The Fed isn’t acting as if its heart is in taking regulation bank regulation seriously. Not that that is any surprise.
Earlier this week, the Wall Street Journal described how banks are sidestepping the more stringent capital requirements regulators plan to implement after Silicon Valley Bank and Signature Bank failed early this year. SVB, as it is often called, took the bone-headed action of loading up on low interest rate mortgages. The bank’s funding was skewed towards very large deposits, and then by wealthy individuals, as opposed to businesses. Keep in mind that quite a few venture capital funds who were investors in SVB required other investee companies to bank at SVB, so the prospect of those companies being unable to make payroll1 because they’d lose their uninsured balances became the rallying cry for Doing Something.
The denouement was that both banks had all their deposits guaranteed, and that the Fed created yet another emergency facility, the Bank Term Funding Facility, to provide relief to similarly-situated players, as in potentially a lot of banks. This was a more permissive way than the discount window to allow banks to access emergency funds, by virtue of not haircutting the collateral pledged for the loan. Remember that while SVB was an extreme case of wrong-footing the Fed’s interest rate increases, nearly all banks are sitting on losses on loans and portfolio investments due to their price going down as interest rates rise. There could be an argument for regulatory forbearance, as in looking the other way and/or finding ways to finesse the paper losses, on the assumption that the central bank will relent in the not-too-distant future and those interest-rate-induced losses will prove to be largely temporary.
This long-winded intro is to establish that the crisis this spring, and the Fed’s combo of relief but tighter capital rules was to solve a problem created by the central bank itself, that of having kept interest rates too low for far too long, and then reversing them though very aggressive rate increase. We’d heard in 2011 or 2012 from Fed-connected sources that the central bank realized its super low interest rate experiment had been a failure and they needed to unwind it. Bernanke talked the prospect of Fed tightening up in 2014, but lost his nerve in the market revolt that came to be called the Taper Tantrum.
Congress and the Fed exacerbated this underlying problem, of an excessively-low-interest rate time bomb that would eventually go off, with Congress voting through laxer rules in 2018 on the cutoff for being a large bank. Nevertheless, the Fed remained the primary regulator for SVB and even released a report on why the bank failed and admitted it had become too hands off with the mid sized banks under the new law.
So now, not at all far past the March upheaval, with new capital rules expected but not implement, the Fed going the other way, of being more permissive. It is allowing big banks to get relief from current rules, while enriching some notorious bad actor hedge funds and less unsavory private equity firms. From the Wall Street Journal:
U.S. banks have found a new way to unload risk as they scramble to adapt to tighter regulations and rising interest rates.
JPMorgan Chase JPM 0.49%increase; green up pointing triangle, Morgan Stanley MS 0.61%increase; green up pointing triangle, U.S. Bank and others are selling complex debt instruments to private-fund managers as a way to reduce regulatory capital charges on the loans they make, people familiar with the transactions said.
These so-called synthetic risk transfers are expensive for banks but less costly than taking the full capital charges on the underlying assets. They are lucrative for the investors, who can typically get returns of around 15% or more…
U.S. banks have found a new way to unload risk as they scramble to adapt to tighter regulations and rising interest rates.
JPMorgan Chase, Morgan Stanley, U.S. Bank and others are selling complex debt instruments to private-fund managers as a way to reduce regulatory capital charges on the loans they make, people familiar with the transactions said.
These so-called synthetic risk transfers are expensive for banks but less costly than taking the full capital charges on the underlying assets. They are lucrative for the investors, who can typically get returns of around 15% or more, according to the people familiar with the transactions….
The deals function somewhat like an insurance policy, with the banks paying interest instead of premiums. By lowering potential loss exposure, the transfers reduce the amount of capital banks are required to hold against their loans….
Banks started using synthetic risk transfers about 20 years ago, but they were rarely used in the U.S. after the 2008-09 financial crisis. Complex credit transactions became harder to get past U.S. bank regulators, in part because similar instruments called credit-default swaps amplified contagion when Lehman Brothers failed…
U.S. regulations have been more conservative. Around 2020, the Federal Reserve declined requests for capital relief from U.S. banks that wanted to use a type of synthetic risk transfer commonly used in Europe. The Fed determined they didn’t meet the letter of its rules….
The pressure began to ease this year when the Fed signaled a new stance. The regulator said it would review requests to approve the type of risk transfer on a case-by-case basis…
But it is not at all clear how stringent the Fed is being:
Fed guidance on bank credit risk transfers could double market size https://t.co/BjsVYox5lB
— Risk.Net (@RiskDotNet) November 1, 2023
And if the central bank is not doing such a hot job of overseeing banks, how can it possibly evaluate the counterparties that are taking on these risks? If they go bust or have liquidity problems, it is the bank that winds up holding the bag. Remember that LTCM was perceived to be super savvy and rock solid until it imploded, and world’s biggest insurer AIG was rated AAA until it started on its terminal slide.
Even worse, the players that the Wall Street Journal mentions first (as presumed market leaders) include hedge funds, which means their exposures can change quickly, and ones with questionable histories. Again from the Journal:
Private-credit fund managers, including Ares Management and Magnetar Capital, are active buyers of the deals, according to people familiar with the matter. Firms including Blackstone’s hedge-fund unit and D.E. Shaw recently started a strategy or raised a fund dedicated to risk-transfer trades, some of the people said.
Ares was one of the firms involved in the CalPERS pay-to-play scandal, which included the bribery of CalPERS CEO Fred Buenrostro. ProPublica won a Pulitzer for its extensive reporting on Magnetar’s sleazy behavior in the runup to the crisis.
However, it remains a sore point that ProPublica missed the real story. As we described long-form in ECONNED, Magnetar was a structured credit arbitrage specialist. Using significantly synthetic CDOs (the 20% of actual mortgages in their structure made them saleable to a much larger group of investors), Magnetar created credit default swaps on the riskiest rated tranches of subprime bonds. Its massively leveraged structure generated enormous exposure that wound up in the hands of systemically important, high leveraged banks. Its trade also had the effect of driving demand to the worst subprime mortgages in the toxic phase that started in June 2005. Experts estimated that from then to the final demise of the subprime market, Magnetar drove the demand for 50% to 60% of subprime mortgage bonds. The reason Magnetar did not get as rich and therefore become as visible as John Paulson was that Magnetar gave up a lot of its perfect subprime trade on a bad bet, rumored to be on gold.
And these are the parties the Fed is comfortable backstopping bank risk? Seriously?
____
1 Businesses of any meaningful size will inevitably have more than $250,000 at the bank. They receive large payments from customers. They have to have cash in the bank to meet payrolls. From an accounting and software standpoint, it’s far too cumbersome to try to manage these money flows across multiple bank accounts.
