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Goodbye Bond King, we hardly knew ye

Goodbye Bond King, we hardly knew ye

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Bill Gross, the erstwhile ‘Bond King,’ has announced his retirement. Over the course of four decades, Gross made his name actively trading bonds and started doing that before those bonds were really even considered things that were actively traded. He co-founded Pimco, then moved to Janus in late 2014 in an abrupt and somewhat drama-filled chapter of market history.

While buckets of ink have been spilt on Gross’s career and legacy, I want to point out two things. The first is that, as the title suggests, there’s still a lot we don’t know about the Bond King’s strategy. While investing in bonds might seem like a straightforward activity, it’s no secret that Pimco augmented its performance with a host of derivatives and ‘overlays.’

See for instance, Zoltan Pozsar’s work on the topic in early 2015, which I wrote up in a column for the Financial Times around the same time:

Reach for returns takes funds into the shadows

… The extent to which low interest rates have driven mutual funds and other asset managers to become entwined with shadow banking is laid bare in a new research paper by Zoltan Pozsar, former senior adviser at the US Treasury.

This shadow banking system has long been described as a network of non-bank financial intermediaries, but it is perhaps better characterised as a reference to a particular set of financial activities.

Classic examples of such activities include financial institutions borrowing money by pawning their assets through ‘repo’ agreements or securities lending transactions, as well as using derivatives.

Traditional notions of shadow banking usually centre on the idea of repo being used to fund the balance sheets of broker-dealers and banks. When entities like Lehman Brothers and Bear Stearns became locked out of the repo market in 2008 they suddenly found themselves starved of financing, triggering an avalanche of stress across the financial system.

Regulators have spent the years since the financial crisis trying to clamp down on shadow banking as they attempt to improve the overall safety of the financial system. Since such activities are rarely associated with traditional mutual funds that invest in bonds and other assets on behalf of large investors such as pension funds and insurers, such funds have rarely been mentioned in conjunction with shadow banking.

Mr Pozsar’s research suggests that is a mistake. For example, a cursory look at the balance sheet of Pimco’s flagship Total Return Fund shows a bevy of derivatives including futures, forwards and swaps. Moreover, its repo borrowings at the end of the first quarter of 2014 stood at $1.12bn. The fund’s subsequent annual report shows repo borrowings for the period averaged $5.73bn — more than five times the amount reported at quarter-end.

Such window dressing is usually associated with big investment banks that cut back on their leverage ahead of quarter ends as they seek to flatter their funding profiles and impress their investors.

Its presence on Pimco’s balance sheet is symptomatic of a long-term trend that has seen mutual funds evolve from staid, largely “long-only” managers into very different beasts. In addition to accumulating billions of dollars’ worth of fixed income securities in recent years, the funds have reached for an alternative financial toolkit of derivatives, securities lending and other forms of leverage, to help boost returns.


Gross was also famously vocal when it came to espousing a short-volatility strategy in mid-2014. Doing so wasn’t necessarily wrong, as Gross noted it was “part and parcel” of an overall investment strategy that rested on sluggish U.S. growth and low interest rates, but it nevertheless raised eyebrows among his peers and competitors who viewed the new crop of buy-side volatility-sellers as tourists in a somewhat dangerous market.

The second point is that the sheer size of Gross’s creation — Pimco — has at times had massive effects on the wider market. “Big West Coast player” means just one thing for many in fixed income, and Pimco was said by plenty of observers to have frequently thrown around its gorilla-esque weight to get favourable pricing and allocation on new bond deals. Conversely, however, the sheer size of the Total Return Fund (which from memory peaked at almost $300 billion), was also said by market participants to pose challenges for its managers, the idea being the fund had grown so large it effectively struggled to beat its benchmarks.

That size could also have more deleterious effects. Few people seem to remember now, for instance, that when Gross left Pimco, it coincided with a noticeable sell-off in inflation-linked bonds and junk-rated paper. Or that the flash crash in U.S. Treasuries in October 2014 was rumoured to have been sparked by a sudden liquidation of interest rate positions favoured by Gross. There are still so many interesting open-ended questions posited by Bill Gross’s adventures in Bond Land, and from that perspective I’m somewhat sorry to see him go.

Anyway, for those interested in mulling these questions more, here’s some previous work — much of it done with the FT’s fantastic Mike Mackenzie:

Gross exit from Pimco tests bond market – September, 2014
Pimco upheaval rattles bond market – September, 2014
Wall St sheds light on Bill Gross reign after Pimco departure – October, 2014
Bonds: Anatomy of a market meltdown – November 2014
Caught on the wrong side of the ‘vol’ trade – December, 2014
Reach for returns takes funds into the shadows – February, 2015

Did someone say something about synthetics?

Did someone say something about synthetics?

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Two words excite me like no others.

They are synthetic securitisation (or, for the truly old-school, they are three words: regulatory capital trades). These deals usually involve repackaging loans on a bank’s balance sheet, then slicing them up into different tranches, and selling the exposure to a non-bank entity like an insurer, hedge fund, or asset manager through the use of credit derivatives.

In many respects, they hark back to the early days of securitisation, when JPMorgan first put together its BISTRO trades, otherwise known as the first synthetic CDOs. Banks may be genuinely offloading risk here, and the deals were called reg-cap trades precisely because they offered capital relief that’s so far been genuinely sanctioned by regulators. On the other hand, they seem to speak to some of the worst of the current environment: a pervasive search-for-yield that may see investors put their money in silly things at silly prices (for this reason, you will sometimes hear reg-cap specialists – usually hedge funds – gripe about the non-expertise of new entrants and the need to price the deals perfectly), as well as nagging concern that in fortifying the banking system post the financial crisis, we’ve simply offloaded a bunch of balance sheet risks onto other entities in a classic case of regulatory arbitrage.

In any case, I bring it up because in less than a week we’ve seen two stories published on the market, now said to be booming, first in the Financial Times and then in the Wall Street Journal. Both detail the rise of the market, with issuance described as having jumped by anywhere from 5.6 percent in the first quarter to at least 33 percent so far this year.

Those looking for a graphical representation of the recent rise of synthetic CDOs, could do worse than this chart from Deutsche Bank. It shows European deals only, but the direction of the trajectory is pretty obvious. The WSJ story also references some interesting figures from consultancy Coalition, pointing out that structured credit revenues at the top 12 investment banks more than doubled year-on-year to $1.5 billion the first quarter of 2017, exceeding the growth rate in more conventional trading businesses in the same period.

Growth in the business is not exactly a surprise, though.

More than five years ago I wrote in the FT about some of the bigger banks working hard to get the business going as a way of securing some new fees at a time when many of their other revenue streams were sluggish. In retrospect, that story’s now looking pretty prescient.

Big banks seek regulatory capital trades

 

Big banks are aiming to help smaller lenders cut the amount of regulatory capital they need to hold against loans in an attempt to make money from deals similar to those first created in the early days of securitisation more than a decade ago.

The big banks want to create so-called regulatory capital trades for smaller lenders as they expect demand for these kind of securitisation structures will rise ahead of regulations designed to provide more stability in the financial system.

Such trades, also known as synthetic securitisations, involve repackaging loans on a bank’s balance sheet, then slicing them up into different tranches.

The bank typically then buys protection on the riskiest or mid-level tranche from an outside investor such as a hedge fund, insurance company or private equity firm.

Doing so allows a bank to reduce the amount of regulatory capital it has to hold against the loans – a tempting prospect as banking groups are forced to hold more capital ahead of new regulation such as the forthcoming Basel III rules.

Some of the biggest global and European banks, including Barclays and Standard Chartered, are known to have recently built and used the structures to reduce the amount of capital they need to hold against corporate or trade finance loans.

But some large banks are now hoping to sell their structuring expertise and help distribute the resulting trades to buyers, investors in the trades say.

“The holy grail for some of the investment banks is to try to get some of the second and third tier banks involved, to get structuring fees,” said one investor. The trades hark back to the early days of securitisation in the late 1990s, which helped fuel the financial crisis.

“It’s almost as if you’re seeing the start of the securitisation market coming back in a very modest way,” said Walter Gontarek, chief executive of Channel Advisors, which operates Channel Capital Plc, a vehicle with $10bn in portfolio credit transactions with banks and has started a new fund dedicated to these structures.

Investors such as Channel Advisors say the yields on the deals are attractive compared with other debt securities on offer, and they are able to gain exposure to a specific portion of a bank’s balance sheet rather than invest in the entire thing. The insurers, hedge funds or private equity firms are not bound by the same, relatively onerous capital regulations as the banks. That makes it easier for them to write protection on the underlying loans in a classic case of regulatory arbitrage.”

…MORE… 

Some more early coverage below, for those interested.

Synthetic tranches anyone? – FT Alphaville
Anti-Abacus, anti-BISTRO and anti-balance sheet synthetic securitisation – FT Alphaville
Big banks seek regulatory capital trades – FT, April 2012
Banks share risk with investors – FT, September 2011
Balance sheet optimisation – BOOM! – FT Alphaville, 2010

Safe assets, revisited

Safe assets, revisited

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The idea of a shortage of ‘safe’ assets is a favorite of mine, dating back from 2011 when I first wrote about a crunch in triple-A rated assets for FT Alphaville to more recent things such as this piece for Bloomberg, and sometimes even on this blog. So it was a pleasure to discover, courtesy of Simon Hinrichsen (a former Odd Lots guest whom you should definitely follow on Twitter), a new paper on exactly this topic from Ricardo Caballero, Emmanuel Farhi and Pierre-Olivier Gourinchas. Read it for rather glorious sentences such as this one: “What is relatively new, relative to post–World War II history, is that the global economy is going through a complex structural period where the standard valuation adjustment for safe assets— via interest rate changes—have run out their course.”

Here’s a summary I wrote as part of our morning ‘Five Things’ newsletter, which you can sign-up for here.

“Want a stylized prism through which to understand almost everything that’s happened in the global financial system over the past two decades? Then take a look at this paper on “The Safe Assets Shortage Conundrum.” In it, the authors argue that savers’ desire to put their money in a reliable instrument has created a need for ‘safe’ assets that the financial system has had various degrees of success in fulfilling. In the early 2000s, the private sector tried to fill that need by creating triple A-rated bonds out of subprime mortgages. We know what happened next. After that, safe financial assets became largely the purview of governments via the bonds they sell – first the eurozone (which then experienced its own ratings problems) and then the U.S. Supply has ultimately failed to keep up with demand, however, mostly because slower growth has meant ‘safe’ governments in the developed world have been unable to generate assets at a fast enough pace to satisfy savings from emerging markets. It’s a state of affairs that will probably stick around for a long time, and one that helps explain why bond yields continue to plumb new lows, seemingly without rhyme or reason. But seriously, go read the whole thing.”

A side note: I do wonder what might constitute safe in the current environment. Yes, government debt is the clear winner here but corporate debt issued by cash-heavy, investment grade, national champion corporates – think Apple – can’t be far behind…

It’s not just about the VIX

It’s not just about the VIX

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There’s so much talk about volatility right now — and specifically the stubbornly low behaviour of the VIX  — that I thought I’d do a round-up of some of my previous pieces on it.

Please note, I’m in an anti-paragraph, anti-proofreading kind of mood today. So typos and big blocks of text are ahead.

1. On the VIX 

Let’s start with this one, from September 2013, about a new index trying to challenge the VIX, the index that most people associate with ‘volatility.’ For more than two decades, the VIX index run by the Chicago Board Options Exchange has been the financial industry’s go-to method for measuring expectations of volatility in the wider marketplace, with the CBOE turning the index into something of a cash cow thanks to the launch of futures tied to the gauge. VIX-related futures have in turn allowed a plethora of VIX-based exchange-traded products (ETPs) to also launch. With all that money benchmarked to the VIX, it’s no surprise that we have occasionally seen upstarts attempt to challenge it.

2. Selling volatility

Now let’s go here to this story from December 2014. About six years on from the financial crisis and deep in the era of monetary stimulus, investors are struggling to make returns and seize upon the realisation that selling volatility — whether that be through shorting the VIX or some other derivative-based method — can be a lucrative (if risky) strategy. This was the big shift in the volatility market. Instead of having a bunch of banks or hedge funds (or de facto, GSEs) sell volatility, you suddenly have a bunch of buy-side funds and retail investors who are interested and able to do so, the latter largely thanks to the explosion in VIX-related products. The big question, per the piece, is whether these new sellers of volatility are more likely to behave differently than traditional vol-sellers. Are they more or less likely to react to abrupt shifts in volatility?

3. Self-reflexive VIX

By September 2015, the VIX is again in the headlines after the unexpected devaluation of the Chinese yuan spooked markets. While the VIX did jump on this news, it was the VVIX (in effect, volatility of volatility) that reached an all-time record. Here’s my article about that: “When there’s a sudden spike in volatility, as occurred last month, the price of near-term VIX futures rises. Meanwhile, volatility players — notably hedge funds and CTAs — scramble to buy protection as they seek either to hedge or cover short positions, causing a feedback loop that encourages near-term futures to rise even further.” CFTC positioning data at the time did suggest a classic short squeeze as investors closed out their short vol positions post the spike. In effect there were said to be two major forces impacting the VIX, systematic volatility sellers as well as VIX-related ETPs that have to buy or sell futures to rebalance. This rebalancing act makes the VIX curve important, a point picked up on by Chris Cole of Artemis Capital in a story I wrote about a month later: “VIX term structure inverted at the greatest degree in history in August, so much so and so fast that many structured products that use simple historical relationships to gauge term structure switching and hedging ratios just couldn’t handle it,” he said. The concern is that the explosion in volatility-trading means more demand to buy or sell futures to rebalance, which could impact the shape of the curve itself.

4. VIX and beyond!

The proliferation of ETPs tied to the VIX is a concern insofar as it affects the volatility landscape, but it’s not the whole story. To explain, let’s go to Bill Gross, who became the poster child for volatility-sellers after publicly saying in June 2014 — while still at Pimco — that the company was selling “insurance, basically, against price movements” to juice returns in an era of low interest rates. Not once did he mention the VIX. It wasn’t until October 2014, after Gross’s abrupt departure from Pimco, that we got a better sense of what that insurance-selling strategy might mean when the U.S. Treasury market experienced a sudden melt-up, of sorts. At the time, there was plenty of talk that Pimco was liquidating some derivatives positions, which ended up having an outsized effect on the underlying cash market. The U.S. government’s report on the episode later mentioned that: “In particular, anecdotal commentary suggested that some dealers had absorbed a portion of the sizable ‘short volatility’ position believed to have been previously maintained by large asset managers. As volatility spiked on October 15, those positions would have prompted some dealers to dynamically hedge this exposure, exacerbating the downward move in yields.” Then, in August of last year, the BIS published a paper on asset managers dabbling in eurodollars including the example of Pimco in 2014, which I wrote up in a piece called “This is where leverage lives in the system.” That article contained a laundry list of potentially risky strategies across rates (viz eurodollars, futures, forwards), credit (using swaptions and swaps) as well as equities (options, VIX ETPs, etc.). What’s my point? I don’t mean to underplay what’s happening with the VIX, but my concern is that if we’re looking for potential flash points in the financial system then we may want to broaden our horizons.

Midnight Madness, revisited

Midnight Madness, revisited

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Elisha Wiesel, the son of Holocaust survivor and author Elie Wiesel, is replacing Marty Chavez as Chief Information Officer at Goldman Sachs.

It’s an interesting bit of Goldman kremlinology given his history at J Aron. It’s also an excuse to revisit some of my old work on Midnight Madness – the epic all-night Wall Street scavenger hunt/first-person puzzle/charity fundraiser that Wiesel is credited with inventing and which I wrote about for the Financial Times.

So here’s a fun throwback to 2013, when Midnight Madness was first expanded to include non-Goldman firms:

Wall St lines up for ‘Midnight Madness’

Some time next week Dan Keegan, Citigroup’s head of US equities, will be asked to sing a ballad over the speakers on the bank’s New York trading floors.

The unusual request is part of Citi’s efforts to raise at least $250,000 to enter five teams into a fundraising competition known as “Midnight Madness”.

Traditionally the purview of Goldman Sachs bankers, this year the all-night competition has expanded to include other financial groups. Goldman will now compete in the lavish scavenger hunt and puzzle-solving game against Citi, Credit Suisse, the hedge fund BlueMountain and Secor Asset Management.

The competition takes place on October 5 and has already kicked off a flurry of activity across a competitive Wall Street. The prospect of earning bragging rights in a battle of wits against rivals while raising money for charity is set to lure about 250 traders, quantitative analysts and bankers to this year’s event.

“This type of mental Olympics, combined with adventure, is something that I think might have a broad appeal on Wall Street, and when it’s all for a good cause it’s an attractive combination,” said Michael Liberman, managing partner at BlueMountain.

Goldman has asked participants to stump up at least $50,000 per team. Proceeds go to Good Shepherd Services, a New York City-based charity which offers education and support services for poor or at-risk children and teenagers.

A pamphlet used to pitch Midnight Madness to potential participants describes the games as “a series of cleverly camouflaged, incredibly ingenious and devilishly difficult puzzles – the answers to which indicate the location of the next puzzle . . .”

Last year’s competition saw teams play with lasers in an abandoned building, use circuit boards to reveal locations on a map, and work to change the colour of the lights at the top of a New York skyscraper.

The geekiness of the Manhattan-based event has earned it a reputation for attracting the cadre of “quant” maths experts who have increasingly come to dominate Wall Street institutions and their trading strategies.

This year’s event will include 25 teams of 10 people each, organisers said. Goldman is fielding 16 teams, down from the 20 it sent last year.

From next week, Citi will hold a series of silent auctions and challenge senior staff to “dares” in order to raise the $250,000 in funds it needs to compete. One executive plans to pay $5,000 to challenge Mr Keegan to croon “Danny Boy”.

Citi staff can also pay $20 to wear jeans (usually a no-no on the trading floor), proffer cash to throw pies at their superiors, or enter a hot dog-eating competition. The bank chose team members in a random draw after receiving more than 100 volunteers.

At Credit Suisse, convincing staff to participate in the elaborate competition was relatively more challenging. “It had this reputation of an event that’s very complicated and extreme,” said Dan Miller, head of strategic risk management for the investment bank.

The bank is entering one team into the event and raising cash the old-fashioned way – through solicitation. Division heads were asked to pay $5,000 each to nominate one of their brightest underlings to the Swiss bank’s team.

The Credit Suisse team has also been given a $3,000 budget to buy supplies such as cellphone chargers and copious amounts of Red Bull, the energy drink.

Elisha Wiesel, a partner at Goldman and a member of Good Shepherd’s board, said it is not unknown for contestants to fall asleep on the sidewalk while competing in Midnight Madness, which was started in the 1990s but went on hiatus in 2007 until it was revived last year by Mr Wiesel and other organisers.

“This is really like a marathon. It’s a sporting event,” Mr Wiesel said. “You have to survive a very, very challenging evening, morning and potentially afternoon.”

Last year’s “Madness” raised $1.4m, after about $270,000 of expenses. This year’s budget is “going up a little bit” because the event is “aiming to be more ambitious and make more money for the charity,” Mr Wiesel said.

The hefty budget for last year’s event drew some scepticism, including from Reuters columnist Felix Salmon, who wrote that “at some point you do have to wonder whether they really needed to spend that much money on the game design”.

When asked whether the competition could become an annual Wall Street event, Mr Wiesel said that it would depend on organisers’ ability to commit their time.

But he added: “This is just too cool and too fun not to do.”

Those looking to get on the new CIO’s good side can go here, to an old FT Alphaville post, to try out some Midnight Madness puzzles and practice lateral thinking for themselves.

Peer-to-Fear

Peer-to-Fear

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In January of this year I resurfaced some of my older reporting on the peer-to-peer, or marketplace, lending industry and wrote this line in the first article about Lending Club raising interest rates for the riskiest borrowers on its platform:

It’s worth recalling the words of some investors at the time who criticized LendingClub’s lofty $8.9 billion valuation—reached partly because of overwhelming enthusiasm for all things tech-related.  “These companies are really specialty finance companies, but look at where specialty finance companies trade in the public markets,” said one major marketplace lending investor at the time [of LendingClub’s late 2014 IPO].

It’s a point that, like much of my coverage, has been oft-repeated since – especially in the wake of recent news that Renaud Laplanche, LendingClub’s CEO, resigned following allegations of internal control issues and a rather sloppy ABS deal with Jefferies. My interest in marketplace lending has always been its overlap with traditional finance and the degree to which – as I’ve often written – the disruptive sector has been  co-opted by the very thing it sought to disrupt. In fact, one of the earliest enterprise pieces I wrote on the nascent industry, from January 2013, included the following gems:

“The one thing about peer-to-peer lending is it’s still a relatively manual process. This business needs a lot of scale to be profitable,” said a P2P analyst.

“In order to grow this business one must really have made relationships on the institutional side,” said a P2P CEO.

“On the surface it really almost comes across as too good to be true,” said a P2P institutional investor.

More than three years later and the pressures of scaling a ‘technology’ business that still relies on direct mail for advertising, and which derives much of its value from avoiding the legacy costs (including regulation) of traditional banks, seems to have come to a head viz LendingClub’s apparently lax internal controls, funding and securitization processes.

For those interested, here’s my more recent coverage of the industry’s travails.

When credit market concerns arrive at the marketplace lenders, January 2016 – Recall that the bear case for marketplace lenders was always a turning of the credit cycle that would either produce a rise in borrower defaults or result in a dearth of funding as skittish investors cut their lending on the platform. At the beginning of this year, credit markets spasmed,and LendingClub raised rates on lower-quality loans on its platform by about 67bps as it sought to better compensate nervous investors.

More trouble in bonds backed by peer-to-peer loans, March 2016 – A rating agency slapping a credit rating on a securitization only to downgrade it eight weeks later because of faster-than-expected-delinquencies seems … reminiscent of something.

A new class action suit wants to treat peer-to-peer lenders like mobsters, April 2016 – A scoop about a class action suit that strikes at the heart of the marketplace lending model and came on top of the already troublesome Madden vs Midland Funding decision, completed the ‘doomsday duo’ of funding concerns and regulatory scrutiny for the industry.

LendingClub is turning out to be anything but a direct lender, May 2016 – The resignation of Laplanche sent LendingClub shares plunging and, more significantly, exposed one of the biggest oddities at the center of the company’s business model. While promising to democratize finance by using new technology to directly match borrowers with lenders, LendingClub has turned to a complicated network of middlemen and professional investors to fund its rapid expansion and disintermediate traditional banks.

And the latest edition of our Odd Lots podcast, which sums up some of my thoughts on the matter:

https://soundcloud.com/bloomberg-business/28-how-finances-hot-new-thing-ended-up-in-an-old-school-scandal

Allen Stanford, revisited

Allen Stanford, revisited

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One of my favourite financial scandals of recent years was the $17 billion ponzi run by Sir Allen Stanford, a knighted Texan who had previously achieved some notoriety for attempting to export an altered game of cricket to the U.S. and who ran the 20/20 tournament in Antigua.

I got a chance to revisit the topic on the latest edition of the Odd Lots podcast, when we interviewed Alex Dalmady – the independent financial analyst who helped blow the whistle on Stanford by publishing a now famous ‘Duck Tales’ note on Stanford International Bank.

Have a listen below, and steep yourself in some post-financial crisis nostalgia with the below FT clipping.

https://soundcloud.com/bloomberg-business/episode-17-the-analyst-whose-favor-for-a-pal-revealed-a-7-billion-fraud#t=0:03

twenty1

Bad time to be a bank

Bad time to be a bank

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Bank stocks have plunged in the new year, surprising a number of analysts and investors who had hoped that the long-awaited rate rise by the Federal Reserve would (finally!) help boost financials’ collective profit margins. Instead, the market seems squarely focused on the turning of the credit cycle and the idea of losses yet to come.*

On that note, I think it’s worth reiterating where the froth on bank balance sheets lies.

I’m willing to bet it’s about to get interesting to be a banking reporter again.

Fierce battle for corporate loans sparks US bank risk concerns (May 2013, Financial Times) – US banks were sharply increasing loans to big and small businesses in the aftermath of the financial crisis. In itself, the move to more business lending was not necessarily a bad development for the wider economy, or for the banking system. But the worry, as ever, was that intense competition to extend more commercial loans combined with a desperate need to boost return on equity, could spur banks to offer money at dangerously low rates and on far too loose terms.

Regulators on alert as US banks boost commercial loans (May 2013, Financial Times) – Companion piece to the above. This part proved rather ironic in the wake of collapsing oil prices: “Dick Evans, the chief executive of Texas-based Frost Bank, remembers the recession that hit the Lone Star state in the 1980s: banks that had been lending to booming energy groups suffered when the price of crude collapsed. Then, he says, it was real estate lending that banks turned to in an effort to replace some of their lost returns from commercial lending. Three decades on, that history may be reversing across the US [as banks trade real estate lending for commercial loans].”

Wall Street trades home mortgages for corporate credit – (July 2014, Financial Times) – Home mortgage lending stagnated as banks and other lenders grappled with new rules and the continued fallout from the biggest housing crash in US history. At the same time, lending to many American companies surged, helping shift Wall Street’s once-dormant securitisation machine into gear, while the market for corporate bonds also boomed (with much of that money flowing into the energy sector). Where once the origination and bundling of home loans was big business, corporate credit has for the past few years been the thing keeping banks and other financial institutions busy.

Commercial credit is the new mortgage credit – (September 2015, Bloomberg) – Key sentence: “Whether the surging popularity of commercial credit in all its forms results in the same kind of bust that overtook the housing bond market remains to be seen. Plenty of analysts, investors and regulators have certainly expressed concerns about an asset class that is being chased by so many yield-hungry investors, and pitched by so many profit-hungry financial institutions.”

All that commercial lending by banks suddenly isn’t looking so hot – (January 2016, Bloomberg)  – Written a day or two before the beginning of bank earnings season, this post pointed out that financial institutions; commercial and industrial (C&I) loan portfolios were showing signs of cracking. Sure enough, the fourth-quarter earnings season yielded a bunch of big-name banks setting aside more loan loss provisions to cover soured energy loans, which fall into the C&I classification.

*And I haven’t even mentioned the impact of negative rates, which wreak havoc on the business model.

Ding dong, the DVA is dead

Ding dong, the DVA is dead

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Debt valuation adjustments, otherwise known as the bane of every bank reporter, analyst and investor relations’ team existence, are finally being phased out.

I don’t have much new to add so here, other than I wonder whether we’ll see any impact from the withdrawal of fake and flimsy – but countercyclical – capital).

In the meantime, and in memorium, here’s an old thing from 2012 that I wrote on the subject.

Banks face profits hit as fog descends

It’s the attack of the accounting quirk.

One day into bank earnings season on Wall Street and we have already seen the dreaded “debt valuation adjustment”, or DVA, wallop JPMorgan , knocking $211m off the supersized bank’s $5.7bn of third-quarter profits.

DVA is the flipside of the recent rally in bank debt. While investors have been clamouring for the extra yield on offer from banks’ bonds, pushing up prices, they are now experiencing the counter-factual of narrowing bank debt spreads.

That’s because the accounting option known as DVA effectively gives banks the ability to book profits when the value of their bonds decreases, but also requires them to record losses if the value of their debt increases.

The motivation behind the option, the US accounting standards board says, was “to reduce both complexity in accounting for financial instruments and the volatility in earnings caused by measuring related assets and liabilities differently”.

The ultimate effect of the standard, issued in 2007, was the exact opposite. When the value of banks’ own bonds fell precipitously during the financial crisis, banks used the accounting option to record significant profits. Lehman Brothers, for instance, posted a more than $1bn DVA gain just days before it filed for bankruptcy.

In early 2009, when banks were publishing results from the dark days of the 2008 fourth-quarter, DVA reached new heights of absurdity as financials, en masse, reported stellar profits based on the plummeting value of their bonds. Between 2007 and the first quarter of 2009, US banks posted DVA that averaged 10-20 per cent of their pre-tax earnings, but reached as much as 200 per cent, according to research by specialists at UBS.

When the value of their bonds recovered in later years, they were compelled to post losses. Now, with the price of the bonds having surged in recent months, the accounting quirk is about to eat into banks’ third-quarter results once again.

It’s an impressively counter-cyclical accounting standard, but one that does nothing to shine a light on the already impenetrable thicket that is bank earnings.

There is an added complexity in that some banks have not been content with the weird and wacky world of DVA. To help hedge – or offset – the profit and loss swings caused by the value of their own debt, some have taken to selling credit protection on correlating banks. In late 2008, for example, some banks were said to have sold protection on Lehman as a hedge against their own DVA gains.

This creates another baffling dynamic; banks may record losses as the value of their own bonds increases, but not to the extent that they have hedged that loss and profited from the rising value of credit protection written on other banks…

More here, here, here and here.

Sympathy for the repo trader

Sympathy for the repo trader

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Sometimes, when you’ve written multiple articles on the same subject, you get bored.

Poetry is what happens when I get bored.

Ballad of the Repo Trader

Regulators do not like us repo guys, that much I do know,
They decided to take aim at us with the net stable funding ratio.
Instead of holding capital against all our riskier stuff,
We have to hold it against everything—it is truly very rough!

Read the Ballad of the Repo Trader over here and apologies in advance for the imperfect Iambic pentameter (this was written in 30 minutes on a quiet pre-holiday Wednesday). For previous coverage on the incredible shrinking repo market and associated fallout, see the links below.

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