14 September 2010

This weekend saw the official birth of Basel 3.  Markets are up, people are happy.  Once reporter called it a biggest change in banking since Glass -Steagall Act.  A lot of people are very excited indeed.  Basel, Switzerland, 3, banking, capital.  All the right buzz words for the 10pm news headline.

Last week also saw a relatively unnoticed piece of news coming from Ireland, where their Minister of Finance has said that Ireland is being penalized for coming out about the state of its banking sector.   Brian Lenihan was slightly too honest, and the markets gave him a reality check, and now he allegedly feels is not fair that the other countries are not affected.

So lets add all the pieces together and try to work out what is going on.


Anybody who knows anything about Basel, capital adequacy ratios, will tell you that there are three fundamental areas concerning Basel topic:

1.  amount of capital the bank is required to hold AGAINST ITS RISKY ASSETS
2.  method of calculating capital (instruments)
3.  method of calculation of value of risky assets

Amount of Capital

This weekend, the issue of capital was raised, and it was decided that yes, the banks will become less leveraged (very slightly).  Yet the change stops here (though I think that it was very smart to add the elements that no dividends and bonuses are paid if ratio is not met - finally some actual power, and what a medial stunt).

So the new key capital ratio of 4,5%, more than double the current 2% level, plus a new buffer of a further 2,5%.  Well, most of you know (apart from politicians), vast majority of banks already meet these requirements.  To give banks time till January 2019 to adjust, is simply strange.

To compare, during the great depression banks had their capital ratios at approx 1/3 level, and still 5,000 banks went bust.

What is Capital

During the height of the crisis, banks cleverly developed a system of leveraging by issuing junior debt, which RIGHTLY was treated as senior equity.  It had all the characteristics of the equity (no coupon no principal repayment!), and if the investors were brave enough to invest into these underyielding bonds (when compared to equity returns), good for banks. Of course with the emergence of the crisis, the demand for Hybrid Capital evaporated, as people started to apply basic level mathematics to realize that they are totally underpaid for the risks they are taking.  Banks honoured some bonds, extended others, but in summary this source of financing dissapeared - requiring banks to raise equity just to cover for this missing portion of capital.

Now, while Basel 3 does not mention this area, luckily the markets themselves managed to bring some commonsense to it. Basel 3 does however enable banks to use deferred taxes as capital, until 2014, what even an econ 100 student will tell you makes no sense at all.  Could this be deliberately left open "door"?

What is a risky asset
By far the biggest problem with Basel is in the calculation of asset values (what is risky and how risky?).  While capital changes from 2% to 4,5%, the assets are by my measure often some 30 - 50% underwater, and it would take an increase of capital from 2% to 50% to save these banks.

What is going on?  Well, read my product offering for the start to understand what can be done to save the banks, but here are few examples of what is going on:


example 1:  mortgages and other investments

Imagine a UK bank which granted people mortgages at BoE +  0.39% spread, interest only for say 35 years.
Now this deal was perfectly rational at the time when this deal was done, as this deal, like others was sold of via securitisation, and it was the RMBS investors who took the risk (and lost).  I would also buy coca cola for USD10, if there was a dude around the corner paying USD11 for it.  The problem happens if i bough a track of cola, and the dude suddenly run out of cash.  I am left with all this product, worth USD1 per can.  My pyramid of stupidity had suddenly stopped.

So I am left with all these sodas.  Do I tell my wife?  Hell no.  Ideally I could pretend that they are worth USD10 each, or maybe I could ask my friend to buy them from me (with the money I lend him)?  Wife is happy, I am happy, friend is happy.

So lets bring our mortgage asset yielding BoE + 0.39%.  Yes, these banks finance themselves at some BoE + BoELibor Basis + margin  - ie say BoE + 2,39% on the open market (and for max 10 years transaction).  A econ 100 student will know that there is something wrong here, as the bank is LOSING 2% per year.

Now these loses will happen for 35 years. If you would want to remark this asset to the current value, you would probably need to take of some 35% of its value.  Instead, the banks keep the value of these assets at 100, and will wait for 35 years realising 2% of losses.

example 2:  when in trouble convert to equity

Imagine making a USD100m loan to the company, which will turn around at the end of the loan and tell you:  sorry can't pay.  Normally the loss of USD100m - recovery level would be booked, losses announced, equity raised (government?),  potentially some bankers fired.  However there is a much smarter way of dealing with this problem.  Lets convert USD100m into the equity of the company, at least 1/3% of it so that it is not an investment, and for a long time. The book value of equity... you guessed it  USD100m. Losses on the book?  0.

example 3:  why don't we solve our problems all at once

Are you a CEO of the bank?  Why don't you 
  1.  form the SPV
  2.  lend it 100m usd
  3.  get the company to buy back from you assets worth 100m usd (book value)
  4.  write an option mitigating the risks

Problems are solved.


Call Vision Finance to find out what more can be done to help your bank to join the game.  Afterall, though all the above defines logic, the market is at the best state for years, economy is booming, stability is emerging.  Ireland might hence not understood, that banking has its own rules, and the rules are simple - to benefit the shareholder - and as ultimately the shareholder is the government.  

"Who is John Galt?"