There is something wrong with the fractional reserve banking system. It should have become clear post 2008 but it hasn’t.

Banks at their simplest form take deposits, (borrow money) usually short term, and lend money, usually medium to long term. They also augment their short term borrowings with the issue of longer term debt instruments. So banks borrow on the one hand and lend on the other, making a margin, being the difference between the rate at which they borrow and the rate at which they lend.

For the borrower, banks provide services by seeking the capital and  aggregating it. Along the way they also provide corporate finance advice. There are costs associated with seeking capital and aggregating it, and there are costs associated with administering the business as well. What borrowers seek from a bank is the ability to provide the requisite capital at attractive terms and pricing. Banks do represent some risk to a borrower, if they unexpectedly withdraw funding or are otherwise unable to support the borrower further. With the complex array of structures through which a bank aggregates and directs capital, for example with securitizations, the risks that a bank poses to borrowers can be complex.

For the depositor or lender, the bank provides safe keeping of and interest on their money. Often the bank will provide a bewildering array of other products and services as well but these are ancillary to the primary business of borrowing cheaply from the public. The risks to the depositor or lender are simple enough. Credit risk. In the case of securitizations, the risk is transferred away from the bank, to the particular pool of borrowers. For the depositor, the risk is in the bank defaulting. As long as banks act as nothing more than intermediaries of capital, the analysis of bank’s credit default probabilities is straightforward. Banks use depositors money to lend and make a spread. The financial strength and performance of a bank are the result of its credit underwriting standards and balance sheet management. As banks have evolved and drifted into other activities, the volatility of the asset base becomes less correlated or related to its liability base. Fee income is fine as it is compensation for a stable business activity; there are no negative fees. The risk increases with trading profits which can be positive or negative and introduce uncertainty of cash flow and mark-to-market variation to the assets of a bank. The asymmetric pay-offs to traders in a bank are well documented and represent a serious agency issue to shareholders and depositors. Basically, the trading desk gambles with the capital provided by shareholders and depositors. The risk reward to the depositor is particularly poor as their upside is capped.

In a low interest rate environment, the disadvantage to the depositor is amplified. Not only is the compensation for holding cash, (lending it to the bank) low, but banks are likely to engage in more risky activities to maintain returns on equity and assets as well as to generate generous bonus pools for management.

The current environment is interesting. Interest rates are low, unilaterally depressed by most developed world central banks. It is unclear what the ultimate lenders would be happy to charge in a competitive environment to ultimate borrowers in the absence of the intermediary bank. It is safe to assume that the interest rate would be significantly higher than it is today.

Banks are unwilling to lend to private borrowers due to increased capital requirements under Basel 3 and tighter credit underwriting standards post the 2008 financial crisis. Private enterprise therefore faces a shortage of capital at current low rates of interest. Lenders or depositors face near zero interest rates, and are unable to disintermediate the banks to earn a higher return on their cash. The banks end up hoarding cash out of fear of the next liquidity crisis, (or perhaps they know something we don’t about the quality of their own balance sheets), or they invest in assets which consume little or no capital, such as sovereign bonds.

The European Central Bank’s LTROs are still not well understood even by some industry pundits. The LTRO provides liquidity and not capital. Since banks are capital already constrained, LTRO funds can only be deployed in assets that carry a zero risk rating under Basel 3 capital rules. This limits banks to investing in sovereign bonds, and rationality dictates that they invest in their own sovereign’s bonds.

Basel 3 capital rules must be one of the most effective means of crowding out private investment. Regulators beholden to governments are happy to encourage the refinancing of government debt which might otherwise struggle to find free market investors.

The result is a banking system that sweats depositors by paying them nothing for their capital, and starves the private sector of access to credit. It is hardly the picture o
f efficient free market capital allocation. The banking system has become the de facto lender of last resort to government, which is hardly the most efficient allocator of resources or producer of output.

The long term impact on economic growth must be felt.

A substantial volume of capital has been raised by various asset managers to capitalize on the imminent or eventual fire sale of distressed assets by European banks and financial institutions. Its going to be a long wait.

Mark Scott writes in the NY Times that the likes of Carlyle, Oaktree, Apollo, Cerberus, Avenue et al are raising billions of dollars in funds seeking to buy loans, bonds and other assets from European financial institutions, but that the great European fire sale has not begun. Here is why.

The European regulators definitively do not want a fire sale by their banks precisely because to do so would burn more bank capital and require further recapitalizations. Absent the risk of total and catastrophic failure, no bank would sell its distressed assets at distressed prices. From a capital perspective, it is more rational to sell performing assets at non-distressed market prices. This is typical in any liquidity crisis, one sells the higher quality assets, because they can be sold more easily and at better prices, and is left holding the poorer quality assets. It exacerbates the situation later down the road but in the immediate time frame, is the easiest, most intuitive, and emotionally inexpensive thing to do.

There was a bit of a fire sale in late 2010 early 2011 as the European sovereign crisis threatened bank failures. The ECB, however, stepped in to provide long term funding to the European banking system in December of last year, both to avert a collapse of the banking system as well as to provide capital to refinance maturing sovereign debt. The effect of this was to remove the near term stress that would necessitate the fire selling of assets. Put simply, fire sales are like amputations; you don’t do it unless there is no choice. And now there is a choice. Sit and wait and hope.

As a result of the above, on a risk and quality adjusted basis, one could say that higher quality assets are underpriced relative to poorer quality assets. The resolution to the European bank’s issues is not clear. Ideally, assets would have been placed into segregated ‘bad banks’ which would require discrete capitalization and would then wind down the problem portfolios. The pain would be shared between taxpayers who would almost certainly be called to capitalize the bad banks, and the bank shareholders would also take a hit from the valuations at which the bad assets were contributed to the ‘bad banks’. Alas, public finances are sufficiently impaired that this route is not viable.

The ECB’s LTROs but postpone a problem for which no solution has been put forward. Neither does it appear that anyone is seeking a long term resolution. Instead we have a stand off between buyer and seller of distressed assets with bid offers of 20% and wider.

It would arguably be better if the ‘bad banks’ were created and allowed to access the LTROs than the current situation where the LTROs support balance sheets with an unknown mixture of good and bad assets, with the uncertainty over the proportion of bad assets and the loss severities overhanging sentiment and thus bank’s access to subsequent capital or liquidity.

In such an environment where there is no segregation of assets by quality, there is an opportunity for privately negotiated bilateral solutions which help provide capital solutions to banks, and maintain the opacity that these banks desire. Such structured solutions typically involve the provision of first loss capital against a pre-identified pool of assets, in return for a hefty coupon usually structured as a senior claim and priced in such a way as to dominate the capital on a net present value basis. The bank then seeks from the regulator capital relief on the defined pool of assets.

Both the LTRO and such capital relief solutions buy time for the banks to either recapitalize directly or structure profitable and capital efficient carry trades to bolster capital.

All of the above discussions still do not present a solution to the debt crisis once the current LTROs mature. The macro economic issues are not the scope of this blog post.

Diversification hides a multitude of sins. The idea of diversification is to ensure that no single investment or risk factor causes a catastrophic and irrecoverable loss. Too little diversification and you become vulnerable to being taken out by a single factor or event.

Too much and you lose control and understanding of your portfolio. If you cannot recall all the line items in your portfolio and the rationale for each position then likely you are over-diversified. Over-diversification can introduce all sorts of unforeseen risks as well since the behaviour of a large collection of instruments can result in complex interdependencies which were not envisaged before. 

Complexity is a double edged sword that is super sharp, has serrated edges and often has no scabbard. In a complicated world the ability to deal with complexity and the willingness to assume complex risks can and does pay handsomely. However, taking on complex risks with poor or no understanding of them almost always results in you paying handsomely. Complexity for complexity’s sake is irrational. Arbitrage and other trades offering asymmetric risk reward characteristics require complex analysis and complex trade construction. However, complex trade construction does not imply attractive risk reward characteristics. In fact, when offered complexity prior to the risk reward proposition, the beneficiary of the complexity is likely your counterparty and not you.

So, an investment product that involves you getting this payoff unless that happens, until this date whereupon you get that, until this other thing happens unless something else happens first in which case you get the worst of the following, until the product is called, is a nice little distraction which should be analysed in the context of ‘what do I think will happen and how do I think the markets will unfold’ and ‘given my view of the world, what is the right trade expression.’ Also, it is amusing and illuminating to ask, ‘well if someone took the opposite side of this trade, what are they trying to achieve?’

Even apparently simple products like, ‘we will pay you so much per day as long as something stays within a certain range, otherwise we pay you nothing, and we may call the deal at par at anytime after such and such a date’ are made up of more basic things like a floating rate note, a swap, receivers, payers, caps or floors, and all sorts of wonderful financial novelty items like that.

If your financial advisor is recommending these cool products, don’t just buy them, ask them what these products are made up of, and what the components are, how each component is priced, how it is all put together, and priced, and who are the counterparties for each leg, how is the counterparty risk managed, how is collateral managed. If any of the answers is ‘I don’t know’ then the appropriate response is to let the great and glaring opportunity pass. Damage is multiple times more difficult to undo than it is to do.

Oh, don’t forget to ask your discretionary portfolio manager the same questions before you give them the discretion to buy these products. Nothing is good or bad, its just how you use them. 

The Euro is a chronic disease. But you can bet on the good days and bad days in Europe as the governments and the ECB sequentially crash and revive the patient.

Spain is a case in point. Its government is financially unviable, its real estate market is terminal, its banks are, with the exception of the international ones, skint, its factor prices are all wrong and its fiscal strategy is misguided.

Fortunately, the ECB will co-opt the banking system to refinance maturing Spanish government debt thus prolonging Spain’s Euro membership and liquidity even while its solvency is indeterminate.

What does this mean?

Well, it means that every so often you can buy a levered structured product called Santander, which does the majority of its business in Lat Am, in Brazil to be precise (its Argentinian exposure is tiny), which basically borrows at cheap rates and lends them either to good private credits abroad, or dodgy sovereign ones at home.

It means you can buy Telefonica, whose bonds still yield close to AAA, but whose equity is a levered cash flow pass through of telephony contracts both in Lat Am and Spain.

It means you can periodically get good assets on the cheap just when fearful investors are dumping, and you can sell it back to them again when markets stabilize and these same investors have their bouts of confidence.

Apply the above to Italy and France as appropriate.

The Euro will be an incredibly rich investment opportunity as long as we recognize a couple of things.

1. As a unified currency, it doesn’t work. Or at least it is destabilizing of domestic prices, and it encourages imbalances to accumulate.

2. European governments are wedded to the idea of the Euro and have equated it with social and indeed martial and strategic cohesiveness.

3. Imbalances will therefore accumulate until they need to be addressed. This will occur cyclically and provide the necessary directional volatility and relative value dislocations.

Don’t let it go to waste.

If anyone believed that the proceeds of the LTRO were meant to be spent buying bonds in the secondary market, they have misunderstood the raison d’etre of the LTRO. The ECB has made available this 1 trillion EUR so that banks may purchase new issues of their respective sovereign debt. They will not be making SME loans, or buying sovereign debt in the secondary market, or other sovereign’s debt within the Eurozone. The ECB is not refinancing the banks; it is refinancing the sovereigns. Once this is understood the high cash balances of the banks with the ECB generating negative cash flow is explained.

The risk of sovereign default is therefore low, at least in the next 12 months. If the risk should rise, the ECB will find some way of helping these countries refinance themselves, either through direct bond purchases at auction or further LTROs. The foregoing is therefore academic but it may be amusing to look at the refinancing risk in the next 12 months anyway.

All eyes are on Spain and Italy. Spain’s 5 year CDS spread is now 510bps, an all time high, rising from 350 bps in early February. Italy’s 5 year CDS is 470bps, from 350 bps in mid March. This year, Spain will need to refinance 46 billion EUR of debt, and plans to issue 87 billion EUR of new debt. Italy on the other hand has 193 billion EUR to retire in 2012 and a planned issuance of 245 billion EUR. Which country would you worry about more?

Well don’t worry. The ECB has been and will be the lender of last resort, directly or indirectly, to the European sovereigns. In many ways, this takes central banking to its roots. The world’s second oldest central bank, the Bank of England was established to fund William III’s military expenditure in rebuilding the Royal Navy.