Commentaries

Do banks really need to hoard liquidity?

That’s the provocative question posed by Willem Buiter. His latest, characteristically lengthy, blog post tackles the regulatory vogue for forcing banks to hold much greater reserves of liquid assets – in practice, government bonds.

Buiter’s missive follows new rules from Britain’s Financial Services Authority, which will force banks to increase their reserves of government bonds by more than a third. The rules have been met with predictable bleating from the industry, which accuses the regulator of undermining Britain’s competitiveness and promoting the fragmentation of the global financial system. Another concern is the FSA’s handling of the transition.

Buiter’s objections are more fundamental. He’s not convinced banks should be preparing to deal with a seizure in the markets. That, he argues, is the job of central banks:

It may be possible for private banks to hold enough liquid assets (government debt, effectively) on their balance sheets to survive even a major liquidity crunch without recourse to the central bank.  But that would be socially inefficient.  Banks are meant to intermediate short liabilities into long-term assets, and frequently into long-term illiquid assets.  It’s what their raison d’être is.

By contrast, Buiter says: “Providing liquidity is what God made central banks for.”

It’s an argument which deserves to be explored further, though it does raise some practical concerns.

The first is whether central banks are able to prop up individual lenders without making matters worse. After all, the run on Northern Rock started after  the Bank of England announced it was providing support to the mortgage bank. The Bank of England has since installed a permanent discount window similar to the one used by the Federal Reserve. But it remains to be seen whether banks will dare use it once markets have returned to normal.

Granite crumbles

Standard & Poor’s dropped a minor bombshell last night when it placed over 100 bonds issued by Northern Rock’s mortgage funding vehicle Granite on creditwatch negative.

Of course the rating actions are lagging the market and a lot of pain is already priced into the bonds. Some of Granite’s mezzanine BBB bonds are trading below 20 pence on the pound.

Nonetheless, there will be some psychological damage to the market if a large UK prime mortgage-backed issuer is severely downgraded. It certainly won’t do anything to help revive the primary market for UK RMBS, which some hope is set for a comeback. The good news is that so far the AAA rated bonds have not been placed on watch.

There’s little cheer to be found in S&P’s statement on the rating actions, which casts doubt over recent signs of recovery in the mortgage market, including house prices rises.

“Although we have observed that the more recent upward trends in severe delinquencies have tempered somewhat, at a time where house price indices have registered their first meaningful rises in almost two years, we do not yet consider that either of these trends is sustainable.’’

Granite now has long-term arrears of 4.67 percent, according to S&P, worse than the Rock’s average of 3.92 percent. Thirty-four percent of the Granite mortgages are in negative equity, compared with 39 percent for Northern Rock’s overall book.

Don’t underestimate the European Commission

Will RBS and Lloyds have to follow Northern Rock and defer coupons on their hybrid debt? There’s a nagging fear that any bank that has needed large amounts of state-aid may have to make subordinated bondholders take some of the pain.

Fitch Ratings has just added to the debate with a slew of downgrades of RBS, Lloyds, and six other banks’ subordinated debt, citing an “increased risk of deferral.” The chief threat here is the European Commission, which is getting very keen on the concept of “burden-sharing”, a euphemism for crucifying bondholders.

“The capacity for the Commission to materially influence both the capital remuneration policy and the future shape of state-aided banks should not be under-estimated,” warns Fitch.

Are Lloyds shares cheap? Not as cheap as this funny money

Shares in Lloyds Banking Group are worth 150 pence apiece, according to the analysts from Royal Bank of Scotland, who think the shares offer “a compelling restructuring opportunity” around today’s 95 pence.

Lloyds, say the brokers, is going to recover sufficiently to pay a nominal dividend next year, and something quite substantial in 2011, thanks to margin expansion, cost control and normalising bad debts.

Well, maybe. Over in the distressed debt market, they are a lot less sure. Mind you, they are not very sure of anything, and anomalies abound. Brokers Collins Stewart, who have specialised in the backwaters of preference shares and PIBs, have one this very day. They are offering the snappily-titled HBOS Capital Funding 9.54 percent fixed-to-floating perpetual preferred securities at 65 pence.

The buyer gets a 14.68 percent return until 2018, when he either gets 100 pence, or the coupon is reset at Libor plus 6.75 percent, a rate deliberately designed to be punitive for the borrower, which is of course, HBOS’ parent, Lloyds.

That, at any rate, is the theory. Existing holders of these obscure instruments have little idea how to value them. As Collins Stewart point out,  similarly-ranked paper from Lloyds itself yields 11.28 percent. There’s the additional risk of Lloyds following Northern Rock’s example and electing not to pay the interest, since it’s clear that the bank is still short of capital.

The point, though, is that Lloyds cannot pay a dividend if interest on these higher-ranking securities is not up to date. If the RBS analysts are right, then the mouthful of HBOS stock above is cheap; it looks better value than the shares, at any rate.

Reality arrives at The Rock

The surprising thing about Northern Rock’s decision to defer coupons on 1.6 billion pounds of its subordinated debt is the timing — arguably, it’s a miracle investors were getting paid anything at all.

The bank on Tuesday said it would stop paying coupons on various subordinated bank bonds, securities that count as regulatory capital.

The 12.625 percent subordinated notes fell to about 15-25 pence, down from as high as 50 before the announcement. Other tier 1 bonds that have been trading at around 20 percent of face for most of the year and fell below 10 today after being quoted around 15 last week.

While they all have differing terms and conditions, these bonds share the feature they can be deferred without counting as a default. That enables them to qualify as regulatory capital, the buffer banks must hold to absorb losses and protect depositors.

This feature meant Northern Rock might have deferred at any time since it was taken over by the UK government nearly two years ago. Bradford & Bingley, which the government broke up and placed into run-off, chose to defer coupons earlier this year.

The odds on Northern Rock following suit rose in July when the bank announced its capital position had fallen below regulatory minimum limits. The government now wants to restructure it by hiving off its dud assets into a bad bank. That will need state aid approval from the European Commission, which has become increasingly keen to see bondholders take their fair share of pain in bailed-out banks.

Market prices suggest there is some value left in the debt, perhaps if the debt is turned into equity or bought back at a discount.

from Neil Unmack:

UK mortgage debt: remain calm! All is well!

That's the message given by Moody's today on the resilience of UK mortgage-backed securities to the current downturn. The survey is based on so-called master trusts, a kind of securitization vehicle first applied to U.K. mortgages about a decade ago which quickly became the most efficient way for a large bank to securitize home loans. The master trusts grew so big that they now finance about a fifth of all UK home loans (although a large chunk of this must have been from deals issued by banks after the credit crisis to use as collateral for borrowing with the central banks).

Master trust bonds haven't been immune to the credit crisis. Forced selling by SIVs and funds caused yields on AAA master trust securities to gap out sharply from their low of around a tenth of a percentage point over Libor. Spreads have rallied in recent months, but they are still around 2 percentage points over Libor, largely because many asset managers simply won't touch illiquid asset-backed debt, even if the returns are much higher than equivalent corporate bonds. 

Anyway, Moody's latest report on the sector may give some grounds for cheer. The firm conducted a stress test of the master trusts to see how the deals would perform in a 1990s-style housing downturn. The result; no bonds, not even the sub-investment grade securities, would suffer a loss, Moody's says. Moreover, no bonds would even be downgraded under the stress, which applied the same level of reposessions as seen in the last downturn.

There is one caveat here. Moody's analysis assumes that loss severities -- losses after repossessing and selling a house and taking into account accrued interest -- will remain at similar levels to those seen so far this year. That may yet prove optimistic if prices start to fall again.

Kingman to go private

So John Kingman is leaving UK Financial Investments “in due course” to spend more time with the private sector. That, at least, is the line put out by Robert Peston, the BBC reporter who could sometimes be confused for his personal press officer, on his blog.

As Pesto observes:

He’s wanted to move into the private sector for a couple of years – and said as much to the Treasury’s permanent secretary, Nick Macpherson, last summer.

That Kingman is leaving so soon into his mission may, as Pesto observes, occasion surprise. He slyly implies that Kingman is leaving to avoid political interference by the beastly Tories should they win office.

In reality, he’s probably moving on because he rightly perceives that it is going to be a long and thankless slog at UKFI. The shares will take years to sell, and in the meantime UKFI will probably be the whipping boy for a government that wants to get the best price for its shares while urging banks to lend more, protect consumers, etc.

Perhaps the most intriguing thing is what Kingman does next. Presumably in this case the private sector is probably a euphemism for the City. UKFI is conducting a beauty parade to pick a panel of banks to advise it on its shareholdings.  It would be a bit weird were Kingman to audition City firms during working hours and then entertain job offers from them in his lunch break.

Kingman is still employed by the Treasury (he is seconded to UKFI). Maybe the mandarins should take a quick squint at the gardening leave provisions in his contract, depending on where he chooses to go.

from Neil Collins:

Northern Rock bondholders brace for pain

The shareholders in Northern Rock have been wiped out, but all the various classes of bondholder have - so far - been paid out on time. That may be about to change. The European Commission is about to rule on the sensitive issue of the state aid poured into the failed bank nearly two years ago, and the UK government may offer to bite the bondholders as a quid pro quo for Commission approval.

Last week Fitch downgraded Northern Rock's vast range of debts, arguing that the treatment meted out to Bradford & Bingley would be extended to the Rock. It seems likely that the Rock will be split into a legacy bank containing the 67 billion pounds of old mortgages, while the 20 billion pounds of deposits would go into a new bank.

The bonds would stay with the legacy bank, and the holders would have to bear the cost of the bad debts from old mortgages. According to The Times  today the Treasury has decided that the bondholders can take a haircut, which would reduce the amount of state aid the bust bank would need in future.

It hurts to say so, since I'm a Northern Rock bondholder, but this seems eminently sensible. The bonds at the bottom of the pile, confusingly called Tier 1, are risky, which is why they always yield more than those above them (confusingly called Tier 2). A blanket government guarantee on all the Rock's debts would bring an unreasonable reward to the risk-takers.

The tougher question is whether the Tier 1 holders should be potentially wiped out before the Tier 2 holders suffer anything, as a strict legal interpretation implies. In practice, the legal niceties are subordinated to political reality, as we saw in the US with General Motors, and in the UK with Bradford & Bingley. A new Banking Act means that missing an interest payment  on subordinated debt is not an event of default.

It's going to be painful. We just have to hope, as one unfortunate GM bondholder put it, that the haircut isn't going to be a headcut.