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Banks Resorting to Old Tricks to Reduce Capital Levels

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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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43 comments

    1. Capo Regime

      +10. It can’t be fixed and probably collapse will be the only thing that compels a new system/approach.

    2. Cynthia

      Yes, we all have been so convinced that this shit was going to hit the fan and while many of us have seen our own situations backslide, we have also had to watch the constant rise in the markets. While I think the whole thing is corrupt and want nothing to do with it, up or down, I think this may well be the moment we have been waiting for. Our momentary sense of defeat might well be the catalyst that propels the market over the top and down the cliff. This little signal is all that many will need to go in, guns blazing, which ultimately is what the thieves have been waiting on. On the other hand, I could just be rationalizing victory from defeat. Kind of like hoping they choke on me while they are trying to eat me.

      1. darms

        “Kind of like hoping they choke on me while they are trying to eat me.”

        Very well put, thank you.

        1. Dave of Maryland

          You are of course aware that a bail-in requires the equal participation of all banks, guilty or not, in a single political jurisdiction.

      2. jrs

        The big players may play both sides of the trade and with inside information, the banks may be bailed by the powers that be, that’s how the game is played, in the world of too big to fail. But, but … another crisis is a time for radicalizing the rest and radical bottom up change. I don’t necessarily want that moment, but if it comes, make the most of it.

    3. sgt_doom

      Just prior to Bear Stearns’ meltdown:

      they had $190 billion external debt, and there was an estimated $2 trillion of credit default swaps (naked swaps) against it…..

      1. OpenThePodBayDoorHAL

        What a quaint concept “regulators”, I could see how something like that might actually work, put people in charge of enforcing “laws”, so when banks steal money from people these so-called “regulators” would be able to step in and say “no no, you’re not allowed to steal quite so quickly, you need just to steal a little more slowly”
        That concept might catch on, before you know it these things called “crimes” would start to be “punished”.
        (…pinches himself, wakes back up into Corrupto-World, tries to find cognac bottle…)

    4. sgt_doom

      An absolutely corrupt system cannot be fixed, just as it is an arithmetical impossibility for there to be any recovery (yeah…yeah….I know Marty Feldstein, who was a director at AIG’s Financial Products during the largest insurance swidnle in human history, claims from his perch at NBER that the recovery is in progress, I’ve never trusted that guy, plus there’s that time he was director at Eli Lilly when they were hit with the largest criminal penalty in American history, and that time he was a director at HCA (Hospital Corporation of America, remember them?) when they were hit with the largest out-of-court settlement/penalty for Medicare/Medicaid fraud, and that time…….).

    5. nonclassical

      ..we could just read Satyajit Das’ book, “Traders, Guns Money”-understand what-how “investment bankers” are “trading” or “speculating”…on “inside information” or “overwhelming force”..

      ..cannibalizing each other-anyone-everyone else involved…

  1. diptherio

    This is why I am convinced that States need to get their money out of Wall Street ASAP, either through the creation of State-owned Public Banks, or through changes to State Boards of Investment. I see no reason why States cannot invest all State revenue within their own borders. North Dakota manages it and I’m sure with a little creative thinking, so could the other 49 States. Why should we continue to allow State tax revenues and pension funds to be put at risk by unaccountable Wall Street bankers?

    http://www.publicbankinginstitute.org/

    1. Susan the other

      Agree totally. This would also kill the TPP somewhat indirectly, because it would deprive the TBTFs and Corps from the easy cash they require to hold on to their monopolies.

    2. Gerard Pierce

      I don’t remember the details of how North Dakota’s system works, but I believe that much of their investment program involves a network of community banks that was built up over the years.

      It would be interesting to see what kind of creative system you would find in Arkansas, Illinois or Florida.

      It would be interesting to watch the selection of management for the new institutions. Kind of like feeding time in the shark tank.

      1. Capo Regime

        Indeed, imagine Florida and Nevada left to their own devices would bring back ninja loans with 500 to 1 leverage. Somehow I think the folks in Little Rock would be a bit more circumspect than the sleazebags in Florida. Still, the creative systems arising in such places would be a sight to behold!

      2. diptherio

        The “network” was pre-existing, just as it is everywhere. The BND (Bank of North Dakota) partners with local banks and credit unions to provide loan participations, interest rate buy-downs, and other services for commercial, ag, student and mortgage loans. All state monies are invested in the state in this manner and it’s been working for about 100 years.

        Because of the BND, small local banks are able to make much larger loans than they would otherwise be able to handle, which allows them to compete for the high dollar loans with the TBTFs. For this reason (one assumes) ND has the highest number of local banks per capita of anywhere in the country. And because ND’s local banks are run much tighter than their Wall Street counterparts, they only make loans to good credit risks. ND did not experience a foreclosure crisis or a credit crunch in 2008 when the commercial paper markets froze up.

        The BND website is a treasure trove of good ideas with actual track-records. It’s definitely worth the time to look through:

        http://banknd.nd.gov/lending_services/index.html

    3. cwaltz

      I don’t think the system of a state run bank could be much worse riskwise for taxpayers then this system anyways.

      1. RepubAnon

        At some point, the state banks would start getting pressured to show better yields – and get stuck with a bunch of bad paper.

        1. diptherio

          The Bank of ND has not had this problem in nearly a century of operation. The drive to increased yields is not a part of the BND’s mission statement, and so the directors focus instead on making good quality loans. Remove the profit motive and you get rid of a lot of shenanigans as well.

    4. diptherio

      Also, for anyone interested in the Bank of North Dakota, I would recommend listening to this conference call with a number of the BND’s staff and Marc Armstrong of the Public Banking Institute. The sound quality is a little poor, but there’s a lot of good information here (skip past the ‘hold’ music at the beginning):

      Banker’s Roundtable with BND President, et al

  2. down2long

    Not to worry. Obomba dumps his sh*t sandwich on America’s most vulnerable yesterday, today he’s meeting with Slimin’ Dimon, Moynihan, the Bankster Cabal, et. al. in the White House, reports CNBC, as the Boffo Banksters assemble for their Family “Sit-Down” in DC. Oh Hallelujah we are saved.

      1. NotTimothyGeithner

        Obama won’t ever command that kind of cash. After his attacks on Social Security, no one will want to touch him with a 10 foot pole.

        The Obots will move onto their next fetish or will be too broke to help. Jaime Dimon won’t give Obama the time of day unless Obama can help him, and a guy who is only popular with poor minorities isn’t going to bring in the big bucks.

        Think “Wakeup Chicago with Barack Obama and the early drive bunch!”

        1. down2long

          Odd that CapoRegime should post just when I’m getting ready to post about La Cosa Bankster and their consigliere Morrali Baroke Ombomba. Having a sit-dowm with the capos to get their caporegimes, i.e. the SEC, OCC, DOJ, Dept. of Treasury, Reservo Federale, etc. to implement the new hit on the stooges.

          Guess over in the Senate, Warren and Brown did do a little dalliance with the OCC. To no end whatsover, but I love that they are trying. (Brown actually seems committed to the project, in Warren I still hold hope.)

          1. down2long

            I think I need a visit to the “BadaBing.” Sadly, La Cosa Bankster stole my money. This is not a sustainable business model, guys.

          2. Carla

            Sherrod Brown has been in the trenches on this for years. Warren’s a mere apprentice compared to Sherrod. On the other hand, he’s a U.S. Senator, so don’t expect him to support public banking, any more than Warren, or for that matter Socialist Sanders would.

            I’ve heard some rumours that the U.S. Postal Service is considering bringing back the postal savings accounts that (although most of us may not have known it) actually existed in this country until 1965.

  3. digi_owl

    A image of a couple of suits playing hot potato with a live nuke would seem appropriate…

  4. Susan the other

    Why did Lehman think it could get away with shuffling its bad assets off the books? It was interbank warfare that brought Lehman down. Now they are calling this stuff “regulatory relief trades” – isn’t that unnecessary since the european banks have been getting money directly from the Fed? Is the Fed just so overwhelmed policing the banks to act nice with each other that no other regulatory action has been possible? Nevermind. I’m not in a state to comprehend this stuff. It isn’t scrambled eggs, it’s an all-out food fight. These guys need to be history.

      1. tawal

        They all used to shuffle it back and forth to each other as they all had different year ends. Now that they are bank holding corp.s, they are required to have calendar year ends. Now they shovel it on to the Fed’s balance sheet and the hedgies. With the hedgies they even lend them the money to by the dreck, probably at 30 day Liebor + 50 bp

  5. Erik

    I completely agree. However, I have one question, considering that I am not well-versed in the complexities of modern finance:

    The article spoke specifically about shipping insurance. Now I know that these CDOs and similar arrangements are not limited to this category, but specifically around shipping: isn’t the risk that is insured against the risk that a flow of trade goods will not physically reach its destination, e.g., from a loss at sea?

    Assuming that is true, then isn’t this at least a slightly more appropriate use of these types of vehicles than the AIG subprime affair? After all, it’s risk to bet on a financial market that could swing fickly in one direction or another. If the winds align wrong, then even a market that was once fractured could turn in unison (housing), wiping everyone out. What are the chances that ALL shipping losses are incurred simultaneously? If that were to occur I think we would have much bigger problems on the scale of global catastrophe.

    I realize that this is probably a naive read of what they meant by shipping insurance. It probably has more to do with the VALUE of commodities that are constantly changing hands even as they cross an ocean (e.g., oil). That would indeed make the situation market-based and bring with it the same risks as writing CDOs for housing.

  6. p78

    My favorite quote from Hoenig is about the comparison of his proposed measure, “tangible level ratio”, with the Basel-sanctioned risk-weighted asset models, which are left to banks’army of former physicist to model:

    “If the Basel risk-weight schemes are incorrect, which they often have been, this too could inhibit loan growth, as it encourages investments in other more favorably, but incorrectly, weighted assets.
    Basel systematically encourages investments in sectors pre-assigned lower weights — for example, mortgages, sovereign debt, and derivatives — and discourages loans to assets assigned higher weights — commercial and industrial loans. We may have inadvertently created a system that discourages the very loan growth we seek, and instead turned our financial system into one that rewards itself more than it supports economic activity.”

    Wish I knew how to compute the Tangible Leverage Ratio for my local bank, from the figures they released at the end of 2012, regarding Tangible assets, Intangible assets and Equity. I wish there were some guidance formulas somewhere such that I can exclude from the bank computation the “intangible items that can’t absorb losses in a crisis”, the “goodwill”, the “deferred tax assets”.

  7. Eureka Springs

    What’s a bankster and a hedgies answer to STD’s? (sexually transmitted derivatives)… We need another orgy!

  8. scraping_by

    Shades of the Enron SPVs.

    But of course, Enron still owned the losses. It was just a different name signed on the dotted line. It all built up while the Smartest Guys in the Room sucked in their bonuses.

    If the banksters’ transaction is really a transfer, and not just a renaming, the so-called professionals who run the hedge funds are showing large disregard for their principles. Which may be another Enron echo.

  9. Hugh

    “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.”

    And that folks, is kleptocracy in action, a feature, not a bug.

    “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.”

    Not only does it not eliminate it, risk can be multiplied. It’s like being on the Titanic, making bets on the ship’s speed, and pressuring the captain to increase that speed. It all works out great until you hit an iceberg.

    1. Chauncey Gardiner

      Re: … “kleptocracy in action, a feature, not a bug.”

      +1. Thanks, Hugh.

      IMO Derivatives WMDs – as none other than Warren Buffett characterized them – are designed and intended both for speculation and extortion… and ultimately for massive financial destruction.

      Unless the status quo is maintained into perpetuity without sudden material disruptions, and material changes implemented very gradually, the damage to the financial system could prospectively be so severe that restoration of the system will be very difficult, even if that should again be deemed the desired outcome by policy makers.

      … Um, what’s Murphy’s Law again? And that’s assuming key players have the best of intentions.

  10. Phichibe

    Yves,

    I’m so glad you called people’s attention to the Dealbook article. I read it this morning and my jaw dropped. Regulatory arbitrage? Again? Using CDS’s from the shadow banking system? I’m stunned. Given that the CDS’s are probably written to evade the requirements of the central clearinghouse, we have no idea of the counterparties involved or their capital levels. My God, this is worse than AIG since there, at least, we had an idea of the size of the problem (once the meltdown started) because it was a public company. Now the risk is being picked up by dozens (hundreds?) of shadowy hedge funds, the failure of any one of which could trigger a chain reaction meltdown, not least because the question of netting further exposes the possibility of an insolvent CDS issuer bringing down the whole house of cards.

    Bernanke should resign and just join Promintory now. He’s earned his pay.

    P

  11. RBHoughton

    There’s nothing new under the sun Yves.

    The old mercantilist companies of London and Amsterdam paid fabulous dividends and appeared solid but everyone of them was insolvent – it guaranteed political protection.

    The same situation exists today with TBTF. In UK our banks write their own capital adequacy reports and transfer stuff to “special purpose vehicles” to make the figures work.

    At tiny interest rates, its surprising people still keep their spare dollars there.

  12. JTFaraday

    It seems pretty obvious that one effect of the “austerity discourse” following the financial crisis was to change the topic of public discussion and create a distraction from the way that the crisis last time was never resolved in any meaningful way.

    Those who relentlessly flogged the austerity topic in public discourse, on both sides of the issue, participated in the creation of this distraction. This change in topic was deliberate.

    Since the austerity topic isn’t likely to go away any time soon, it would be nice to put the financial sector perps who put the major western governments they corrupted into a state of immediate crisis in the first place, back into the picture where they belong.

    I don’t really expect this to happen at this point. And neither do they.

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