Tuesday, July 5, 2016

Student Loan ABS Update & Ratings Mismatches

We've kept a look-out on the National Collegiate Student Loan Trust (NCSLT) shelf we inspected more fully in January this year.

At the time, we commented on the nature of all outstanding notes, originally rated AAA by Fitch or S&P, being currently rated junk (sub investment grade) -- and often in deep junk territory.  

In January, S&P had some of those notes on watch for upgrade, but those have since been attended to by S&P.  As we revisit these notes, none of those notes on watch for upgrade was upgraded by S&P into investment grade territory (BBB- or above).  And, due to a technical dispute having arisen in respect of a servicing agreement, some of the Moody's-rated investment-grade notes were placed on downgrade watch.

This shelf really shows the difference between rating agencies' approaches.  The ratings performance may say more about the viewer than the viewed.   

Just have a look at the currently ratings for each note outstanding that was originally rated AAA by Fitch/S&P or Aaa by Moody's.  For each rating agency, there are roughly 55 notes described in the table below. Moody's has roughly half of their outstanding notes, originally Aaa still in investment grade territory.  Fitch and S&P have none.

Meanwhile the following, originally AAA, note successfully paid off in full in November 2015, at a time that it was rated C by Fitch, CCC by S&P and Aa1 by Moody's. (Moody's subsequently upgraded it in December, after it had been paid off, but this was probably just due to an administrative or technical shortcoming on their side.)

The next one is a good example, too.  Originally AAA it was downgraded to CC by Fitch in 2013 and has remained there since.  Then in 2014 Moody's upgraded it to Aa1 and then in December 2015 back to Aaa, its original rating.  But in May 2016, while Moody's had just upgraded this note to Aaa, S&P took it off watch for upgrade, and left it at CCC.

Your AAA, is my CCC, is my CC...

Ratings history snapshots, above, courtesy of Bloomberg LP.

Friday, July 1, 2016

A Rocky Start to Q3

It's been a week since the Brexit vote.  And silver, not gold, has been taking off.

Usually in lock-step with gold, silver has outperformed gold by roughly 9.2% over the last 4 days.  Gold has been up 1.3%.  Silver, on relatively high volume, has gone up more than 10%.

This graph shows silver in green, each day adding to its gains over gold, in white (both were normalized at 100 for the comparison).  And we're again pointing out the suspicious volume, in red, at roughly 3:33 pm yesterday in SLV, which we commented on yesterday, almost a half hour before the day's close, (which was importantly also quarter-end).  

By yesterday, silver had moved 4.5% relative to gold.  Today, it moved another 4.5%, after opening again far higher on high volume.

Silver futures, too, show similar patterns to the ETF, and volume spikes.  Our hunch is that a bigger play was at large here behind the scenes, possibly involving or culminating in the squeezing our of some silver shorts.  Certainly, if it were a drive purely to protect against economic concerns, pertaining for example to Brexit, we would have expected to see the gold markets move in similar fashion.

Thursday, June 30, 2016

Silver is Golden ... or Gold has Lost its Luster (for today)

The last 2 days have been pretty good to silver's ETF (SLV) and pretty ordinary for gold ETF (GLD).  
Gold and silver, often joined at the hip, have disconnected from a price perspective ... and there's some interesting trading at the center of it.  Overall, silver is showing gold who's boss, disconnecting from gold for a 4.6% gain over the last two days.  

Is somebody (or some firm) keen on silver and not so keen on gold, or might a barrier have been tested on an option expiring at quarter-end?

We just moved into quarter-end, and both GLD and SLV moved slightly higher into the 4 pm close, on some synchronized, high volume (right around 3:59 pm).  

But perhaps the 3:33 pm move, unique to silver, (on high volume) is interesting.  Silver hits a peak at 3:33 pm, so perhaps a barrier was tested, say on a knock-in knock-out option.

You can see the additional volume spike in the lower silver graph -- but not in the gold above -- just before the close.

And this graph zooms in on the price movement (up) on the very short infusion of interest in the silver market at 3:33 pm today. It then losing some of its gains before pushing higher again into the close at 4 pm.

Graphs courtesy of Bloomberg LP.

Thursday, June 23, 2016

Bank Stress Tests and the Problem of Ignoring Reality

“Too large a proportion of recent "mathematical" economics are mere concoctions, as imprecise as the initial assumptions they rest on, which allow the author to lose sight of the complexities and interdependencies of the real world in a maze of pretentious and unhelpful symbols.
                                                                                        - John Maynard Keynes

The 2011 European Bank stress tests were largely held in disregard.  They had managed to assume away the implications of a chief risk held by the banks being tested – that countries within the EU could default – culminating in several banks easily passing the tests, only to fail soon thereafter.

The results were released in July 2011, with Dexia and Bankia and the Cypriot banks passing and sometimes easily passing the tests. Dexia failed in October 2011. Bankia survived a little while longer, before being nationalized in May 2012. The Cypriot banks never triggered any kind of concerns among the key monitoring agencies, the EU, EBA, IMF or BIS, well, not before the Cypriot banking collapse.

The editorial board at Bloomberg View just put out a piece on why the US Fed's bank tests lack credibility.  Same problem, here: a lack of basis in reality:
"...the simulation [being run] is a far cry from what happens in a real crisis. It doesn't fully capture how contagion can afflict many of a bank's counterparties at once, magnifying losses many times over. It also assumes that a thin minimum layer of equity capital -- just $4 per $100 in assets -- would be enough to maintain the market's confidence in a bank's solvency. These flaws make a passing grade almost meaningless."
Reality is very different, and modeling behavior in a stressed environment is necessarily a different process from modeling a normal environment, as what was previously uncorrelated or even inversely correlated can suddenly become correlated ... as the economic principles break down and legal rules change.

We're not saying this is easy – but there's little comfort to be gained in performing a test if that test fails to capture the harsh reality that, in times of crisis, our (joint) behavior itself will compromise the predictive value of the theoretical process we're modeling.  

Perhaps a picture will say it best:

Tuesday, June 21, 2016

GFC 2.0 – Could it Happen Again?

We returned recently from an enjoyable and enlightening trip to Australia.

This post covers some of the recurring themes that emerged from our discussions Down Under. Given NY’s central positioning in the "GFC" (Australia’s initialism for the Global Financial Crisis) and so many of the subsequent reform efforts, the Aussies were curious to hear our view on whether it can happen again. 

With assistance from some graphics and helpful references, we are going to try to answer this question in a short-ish blog. 

A recent post by Bruce MacEwen over at Legal Business does a solid job of summarizing a number of indicators suggesting that economies across the globe are failing to respond to monetary stimulus efforts as central bankers would have hoped, and we were asked about many of these same issues. MacEwen ends his post: “I submit that we have positive confirmation of that hypothesis [Growth is Dead] and that our attention has to turn now, if it hasn't already, to the 'Now What?’” 

Rather than focusing on what might precipitate a GFC 2 – Mohammed El-Erian recently posted some thoughts on this here – we focus on what has been happening, and whether we might be particularly vulnerable to a shock, major or minor. 

In short, the Fed’s response to the first GFC was to expand the monetary base in support of financial asset prices: the "Greenspan Put" which has been handed down to Bernanke and then on to Yellen: 

The emerging narrative is that Central Banks around the globe have in quick succession reduced borrowing costs to record lows (over $10 trillion in negative-yielding sovereign debt), stimulating monetary supplies as a temporary measure to buy time and allow economies to recover from the shock of 2008. However, politicians have typically not had the stomach to implement the structural fiscal reforms required for sustainable economic growth … and have simply used the liquidity injection from central banks to borrow additional cash to fund deficits rather than cut benefits or restructure meaningfully. 

Furthermore, the other (some would say main) engine of economic growth – private-sector corporations – have more generally retreated from capital investment that would normally be conducive to economic growth. This pullback can be attributed to a range of reasons, from repairing their own balance sheets to an uncertainty in the economic environment that has culminated in their being conservative in their capital planning. The net effect has been an increase in system-wide leverage, with global debt rising to ~240% of GDP at the end of 2014 (from ~200% pre-GFC).

US corporate debt has climbed as earnings have stagnated: 

Over at Casey Research they highlight that (non-financial) corporate debt growth is outpacing GDP growth and has now eclipsed the debt-to-GDP ratios seen in each of the past three US recessions. This is not to say it makes another GFC imminent, as the lead time between the increase in corporate debt relative to GDP and previous recessions has varied.  Rather, it simply highlights that not much has improved from previous cycles with regard to the amount of leverage in the system. 

Now, one might argue that the increase in leverage / debt loads would be sustainable if sovereigns or corporations were taking advantage of record low yields to invest in growth via infrastructure projects or R&D, which would likely be the policymakers’ preference. 

However, instead of capitalizing on low borrowing costs to invest in growth, borrowing cheaply has allowed them to maintain a certain level of politically "easy" spending, enabling them to delay making the hard choices.   As for corporations’ use of their increased borrowings, Bloomberg’s Matt Levine will often tell us that “people are worried about stock buybacks”... This suboptimal use of borrowings, at least from the perspective of driving revenue growth, has been among the factors leading ratings agencies to downgrade their assessments of corporations’ ability to repay their increasing debt burdens.  Only two companies remain with AAA ratings from S&P.

Some may then argue that since the GFC, regulators have learned the lessons of what precipitated the crisis. They have worked to stabilize the financial system through increased scrutiny of banks’ activities, such as the Volcker Rule, and capital planning through annual stress tests such as CCAR – and this rather looks to continue to increase bank’s market risk capital requirements by roughly 40% from pre-crisis levels. However, John Kay’s “Other People’s Money” argues that while the extent of regulation has increased, it is an expansion of a flawed methodology and does not address the fundamental issues within the banking sector: so these capital increases are unlikely to save us. 

Further, even if regulators do get the house in order for individual banks, Adair Turner’s “Between Debt and the Devil” argues that one should think of debt as a negative externality akin to pollution. That is, while it may be rational for an individual borrower and lender to come to terms, one must consider the overall amount of leverage in the system, which is not something we are aware of regulators explicitly controlling (yes, the Fed has attempted to limit US banks from underwriting / syndicating leveraged loans where resulting leverage would be greater than 6x EBITDA, though that has simply pushed the underwriting to shadow banks / foreign regulators banks such that the impact on overall system leverage is doubtful). We have only seen individual bank stress tests, and some macro-prudential initiatives around housing markets from our Antipodean friends – so even if banks are individually well capitalized, which we previously said they may not be, it is the overall leverage across the system that should concern us. 

With tepid growth across most of the developed world, corporate and government balance sheets more levered than any time before, and interest rates already at historic lows, central banks may have few levers left to battle any further deterioration in economic performance, regardless of the drivers. And drivers there are, from consumer debt growing in worrisome fashion, to debt being sold to insure banks against rogue trades, to one-off securitizations being done to the tune of $6 billion. And the list goes on, in addition to El-Erian's factors mentioned above.

If we agree that our central banks may not be well positioned to play as formidable a role, we would have to hope that structural reforms are in place to allow private institutions and individuals to step in.  And that, too, seems hardly to have been corrected since the GFC with, among other things, self-perpetuating vicious cycles still being a problem – in the pricing and rating of securities – during a stressed environment or a liquidity event.  

Outside of the central banks, we don't seem yet to have a functioning correction mechanism.  So, when asked whether it can happen again, our response has been: "We hope not, but what could possibly go wrong?”

Monday, June 6, 2016

Subprime Autos: Bubble or Overblown?

Back in March Bloomberg View columnist Barry Ritholz told us not to worry — that subprime autos were not like subprime mortgages.  Right he is.

Last week, JPMorgan CEO Jamie Dimon told us we should be a little concerned about the auto loan market, now with balances outstanding exceeding $1 trillion: “Someone is going to get hurt,” he said. “It won’t be us.” 

Perhaps they're both right. Perhaps it's not quite the systemic issue that accompanied the mortgage crisis. 

But then again, sometimes a straw can break a camel's back, and our economy may not be on the solid ground it held when the mortgage crisis started to kick in. And perhaps the auto situation will not come along as a solo problem: other consumer issues like student loans and credit card receivables might cause their own little sensitivities too. Their own straws. 

We hope not, but we looked into it. Turns out, the signals are not great, although it's not quite yet time to panic. But it's worth taking a deeper dive. Dive in below, or by clicking here.

Monday, May 23, 2016

Probes into Trading Executions

We've been keeping logs of valuation/pricing disputes and issues pertaining to fees charged (more regularly buy-side probes).

This new set is a little different.  Here, we're looking at investigations into whether the buyer/client/customer got a fair execution from the broker-dealer (primarily sell-side probes).

As you'll see from the following list, the regulatory heat is on...
  1. May 2016. Why Merrill Lynch and Stifel Were Fined by FINRA. "Merrill Lynch, Pierce, Fenner & Smith, a subsidiary of Bank of America (BAC), was ordered to pay $422,708 in fines and restitution by the Financial Industry Regulatory Authority for charging customers excessive markups and markdowns on municipal securities." 

  2. May 2016: State Street Nears Settlements to End Probes Into Alleged Overcharges. "The lawsuits accuse State Street of promising to execute foreign exchange trades for clients at market prices, but instead using inaccurate or fake rates that included hidden markups. The alleged overcharges occurred between 1998 and 2009, ..."

  3. May 2016: U.S. investigates market-making operations of Citadel, KCG.  "Federal authorities are ... looking into the possibility that the two giants of electronic trading are giving small investors a poor deal when executing stock transactions on their behalf." 

  4. May 2016: Lawson Financial, Its Top Officials Charged in Muni Case. "[FINRA] has filed a complaint against Phoenix-based Lawson Financial Corp. and the firm's president and chief executive officer, charging them with securities fraud in connection with the sale of millions of dollars of municipal revenue bonds to customers." 

  5. Apr. 2016: Three Firms Ordered by FINRA to Pay $115K for Muni, Other Violations. "Alton Securities Group, based in Alton, Ill., did not receive a fine for its conduct but was ordered to pay $75,000 in restitution, plus interest, to customers for taking excessive markups and markdowns in muni and corporate debt and for not making suitable recommendations on exchange traded funds. FINRA found in 104 muni trades occurring between February 2009 and June 2013, markups ranging from 3.01% to 4.53% that [] violated MSRB Rule G-30 on prices and commissions."

  6. Feb. 2016: Oppenheimer One of 7 Firms FINRA Fines Over Minimum Denominations. "Oppenheimer & Co., WFG Investments, and E*TRADE are three of seven firms that [FINRA] fined ... for trading municipal securities below the minimum denomination." 

  7. Jan. 2016: BNY Mellon faces lawsuit claiming FX transaction overcharges on ADRs

  8. Jan. 2016: The Hidden—and Outrageously High—Fees Investors Pay for Bonds

  9. Jan. 2016: Barclays, Credit Suisse Charged With Dark Pool Violations. “Dark pools have a significant role in today’s equity marketplace, and the firms that run these venues must ensure that they do not make misstatements to subscribers about their material operations,” said Andrew Ceresney, Director of the SEC’s Enforcement Division. “These largest-ever penalties imposed in SEC cases involving two of the largest ATSs show that firms pay a steep price when they mislead subscribers.” 

  10. July 2015: Banks are ripping off investors in overseas markets. "...these are the first in history by ADR shareholders against depositary banks, in this case Citibank and JPMorgan, according to Germinario. In the Citibank case, ..., the investors claim the bank docked fees from dividends and cash distributions by foreign companies without proper disclosure ..." 

  11. Mar. 2015: BNY Mellon Agrees to Pay $714 Million to Settle Forex Probes. "Federal and state officials alleged in lawsuits filed in 2011 that the bank misled investors about foreign-exchange deals by promising it would provide the best rates available when executing trades. Instead, the bank obtained the best rates for itself and gave less favorable terms to customers, pocketing the difference,..." 

  12. Jan. 2015: SEC Charges Direct Edge Exchanges With Failing to Properly Describe Order Types

  13. Aug. 2014: Edward Jones to Pay $20 Million for Overcharging Retail Customers in Municipal Bond Underwritings

  14. Mar. 2014: SEC Said Examining Hidden Electronic Bond Trading Prices. "The practice of dealers showing clients different prices for the same securities on electronic bond-trading platforms is drawing the scrutiny of the [SEC], which is concerned that smaller investors are being penalized." 

  15. Feb. 2014: Regulators Are Probing How Goldman, Citi and Others Divvied Up Bonds. "The Securities and Exchange Commission has sent requests for information about how banks allocate corporate-bond deals and how they traded those bonds after they were sold, the people said."
Visit our recent research piece on financial markets probes and litigation, here.

Thursday, May 5, 2016

How About a Real Federal Bailout for Puerto Rico?

Later this month, Congress will begin its race against a July 1st deadline to pass legislation addressing the financial mess in Puerto Rico. July 1 appears to be the date on which the Commonwealth will default on general obligation debt service payment – the first such default by a state or territory since 1933. The proposed bill, HR 4900, includes a combination of federal oversight over Puerto Rico finances and a mechanism to restructure the island’s public sector debt. Although the restructuring procedure would begin with voluntary negotiations between issuers and bondholders, the bill would authorize courts to impose cram-downs on holdout bondholders.

This last aspect has displeased hedge funds that own Puerto Rico bonds, and they have been trying to kill the legislation. The most visible part of this effort has been a spate of issue ads on TV urging voters to call their Representative to stop the so-called federal bailout. When people think of a bailout, they normally assume that taxpayer money is being spent on some objectionable purpose. In this case, the ad misleads viewers to think that Congress is trying to send more federal dollars to the island. In fact, the legislation does not provide any new funding to Puerto Rico whatsoever. Even the federal oversight board is to be funded with proceeds from new bonds that will be obligations of the Commonwealth. 

Although I like HR 4900 overall, I think it would be better if the federal government did make a financial commitment. Specifically, I suggest that Puerto Rico Commonwealth bonds be exchanged for newly issued US Treasury Bonds with similar maturities. The federal government would service these new Treasury Bonds by diverting grant monies earmarked for the Commonwealth government.

Right now, most Puerto Rico bonds carry coupons of between 5% and 8%. Treasury rates are below 3% at all maturities. Refunding Puerto Rico bonds at par with Treasuries saves bondholders from taking a haircut and saves taxpayer money viz.-a-viz. fully servicing the current bonds. The swap is thus a win/win situation.

While the debt burden would then be shifted onto the federal government’s books, there is a surefire way for federal taxpayers to be made whole. Each year, the federal government provides over $7 billion in grants to Puerto Rico’s public sector to support a variety of services. Under my proposal, any money needed to pay principal and interest on the newly issued Treasury bonds would be withheld from Puerto Rico and used instead to pay holders of the new Treasury bonds.

This concept has a rough precedent in the municipal bond market. Several states provide credit support to local school district bonds through aid intercepts. The state deducts principal and interest from money that would otherwise be apportioned to the school district borrower and remits it to bondholders. School bonds serviced this way carry ratings similar to those of the state, allowing small districts to realize substantial interest savings. (Typically the aid intercept mechanism is just a backup in case the school district fails to pay, so this is a bit different from my recommendation for Puerto Rico).

I propose this only as a solution for Commonwealth-issued bonds including General Obligations and COFINA sales tax supported debt. Debt issued by other Puerto Rico borrowers should be restructured either according to procedures laid out in HR 4900 or using the Chapter 9-like mechanism provided by the Puerto Rico Corporations Debt Enforcement and Recovery Act of 2014 now being reviewed by the Supreme Court. This non-Commonwealth debt is more akin to municipal bonds on the mainland that have been adjusted under Chapter 9, so there should be less political concern about using these mechanisms to restructure them.

* * *

I have been writing a lot about Puerto Rico lately. Here are some of my other recent commentaries on the web:

Thursday, April 28, 2016

So You Think You Can ... Run a Bank?

You’re probably not alone in thinking you could have done a better job running one of the banks.  

Now you can see if that’s true, thanks to the Banking Simulator, a creative, educational tool designed by PF2 team member Joe Pimbley.  Like a flight simulator for pilots, it will give you a chance to hone your skills in simulated, but realistic, market conditions and risk scenarios.

Bank managers and executives use models for VaR, loss distributions, economic and regulatory capital, to help with decision-making, but of course those cannot capture the human element of a manager’s decision-making process during a downturn or in reaction to a “black swan” event.
Click on the slideshow for detailed instructions
In the Banking Simulator, you'll be playing the part of the bank CEO or CFO; you'll have to make many quarterly decisions and contend with several risks to keep your bank afloat in whatever situations we throw at you... including bank runs. You decide on the level of debt and equity to issue, and the amount of risky assets to acquire. You also decide the strength of your risk management.

You must make quarterly decisions to: 
  • buy and sell risky assets
  • issue deposits
  • issue, redeem, and repurchase debt
  • issue and repurchase equity
  • pay dividends  

The simulator will show you your bank’s net income and stock price at the end of every quarter. You'll be encouraged to monitor and manage your asset-to-debt and reserve ratios, and you'll need to buffer against asset-liability or maturity mismatches.

Can you run a profitable bank, and at the same time maintain your reserve ratio, satisfy regulatory stress tests? 

Take your chances.  Let's see how resilient you can be, under changing market conditions.  Will you survive a run on the bank?

Monday, April 25, 2016

Rogue Bonds

We received a couple of calls late last week about the securitization structure (or catastrophe or "cat" bond) deal that Credit Suisse is preparing.

We haven't seen the deal docs, but from what we understand and have read, the concept is interesting:

Credit Suisse would free up some capital by insuring itself (by way of the bond sale) against certain operational risks, like fraudulent transactions, trade processing errors, regulatory or compliance shortcomings ... or the all-important concern of rogue trading, which caused JPMorgan and SocGen a pretty penny (just look up London Whale or Jérôme Kerviel).

We understand that CS would issue a two-tranche securitization, reportedly backed by a 700 million franc policy from Zurich Insurance Group.  Zurich would retain the first 10% of the risk, with the senior notes being sold off by way of a Bermuda vehicle.  From the reports we've seen, the senior notes would attach at losses of $3.6 billion and detach at losses of $4.3 bn. It's not immediately clear to us whether Credit Suisse would stomach losses above $4.3 billion, but that would seem unlikely ... we assume there's more to it than is publicly known at this time. 

Operational Risk, or What Credit Suisse Will

There are some serious questions.

It would seem Credit Suisse would have a massive informational advantage over the other side: they would know their operational strengths and weaknesses better than anybody else.   That's okay, as long as it's well understood.  

But the real questions start when there is a loss, 

Can one always put a value on the operational portion of the cost, easily separating out all of the factors?   Suppose for example that a loss is magnified as the market turns against a bank while it was slowly extricating itself from a large, unauthorized trade -- as happened in the case of JPM's London Whale?  Is that additional writedown the fault of the bank or the operational shortcoming?  How much of the supposedly unauthorized trade would have been "okay" and how much was "unauthorized"?  One issue here is that the party that knows best if probably Credit Suisse ... but it may often be a conflicted party, benefiting directly or indirectly through the decisions in makes in quantifying the losses.  

Next, the category of operational risk can be difficult to define, and items may fall in the grey zone. Might CS, knowing it has insurance, be more likely to categorize the marginal loss as operational?

And might it change Credit Suisse's approach to fixing up an issue to the extent it knows of certain insurance providers' interests or exposure?  At worst, knowing that they're insured, might they be less particular about buffering against the risk?  Could that create an adverse incentive from a cultural perspective? 

Banks might not need a second invitation!

If this all goes wrong ... we're insured!  Double down!  Lock and load!