Don’t watch the miners, watch the canary.
Prior to the 2008 financial crisis, banks famously thought that they’d managed to off load questionable loans by bundling them into securities and selling the risk to investors. It’s hard to beat the explanation of how this works than Michael Lewis’ The Big Short. If an entire whole book is too daunting, or it all explained by Margot Robbie drinking champagne in a bubble-bath – just watch the movie.
In the aftermath of all that, regulators in Europe and the US were determined to install safeguards – mainly in the form of higher capital requirements against assets and curbing riskier activities. On the surface, the regulations seem to have worked. Having recently passed Federal Reserve stress tests, America’s largest banks – including Goldman Sachs, Morgan Stanley, Citi, Bank of America and Wells Fargo have announced increases in shareholder dividends. JPMorgan Chase, the largest of the lot, has announced a raise in shareholder dividend of 9% and $30bn in share buy-backs.
Still... the financial world, being the financial world, has adapted to the new rules in way that regulators, being regulators, didn’t foresee. The first is the rise of private-credit – which barely existed prior to the financial melt-down – which has now made some $1.5trn in loans. Big, legacy blue chips, which rely on the $7trn corporate bond market, don’t need private credit. Smaller, riskier firms, often loaded with debt, however do. Which is all well and good: Private investors stepping in where banks fear to tread and in doing so keep the riskiest ventures away from banks.
But do they? Private credit firms borrow from banks to make some of their loans. And insurance companies and pension funds that buy that risk often borrow against their portfolios in order to boost returns.
Without access to Margo Robbie in a bath, the metaphor for the creeping danger struck me while yelling at the dog to quit eating her poo. Synthetic Risk Transfer (SRT) is an asset wherein a bank bundles loans, divides them into tranches, and sells them off to investors to move the risk off their books. True, they are selling the top tranches that take less of a haircut if the loans fail, but that means that the banks are keeping the lowest tranches – the most exposed to non-performing loans – on their books. Sound familiar? Some major banks, like Nomura and Morgan Stanley, accept SRTs as collateral against loans.
Which puts banks in the strange position, again, of eating the some of the toxic risk they’d previously flushed off their books. In the event of a major economic downturn – and I assume that it has to happen eventually, even in America – the banks will not be the first to get wiped out, these things tend to take on a life of their own. Like in 2007 – hedge funds started getting knocked out prior to the crisis reaching its tipping point in the banking system.
If I have a claim to fame for my time as the world’s most mediocre bond salesman, it’s that I called the crisis before it happened managing, somehow, to unwind positions at a profit. As I explained to clients at the time, I wasn’t watching the banks, I was watching the hedge funds. It bears to keep an eye on the canary in the coalmine.
Granted, no one else listened, but who can blame them? I don’t look like Margot Robbie and no one wants to see me in the bath.
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