Friday, July 20, 2012

Banks & Sovereigns - Why are they so intertwined?

Occasionally, I am asked why I care so much about a bank’s parent sovereign when evaluating them. Here’s a short comment on why I believe the two are strongly interrelated and why bank risks cannot be considered in isolation of their country. This is from the perspective of a market practitioner rather than a regulator or academic.

There are five essential connections between modern banking systems and their host country that makes the two systems vulnerable to shocks between each other. These connections include:

                     Fractional Reserve Lending
                     Central Banking
                     Fiat Money
                     Depository Insurance
                     Regulatory Control

Fractional reserve banking means that banks can take in deposits and subsequently loan out most of the funds, while keeping only a small percentage as cash in their vaults. Think of this as the bank borrowing money in the short term (such as taking in deposits) and lending it for the long term (like making a mortgage loan).  As long as short-term interest rates are lower than long-term interest rates, banks make money on the difference between the two since they “pay” the short-term rate to depositors and “receive” the long-term rate from borrowers.  Keep in mind that this cycle repeats itself: The borrowers spend the money that they borrowed, which ends up in the hands of another person who deposits it with a bank.  That bank then loans out most of these deposits, and the cycle continues.  As this cycle keeps getting repeated through the economy, these deposits are effectively multiplied many times over, allowing the amount of money created (“printed”) by the central bank to grow larger. When the financial system is functioning smoothly, the system is stable because depositors do not need their money all at once. The amount of reserves that need to be held for the demand deposits (i.e. cash in the vault) is a key connection between the sovereign and the bank system.

Central banks are the only entities which can print currency, and while enjoying such rights they also manage the money supply and short term interest rates for the sovereign. In addition to those roles, central banks have a key nexus with the banking system in their role as lenders of last resort during times of financial crisis. When depositors are fearful and demand to be repaid, banks may not have enough cash on hand to meet claims. If banks are properly performing their economic role of transforming short maturity lending (i.e. deposits) into longer dated lending, then the risk of a bank run is an ever present possibility for any bank, no matter how well a bank’s loan portfolio may be performing. Central banking addresses the risk that depositors may not be able to claim their money by providing emergency funding for member banks.

Over the course of monetary history, money has played its role as a medium of exchange and store of value in many forms – metals, shells, arrowheads, even cigarettes. Fiat money is a form of currency that is non-convertible, defined as legal tender, and lacks intrinsic value. Modern fiat money has the property that its value is unmoored from anything tangible: prior to the 1971 Bretton Woods withdrawal, foreigners could redeem a US Dollar via the “gold window” and collect physical gold at a rate of $35/oz.
Governments retain the ability to decide what fiat money can be used for (all debts, public and private) and can declare various contract terms to be illegal (such as gold clauses). Government’s ability to change the rules around the unit of exchange, by fiat, is another manner that tethers banks to their parent sovereign.

Depository Insurance is an additional way that banking systems are conjoined with their governments. There are many ways to set up a depositary insurance system: they can be prefunded, or losses can be mutualized on an as needed basis, and there is debate on what is a rational way to assess costs, and then upon what scope of activities. However, even when limits are fairly low for coverage, during a time of systemic strain, a commercially operated insurance system may be unable to meet all claims, without having a backstop. For example, the FDIC, as a US government chartered corporation, is able to call upon resources that ordinary insurance companies would not be able to summon. In exchange for providing this extraordinary coverage, the FDIC is able to exercise close supervision of certain banking activities. This explains why deposit insurance is another way that banks and sovereigns end up linked, and how a financial virus can flow between the two.

In addition to the controls that the FDIC, and its international analogs, place upon banks, there are other regulatory controls that the sovereign can impose on banks to meet political objectives. Examples might include Community Reinvestment Acts, Anti Money Laundering Laws, Capital Reserve Rules etc. These all end up reducing the pure profit motivations of the banks and blur the difference between a commercial bank, and a “policy” bank such as the GSE’s. The ability of the sovereign to impose/change these requirements, perhaps arbitrarily and capriciously, and often for its own convenience is another aspect of the interconnection between banks and the sovereign. For example, when FannieMae and FreddieMac needed to shore up their capital during the beginning stages of the financial crisis, regulators assigned a highly attractive risk weighting to their junior securities for any US bank that held them for regulatory capital.  Many banks gorged themselves on these since the preferreds delivered higher current income than other comparable zero risk weighted assets; of course in the fullness of time those banks took massive capital losses. Remember that these regulatory levers extend beyond the narrow definition of “banks” and cover the entire financial system: insurance companies and pension funds can just as easily be directed to hold more government bonds by a shaky sovereign having trouble financing a deficit.

After reviewing all of the above, I hope this briefly explains why I consider a bank’s risk profile to be highly intertwined with its parent sovereign’s risk.  Sovereigns are the ultimate backstop for the banking system while banking systems are important ongoing financiers of government borrowings. There is a long history of their mutual problems ending up contaminating each other, so taking an approach that the two are truly independent is unwarranted.

Wednesday, July 11, 2012

mREITs and Computing "Expense Ratios"

I tend to think of the mREIT sector like closed end funds: they are basically levered up bond portfolios, with in rare cases some tiny sideline businesses that may add a smidge of fees.  But basically to me they are like mortgage CEFs.

However, I find their fee structures somewhat opaque.  (Perhaps kudos to TWO for being fairly plain about their mgt fee)  So I tried to back into what their expense ratios would look like, if they were measured the same way as CEFs.  I compared my calc's to some other numbers I've seen, and they seem in line.  Unfortunately, I could not run the whole sector, as there are many new sponsors, and I don't have 12m costs for them yet.

My main takeaways from this are
  • there is quite a range of fees and I doubt investors notice nor care, blinded in the pursuit of fat yields
  • levered mortgage management is very expensive in general (compare to Wellington's cheap GNMA funds available for something like 10-20 bps)
  • these are pretty close to what you would expect to pay in CEF land, when you exclude interest costs.
  • credit sensitive mortgages are costly in terms of analysts, data, trading etc.
<>  <> 
TickerEquityT12M Op ExInterestTotalMgt CostAll In Cost
HTS2,080 19 145 1640.91%7.87%
ANH1,010 15 89 1041.44%10.28%
AGNC6,212 91 285 3751.46%6.04%
CIM3,683 58 152 2101.58%5.71%
NLY15,793 253 480 7341.60%4.65%
IVR1,917 35 155 1901.83%9.92%
CYS1,077 24 19 432.22%3.96%
TWO1,270 31 23 542.46%4.25%
RWT893 51 99 1505.69%16.79%
PMT546 48 17 658.76%11.87%


After looking at all this, I realize what a good deal certain levered mortgage OEF's are.

What I find disappointing, given how much efficiencies of scale/scope are in money management, is how the larger trusts do not seem to get more efficient as they scale up.  Running an incrementally larger amount of money doesn't cost as much as the earlier pool, so I would expect that that as trusts grew larger than 2bn they would see their costs grow more slowly than AUM.

Saturday, July 7, 2012

Anecdotes on Specialty Finance


Mezz debt is, almost by definition, lending to companies that banks won't/can't fund any more so borrowers are at real risk of having problems if the economy falters. You can look at the sectors results during the 08 - 09 timeframe to see how credit bubble lending worked out -- AINV is a case study worth reviewing.
I had lunch with an ex-specialty finance lender yesterday and heard a surprisingly bullish story from him, especially considering he'd quit the field, repulsed by its excesses during the go go years.  He didn't have an axe to grind or product to sell either, so I considered it a fairly neutral viewpoint.
He told me that there are some differences between survivors practices today that may give a little more comfort:
  • originators have now seen a down cycle
  • loans generally 3 years in maturity but unlike banks generally have to be marked to market even if performing
  • be alert to deteriorating credit profiles if lots of consent agreements (for fees of course) are being signed.  this is analgous to a credit card co. collecting late fees from dodgy borrowers...when what they really need to be doing is pulling the line immediately to minimize the losses that are accruing silently.
  • more lending taking place at the senior secured loan position as banks pare back their lending into the real economy
  • loans originated in recent years have much tougher covenants (personal guarantees etc. for principals) and more sober ratios
  • much less competition to lend to middle market America