Two words excite me like no others.
They are synthetic securitisation (or, for the truly old-school, they are three words: regulatory capital trades). These deals usually involve repackaging loans on a bank’s balance sheet, then slicing them up into different tranches, and selling the exposure to a non-bank entity like an insurer, hedge fund, or asset manager through the use of credit derivatives.
In many respects, they hark back to the early days of securitisation, when JPMorgan first put together its BISTRO trades, otherwise known as the first synthetic CDOs. Banks may be genuinely offloading risk here, and the deals were called reg-cap trades precisely because they offered capital relief that’s so far been genuinely sanctioned by regulators. On the other hand, they seem to speak to some of the worst of the current environment: a pervasive search-for-yield that may see investors put their money in silly things at silly prices (for this reason, you will sometimes hear reg-cap specialists – usually hedge funds – gripe about the non-expertise of new entrants and the need to price the deals perfectly), as well as nagging concern that in fortifying the banking system post the financial crisis, we’ve simply offloaded a bunch of balance sheet risks onto other entities in a classic case of regulatory arbitrage.
In any case, I bring it up because in less than a week we’ve seen two stories published on the market, now said to be booming, first in the Financial Times and then in the Wall Street Journal. Both detail the rise of the market, with issuance described as having jumped by anywhere from 5.6 percent in the first quarter to at least 33 percent so far this year.
Those looking for a graphical representation of the recent rise of synthetic CDOs, could do worse than this chart from Deutsche Bank. It shows European deals only, but the direction of the trajectory is pretty obvious. The WSJ story also references some interesting figures from consultancy Coalition, pointing out that structured credit revenues at the top 12 investment banks more than doubled year-on-year to $1.5 billion the first quarter of 2017, exceeding the growth rate in more conventional trading businesses in the same period.
Growth in the business is not exactly a surprise, though.
More than five years ago I wrote in the FT about some of the bigger banks working hard to get the business going as a way of securing some new fees at a time when many of their other revenue streams were sluggish. In retrospect, that story’s now looking pretty prescient.
Big banks seek regulatory capital trades
Big banks are aiming to help smaller lenders cut the amount of regulatory capital they need to hold against loans in an attempt to make money from deals similar to those first created in the early days of securitisation more than a decade ago.
The big banks want to create so-called regulatory capital trades for smaller lenders as they expect demand for these kind of securitisation structures will rise ahead of regulations designed to provide more stability in the financial system.
Such trades, also known as synthetic securitisations, involve repackaging loans on a bank’s balance sheet, then slicing them up into different tranches.
The bank typically then buys protection on the riskiest or mid-level tranche from an outside investor such as a hedge fund, insurance company or private equity firm.
Doing so allows a bank to reduce the amount of regulatory capital it has to hold against the loans – a tempting prospect as banking groups are forced to hold more capital ahead of new regulation such as the forthcoming Basel III rules.
Some of the biggest global and European banks, including Barclays and Standard Chartered, are known to have recently built and used the structures to reduce the amount of capital they need to hold against corporate or trade finance loans.
But some large banks are now hoping to sell their structuring expertise and help distribute the resulting trades to buyers, investors in the trades say.
“The holy grail for some of the investment banks is to try to get some of the second and third tier banks involved, to get structuring fees,” said one investor. The trades hark back to the early days of securitisation in the late 1990s, which helped fuel the financial crisis.
“It’s almost as if you’re seeing the start of the securitisation market coming back in a very modest way,” said Walter Gontarek, chief executive of Channel Advisors, which operates Channel Capital Plc, a vehicle with $10bn in portfolio credit transactions with banks and has started a new fund dedicated to these structures.
Investors such as Channel Advisors say the yields on the deals are attractive compared with other debt securities on offer, and they are able to gain exposure to a specific portion of a bank’s balance sheet rather than invest in the entire thing. The insurers, hedge funds or private equity firms are not bound by the same, relatively onerous capital regulations as the banks. That makes it easier for them to write protection on the underlying loans in a classic case of regulatory arbitrage.”
Some more early coverage below, for those interested.
Synthetic tranches anyone? – FT Alphaville
Anti-Abacus, anti-BISTRO and anti-balance sheet synthetic securitisation – FT Alphaville
Big banks seek regulatory capital trades – FT, April 2012
Banks share risk with investors – FT, September 2011
Balance sheet optimisation – BOOM! – FT Alphaville, 2010
The idea of a shortage of ‘safe’ assets is a favorite of mine, dating back from 2011 when I first wrote about a crunch in triple-A rated assets for FT Alphaville to more recent things such as this piece for Bloomberg, and sometimes even on this blog. So it was a pleasure to discover, courtesy of Simon Hinrichsen (a former Odd Lots guest whom you should definitely follow on Twitter), a new paper on exactly this topic from Ricardo Caballero, Emmanuel Farhi and Pierre-Olivier Gourinchas. Read it for rather glorious sentences such as this one: “What is relatively new, relative to post–World War II history, is that the global economy is going through a complex structural period where the standard valuation adjustment for safe assets— via interest rate changes—have run out their course.”
Here’s a summary I wrote as part of our morning ‘Five Things’ newsletter, which you can sign-up for here.
“Want a stylized prism through which to understand almost everything that’s happened in the global financial system over the past two decades? Then take a look at this paper on “The Safe Assets Shortage Conundrum.” In it, the authors argue that savers’ desire to put their money in a reliable instrument has created a need for ‘safe’ assets that the financial system has had various degrees of success in fulfilling. In the early 2000s, the private sector tried to fill that need by creating triple A-rated bonds out of subprime mortgages. We know what happened next. After that, safe financial assets became largely the purview of governments via the bonds they sell – first the eurozone (which then experienced its own ratings problems) and then the U.S. Supply has ultimately failed to keep up with demand, however, mostly because slower growth has meant ‘safe’ governments in the developed world have been unable to generate assets at a fast enough pace to satisfy savings from emerging markets. It’s a state of affairs that will probably stick around for a long time, and one that helps explain why bond yields continue to plumb new lows, seemingly without rhyme or reason. But seriously, go read the whole thing.”
A side note: I do wonder what might constitute safe in the current environment. Yes, government debt is the clear winner here but corporate debt issued by cash-heavy, investment grade, national champion corporates – think Apple – can’t be far behind…
A recent Barron’s interview with James Montier got me thinking. In it, the GMO man answers a question about lofty valuations across both bonds and stocks that have caused consternation for asset allocators seeking good value in the market. In response, he says: “The US market is at its second or third most expensive point in history. So people are saying, ‘I either don’t understand the world anymore, or I don’t think that valuation matters anymore.'”
I think he has a point but maybe not the one he means. Valuations do matter because in a world of inflated asset prices but suppressed actual price inflation or economic growth, they’ve become the easiest and most surefire way for investors to generate outperformance, and so, that is what they are chasing. I still think Citigroup’s Matt King put it best, when he argued two years ago that something fundamental had changed in the market’s behaviour.
The crux of this argument is that markets used to be self-limiting. Prices of securities would move up to a point where their yields would become unattractive, at which time investors would trim some of their positions, causing prices to go down and yields to recover. Now the intense search for returns has altered that dynamic, with investors chasing inflows as a means of getting higher prices and higher profits.
While the notion that value investing is disappearing in a market that has moved ever upward for the past five years is not exactly new, King’s presentation here is stark. Investors have been moving in tandem, he says, making markets far more homogenous. The chart below shows investor positioning in credit markets, where the number of longs has vastly outnumbered the shorts, along with the International Monetary Fund’s herding metric. In short, investors across a number of asset classes are going mooo as one-way positioning dominates…
We often say the market can stay irrational longer than you can stay solvent. Maybe the updated version should be that the market can self-perpetuate for longer than expected.
There’s so much talk about volatility right now — and specifically the stubbornly low behaviour of the VIX — that I thought I’d do a round-up of some of my previous pieces on it.
Please note, I’m in an anti-paragraph, anti-proofreading kind of mood today. So typos and big blocks of text are ahead.
1. On the VIX
Let’s start with this one, from September 2013, about a new index trying to challenge the VIX, the index that most people associate with ‘volatility.’ For more than two decades, the VIX index run by the Chicago Board Options Exchange has been the financial industry’s go-to method for measuring expectations of volatility in the wider marketplace, with the CBOE turning the index into something of a cash cow thanks to the launch of futures tied to the gauge. VIX-related futures have in turn allowed a plethora of VIX-based exchange-traded products (ETPs) to also launch. With all that money benchmarked to the VIX, it’s no surprise that we have occasionally seen upstarts attempt to challenge it.
2. Selling volatility
Now let’s go here to this story from December 2014. About six years on from the financial crisis and deep in the era of monetary stimulus, investors are struggling to make returns and seize upon the realisation that selling volatility — whether that be through shorting the VIX or some other derivative-based method — can be a lucrative (if risky) strategy. This was the big shift in the volatility market. Instead of having a bunch of banks or hedge funds (or de facto, GSEs) sell volatility, you suddenly have a bunch of buy-side funds and retail investors who are interested and able to do so, the latter largely thanks to the explosion in VIX-related products. The big question, per the piece, is whether these new sellers of volatility are more likely to behave differently than traditional vol-sellers. Are they more or less likely to react to abrupt shifts in volatility?
3. Self-reflexive VIX
By September 2015, the VIX is again in the headlines after the unexpected devaluation of the Chinese yuan spooked markets. While the VIX did jump on this news, it was the VVIX (in effect, volatility of volatility) that reached an all-time record. Here’s my article about that: “When there’s a sudden spike in volatility, as occurred last month, the price of near-term VIX futures rises. Meanwhile, volatility players — notably hedge funds and CTAs — scramble to buy protection as they seek either to hedge or cover short positions, causing a feedback loop that encourages near-term futures to rise even further.” CFTC positioning data at the time did suggest a classic short squeeze as investors closed out their short vol positions post the spike. In effect there were said to be two major forces impacting the VIX, systematic volatility sellers as well as VIX-related ETPs that have to buy or sell futures to rebalance. This rebalancing act makes the VIX curve important, a point picked up on by Chris Cole of Artemis Capital in a story I wrote about a month later: “VIX term structure inverted at the greatest degree in history in August, so much so and so fast that many structured products that use simple historical relationships to gauge term structure switching and hedging ratios just couldn’t handle it,” he said. The concern is that the explosion in volatility-trading means more demand to buy or sell futures to rebalance, which could impact the shape of the curve itself.
4. VIX and beyond!
The proliferation of ETPs tied to the VIX is a concern insofar as it affects the volatility landscape, but it’s not the whole story. To explain, let’s go to Bill Gross, who became the poster child for volatility-sellers after publicly saying in June 2014 — while still at Pimco — that the company was selling “insurance, basically, against price movements” to juice returns in an era of low interest rates. Not once did he mention the VIX. It wasn’t until October 2014, after Gross’s abrupt departure from Pimco, that we got a better sense of what that insurance-selling strategy might mean when the U.S. Treasury market experienced a sudden melt-up, of sorts. At the time, there was plenty of talk that Pimco was liquidating some derivatives positions, which ended up having an outsized effect on the underlying cash market. The U.S. government’s report on the episode later mentioned that: “In particular, anecdotal commentary suggested that some dealers had absorbed a portion of the sizable ‘short volatility’ position believed to have been previously maintained by large asset managers. As volatility spiked on October 15, those positions would have prompted some dealers to dynamically hedge this exposure, exacerbating the downward move in yields.” Then, in August of last year, the BIS published a paper on asset managers dabbling in eurodollars including the example of Pimco in 2014, which I wrote up in a piece called “This is where leverage lives in the system.” That article contained a laundry list of potentially risky strategies across rates (viz eurodollars, futures, forwards), credit (using swaptions and swaps) as well as equities (options, VIX ETPs, etc.). What’s my point? I don’t mean to underplay what’s happening with the VIX, but my concern is that if we’re looking for potential flash points in the financial system then we may want to broaden our horizons.
Is this the end? Are you my friend?
It seems to me, you ought to be free.
You used to be mine when the chips were down.
You used to be mine when I weren’t around…
– The Doors.
Those immortal lyrics spring to mind courtesy of this Citi survey of investors:
I’ve been surprised by the suddenness with which markets appear to have shifted gears from an apparent six-year reliance on easy monetary policy to pinning their hopes on the expectation of fiscal stimulus that is still far from materializing. We’ve touched on it in our various coverage at Bloomberg but it seems this will be the theme to watch in 2017. How rapid is the tightening? How pervasive? And, crucially, can the market remain relatively resilient in the face of rising rates and investors who still have a massive long position on credit?
Speaking of which, as is becoming tradition around here, here’s this year’s list of credit coverage. You’ll notice it peters out as the year goes by. That’s because I got busy with a new home and some new work. See you in the new year and here’s hoping your 2017 be filled with all the right kind of surprises.
About a year ago, Joe Weisenthal and I started a podcast called Odd Lots, a reference to atypical trade sizes and also an indication of what we hoped would be a whole bunch of unusual subject matter. This week we published our 50th episode and I believe we’ve kept our promise.
We’ve covered everything from the evolution of bananas, to psychoanalytic philosophy, Seinfeld economics, and pirate insurance, to a Middle East highway and country music – all with a markets angle of course! Along the way, we’ve also discussed more traditional financial topics such as the 2008 crisis, ponzi schemes, oodles on market structure, central bank stimulus, exchange-traded funds, bubbles and shadow banks.
Despite this grab bag of subjects and a sometimes esoteric bent, we’ve consistently made it into the top 10 ‘Business News’ podcasts on iTunes – not least thanks to our amazing producers, Magnus Henrikkson, Sara Patterson and Alec McCabe. Here’s to another 50 episodes.
This story is about oil drilling components.
More than that, however, it’s about how energy companies are trimming the fat in some of the most basic ways possible – by standardising subsea drilling components, engineering contracts, even light bulbs. It’s at once an indictment of the oil industry, and the amount of fat that still has left to be trimmed after a period of excess, and an illustration of the degree to which technological revolution beyond shale drilling is now bringing down costs – in some cases by as much as two thirds.
… While the specs for Norwegian Sea drilling might provoke reactions akin to the oil field’s name—the Snorre—such standardized pipes and casings could hold the key to a pervasive mystery about today’s energy market: Why is everyone still drilling when prices are in the basement?
Even as oil producers have planned $1 trillion worth of spending reductions between 2015-to-2020—cutting staff, delaying projects, and squeezing contractors—they’ve continued to green-light new wells from the Norwegian Sea to Brazil, and from Uganda to the Gulf of Mexico. Those initiatives mean oil production will continue to grow, adding to the supply glut and putting downward pressure on prices.It’s a development that has both baffled and frustrated the world’s biggest producers of crude, who have been waiting for lower prices to force a rollback of global production. They have largely blamed the resilience of the world’s oil drilling on U.S. shale producers, as well as efforts to maintain market share, but the Snorre and other projects like it suggest there may be another–much more boring–culprit at fault …
In January of this year I resurfaced some of my older reporting on the peer-to-peer, or marketplace, lending industry and wrote this line in the first article about Lending Club raising interest rates for the riskiest borrowers on its platform:
It’s worth recalling the words of some investors at the time who criticized LendingClub’s lofty $8.9 billion valuation—reached partly because of overwhelming enthusiasm for all things tech-related. “These companies are really specialty finance companies, but look at where specialty finance companies trade in the public markets,” said one major marketplace lending investor at the time [of LendingClub’s late 2014 IPO].
It’s a point that, like much of my coverage, has been oft-repeated since – especially in the wake of recent news that Renaud Laplanche, LendingClub’s CEO, resigned following allegations of internal control issues and a rather sloppy ABS deal with Jefferies. My interest in marketplace lending has always been its overlap with traditional finance and the degree to which – as I’ve often written – the disruptive sector has been co-opted by the very thing it sought to disrupt. In fact, one of the earliest enterprise pieces I wrote on the nascent industry, from January 2013, included the following gems:
“The one thing about peer-to-peer lending is it’s still a relatively manual process. This business needs a lot of scale to be profitable,” said a P2P analyst.
“In order to grow this business one must really have made relationships on the institutional side,” said a P2P CEO.
“On the surface it really almost comes across as too good to be true,” said a P2P institutional investor.
More than three years later and the pressures of scaling a ‘technology’ business that still relies on direct mail for advertising, and which derives much of its value from avoiding the legacy costs (including regulation) of traditional banks, seems to have come to a head viz LendingClub’s apparently lax internal controls, funding and securitization processes.
For those interested, here’s my more recent coverage of the industry’s travails.
When credit market concerns arrive at the marketplace lenders, January 2016 – Recall that the bear case for marketplace lenders was always a turning of the credit cycle that would either produce a rise in borrower defaults or result in a dearth of funding as skittish investors cut their lending on the platform. At the beginning of this year, credit markets spasmed,and LendingClub raised rates on lower-quality loans on its platform by about 67bps as it sought to better compensate nervous investors.
More trouble in bonds backed by peer-to-peer loans, March 2016 – A rating agency slapping a credit rating on a securitization only to downgrade it eight weeks later because of faster-than-expected-delinquencies seems … reminiscent of something.
A new class action suit wants to treat peer-to-peer lenders like mobsters, April 2016 – A scoop about a class action suit that strikes at the heart of the marketplace lending model and came on top of the already troublesome Madden vs Midland Funding decision, completed the ‘doomsday duo’ of funding concerns and regulatory scrutiny for the industry.
LendingClub is turning out to be anything but a direct lender, May 2016 – The resignation of Laplanche sent LendingClub shares plunging and, more significantly, exposed one of the biggest oddities at the center of the company’s business model. While promising to democratize finance by using new technology to directly match borrowers with lenders, LendingClub has turned to a complicated network of middlemen and professional investors to fund its rapid expansion and disintermediate traditional banks.
And the latest edition of our Odd Lots podcast, which sums up some of my thoughts on the matter: