Banking Crisis - Treasury Contents


Further memorandum from Odey Asset Management

ACTION ON TROUBLED DEBTS AND HOW TO KICK-START CORPORATE LENDING

  We judge there is a significant opportunity for government to restart the credit flows through the financial and real economy of the UK, to make that happen fast, to ensure fair value for tax payers, and to do this with an exit strategy in mind.

  We recommend a two-stage package of UK government intervention:

    —  a national bank for troubled debts or government guarantee scheme; and

    —  active intervention to kick-start corporate debt markets.

  ... other interventions will be necessary as the crisis progresses and should be coordinated with this package. Without this scheme as a foundation, existing and future measures look likely to fail.

  We also offer a comment and proposals on HM Treasury's latest guidance on the proposed asset protection scheme to deal with bad debts (page 3).

KEY ARGUMENTS

    —  a recent IMF working paper* showed that 60% of all global banking crises in the last 30 years (42 crises in total) were ended by a bad bank or troubled debt guarantee structure. This structure is missing from the policy response in the UK today;

    —  the buyer of last resort approach for company debt is analogous to the US TALF intervention scheme. The TALF provides evidence that this approach delivers significant positive effects for the wider economy and population;

    —  international experience provides elements of successful road-maps for implementing the proposals;

    —  these measures would not hand UK banks a "free lunch". It will ensure that solvent UK banks remain in private sector control;

    —  the two building block measures will work best when accompanied by other sensible policy measures including credit guarantee schemes, and the much needed flexing or suspension of those Basle 2 rules which have a pro-cyclical impact; and

    —  there is no reason for government to make a loss over the life of the project.

Stage One: create a National Bank for Troubled Debts or government guarantee scheme

  1.  A bad bank or troubled debt guarantee scheme is an essential part of a successful healing process to this banking crisis.

  2.  The fundamental problem is too much debt. This is exacerbated by the fact that all investors and lenders know that the UK banks have bad debts inside them still to come out, but they do not know how bad those debts are. As long as opaque, impaired assets remain on bank balance sheets the negative feedback loop of deleveraging and losses will continue. This means that markets will remain dysfunctional, credit availability scarce, and the banks will be focused on reducing their exposure through de-leveraging.

  3.  De-leveraging is ultimately quite simple, either you attract more equity or you shed assets. Without balance sheet repair, it is currently near impossible for many UK banks to raise equity capital. Therefore they have to de-leverage, reducing lending to companies and households.

  4.  Banks in the EU are now valued at below their audited measures (tangible book value or net assets) which makes it very difficult to raise new capital. Barring full-scale nationalisation of swathes of the banking sector at huge cost to the taxpayer they will therefore de-leverage. This is the negative death spiral in which we currently find ourselves. So if banks cannot raise equity we must help the sector shed troubled assets. The most transparent, efficient and scalable way to do this is a national bank for troubled debt (a bad bank structure).

  5.  The banking crises in Sweden in the 1920s and the early 90s make a relevant case study. To quote the Governor of the Swedish Central Bank in 1997** (the Riksbank) the problems of the early 90s "seem to have been more extensive than those which arose in Sweden in the early 1920s". Yet in the 1920s the fall in GDP totalled 20% versus around a decline of "only" 6% in the 1990s. Why the difference? In large part because "the two periods differ substantially in the management of the crisis". The early 90s Swedish model is one of prompt, transparent handling of the banking sector problems following the trusted route of:

    liquidity—recapitalisation—bad bank structure.

  6.  The mechanism for establishing the price of an asset as it enters the bad bank, coupled with the extent to which the banks could participate in any eventual upside are key points in the process. But the models (details below) show solutions are possible, whether at strategic level the means is (a) a separate bad bank or (b) guarantees issued by government, in exchange for premiums paid by the banks, but with the now underwritten assets staying on banks' balance sheets. The troubled assets are currently so realistically marked to market that this scheme could operate on the calculation that government can avoid a loss over the life of the scheme. If any UK banks chose not to participate, negotiating for higher prices from government, then that would be left up to them. All UK banks would be treated equally.

COMMENT ON HM TREASURY INITIAL INFORMATION ON PROPOSED ASSET PROTECTION SCHEME

  7.  We welcome the fact that the government is considering an asset protection scheme, however the lack of detail in the initial 4 page release from 19 January is disappointing.

  8.  We assess that markets, investors, and savers will judge it essential to have the detail fleshed out and the policy implemented, at the very latest, alongside the full-year results of the banks in mid/end February 2009.

  9.  Waiting until co-ordinated agreement has been achieved amongst the G20 is likely to have further very negative consequences for the UK banks.

  10.  It is not only the share prices which have fallen, but the value of subordinated debt instruments issued by the banks have in many cases reached badly distressed levels. This creates risk for pension holders as the insurance sector holds substantial amounts of this type of bank debt. For example, Legal & General and Prudential collectively own £4 billion of subordinated bank debt.

  11.  Our analysis shows that the reduction in risk weighted assets (RWAs) which the banks could gain from a guarantee scheme would be highly beneficial. But since the public policy objective is to make bank balance sheets sufficiently strong for them to substantially increase lending, additional measures will be necessary. We recommend that the Committee consider the following:

    (i) the first loss tranche of 10% to be borne by the banks, according to the Treasury plan, will need to be booked against FY09 profits and staggered throughout the year, if it is not to further destabilise the banks;

    (ii) the further residual exposure of c10% of the credit losses which exceed the first loss amount must at least be staggered through 2010-11;

    (iii) the government must recognise that receiving a fee for the guarantee reduces the ability of the banks to raise lending in the short-term. The two policy objectives are directly opposed. We think it better that the policy measures achieve their prime objective, and therefore counsel against sending more mixed messages to the banks, and against giving with one hand while taking with the other; and

    (iv) for the guarantee scheme to be effective it has to fully address market fears over further heavily dilutive recapitalisations or nationalisations at a future date. The means to do this, are to add the above measures to the package, and to demonstrate that banks will be able to significantly improve profit margins so that capital can start to rebuild "organically" via retained earnings. We suggest the optimum way for banks to achieve this is to purchase corporate debt, which will help fund companies and in the current climate offers banks significant profitable opportunities. In short, for some of the UK banks to remain going concerns it is necessary that their bad debts are dealt with; that the costs of that are distributed over a period of years because the banks' capital is too fragile to pay for it upfront; and that it is made possible for investors to see how banks are going to earn their way back to health in the coming years.

  12.  What is imperative is that policy-makers act at speed.

Stage Two: intervention to kick-start corporate debt markets

  13.  This part of the package has elements similar to the steps taken under the TALF scheme in the US. The Term Asset-backed securities Loan Facility (TALF) scheme is bringing down the cost of mortgages to American home-buyers. It is a $200 billion facility that helps market participants meet the credit needs of households and small businesses by supporting the issuance of asset-backed securities (ABS) collateralized by student loans, auto loans, credit card loans, and loans guaranteed by the Small Business Administration (SBA). It is all about changing practical things in the real economy for the benefit of the public at large.

  14.  In our view, a European model would work best via purchases of corporate debt by the UK government, either through a new agency founded for the purpose or, and this would be most effective, through the UK banks. It could also function EU-wide.

  15.  In outline, the government provides financing, for a fee, to the UK banks (or to a new agency) which can be used under this scheme only to purchase corporate debt in the secondary market. The effect of this is to reduce credit spreads, thus making it possible for companies to borrow again in the primary market at sensible prices. The benefit for the banks is that they will be able to make a profit margin on the secondary market debt which is higher than their existing business. This may require an element of compulsion being exerted on the banks. However, the margin uplift they receive would be substantial enough, we estimate, to more than cover the most extreme impairment scenarios on the banks' real economy loan books as the recession bites. But without the bank for troubled debts, many UK banks will be in no position to be purchasing more debt in secondary markets or to make fresh loans.

  16.  So under our scheme, companies get cheaper credit, banks get to become going concerns once again, the virtuous circle benefits the wider economy, and public policy objectives can be achieved.

  17.  The two measures in the package are interdependent. Without such a transfer of bad assets banks may be encouraged to defer the reporting of losses for as long as is legally possible. The Japanese banking system of the 1990s and the US post Savings and Loans crisis point up how such lack of transparency compounds and extends the problem.

  18.  Policy-making, thus far, has been far more proactive than the 1930s, yet credit spreads are comparable to those in the 1930s (see Fig 17 below). Intervention in corporate credit markets is necessary to resolve the crisis.


Facts and models for a troubled assets bank—what we have so far

(i)  US TARP—troubled asset relief program, size $700 billion

  The TARP scheme embraced the concept of a `bad bank' since its initial purpose was to purchase difficult-to-value assets from banks and financial institutions. However the concept was lost in the immediate need to provide liquidity and stop banks going bankrupt. Also there were problems over how to value and purchase these opaque troubled assets in non-functioning markets. The first $350 billion of TARP capital was used mostly to recapitalise financial institutions, including the car finance industry ($255 billion in varying amounts to <120 banks, $40 billion in pref shares of AIG, $20 billion to Federal reserve bank NY as equity tranche of TALF, $20 billion to Citigroup, $14 billion to GM/Chrysler).

(ii)  The Citigroup model

  However, of all the first-round TARP money, the $20 billion to Citigroup came closest to fulfilling the original "bad bank" concept. For the $20 billion investment the US Treasury and Federal Deposit Insurance Corporation (FDIC) received $7 billion in pref stock with explicit participation in gains and losses for $306 billion of ring-fenced troubled assets. The potentially toxic assets remain on Citi's balance sheet and their precise composition will be disclosed at some future date. So this approach gets around the issue of having to value and disclose the assets in question. In many ways though, the Citi model is an imperfect solution. It lacks transparency and, in not removing the assets from Citi's balance sheet, the capital relief is not substantial or immediate, meaning that the bank is less likely and less able to go out and write new loans. The bank is strengthened, but the wider public policy objectives are not achieved.

(iii)  TALF, term asset-backed securities loan facility

  Not a "bad bank", but highly significant as it marked a new form of intervention with government acting as a buyer of last resort. The Fed was mandated to go into the market and buy $600 billion of agency Mortgage Backed Securities debt (MBS). The result was that agency MBS yields tightened significantly and mortgage rates (closely correlated to MBS yields) have fallen from 6% to 5.1% today (see graph). The remaining portion of the TALF sees $20 billion of Fed equity being levered 10x to create $200 billion of loans to buy AAA rated Asset backed securities for newly originated auto/student/credit card/small and medium company loans. As this portion of the TALF commences in February 2009, it should start to have a similar impact on consumer credit pricing/credit availability in the US as it is already having successfully on US mortgage rates.

  Chart below shows falling US mortgage rates, with TALF impact at end of period.


(iv)  UBS model, similar to Citi except assets moved off balance sheet into a Special Purpose Vehicle (SPV)

  $60 billion of risk assets placed into an SPV funded by a $54 billion 8 year loan from the Swiss National Bank (SNB) at Libor+250bp and $6 billion of equity from UBS. This $6 billion of equity in the JV was effectively sold to SNB by UBS for $1, and UBS had to raise a further CHF6 billion to restore its capital ratios. There is no further recourse to UBS, but in the event of any upside UBS stand to gain a share of profits. This approach reduced UBS' hard-to-value assets from CHF55 billion to <10 billion, with resultant capital relief, in one fell swoop.

*  IMF Working Paper: http://www.imf.org/external/pubs/ft/wp/2008/wp08224.pdf

**  Riksbank: http://www.riksbank.se/upload/1722/970829e.pd

January 2009






 
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