Tag Archives: balance sheet management

A Trillion Here, A Trillion There, Pretty Soon You’re Talking About Real Money

What a way to start out the week:

The European Central Bank, the Bank of England and the International Monetary Fund have all recently warned of a looming crunch, especially in Europe, where banks have enough trouble raising money as it is.

Their concern is that banks hungry for refinancing will compete with governments — which also must roll over huge sums — for the bond market’s favor. As a result, credit for business and consumers could become more costly and scarce, with unpleasant consequences for economic growth.

via Crisis Awaits World’s Banks as Trillions Come Due – NYTimes.com.

Wow.  I didn’t know I could get a S**t Sandwich special first thing on a Monday…

And in case that wasn’t enough, they threw in a menacing chart for emphasis:

And just in case you still didn’t get the message, there’s this quote from the article:

“There is a cliff we are racing toward — it’s huge,” said Richard Barwell, an economist at Royal Bank of Scotland and formerly a senior economist at the Bank of England, Britain’s central bank. “No one seems to be talking about it that much.” But, he added, “it’s of first-order importance for lending and output.”

And so this is where I roll out one of those Minsky charts that illustrates this.  Oh, wait:

But why all the fuss over banks being able to roll the debt over?  Forget the amount for a second.  The key is to look at the average maturity:

A study in November by Moody’s Investors Service found that new bond issues by banks during the past five years matured in an average of 4.7 years — the shortest average in 30 years.

Now why does that matter?  It matters because there’s this issue called a maturity mismatch, where the assets and liabilities have different maturities.  Usually the assets are longer dated than the liabilities because when a yield curve is upward-sloping like this (from the FT)…

The incentive is to borrow short-dated funds and lend on long-dated assets.  I’ve covered this in similar ways before talking about duration hedging in the past where you measure sensitivities to interest rate moves, and this follows in a related vein.  When the yield curve inverts, or you have rate shocks at the front-end of the curve, you can find yourself in a precarious position if you have a lot of paper to roll.  Which is exactly where a lot of banks are finding themselves now.

But take a look at this section from the article (emphasis mine):

The financing crunch has its origins in a worldwide trend for banks to borrow money for shorter periods.

The practice of short-term borrowing and long-term lending contributed to the near-collapse of the world financial system in late 2008 when short-term financing dried up. Banks suddenly found themselves starved for cash, and some would have collapsed without central bank support.

Government bank guarantees extended in response to the crisis also inadvertently encouraged short-term lending. The guarantees were typically only for several years, and banks issued bonds to match.

So the maturity mismatch issue played a huge role in getting us into this mess, and the government’s response may very well end up in exacerbating the problem.

Brilliant… I might as well go build a house and then torch it myself…

And Tim Backshall has a very interesting chart that shows the spreads between senior bank debt and sovereign are highly correlated and compressing.  That means the lines between sovereign and bank debt in Europe are getting blurrier:

One other facet about this problem: the link between external bank funding and Euro Libor:

Bond issuance by financial institutions in Europe plunged to $10.7 billion in May, compared with $106 billion in January and $95 billion in May 2009, according to Dealogic, a data provider. New issues have recovered somewhat since, to $42 billion in June and $19 billion so far in July.

My take: proof positive that the funding crisis for European banks is ongoing and getting worse.  How so?  Simple.  Longer dated bond issuance has fallen, which has led to a change in the maturity profiles of European bank liabilities.

Because the banks are rolling into shorter-dated Libor based funding…

Which has lead to the run-up in the Euro…

One way to mitigate this risk is matched maturity funds transfer pricing – where the asset side of the balance sheet has the same maturity profile your liabilities has.  I’m going to leave you with this paper which I also posted on Scribd:

And a link to this post by Don van Deventer at Kamakura, that has some really good ideas on how to implement funds transfer pricing effectively.

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Why LIBOR and Obscure Funding Market Metrics Matter

My friend Tim Backshall sent me this yesterday, which I think is worthy of considering for a couple of reasons:

First, the information he encapsulated in under 140 characters is fantastic stuff.  Noting rate rises like this – especially when a high/low like this is reached – is important stuff.

But there’s another reason, too.  It’s because commercial paper and overnight funding matters tremendously.  But to understand why, let’s look at a yield curve:

To build it, you need two things: an interest rate and a timeframe/duration of the credit.  Now to be fair, the CP market and the money markets are not the same as the bond markets.  They’re supposed to be safer, largely because they should be more liquid, the borrowers are supposed to be high quality credits, and the durations are usually really short.  Boring stuff.

But it’s been anything but boring…

The U.S. market for short-term IOUs, commercial paper, declined $10.2 billion to $1.06 trillion in the week ended June 2, the lowest since at least 1999, data compiled by Bloomberg show. Without seasonal adjustment, debt outstanding fell $5.5 billion, the fifth straight week of declines, to $1.05 trillion, also the lowest on record.

In Europe, financial companies’ overnight deposits with the European Central Bank rose to a record amid bank wariness of lending to each other during the continent’s sovereign debt crisis. Banks placed 320.4 billion euros ($389.9 billion) in the ECB’s overnight deposit facility at 0.25 percent, compared with 316.4 billion euros on June 2, the central bank said. That’s the most since the introduction of the euro in 1999.

via Loan Selloff Forcing Borrowers to Boost Rates: Credit Markets – BusinessWeek.

Here’s the latest and greatest charts that show the ongoing decline in commercial paper here in the US.  One is for ABCP (asset backed commercial paper) and the other is financial commercial paper.

Tim also put this out on Scribd, which shows bank lending and CP combined:

And in case you ever wanted to know what these instruments ever were, here’s the definitions:

Commercial paper consists of short-term, promissary notes issued primarily by corporations. Maturities range up to 270 days but average about 30 days. Many companies use commercial paper to raise cash needed for current transactions, and many find it to be a lower-cost alternative to bank loans

via FRB: About Commercial Paper.

As long as they are willing to continuously roll the paper over and the curve stays upward sloping, it can be.  But when the yield curve inverts, it gets expensive really fast.  So it’s generally not a good idea to rely heavily on the front end of the curve to finance, well, anything.  Duration matching, an interest rate risk management technique where your assets and liabilities are neutral to changes in interest rates, is a straight forward way to do this:

But why are they important?  Well, with short durations comes correlation to Fed funds.  And so through the Fed funds lever, the Fed tries to influence the nature of short-term rates and maybe long term rates by extension.  But truth be told, longer term rates are not as responsive to Fed actions as the front end of the curve.

But the Fed only regained its influence over the short end of the curve by moving to a target range on Fed funds (instead of a target rate) and by purchasing all those RMBS.  How do we know?  The spread between high/low quotes in daily effective Fed funds:

The dampened volatility of the recent past will only stay that way for so long.  Because like with European CP and European banks, we can see everything that’s happening over there happen over here again.  Why?

Our banks lend to theirs…

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A Few Brief (But Hopefully Deep) Thoughts

John Authers at the Financial Times has an excellent article out about synthetic CDOs.  I’ve been discussing this with some folks, and we seem to be on the same page.  I think there’s a serious question about the behavior of the parties involved on all sides of these transactions.  While I think ultimate culpability lies beyond the agents involved, I think it’s safe to say we have to have better, clearer lines of demarcation about what’s acceptable and what isn’t.  I won’t get into more depth here, that’s what a book is for.

About the Goldman emails: that seems like there’s a lot more smoke than fire.  I don’t begrudge Goldman for making the trades they did, when they reached that point of recognition in December ’06.  In fact, if anyone bothered to ask me while I was at Wachovia in their corporate treasury, I would’ve begged to offer that we needed to take many of the same actions.  Would I have recommended going the same size as Goldman did?  Probably not, but it would’ve helped the bank avoid being embroiled in this with Citi and Wells Fargo later:

But alas, I was already gone from the bank and they decided to purchase Golden West.  Or as I refer to it: Money Store, Part Deux.  Kind of like “Hot Shots Part Deux!” except much more overvalued…

When is a hedge not a hedge?  When it becomes a directional trade, of course.  And the only difference between the two at that point is the size of the exposure.  Would I have advocated legging into a long position on ABX and CMBX protection?  Absolutely.  Would I have also advocated winding down and selling the loans we had, in spite of the losses on the balance sheet?  Yes, because it’s like dealing with Band-Aids.  Do you try to p e e l it off s  l  o  w  l  y or just rip it off?  Rip it off, of course.

That is all…

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