Friday, September 5, 2008

Regulators share blame for financial crisis

In September 2007, I wrote an article in which I argued that banks’ profits were under pressure and banks were facing a crisis. Consequently, the Fed and ECB would have to lower interest rates, and banks would have to take losses and increase their capital. The latter has now happened with more than $500bn in writedowns or losses and more than $350bn in capital increases, according to Bloomberg.

While the banking sector is the proximate cause of the crisis and there were other factors, I believe the crisis has its origins in regulatory changes with large unintended impacts in the financial sector. Specifically, the 1988 Basel I capital accord (updated 1998 version here) prepared and completed under the supervision of the Bank of International Settlements, endorsed by the Group of Ten central bank governors, and fully implemented by 1992; and the 1990s reduction of bank minimum reserve requirements by the US Federal Reserve and other central banks.

These regulatory changes have to be seen in the context of the 80s. The growing role of non-bank financial intermediaries and high interest rates, put the business model of banks under growing competitive pressure, which led banks to take on increasing risk. Banking crisis ensued, notably, the US Savings and Loan Associations crisis. The regulatory changes sought to protect taxpayers from liabilities arising from moral hazard incentives of deposit insurance, and sought to create the conditions whereby banks could more effectively compete with the new non-bank financial intermediaries.

Specifically, Basel I aims were to ensure that banks kept high capital ratios, to guarantee a competitive “level playing field” between banks from different countries, and to penalize risky behaviour by means of a target risk weighted capital requirement, such that the higher the risk of assets held by the bank the higher the required capital.

However, Basel I created a strong incentive for banks to increase their exposure to certain types of assets, deemed less risky by Basel I planners, such as interest rate derivatives, agency securities, and mortgages. For example, under the Basel framework, the risk of holding Fannie Mae and Freddie Mac debt was 20% of the risk of holding an industrial loan of identical amount. Little wonder then that Fannie and Freddie were able to grow so much.

Indeed, nearly all financial asset classes that Basel I endorsed with lower risk weightings have grown rapidly since 1992, and are right at the center of the current financial crisis. According to the Bank of International Settlements, the notional amount of outstanding over-the-counter (OTC) interest rate derivative contracts, which had a very low risk weight, the lowest risk weighting among derivative instruments under Basel I, have grown to over $319 trillion, or 75% of the total OTC derivatives exposure. In summary, despite the good intentions underlying them, the risk weightings of the Basel I accord are a bad idea, and have contributed instead to an increase in the overall risk assumed by banks.

Fortunately, all US banks must comply with US-specific minimum leverage ratio regulations implemented in 1990, which do not depend on risk weights. In addition, according to these regulations, only institutions with at least 5% leverage are “well capitalized”, where the leverage ratio is defined as the ratio of so-called “Tier 1” capital to adjusted average total non-weighted on-balance-sheet assets. Unfortunately, these regulations do not include off-balance sheet assets.

While off-balance sheet accounting predates the accord, Basel I legitimized and made it acceptable to hold assets off-balance sheet, by defining the credit factor and risk weighting of different types of assets, and was also permitted under Financial Accounting Standards Board (FASB) accounting rules. This loophole meant US banks had an incentive to instead expand their off-balance sheet assets. Likely as a consequence, according to the Financial Times, there are an estimated $5 trillion in off-balance sheet entities that would have to be brought to the bank balance sheets according to new FASB rules proposal, an amount that does not include all off-balance sheet assets held by banks, and that represents nearly half of the total assets ($11 trillion) of US commercial banks.

According to March 2008 Federal Deposit Insurance Corporation data, the leverage ratio for US banks was a quite healthy 7.5%, slightly higher, in fact, than in December 1992, the earliest date Tier 1 data is available. However, an analysis of the annual reports of large US and international banks indicates that large banks have much lower leverage ratios.

In December 2006, on the eve of the financial storm, Basel I instilled a false sense of security by showing Tier 1 risk-weighted capital ratios of large banks around a conservative 8%. For example, Citigroup had an 8.6% Tier 1 risk-weighted capital ratio and a 5.2% leverage ratio. However, according to its 2006 annual report, Citigroup had $1.7 trillion off-balance sheet assets, which meant its overall leverage ratio was 2.5%. In other countries, banks had even lower leverage ratios. For example, Barclays Bank, Deutsche Bank, and UBS had leverage ratios of 2.3%, 2.2%, and 1.7% to on-balance sheet assets, respectively, while displaying Tier 1 risk-weighted capital ratios of 7.7%, 8.9%, and 11.9%, respectively. If my analysis is correct, Basel I conferred legitimacy to increasingly risky behaviour by banks, by painting an incorrect picture of the financial strength of banks.

Finally, and most importantly, Basel I risk weightings directed the allocation of financial resources towards certain economic activities deemed by the Basel I planners to have less risk, as shown by the empirical results of several academic papers.

The Basel I capital accord was defined in such a manner that it meant common sense and facts had no relevance in decision-making, similar, in fact, to what often happens in planned economies and large bureaucracies. A bank faced with two financial applications, one for a Fannie Mae security and another for a promising industrial loan, might prefer the former since, in terms of scarce bank capital, the Fannie Mae security cost it only one fifth of the industrial loan. No matter how well intended and knowledgeable, it is the essence of market economies that the choices of central planners will ultimately prove inferior to those made by some risk taking market participants, as has now become apparent.

The second main factor that allowed banks to take increasing risks was the reduction in the minimum reserve ratios, implemented in several steps in the 1990s by the Federal Reserve and other central banks. These reductions in the minimum reserve requirements aimed at reducing the bank costs associated with non-interest yielding reserves.

As a consequence, average US bank reserves (including surplus vault cash) fell from 2.9% of total deposits in January 1990 to 0.9% in March 2008. While the change may seem small, as the ratio approaches zero, credit creation by banks grows exponentially. Explained in a somewhat oversimplified manner, in 1990, a deposit of a newly Federal Reserve issued US dollar would be expected to originate, on average, total loans of $33, whereas in 2008 the same one US dollar deposit would be expected to originate, on average, total loans of $110.

Banks face two inter-related but separate constraints when they attempt to grow their loan book and assets: bank capital and minimum reserve requirements. Basel I and the off-balance sheet loophole allowed banks to skimp on bank capital. The changes implemented in the 1990s by the Federal Reserve and other central banks, relaxed the other remaining and more important constraint on the banks ability to grow. Thus, there was what must have seemed like unlimited demand for Basel-endorsed assets, and the unregulated part of the market (think subprime mortgage lenders) duly rose to the occasion and supplied the banks with the goods in the format required by Basel (e.g., AAA rated CDOs).

While most consider the Federal Reserve’s decision to sharply lower interest rates in 2001-2003 the cause of this crisis, I believe it was but an important aggravating factor. It provided an incentive to increase leverage and speculate on the short and long term interest rate differential, namely through interest rate derivatives. In addition, it also rescued several banks from having to take some hard decisions. Had the interest rate not been lowered by so much, a few of these banks would have failed, but more importantly, the managers and the strategies that had been followed at the banks that survived would have changed. Consider, for example, how many top managers lost their jobs since August 2007. Instead, the low short term interest rates allowed these firms to keep on using the same strategy. The consequence is that the level of risk in the financial system is much larger than it was in 2002 and therefore the crisis is far more difficult to address.

Still, the above-mentioned regulatory measures do not excuse banks from their ultimate responsibility. The regulations did not force banks to buy only what was perceived as being low-risk assets, nor forced them to expand their off-balance sheet liabilities. Large banks in particular, were free to exercise good judgment, but instead chose to lead.

There are few palatable options available. Bank failures are costly and painful events to be avoided to the extent possible. Yet, a market system is based, in no small part, on failure. Among other things, failure importantly means the loss of equity and debt for those economic activities where there was previously an excessive allocation of economic resources.

Unfortunately, the situation is such that losses of, for example, 5% of total assets, which are not unconceivable given the size of large banks’ trading assets and current estimates of the total losses by the IMF and others, would mean insolvency for several large US and international banks. Therefore, it is no longer realistic to think that capital increases alone will suffice to solve the crisis.

The financial health of large banks can only be restored through a restructuring of their liabilities, so as to put the large banks’ Tier 1 leverage ratios well above 5%. The question then is which groups of liabilities owners have to bear the cost of the restructuring. I believe that, despite moral hazard and legal considerations, deposits and inter-bank loans, which represent the bulk of bank liabilities, should be fully protected, to avoid bank panics and ensure that the credit creation process is not unduly affected by the crisis. This means that the remaining liability owners, foremost equity and debt holders, which represent around 25% of US bank liabilities, would have to bear the brunt of the balance sheet retrenchment. Indeed, the reduction of the large banks’ liabilities, necessary to put the banking system in a more sure footing, has to happen before the economies can recover. The sooner it is done, the better.

*Copyright Ricardo Cabral, 2008. All Rights Reserved. This article may be reproduced with appropriate attribution.

Sunday, December 16, 2007

Porsche AG's Volkswagen takeover

by Ricardo Cabral

First version: November 19, 2007
This version: December 16, 2007 (Text in italics added December 30th, 2007)

Porsche AG's two and a half year campaign to take over Volkswagen AG (VW), a DAX30 and EuroStoxx50 stock, and create an European car and truck giant nearly 20 times its size, with over €135bn of sales, is a daring bet in high finance.[i]
However, the takeover has not been casuistic or innocent. Porsche's actions under CFO Holger Härter show flawless execution, exactly what one would expect from a manufacturer of niche high performance cars. The initial build up of a 27.4% stake in 2005 and 2006 was well timed and achieved on the cheap. The March 2007 low-priced VW takeover offer, which aimed to fail, but allowed Porsche to raise its stake to 31%, reveals innovativeness. But it is the current move, which shows the brilliance of the strategy pursued by Porsche.

The basic assumption when a firm acquires another is that it wants to pay the lowest price possible. What better way for Porsche to achieve its goals than by aiming for exactly the opposite of what the market expects it to do, and to do it in plain sight. In my view, Porsche's objectives were best served by having Volkswagen’s share price rise the maximum extent possible.

On November 28th, 2007, Porsche announced record profits of €5.7bn of which €3.6bn were gains from options investments on VW shares. Based on the half-year letter to shareholders, analysts estimate that €3bn were achieved in the second half of the 2006/2007 fiscal year (FY). To be able to earn €3bn from options, considering the VW share price change from around €85 on January 31st to around €132 by July 31st, Porsche would have had to hold options contracts equivalent to holding about 650 000 “in-the-money” options contracts between these dates. Such large number of contracts, if fully exercised, would correspond to about 65 million shares, or about 22% of the voting capital of VW, and would represent nearly 50% of the total number of Eurex option contracts for VW, 85% of which were puts. This high proportion of puts was unusual. The number of put and call options contracts on any given stock are normally similar.

Porsche could not have made so much money with options had it held a much smaller number of contracts or “out-of-the-money” options. Indeed, since it would be nearly impossible to hold that many options that remained in the money during the entire period, it is likely that Porsche held far more options contracts for only part of the period, and that it used a particular type of options contracts, so-called “deep in-the-money naked puts”. For example, if Porsche sold a €130 “deep in-the-money naked put” contract when the VW share price was €100, it would have received a premium in excess of €30 per VW share, or €3000 per contract. This contract would confer to the buyer, the right to sell 100 VW shares to Porsche, at the price of €130 per share. That means Porsche would not have had to spend any money in building its large options investment.

According to Eurex exchange’s regulations, there are no restrictions to the size of “naked puts” contract holdings, unlike other bourses and its own practice before 2003. On the other hand, so-called “long call” option contracts, which confer the right to buy the share at a given price, face positions limits equal to 25% of the free-float.
[ii] The regulations have been in place since 2003 but were explicitly laid out in an July 2004 circular, which also substantially increased positions limits. This was a surprising policy change, as investments in “naked puts” affect the price of the underlying shares in a similar manner to “long calls” options.

Large sales of “deep in-the-money naked puts” by Porsche would have had the effect of moving the underlying VW share prices higher as if Porsche had directly acquired additional VW shares. This happens because the buyers of the put options, on the other side of the Porsche trades, either own shares or hedge their put options investments by acquiring shares. These buyers would be unwilling to part with their VW shares at prices lower than the exercise price of the puts they had previously acquired. In practice, Porsche would control, by proxy, a large number of VW shares.

Only about 41.4% of the VW shares were theoretically available for trading to start with, the so-called free-float. However, if you account for the large Porsche’s holdings in the options market, and holdings by exchange traded funds (ETFs), which may own up to 25% of the free float, the true percentage of VW shares available for trading was probably well under the 15% minimum required by Deutsche Börse for a DAX30 stock. As a result, small changes in the volume of traded shares would have exacerbated VW share price changes. In fact, the large Porsche’s holdings of VW shares and options may have allowed one or more unknown entities to corner the market for VW shares, leading to large VW share price increases, and to the large Porsche’s options profits.

VW shares rose by 50% to close to €200 between July 31st, the end of Porsche’s FY, and November 1st, during a period of turmoil in worldwide stock markets, in the context several news reports and interviews in Der Spiegel and other newspapers about Porsche’s stated interest to acquire a majority stake of Volkswagen by January 2008. Therefore, assuming Porsche did not unwind its options portfolio before late October, I estimate that Porsche is sitting on top of at least an additional €3.5bn to €4.0bn of profits from options in the first half of FY 2007/2008. According to a Nov. 29, Financial Times article “Porsche profits by CFO’s hedges”, traders have estimated similar options profits in this period.

On November 3rd, a Der Spiegel article indicated that due to conflict with the VW unions and the high price of VW shares, Porsche had decided to postpone the acquisition offer for VW beyond January 2008. In addition, the Der Spiegel referred that CFO Holger Härter preferred to realize Porsche’s options gains since current VW share prices were too high. A Porsche spokesman later stated that it had already cashed in most of its options. To do so, Porsche probably bought back the put contracts it had previously sold, realizing large gains in the process, and with the result that the VW share free float would have increased again.

If my analysis is correct, Porsche’s 31% share of VW, considering the after-tax gains from options investments, did not cost Porsche anything. At current market prices Porsche’s stake in VW is worth about €14bn. But I think the important point is that, while insiders have gained substantial sums, the general public and some investors on the other side of the Porsche trades will make large losses, even if some of these losses have not materialized yet.

While Deutsche Börse and the Frankfurt stock exchanges regulator do not come out of this affair in good light, Porsche has thus far shown perfect command of the German stock exchanges regulations and intricacies. Therefore, there is no doubt in my mind that Porsche’s behaviour has been legal. Nonetheless, it seems as if normal investors have been deceived by the deficiencies in Eurex regulations.

Finally, whatever its next move may be, Porsche seems to have forgotten the dictum often attributed to Abraham Lincoln: “You may fool all the people some of the time; you can even fool some of the people all the time; but you cannot fool all of the people all the time”.

P.S.- Some opinion makers in the US and Europe argue that firms should not be required to report quarterly earnings reports, as they result in businesses having an excessive short-term focus. I believe this case shows that the opposite is true. Porsche fought Deutsche Börse’s requirement for quarterly earnings reports. They release a puny 6-page half-year brief to the shareholders, with little details available. Only with the release of its 2006/2007 FY Press Release on November 12, is it possible to infer Porsche's actions, and that with a delay of three and a half months on the end of their FY. Surely, this does not aid the cause of market transparency. Insiders must have had a feast this last year.

[i] VW has large stakes in the truck makers MAN AG and Scania.
[ii]Eurex Circular 097/04: Position Limits – New Mode of Calculation as of August 2, 2004”, Eurex Deutschland, 2004, (accessed: Nov. 2007)

Copyright Ricardo Cabral, 2007. All Rights Reserved.
This article may be reproduced with appropriate attribution.

Friday, October 12, 2007

Banks face perfect storm*

by Ricardo Cabral

First version: September 24, 2007
This version: October 12, 2007

The current financial crisis follows several years of rapid growth of financial sector revenues and profits. Revenues for large European complex financial institutions grew above 20% in 2006, and profits grew even faster.[1] In the US, the financial sector represented 21% of the S&P500 market capitalization and approximately 30% of the profits. However, the financial sector has been under growing pressure which now comes to light. In reality, what we now face is a banking sector crisis.

Banks derive their revenues from three sources. First, service income from fees, commissions, and other services such as investment banking. The second source of revenues is a pure term premium, the difference between the “risk-free” short- and long-term interest rates, as banks loan or invest long-term their mostly short-term liabilities, essentially a play on the yield curve. The third source of revenues is a risk premium, as banks pay depositors and creditors a reduced risk premium given their strong financial ratings and depositors insurance, but apply these funds in loans or financial assets with typically higher risk, charging for that reason an interest rate spread.

Recent years have seen strong innovation in the financial sector particularly the origination and distribution of credit exposures through structured securities, which in combination with cyclical business such as LBOs and M&As resulted in large increases in the revenues derived from services. For example, according to the Bank of England’s Financial Stability Report, in 2006 large complex financial institutions saw fees and commissions revenues grow 20%, net interest income grow only 5% (from term and risk premia), and trading activities revenues, associated with an increasingly large trading asset portfolio, grow 35% (risk premium). However, the growth in services revenues masked growing competitive pressure on prices and margins of banking services, due to the growing role of “low-cost” banking and securities (e.g., ETFs). The current crisis affects the former revenue streams, and thus in the short run service revenues are likely to fall.

The term premium has basically vanished as central bankers in the developed world raised short-term reference interest rates but long-term rates remained nearly unchanged or even fell. Since 2004 short term reference rates rose from 2% to 4% in the Eurozone and from 1% to 4.75% in the US, after the cut in the Federal Funds Rate last week. On the other hand, German government 10-year bonds yielded 4.11% and US treasury 10-year bonds yielded 4.67% in August 2007. As a result, in August, 10-year term premium spreads over the overnight reference rate were 11 basis points in the Eurozone and -35 basis points in the US. For comparison, the monthly average term premium between the US federal funds rate and 10-year treasury bonds has been 140 basis points since January 1982. Since the reference interest rate in practice functions as a ceiling for the short-term price of money (time deposits and short-term money market), the term premium has historically been one of the largest sources of revenues for the commercial banking sector. In summary, the second source of bank revenues has been under strong pressure since 2004.

The remaining source of revenues arises from the risk premium. The banking sector revenues and profit growth over the last few years can only be explained by the growth in revenues associated with the risk premium, in a period where the risk premium fell significantly. The risk premium fell precisely due to the growth in the supply of credit, as evidenced by the growth in banks’ balance sheets since 2002, but also due to the growth of investment capital willing to “borrow short-term and lend long-term”,[2] in some cases backed by bank credit lines. For example, an often used measure of risk, the spread between junk bonds and 10-year US treasury bonds fell from 11 percentage points in 2002 to under 3 percentage points in the beginning of 2007, while assets of large complex financial institutions rose from under $12 to $23 trillions, with trading assets representing more than 25% of total assets. For comparison, hedge-fund, bank conduits, and structured investment vehicles (SIVs), which it is often argued are a source of systemic risk to the financial system, are thought to hold assets of $2.7, $1.4, and $0.4 trillions, respectively, and thus play a much smaller role in the financial system. Despite the fall in the risk premium, bank revenues grew due to the increase in the volume and average risk of bank assets. Given the current increase in the risk premia and fall in asset prices and capital ratios, banks will have to reduce asset growth, suggesting that the revenues associated to the risk premium are also likely to decline.

Little can be done in the short run regarding service revenues, but price increases for retail bank services and cost cuts are likely. To allow banks to earn again some term premium either short-rates go down or long-rates have to go up. The first option, for example through a massive increase in public debt, would reduce the market price of “risk-free” long-term assets and, if achieved through higher public spending, increase inflation, both not palatable options. Thus, substantial reductions in the short-term reference rates are now unavoidable to prevent a more severe banking crisis, despite the talk emanating from the ECB, the Bank of England, and the Federal Reserve. Moreover, it is important to ensure that the long-term yields do not fall significantly, so as to maintain the increase in the term premium achieved by the reductions in the short term interest rate, and to prevent further bubbles of financial assets. The 10-year term premia have risen by more than 20 basis points in both the Eurozone and the US since August. Furthermore, the yields for the 3- and 6-months bond yields have fallen significantly since July. In the US, the 3-month Treasury bond yield has fallen by 112 basis points. As a result, the yield curves are again positively sloped and the markets, despite the central banks’ reference rates, are again willing to pay some pure term premium, clearly a positive development for the banking sector. Finally, to restore the third source of revenues to banks that have not engaged in risky behaviour and to ensure that the banking sector is willing to extend new loans, policy makers have to let the risk premium rise from its current abnormally low level. Specifically, governments and central banks should not buy financial assets to prevent a rise in the risk premium.

The increase in the risk premium will put the capital ratios of great many banks under strain. While it is often argued that large banks are well capitalized, UK major banks, for one, seem inadequately capitalized with only 4% Tier 1 non-weighted capital ratios, and a similar argument can be made relative to a few of the largest American and Eurozone banks. Since the risk spread for higher quality assets fell to near negligible amounts during the credit expansion, the repricing of risk may cause the market price of high quality assets to fall significantly more than expected because the implied asset yield for higher quality assets rises from a lower base than that for riskier assets. In fact, the market prices of investment grade corporate bonds have already fallen significantly since February, following a rise in spreads of 72 basis points. Given that Bank of International Settlement capital rules for international banks requires much lower Tier 1 weighted capital ratios for higher quality assets (only 0.6% capital allocation for AAA securities), banks with higher quality illiquid assets may paradoxically be more exposed to the repricing of the risk premium than banks with riskier assets. Alas, this issue, rather than simply lack of liquidity, may be one of the main causes of the problems besetting the English bank Northern Rock.

In conclusion, I believe the banking sector is at the origin of the current crisis, which is not a liquidity crisis but instead a revenues and capital adequacy crisis. Therefore, the crisis cannot be solved by liquidity injections by central banks, but by measures that will restore the market incentives for the banking business. Given that a large number of market participants do not know or do not agree how to quantify the extent of their losses on their illiquid assets, bank supervisors should step in and force banks to incorporate in their balance sheets their off-balance liabilities and to re-price illiquid financial assets (e.g., CDOs) using simple, but aggressive discount rules. As usual, should a bank fail to meet minimum capital ratios, the supervisor would require capital increases or in the extreme cases impose bank receivership. While these measures might affect several banks, they would restore the necessary confidence by introducing transparency about maximum bank exposure.

Finally, this crisis raises questions about the reliance of monetary policy on the short-term reference interest rate, and may lead to the ascendancy of the so-called bank capital channel hypothesis[3], a quite recent research topic within the vast transmission of monetary policy academic literature that emphasizes the effect of monetary policy on the capital of banks, and through it on economic activity.

[1] “Financial Stability Report”, April 2007, Bank of England, Issue No. 21
[2] Paul De Grauwe, July 10, 2007, “The eurozone is missing the point”, Financial Times
[3] Van den Heuvel, S. J. (2007) “The Bank Capital Channel of Monetary Policy”, Wharton University, mimeo. This literature focuses on the impact on bank costs of interest rate rises, whereas in this article I take the view that the important impact of monetary policy is through the reduction in the banks margins arising from the compression of the yield curve term premium.

*Copyright Ricardo Cabral, 2007. All Rights Reserved. This article may be reproduced with appropriate attribution.