Guest Post: The Inner Circle of Systemic Risk?

Submitted by Leo Kolivakis, publisher of Pension Pulse.

Wall Street had its best day of the year, storming higher after some good news from Citigroup:

Citigroup Inc. says it operated at a profit during the first two months of the year. That energized financial stocks and in turn, the entire stock market. Surprised investors drove the major indexes up more than 5.5 percent to their biggest one-day rally of the year. The Dow Jones industrials shot up nearly 380 points.

However, many analysts are still cautious — noting that Wall Street has seen many blips higher since the credit crisis and recession began. Word of Citi’s performance broke a months-long torrent of bad news from the banking industry but analysts weren’t ready to say the stock market was at a turning point and about to barrel higher after a slide that’s lasted more than 16 months.

“To have a sustained rally, we have to have a shift in sentiment,” said Kurt Karl, chief U.S. economist at Swiss Re. “One day isn’t going to make a trend.”

Still, the Citigroup news offered investors some hope that the first quarter will show signs of improvement.

In a letter to employees Monday, Citi Chief Executive Vikram Pandit said the performance this year has been the bank’s best since the third quarter of 2007 — the last time it booked a profit for a full quarter. Based on historical revenue and expense rates, Citi’s projected earnings before taxes and one-time charges would be about $8.3 billion for the full quarter.

Pandit declined to say how large credit losses and other one-time items have been that would at least partially offset profit.

Citi surged 38 percent while Bank of America Corp. jumped 27.7 percent. The stocks are among the 30 that make up the Dow. All the components of the index climbed Tuesday.

Today’s action reminded me of what happened back on September 18th when Operation “AIG” went into full effect. On that day too, financial dogs rallied sharply as short-sellers covered their positions and the Dow surged 410 points (3.86%) in a frenzy of short-covering activity.

The explosive rally followed comments that the SEC may revive the “uptick” rule and that Federal Reserve Chairman Ben Bernanke was considering modifying mark-to-market accounting.

The question on everyone’s mind is whether this rally has legs. David Spurr writes this rally is the real deal (for a while anyways), but the Financial Ninja reminds us that you don’t put THE bottom with a spike in Libor.

I chatted with my favorite strategist this afternoon, Martin Roberge of Dundee Capital Markets, who recently called for a second chance in the second quarter:

Need a psychological boost as U.S. stock markets touch new 12-year lows? In addressing the key issue of whether this latest dip will be temporary or sustained, Martin Roberge, portfolio strategist at Dundee Capital Markets, believes the answer is temporary. But you may have to wait until the second quarter to see any gains.

He pointed out that global cyclicals (including energy stocks, materials and technology) have recently outperformed defensive stocks (consumer staples, telecoms and utilities), which suggests that investors are not positioning themselves for a sustained stock market trough.

“Thus, as long as liquidity/credit conditions are thawing, market breadth is resilient and global cyclicals’ outperformance is maintained, investors should not assume sustained new market lows,” he said, in a note.

He said that if history is any guide, then the first quarter will mark the low point for the stock market, while the second quarter – hey, just one month away – will mark a recovery. For that reason, he is bullish on crude oil and energy stocks.

“Surprisingly, history shows that crude’s upside potential is the highest when supply is contracting and demand… falling,” he said.

We will see how things shape up in the coming days and weeks in the stocks market, but I am cautious knowing that it could just be another massive short-covering rally.

The possibe changes to mark-to-market accounting, however, couldn’t come soon enough for private equity feeling the pain as investment values fade:

For a brief moment, as record after record was smashed, it seemed that private equity buyout prices were destined to keep rising.

As the last few weeks have demonstrated, it was a falsehood – and a grossly expensive one at that.

After the boom period saw private equity firms compete among themselves to buy ever bigger companies for even bigger sums, the value of those investments is now tumbling.

Last week, Candover Investments and SVG Capital, which are listed, wrote down their 2008 net asset value by 50pc and 64pc respectively. Both are now reviewing their strategic options.

3i, meanwhile, saw the value of its top 50 investments fall 21pc in the fourth quarter.

Of the unlisted firms, Guy Hands’s Terra Firma wrote down EMI, its biggest investment, by €1.3bn (£1.2bn), while Permira made the unusual (for it) decision to confirm it too had written down its portfolio, by 36pc.

Of the US firms, Blackstone wrote down its private equity portfolio by 20pc for the fourth quarter, while KKR Private Equity Investors – known as KPE, it is the New York buyout giant’s listed arm – reported a 47.5pc annual decline in NAV.

That included a $170m (£121m) writedown on Alliance Boots, the high street chemist and wholesaler. The sale of the FTSE 100 group was one of the most high-profile private equity deals of recent times, selling in 2007 to Kohlberg Kravis Roberts and Stefano Pessina, the group’s deputy chairman, for £11.1bn.

Private equity firms use various means to value the companies and stakes they acquire. The most common is earnings multiples at comparable public companies and share prices. As the credit crunch and economic gloom widen, these indicators have tumbled to new lows, and firms have had to adjust values – even if the individual businesses are not always performing badly.

Private equity investments are held for the long term, normally for between three and five years. So even if values are falling in the short term, there is every chance comparable prices will recover by the time it comes to exit. But under new accounting rules, firms must value companies as if they were being sold today. Hence the flurry of miserable updates from the normally opaque world of private equity.

And few expect the bad news to stop here. “There will be more impact from comparable multiples in the short term,” confirms Iain Scouller, analyst at Oriel Securities.

Share prices are already lower than they were since the start of the year, with the FTSE 100 off nearly 900 points, and no one is convinced that the market has hit the bottom.

As one private equity insider notes: “We have got to be realistic about these things. Public companies have come off substantially and it’s a really difficult world out there. Will there be more writedowns? It’s just impossible to say.”

Analysts find it less impossible, however, and expect more to come through this year as the recession takes hold and the profits and earnings at portfolio companies start to suffer.

Some in the industry have sought to address this early. Nicholas Ferguson, chairman at SVG Capital, said there was a “reasonable cushion” in the 2008 writedowns.

Speaking after the firm’s results last week, he added: “We live in challenging and uncertain times, no one knows what’s going to happen. The sensible assumption is that it’s going to remain difficult.”

SVG wrote down values across the portfolio, including Valentino Fashion Group, the majority shareholder in Hugo Boss. SVG wrote down its investment by £92.2m to £78.6m, but was harsher with others: it cut Gala Coral’s value to zero. Two other firms own the gaming group with SVG: Candover has confirmed it has written down its investment to zero and Cinven is also thought to have.

There is some good news to be garnered from all this misery, however. The first is the growing expectation of a flurry of secondary buyouts this year. Mr Scouller said that as stock markets continue to fall, some investors – particularly the larger insurance companies and pension funds – may feel too exposed to private equity and seek to exit investments as they rebalance portfolios.

Likewise, a number of private equity firms will not be prepared, or for some even be able, to hold on to badly performing assets.

According to the latest 2009 Preqin Global Private Equity Review, cash is available. While previously strong fundraising dropped off in 2008, “eight of the 20 secondaries vehicles currently on the road are targeting commitments of $2bn or more. If these vehicles were to close on target in 2009, they would raise aggregate capital of almost $27bn.”

The private equity market is by no means over. Buyouts will resume: many firms have cash, but are hampered by credit markets grinding to a halt. Long term, analysts expect valuations to rise again – although the optimism is tempered by a significant caveat.

“The biggest downward risk to values is with the large leveraged deals,” says Mr Scouller. “Where values will hold up better is the mid-cap, European deals. 3i is quite well positioned from that point of view, because it hasn’t been chasing the really mega deals that KKR or Permira were.”

In other words, some private equity firms paid too much at the top of the market and even over the long term, values are unlikely to recover to such heady levels.

Yet smaller, less high-profile deals – where acquired companies were not loaded up with as much debt – should fare better. And after all, the long term is what private equity is all about, no matter what records, high or low, are broken in the short term.

As Mr Scouller notes: “In private equity there are only two numbers: the price you pay for the business and the price you exit the business for. What happens in between shouldn’t really matter.”

That is why some people think that all that matters is valuing private equity at cost and at sale when you exit the deal (cash on cash returns). The problem is that you still need interim valuations as you hold illiquid investments on your books.

Private equity’s woes are now hitting pension funds that are under pressure to meet private equity calls:

Pension funds could come increasingly under pressure to meet private equity fund call-up obligations in the medium to long term, a report a Preqin reveals.

The research firm’s 2009 global private equity review said some institutional investors have expressed concerns about their ability to meet these obligations due to liquidity issues.

It quoted a European investor saying “all limited partners should be worrying about meeting fund call-up obligations” in the longer term.

Despite this, Preqin said 92% of investors surveyed did not anticipate being unable to fund capital calls in the next 12 months, 6% said they might and 2% said they were unsure.

The report also said there were cases of pension funds becoming overweighted towards private equity due to the decline of public market valuations. The California Public Employees’ Retirement System (CalPERS) currently has 13.3% of its total assets allocated to private equity, while its target allocation to the asset class is 10%.

The survey found 21% of investors have already exceeded their optimum level of exposure.

It said many investors took actions to alter their short term plans for investing in private equity because they unexpectedly found themselves closer to their targets – although a majority of them (79%) said they had not exceeded their target allocations to the asset class.

In alternative, some investors widened acceptable private equity allocation ranges to overcome to rebalancing issue.

The California State Teachers Retirement System (CalSTRS) opted to widen the its investment range from 4%-11% to 3%-15%, when it found itself overallocated to private equity with 14.4% of its portfolio invested in the asset class.

In terms of future commitments to the asset class, 40% of respondents said their plans had changed and 56% said they would continue to invest in the asset class as normal.

Of those, 35% will be making fewer investments in 2009 than they had in recent years, 17% have opted not to make any further commitments to private equity and 17% will be more cautious than before.

Investors are right to proceed cautiously in private equity. All they have to do is listen to Stephen Schwarzman, chief executive of the Blacktone Group, who sounded a down note today:

“Between 40 and 45 percent of the world’s wealth has been destroyed in little less than a year and a half” by the global economic crisis, Mr. Schwarzman told an audience at the Japan Society in New York on Tuesday, according to Reuters. “This is absolutely unprecedented in our lifetime.”

Mr. Schwarzman said he saw potential in Treasury Secretary Timothy F. Geithner’s plan to unfreeze credit markets through a new program that would combine public and private capital to buy toxic bank assets of up to $1 trillion.

“In all likelihood, that will have the private sector buy troubled assets to clean the banks out in terms of providing leverage,” he said, “so that we can get more money back into the banking system.”

He said he expected the private sector to end up making “some good money doing that,” but added there were complex issues on how to price toxic assets.

Mr. Schwarzman is feeling the pain of the economic crisis. Earlier this month, Blackstone disclosed that his 2008 compensation had fallen 99.8 percent, to $350,000, as the private equity firm earned virtually no incentive fees from harvesting profitable investments.

Mr. Schwarzman also warned against regulation which he thinks could hurt young people’s desire to enter the financial services industry. (Our society should only be so lucky!)

Finally, on the issue of regulation, Private Equity Beat’s Shasha Dai writes on the inner circle of systemic risk:

Does private equity pose a systemic risk?

That’s an issue much on the mind of the industry of late, as the world’s governments start addressing how to better regulate financial institutions that do pose systemic risk, so that we can in future avoid a crash of the type that we’re currently living through.

Regulators aren’t getting too detailed on this particular issue just yet. While a recent European Commission proposal identified PE firms (and hedge funds) as “systemically important,” Federal Reserve Chairman Ben Bernanke didn’t mention either in a speech this morning in which he outlined a potential path forward for regulators. (Although we wouldn’t have either, given that Carlyle Group’s David Rubenstein was moderating the speech, to the Council on Foreign Relations.)

For the academic view, we turn to professors at New York University’s Stern School of Business, who step directly into this thicket in a recent white paper entitled “Regulating Systemic Risk.”

The paper defines systemic risk as “the failure of a significant part of the financial sector – one large institution or many smaller ones – leading to a reduction in credit availability that has the potential to adversely affect the real economy.” It argues – uncontroversially – that commercial banks aren’t the only ones that present systemic risk. So too does the “shadow banking sector,” which consists of “investment banks, money-market funds, insurance firms, potentially even hedge funds and private equity funds.”

The paper calls for banks to pay a “tax” on their systemic risk that would look something like the insurance that commercial banks buy for their deposits with the Federal Deposit Insurance Corp. Banks could be required to buy insurance against a potential loss to the financial system caused by their failure, the paper says. If they fail, the payout from insurance companies would go to a federal “systemic crisis fund,” instead of to the institutions themselves.

Viral Acharya, a co-editor of the paper, said that more regulation of private equity firms is needed because they receive cheap financing from banks, and if their portfolio companies do poorly, that in turn hurts banks and the broader economy. However, he doesn’t think the tax scheme outlined above should be applied to PE firms.

While regulators can use some transparency into how private equity funds operate, like how their portfolio companies are being run, Acharya said, the private nature of those entities should be protected because “by and large, we find private contracting is quite efficient.”

“If you regulate the banking sector right and tax systemic risk of banks, that will indirectly make it more expensive for private equity firms to borrow from banks,” Acharya said. “I don’t find a strong rationale for directly regulating the shadow banking system. The problem is not private equity funds per se. If banks were not lending so cheaply, private equity funds would not have levered up so much. You need to fix the banking sector, rather than going after private investors directly.”

In a way, what Acharya has in mind is different layers of regulatory oversight, for lenders and for those they lend to. That idea is one that is gaining credence elsewhere. The International Monetary Fund proposes just that in a recent paper, writing that “a two-tiered approach with an outer and an inner perimeter is envisaged.All financial institutions within the outer perimeter would have disclosure obligations to allow the authorities to determine the potential of the institution and its activities to contribute to systemic risk.

Those institutions within the wider groups that are recognized as being of systemic importance, based on broadly agreed and disclosed parameters, would be in the inner perimeter and subject to higher levels of prudential oversight.” The inner circle, the IMF said, would consist of both banks and non-banks.

The NYU paper and others will be published in an upcoming book, called “Restoring Financial Stability: How to Repair a Failed System.” The executive summaries can be downloaded here.

I would add pension funds into the equation as their reckless actions often go unreported but clearly they too contributed to systemic risk by investing trillions into alternative investments.

Moreover, many pension funds invested using “portable alpha” strategies that rely on swaps, exposing them to potentially serious counterparty risks.

Any measures to “regulate systemic risk” must include pension funds into the equation as they go unnoticed but their allocations to alternative investments and exposure to counterparty risk can lead to disastrous results.

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  1. Anonymous

    It would be great if Pandit would put his money where his mouth is. Checking insider trades for Jan’09 is very revealing.

  2. Anonymous

    Some things never change.

    Rating agencies job was/is to assign risk to paper contracts and now with banks circling the toilet bowl, rating downgrades are a touchy subject.

    If the private sector (shadow banking) wants to be left alone, fine, then they can absorb their own losses and stop asking and getting taxpayer bailout money for gambling losses.

    Citi announces good news and the quarter is not even complete yet. Looks like a pump and dump coming with the trailing news of reestablishment of the uptick rule down the road.

    Hedge funds running out of room to short the markets so reenactment of the uptick rule won’t hurt so much now.

  3. Anonymous

    @Anon 1:00am, I like pump and dump, mine is bait and rape. I Can’t help feel sorrow for the innocents that will be undone by this kind of market posturing.

    Until they re-apply the_rule of law_ for all and check for the burnt fingers from the crack pipe of idiopathic malfeasance, intent on diminishing/killing us for affluent lifestyle retention, were screwed.

    Other than that great post. I for one don’t mind the exacting clarity with the guest posts, ammo for discourse.

    Skippy…with out pain their is weak memory.

  4. mmckinl

    “Hedge funds running out of room to short the markets so reenactment of the uptick rule won’t hurt so much now.”


    My take on the uptick rule was to try to short circuit the Tobin Tax now under consideration in a House Bill by DeFazio …

  5. Peripheral Visionary

    Private equity firms are facing the ugly possibility that they may have to actually run the companies they have purchased.

    What started out as good-old-fashioned equity stripping is turning into an exercise in company management, and that in a terrible overall market, something for which the PE firms are manifestly unprepared. A few of the old hands like Bain may be able to keep their companies alive through this downturn, but the newcomers in particular are facing deteriorating fundamentals, mountains of debt, and no buyers for their companies with inexperienced staff who may not be up to the challenge.

    Mark-to-market changes will help with the quarterly reports, but numbers on the quarterly reports are not going to make crushing debt payments.

  6. Anonymous

    It always surprises me that markets rally on hearsay and rumour. I guess all the professional traders are betting Joe amateur trader is buying this and this is just a dead cat bounce to fleece a little bit more money from the unwary trader. As for what Pandit actually said then that is not as impressive as it may appear at first glance.

    “Even if near-term conditions deteriorate significantly, we expect to be able to realize the majority of our DTAs (Deferred Tax Assets)”

    Which I took to mean that booking future tax rebates as capital may not be a too outrageous thing to do.

    “In January and February alone, our revenues excluding externally disclosed marks were $19 billion.”

    Which I took to mean that Citi group were profitable if you discounted all the writedowns.

    “The Fed will conduct stress tests for all large banks in coming weeks. We’ve done our own stress testing using assumptions that are more pessimistic than the Fed has outlined and we are confident about our capital strength. “

    Which I took to mean the FED stress tests are meant to inspire confidence rather than be a real stress test for the banks.

    The problem is that the FED is always fighting the last fight instead of looking for the next ones. We hear from Meridith Whitney that credit cards are the next credit crunch, which does not come as much of a surprise as those struggling with debt switched from using their house as a ATM to credit cards. We also hear of firms stopping payments to 401k’s and final payment schemes with big black holes. At the very least this will take out a few firms but it also undermines the credit worthiness of the government who will have to eventually make up the difference, or face the prospect of very low consumption from the retired.

    More immediately we perhaps should start looking at insurance companies and what drove James Lockhart, the Director of the Federal Housing Finance Agency to plead for capital for the mortgage insurance companies. There is no doubt that housing will take a downturn if mortgage insurance costs have to hiked as much as some are suggesting.

    As for KKR writing down is investment on alliance boots by 121million then it would be my guess that this is significantly short of what they ought to have written it down by. Equity firms would appear to be playing the same accounting games as the banks.

    Whatever way you look at it, the next black swan event may be just around the corner whether its banks, mortgage insurance, private equity, Rumania, GM bankruptcy, pensions,the eventual collapse of US treasuries or more likely something I missed from the list.

  7. ruetheday

    “It argues – uncontroversially – that commercial banks aren’t the only ones that present systemic risk. So too does the “shadow banking sector,” which consists of “investment banks, money-market funds, insurance firms, potentially even hedge funds and private equity funds.”

    If we re-instated Glass-Steagall, and forbade investment banks, hedge funds, and private equity funds from borrowing from real banks, then the systemic risk presented by the former would shrink dramatically.

    Likewise, if we started regulating insurance companies at the federal level, and prevented them from running secret hedge funds in their basements, systemic risk would shrink.

    As for money market funds, there are two choices – we either ban them, or recognize them for what they are (banks) and regulate them as such. Now that some degree of FDIC protection has been extended to them, it looks like we’re going down the second path. That’s perfectly fine, but we have to actually see the journey through.

    A Tobin-esques tax on all financial transaction to make any future systemic-risk mitigation activities self-funding, should complete the new framework.

  8. Leo Kolivakis


    I agree with everything you wrote above, especially for the insurance industry, but I caution you that the Tobin tax is controversial because many economists think it will bring about more volatility.



  9. jmk

    the point re pension funds is especially significant – in the last 5 years they have massively grown their exposure to shadow banking system sources such as hedge funds/private equity – one could even argue that this surplus liquidity ‘crowded out’ these alternative strategies and thus lead to their closer correlation with conventional market beta

    in realisation that what pension funds have invested under the classification of ‘alternative assets’ was not totally uncorrelated to market beta risk – and with so many disaster-stories relating to this sector, one would expect them to withdraw their recent enthusiasm (and liquidity) which will probably simply compound the forced deleveraging selling-spiral being seen by many of these alternative asset managers

  10. mistah charley, ph.d.

    “Between 40 and 45 percent of the world’s wealth has been destroyed in little less than a year and a half” by the global economic crisis, Mr. Schwarzman told an audience at the Japan Society in New York on Tuesday, according to Reuters. “This is absolutely unprecedented in our lifetime.”

    Yes, and no – mostly no, in my opinion. When he says “wealth” he means “putative monetary value” – but what money is used for is buying goods and services* (and storing the ability to buy goods and services* later), and there has been no unprecedented destruction of these.

    World War II is not in my lifetime, but just barely beyond it (i.e. I am a “boomer”) – and there are still millions of people left on this earth who lived through an unprecedented destruction of REAL wealth.

    Metaphorically speaking, the financial system is like the nervous system of the economy – it has cancer (or is it epilepsy, or syphilis?) right now, but the other organ systems are mostly OK.

    *Among “goods and services” we can count the services of “public servants” – as Will Rogers said, “America’s got the best Congress money can buy” – and let’s not leave out the executive and judicial branches, and the guys in charge of the mass murder (war, euphemistically called “defense”) apparatus.

  11. Anonymous

    I can’t stand lazy reporting like this in the Townsend article, “Buyouts will resume: many firms have cash, but are hampered by credit markets grinding to a halt.” If the buyout firms really had *CASH*, they wouldn’t have to worry about the credit markets. They don’t have *CASH* to do these buyouts. They have a small amount of cash to buy an upside option on a company’s value. Embedded in this mularkey is the idea that if one has a small amount of cash, one should be *ENTITLED* to have someone else lend them 80% of a transaction’s amount (and have that lender cap his own return if equity subordinates (or pays an option premium, whatever you like)). It’s just absurd what people feel entitled to nowadays. It’s not just that they feel entitled to the debt, but they feel entitled to the debt at absurdly low interest rates. And the federal government is helping to perpetuate this feeling of entitlement just as the private sector is realizing that it is crazy to continue to lend and cap your return for these risk takers to go for broke.

  12. lineup32

    What everyone forgets is the systemic risk is really political corruption on going by both major political parties. No end to this crisis until the septic pool in D.C. is pumped up and the bad actors get to share cell time with Madoff and his many friends in high places.

  13. Eric L. Prentis

    Reinstating the “uptick” rule will do little or nothing to help the stock market, and may actually hurt. The uptick rule only applied to the NYSE and may have been useful prior to computer trading and when share bid-ask spreads were in eights of a dollar. Now however, share bid-ask spreads are in pennies, computers dominate institutional trading and swaps are easily traded away from the NYSE. In short, the uptick rule is an obsolete relic.

  14. Anonymous

    yah mistah charlie, she is, how we say, fictitious capital but concentrated claims to the future have real consequences.

  15. Richard Kline

    So Anon of 12:46, I totally agree with you. Private equity is a great game if you can lever up in tiers to 30:1 and ultra-cheap rates by any historical standard with a hoard of ‘lenders’ competing to roll over your stake for the fee (which is in effect a kickback since the lend it to you). It was such a sweet game for the last half dozen years that these moneyclowns didn’t even bother to asset strip the legitimate enterprises they were buying and flipping; too much trouble, messy. Now that the name of the game is ‘Investment,’ these folks don’t have any. Game, that is.

    There outta be a law against this—and there is! It’s called The Law of Averages. The wallet size of these Wide Boys is going to approach their hat size. That’s what I call rightsizing.

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