As banks look to shore up their balance sheets in the wake of the credit squeeze, Philip Aldrick asks whether it is all short-term trickery
Investors gather in New York’s financial district after the stock market crash of 1929, which heralded the onset of the Great Depression
‘We are in the midst of the worst financial crisis since the 1930s,” warns the eminent financier George Soros in his latest book, The New Paradigm for Financial Markets. It’s a rather extreme view, but the man who broke the Bank of England is not alone in his dark funk. At a recent event, one banker laced Soros’s sentiment with a little gallows humour, ruefully predicting “10 years of depression followed by a world war”.
Comparisons with the great crash of 1929 are inevitable and the parallels manifold. Then it was an over-inflated stock market that burst before wider economic malaise ushered in the Great Depression.
This time, in the words of Intermediate Capital managing director Tom Attwood, sub-prime was merely “a catalyst” for the inevitable pricking of the credit market bubble as “disciplines were bypassed in favour of loan book growth at almost any cost”. Again the talk is of recession, certainly in the US and possibly in the UK.
Perhaps the most intriguing parallel, though, is the crude attempt at self-preservation made by the investment trusts in 1929 and the banks now.
In the great crash, investment trusts with vast cross-holdings in each other tried to stem their collapse by buying up their own stock in what the economist JK Galbraith in his book, The Great Crash 1929, described as an act of “fiscal self-immolation”. At the time, “support of the stock of one’s own company seemed a bold, imaginative and effective course,” Galbraith wrote, but ultimately the trusts were just “swindling themselves”.
Modern economists have compared the trusts’ actions with what the banks are now doing. “They seem to be just papering over the cracks,” says Brendan Brown, chief economist at Mitsubishi UFJ Securities.
To free their books of the estimated $1,000bn (£505bn) of sub-prime assets and $340bn of leveraged loans banks have been left carrying since the credit markets shut down last year, lenders are offering to sell these damaged assets cut-price and – crucially – are willing to lend investors the money to buy them. In other words, the banks are providing new debt for the old debt they no longer want.
At first glance, as with the investment trusts, the arrangement seems little more than trickery – recycling a bank’s own funds back into its own assets. As one senior industry expert described it: “It is like walking through a hall of mirrors in a fairground. There are far fewer people who really understand it than profess to understand it. Even the central bankers don’t know where all the risk is ending up.”
Sandy Chen, banks analyst at Panmure Gordon, is not convinced the arrangements are anything more than “clever accounting”. He said: “In the case of leveraged loans, if the underlying company gets into difficulties and can’t service the cash flow, then it’s back to square one for the banks.”
It’s an opinion that the credit markets seem to reflect. Despite clear indications that this is how the banks intend to deal with their problems, credit default swaps – the clearest measure of perceived risk – have not narrowed.
But today’s banks are far more sophisticated than the investment trusts of early last century. They claim their actions are an attempt to tackle capital shortfalls and liquidity risk. If they can reduce their credit risk in the process, that’s an added bonus.
There have been two big public deals where the banks have provided funding for the purchase of the debt or sub-prime assets they own. UBS sold a $22bn portfolio of sub-prime assets to US fund manager BlackRock and a consortium of banks that financed last year’s £9bn Alliance Boots merger offloaded £2bn of the debt to private equity.
Less publicly, bankers say “everyone is looking at this”. Citigroup and Deutsche Bank are each believed to have off-loaded $10bn-$12bn of US leveraged loans in recent months, part-funding the purchase themselves. The same banks, as well as Merrill Lynch, have found buyers for tens of billions of dollars of their sub-prime debt, with similar funding arrangements.
The incentive for private equity is clear. The debt in the Alliance Boots case, for example, is being sold at 91 per cent of face value and the interest rate is being lowered. The UBS sub-prime sale is even more extreme. Having written the assets down to $15bn, BlackRock is enjoying a 32 per cent discount. If the debt or assets perform, there is a large potential upside.
The banks hope to benefit in four ways. The first is through capital relief. UBS may be providing $11.25bn of the $15bn BlackRock is paying for the sub-prime assets, but it does mean the Swiss bank is insured against the first $3.75bn of deterioration in the portfolio. With Alliance Boots, the banks are lending the private equity buyers just 80 per cent of the purchase price of the debt.
Because the banks can argue that this is a genuine transfer of risk, they can reduce the amount of capital the rules require them to set against the assets. UBS says that the move will provide 0.2-0.25 percentage points of capital relief – lifting its tier one ratio, a key measure of financial strength, above the current 10.5 per cent.
The second benefit for banks is asset diversification. In the case of Alliance Boots, debt in a retailer is transferred for debt in private equity – the buyers of the £2bn of loans being Apollo, Blackstone and TPG. As private equity is invested in a variety of sectors, its bonds are viewed as safer under the Basle II rules on capital adequacy. The result, again, is a reduction in capital required to be set aside.
The third benefit is the chance to rewrite loan covenants. Covenant-lite arrangements at the peak of the credit boom left banks carrying much more risk than would normally be accepted at very low prices. By reselling the debt, albeit at a discount, the banks have a chance to renegotiate covenants.
The fourth opportunity this provides banks is the chance to crystallise losses and draw a line under their sub-prime or leverage loan positions. By selling the assets, they set a firm market price to use when marking down the rest of their portfolios, providing some stability.
The point of it all is to “tidy up the balance sheet”, as one banker explained. Banks desperately need to improve their capital positions, which can be achieved either through fundraisings or shrinking the balance sheet.
Funding the purchasers of their debt may make banks look like fiscal contortionists, but doing so also makes them appear stronger. As such, counterparties in the money markets will be more willing to accept their bonds as collateral for loans, improving the banks’ liquidity profiles. Liquidity, or the lack of it, is what did for Bear Stearns and Northern Rock.
But questions remain as to whether these clever solutions are anything other than a short-term fix.
As Brendan Brown points out: “Creditors are far more attuned to how the rules work now, and will want to look at what the risks actually are in a bank. These actions are not going to do much to reduce the real problem: their credit exposure.”
Last Updated: 1:30am BST 01/06/2008