Monday, 20 August 2018

Running for cover…

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Anthony Peters warns against the re-emergence of some murky pre-2008 structures.

AFTER A PERIOD of relative torpor – the two main themes in the office have been whether the ECB would succumb to quantitative easing, and where we would go to buy lunch – there was a brief period of frantic activity towards the end of the week. Admittedly, this had little to do with clients trying to buy or sell bonds, but came instead from a problem highlighted by one of the Swiss pension funds we service.

Under the new BVV2 law governing pension funds that took effect on July 1, asset-backed securities will be classified as alternative investments and placed in the 10% bucket reserved for such products. Initially, the rules have created a bit of a grey area for covered bonds such as German Pfandbriefe, French Obligations Foncières and Spanish Cedulas. Until, that is. the regulator got his knickers back out of a twist and ruled that standard covered bonds wouldn’t be dumped in the alternative bucket.

That helps, but does not detract from the fact that even plain vanilla prime residential mortgage ABS has been lumped in by the Swiss with CDOs and whatever the hell else investment banks are currently dreaming up in an attempt to offer supposedly above-market returns for – yes, you’ve guessed it – below market risk. The mind boggles.

So on one hand we have a regulator in one country slamming the door on an asset class which, in its worst form, caused endless pain during the financial crisis – one might argue (falsely) that it in fact caused it – while in another, the Bank of England vocally favours more securitisation.

ALL THE WHILE, we now have the news of Goldman Sachs preparing to blow open the entrance to the cave where all the structured credit nasties were supposed to have been banished for eternity. Enter, stage left, the Fixed Income Global Structured Covered Obligation – synthetic tranches to you, me and anybody who saw the world blow up as hidden time bombs packed into black-box structures went off in 2008 like pigeons scattering when a gun is shot.

The structure purports to be the first cousin of a covered bond, which is – were the Swiss, among others, to be consistent in their thinking – in some respects more dangerous than ABS. Covered bonds are used for funding an abstract portfolio which can and does change all the time. The portfolio which it is initially financing might, within a relatively short space of time, become something entirely different of and over which the investor has neither a clue nor due influence.

Investment criteria for ABS products and even CLOs and CDOs tend to be very tightly defined and even more tightly monitored. The assumption that covered bonds are safer than ABS is usually based on over-collateralisation assumptions and the knowledge that the eligible portfolio assets are tightly regulated.

Remarkably, covered bonds in their own way breach the first rule of bank lending, which is never to take a credit decision based primarily on the security offered. Lending should take place against the quality of the asset that is being financed and the steadiness of future cash-flows which it generates. ABS offers a defined and visible portfolio of assets. They might, as in the case of subprime RMBS, be lousy assets but at least they are transparent.

The secret of covered bonds is in the opaqueness of the underlying asset book and that, in the hands of Goldman’s structuring people, is a scary mix which would give me sleepless nights.

To me the whole thing looked just like some of the synthetic CDOs with unlimited substitution rights we used to build and distribute before the crisis. So I called a friend who has forgotten more on the subject of structuring than I am ever likely to know. He appeared to have, at least on the information available, the same impression.

Goldman is busily pushing out a boat we thought had gone down in 2008 with all hands on deck

SO THERE WE are – on one hand we have legislation trying to define even the simplest of asset backed securities as Frankenstein investments, while Goldman is busily pushing out a boat we thought had gone down in 2008 with all hands on deck. Changing the colour in which a product is sprayed does not change the product. We saw Third World debt go under, be renamed LDC, go under again and return, reincarnated under the name of emerging markets. Difference? Don’t ask me.

Are we about to start to play the same game in the structuring space? Let’s face it, there is far too much money to be made from slicing and dicing risk until buyers can no longer evaluate what there is and what there isn’t for the investment banking community not to want to get in there again. Trust the best of breed to lead the way.

When it all goes wrong again, and wrong it will go as sure as eggs are eggs, the banks will declare that it’s really not all their fault because all they were doing was filling investor demand for yield. Truth is, they’re not entirely wrong. And yet, the crux seems to be the disconnect as to how authorities think they are protecting themselves and their taxpayers and what those taxpayers expect to see in their savings pot when they retire.

Over the years I have seen any number of exciting new products brought to market. They find demand and sell out. The next issue is then either a little bit tighter or it engages in a little more risk. Incrementally, over time, the structure becomes ever riskier for ever less return but as P. T. Barnum already knew, there’s a sucker born every minute. That in the investment business most of those suckers have MBAs, PhDs and CFAs is neither here nor there.

Rather than running around throwing sticks into the spokes of the mainstream investment business while evidently trying to win the last war, authorities would be well served if they listened to market practitioners and heeded warnings of where risk is building up again. Putting “covered” in the title offers no guarantee.

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