the volume of over-the-counter derivatives and the growth in the number and size of leveraged funds inevitably complicate the resolution of the failure of a large financial institution that is active in these markets. The sheer number of financial contracts that would have to be unraveled in the context of a default, the challenge that a former colleague of mine likes to refer to as “unscrambling the eggs,” could exacerbate and prolong uncertainty, and complicate the process of resolution.

And the more you look, the worse these capital relief trades look. They are an exact rerun of the scheme that was popular with Eurobanks in the runup to the crisis:

Most of these trades are structured as credit-default swaps, a derivative that resembles insurance. These kinds of swaps pushed the insurance giant American International Group to the brink of collapse in September 2008. Another red flag is that banks often use special-purpose vehicles located abroad, frequently in the Cayman Islands, to structure these trades.

This account isn’t quite right, but the truth is even more alarming. The credit default swaps that felled AIG were the ones related to subprime, where it had entered into contracts that required it to post collateral (this was more like a classic CDS, while similar agreements by monolines did not have this feature). AIG had to post more and more collateral both because the value of the CDOs it had insured were falling, and it was being downgraded, which led to an automatic requirement to post more collateral. But AIG had ALSO written over $300 billion in regulatory relief capital to Eurobanks. If AIG had failed, the banks would have been exposed as having less capital than they claimed, and that could conceivably have kicked off runs at the weaker ones.

And the investors aren’t necessarily absorbing the risk anyhow:

Some regulators say they are concerned that in some instances these transactions are not actually taking risk off bank balance sheets. For instance, a financial institution may end up lending money to clients so they can invest in one of these trades, a move that could leave a bank with even more risk on its books.

The article proceeds to discuss specific trades done by UBS, Citigroup, and Credit Suisse. It mentions a fund created by Orchard Capital Group with New Mexico pension funds among its investors. I don’t know these pension funds in particular, but some New Mexico funds invested in particularly drecky CDOs the last time around. Given the historical level of corruption in New Mexico’s government investing (considerable), the participation of a New Mexico fund is not an encouraging sign.

And on top of that, the Times tells us that even if Dodd Frank limits some of these trades, they could be restructured to get around it.

One small bit of good news is that FDIC Vice Chairman’ Tom Hoenig’s speech criticizing Basel III pumps for the use of simple leverage ratio and much, much higher capital levels (hat tip Deus ex Machhiato):

In 2007, for example, the 10 largest and most complex U.S. banking firms reported Tier 1 capital ratios that, on average, exceeded 7 percent of risk-weighted assets. Regulators deemed these largest to be well capitalized. This risk-weighted capital measure, however, mapped into an average leverage ratio of just 2.8 percent. We learned all too late that having less than 3 cents of tangible capital for every dollar of assets on the balance sheet is not enough to absorb even the smallest of financial losses, and certainly not a major shock. With the crisis, the illusion of adequate capital was discovered, after having misled shareholders, regulators, and taxpayers….The Basel III proposal belatedly introduces the concept of a leverage ratio but calls for it to be only 3 percent, an amount already shown to be insufficient to absorb sizable financial losses in a crisis…

A leverage ratio as I’ve defined it explicitly excludes intangible items that cannot absorb losses in a crisis. Also, using IFRS accounting rules, off-balance sheet derivatives are brought onto the balance sheet, providing further insight into a firm’s leverage. Thus, the tangible leverage ratio is simpler to compute and more easily understood by bank managers, directors, and the public. Importantly also, it is more likely to be consistently enforced by bank supervisors.

Hoenig points out that bank equity ratios before the creation of the Fed were 13% to 16%, and he clearly thinks bank capital levels need to move a good way towards that level.

Would these capital relief trades be deemed to get the asset exposures off the balance sheet? Hoenig’s cold-water Yankee posture suggests not. Unfortunately, he’s not driving this train, but if the rest of the FDIC is on the same page as him, they may be able to restrict the use of capital relief trades in the US. Or at least one can hope so.

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