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Rcwhalen.com
explains MR. BRADY'S BANKING DILEMMA.
(emphasis mine) [my
comment]
MR.
BRADY'S BANKING DILEMMA
Journal of Commerce
Wednesday, April 22, 1992
By: CHRISTOPHER WHALEN
Treasury Secretary Nicholas Brady has a problem. It's an election year, the
country is in a slump that feels like a depression, and several large banks
in New York and California are teetering, perhaps on the brink of failure.
Notwithstanding the latest interest rate cut by the Federal Reserve and talk
of a "recovery" from the White House, the Cabinet's economic
cheerleader must get things moving fast if his boss is to win in November.
"It's time banks came out of hibernation and started lending,"
Deputy Treasury Secretary John Robson told bankers. "I don't think
federal and state agencies charter these institutions simply to take deposits
and invest them in U.S. Treasury securities. That is not banking."
Mr. Robson, of course, is quite right. But by stating the obvious he
highlights Mr. Brady's dilemma; namely, that banks and
other institutions helping to finance the $400 billion federal budget deficit
cannot also lend money to private borrowers. To make new loans to
Americans for cars and homes, banks must sell the Treasury paper now on their
books, and by so doing would force long-term interest rates higher,
no matter how low the Fed drags the overnight federal funds rate.
It is well known that even liquid, well-capitalized banks now avoid making
new private loans, preferring the safety of holding Uncle Sam's AAA-rated IOUs.
Yet Mr. Brady and his troops urge commercial lenders to provide new credit,
part of a larger political crusade conducted through speeches and the media
against the mysterious gorgon known as the "credit crunch."
Wall Street veteran Brady, for example, proposed to end issuance of
30-year government debt to force home mortgage rates lower, a
striking indication of the influence of the "New Economics" in
Washington. But business leaders know that even the world's last remaining
superpower (and largest debtor nation) cannot long defy the laws of
financial physics with such blatant market manipulation. […at
least not forever.]
Most economists say U.S. borrowing, on net, presently consumes
virtually all excess private capital in the economy. With capital inflows
from overseas down dramatically from the torrential levels of the mid-1980s, foreign
money is no longer available to offset federal borrowing. But
undeterred by such inconvenient facts, Mr. Brady and other monetary
accommodationists grope for the impossible: lower rates on Treasury
debt, increased availability of credit for the private sector,
and all this with stable prices and low inflation.
In fact, the much-feared "crowding out" of private borrowers by
the federal debt is at last materializing after years of warnings from
economists, a byproduct of 12 years of political stalemate in Washington.
During recent testimony, Fed Chairman Alan Greenspan referred to the
"corrosive" effect of the deficit and the "inflationary
bias" it creates in the U.S. economy.
Yet, in almost the same breath, the Republican economist admits the central
bank is considering increasing Fed purchases of long-term Treasury paper. The
central bank uses new money it literally "creates" to buy
government debt, expanding its assets - and the money supply. In fact, the
"independent" Fed has already expanded its holdings of
Treasury paper, and in recent weeks has been seen breaking an old
taboo, buying long-dated government debt, apparently in response to Mr.
Brady's public demand for lower long interest rates.
But a weak economy is not the only reason the Fed is buying government bonds.
The Office of Management and Budget reportedly believes that some of
the nation's largest banks are insolvent and likely to fail. The
total assets of banks and thrifts on the FDIC's "problem list"
jumped 26 percent to $613 billion between Sept. 30, 1991, and Jan. 31, 1992, meaning
that at least one money center bank is now on the government's death
watch.
Chastened commercial banks invest their liquid funds in government debt,
particularly long-dated paper, in order to limit credit risk and soak up an
easy, apparently risk-free "spread" between long-term Treasury bond
yields and money raised from short-term deposits.
Mr. Brady's pre-election strategy, such as it is, calls for boosting (or
at least stabilizing) the economy without actually making any positive
changes in the current fiscal policy mix, such as lowering the
federal deficit. Manufacturing renewed prosperity is
left entirely to the Fed, a dangerous gamble that ignores the true scope of
the still-unfolding economic dislocation, particularly in the East and
California, and how rising unemployment is likely to affect commercial banks
for many months to come.
Mr. Brady thinks he can either merge big failing banks and thrift
institutions with other banks, or provide covert assistance to dying
institutions to prevent a pre-election crisis - what one federal
official privately calls a "managed collapse" of the banking
industry. Trouble is, struggling behemoths such as Chemical
Bank, Citicorp, Chase, Wells Fargo and other banks cannot raise the billions
of dollars more in new capital they need to survive, unless investors
believe that both banks and the larger economy they depend upon are on the
road to recovery.
While some investors worry about government manipulation to stabilize
markets, a more frightening proposition is the notion that there is no plan,
or even the personnel with which a secret support effort might be
implemented. But President Bush cannot long avoid taking responsibility for
what many call a national economic crisis.
The last period of sustained financial instability in the United States,
during the Carter administration, resulted in double-digit inflation followed
by the speculative boom of the 1980s and the eventual deflation now in
process. Given the Fed's expansion of the money supply and purchase of
government debt during the past year, inflation will be a growing factor in
economic policy deliberations as time goes on. But the monetary policy
correction necessary to restrain price increases during even a moderate
recovery could exceed the harsh tightening seen during the early years
of former Fed Chairman Paul Volcker.
Brady's Solution:
Credit Enhancement
Efinance.org
reports that Derivatives and Global Capital Flows.
(Make sure to read the [Key Point])
Derivatives
and Global Capital Flows: Applications to Asia
by J.A. Kregel
University of Bologna
August 1998
…
II. Structured Derivatives
Most people are now familiar with standard derivative contracts used in
hedging risk, such as forwards, futures and options. While foreign-currency
forwards remain the province of bank foreign exchange dealers, most basic
futures and options contracts are standardised and traded in organised,
regulated markets. Banks also offer derivative contracts to their
clients in what is termed the "over-the-counter" (OTC) market.
But, there is no market involved in these contracts, which may involve the
stipulation of standard futures and options contracts outside of the
organised market on a bilateral basis with individual clients. However, the
majority of OTC activity involves individually tailored, often highly
complex, combinations of standard financial instruments packaged together
with derivative contracts designed to meet the particular needs of clients. These
contract packages involve very little direct lending by banks to clients, and
thus generate little net interest income. However, they have the
advantage, given the necessity of meeting the Basle capital adequacy
requirements, of requiring little or no capital, or of being
classified as off-balance sheet items because they do not represent a direct
risk exposure of bank funds. In addition, they generate substantial fee
and commission income. Rather than committing own capital, the banks
serve in these transactions as intermediaries whose services involve not only
matching borrowers and lenders, but as market innovators creating investment
vehicles that attract lenders and borrowers. This activity often requires
banks to accept some of the risks associated with the derivatives in order to
produce packages that permit them to intermediate between independent
borrowers and lenders. These derivative risks may or may not be
hedged by the bank, depending on its own proprietary investment strategy.
When hedging does occur it can be done either by physical hedging (i.e. the
actual purchase of an offsetting position in the underlying financial asset),
through the purchase of derivative contracts in organised markets, or by
producing a package which involves risks which offset those involved in other
packages (cross hedging or risk matching across clients).
The major objective of the active global financial institutions is thus no
longer the maximisation of profits by seeking the lowest cost funds and
channeling them to the highest risk-adjusted return, but rather in
maximising the amount of funds intermediated in order to maximise fees and
commissions, thereby maximising the rate of return on bank capital. This
means a shift from continuous risk assessment and risk monitoring of
funded investment projects that produce recurring flows of interest payments
over time, to the identification of riskless "trades"
that produce large, single payments, with all residual risks the
responsibility of the purchasers of the package. This process has been
accelerated by the introduction of risk-weighted capital requirements. As a
result, banks have come to play a declining role in the process of the
efficient international allocation of investment funds. Rather, they
serve to facilitate this process by linking primary lenders and final
borrowers. This means that the efficient allocation of funds to the highest
risk-adjusted rate of return depends increasingly on assessment of risks and
returns by the lender. Yet, it is the role of most derivative
packages to mask the actual risk involved in investment, and to
increase the difficulty in assessing the final return on funds provided.2 As
a result, certain types of derivatives may increase the difficulties faced by
private capital markets in effectuating the efficient allocation of
resources. By extension, if they make investment evaluation more
difficult for primary lenders, they may also create difficulties for
financial market regulators and supervisors.
These particular aspects can be most clearly seen by reference to structured
credit derivative contracts that expanded dramatically during the 1990s. Most
US institutional investors do not face unlimited investment choices.
Standard limitations restrict investments to assets with a minimum of
risk given by an "investment grade" credit rating on the issue,
and many also preclude certain types of risk, such as foreign exchange risks,
or foreign credit risk (these often are simply the result of the application
of the investment grade restriction).
This means that a large proportion of professionally managed
institutional investment funds cannot be invested in emerging markets or in
particular asset classes such as foreign exchange. Structured
derivative packages, created by global investment banks, have often provided
the means by which these restrictions could be overcome.
Structured derivatives have been used in two ways. In 1992 and 1993, in a
falling interest rate environment, they provided a means to increase returns
for money managers and then when rates started to rise to provide borrowers
with below market borrowing rates. They usually involved structured
credit notes with imbedded options. "These notes only carried a
higher coupon because they contained an embedded short position in interest
rate options. In other words, often when an investor bought a structured
note, he simultaneously sold an interest rate option. ... There is no doubt
that some less knowledgeable investors did not realize that by buying these
securities, they were selling options or engaging in leveraged bets, because
some of these features were quite cleverly concealed" (Chew, p.
54-5). The assumption behind such contracts is that the price of the
instrument underlying the contract would not change sufficiently to produce a
loss that completely eliminated the premium earned from selling the option.
The famous Procter and Gamble and Gibson cases involved contracts of
precisely this type. The interest costs to the borrower were reduced by the
amount of the option premium gained from writing a put option on interest
rates with a highly levered payoff profile.
An example closer to the present context might involve US government agency
dollar denominated structured notes with the interest payment, or the
principal value, linked to an index representing some foreign asset.
The return to these notes would be higher than US domestic rates, but the
increased yield would be accompanied by the increased risk due to foreign
exchange exposure. Such an asset might be a one-year dollar-denominated note
paying a guaranteed above-market interest rate, but with the amount of
repayment of principal linked to an index, say the Thai baht/dollar exchange
rate. Since the asset is denominated in US dollars, and the interest is
guaranteed and paid in US dollars, the notes carry a top investment
grade credit rating and would be carried on the balance sheets
of investors as the equivalent of a US Treasury bill, not as a
foreign investment subject to foreign exchange or country risks. Yet, the
above market interest rate on the note is generated by the sale of a put
option on the Thai baht at a strike price just above the current
market rate that is in fact imbedded in the contract. This is
equivalent to the buyer having purchased the Thai currency. If the
baht remains constant, the written put is not exercised and the option
premium received is retained by the writer to augment the interest rate. However,
if the baht were to depreciate to a value below the strike price, then the
buyer of the put will exercise his right under the option to sell baht at a
price higher than the market price. The writer of the option incurs a loss
determined by the difference between the strike price and the market price
for baht. Since the interest rate is guaranteed, the loss will not cause a
reduction in the rate of interest. However, the margin over the
market interest rate and any loss on the option position will be recovered
through a reduction in the amount of principal returned at maturity.
An investor seeking to maximise yield may be attracted by the guarantee on
the interest rate, and underestimate or even ignore the risk of loss in
capital value. Since the writer of an option has an unlimited
exposure, a large change in the exchange rate could cause a total loss of
capital invested.
Alternatively, this contract could have been constructed by lending the
principal (less the discounted value of the guaranteed dollar interest
payment which is invested in a one-year Treasury bill) directly to a Thai
bank by buying a bank acceptance. Again, the implicit assumption is that
the baht/$ exchange rate should remain constant so that the baht interest and
principal repayment can be converted at maturity to a dollar value equal to
the original investment of principal. If the baht devalues relative to the
dollar, then the amount available to repay the principal will be lower. The
buyer thus has the entire principal at risk, only the interest is
guaranteed. The contract arranged in this way would provide
Thai banks with below market rate funds, provide US investors with above
market returns (US rates were in decline from 1991 to 1994) and the banks
with fees and commissions for arranging the trade, but with no commitment of
capital (most US banks were emerging from the experiences of the real estate
crisis of the 1980s and were seeking to rebuild capital).
It is virtually impossible for the US investor to evaluate the use of
the funds made by the Thai bank, and there is little incentive for the US
bank to do so, since once the issue is sold, the foreign credit and
foreign exchange risks are borne by the US investor. The investor is
not only subverting prudential controls (on its balance sheet these assets
would be classified as exposure to a US entity, with investment grade credit
risk), but is in all probability evaluating the return without any adjustment
for the foreign exchange risk, even if that risk is recognised as such. There
is thus little economic interest or possibility for the market to
either assess the risk or the returns of the investment.
III. Structured Credit Derivatives
Structured products also provided the basis for the growing market in credit
derivative contracts. This was usually via credit swaps embedded in
structured notes to form credit-linked notes. The objective of a credit
swap is for the counterparties to exchange the credit risks associated with
an instrument, while retaining the cash flow characteristics. Total return
swaps "enable counterparties to swap the total economic risk attached to
a reference asset without actually transferring the asset itself. ... Under
the terms of the swap, [the first counterparty] pays [the second
counterparty] the cashflows generated by the reference asset, including
coupon payments and any appreciations in its capital valued calculated on a
periodic mark to market basis. [The second counterparty], in exchange,
pays a LIBOR-linked margin plus any depreciations in the capital value of the
reference asset." (Ghose, p. 3). A credit swap or equity swap, thus
transfers the credit risk, including the impact of a credit event on the
capital value of the asset.
[Key point: “IT WAS THE CREATION OF THE BRADY BOND THAT
PROVIDED THE RECIPE FOR THE EXTENSION OF MANY OF THESE STRUCTURED LOANS TO
EMERGING MARKETS”]
It was the creation of the Brady Bond that provided the recipe for the
extension of many of these structured loans to emerging markets. A
Brady Bond is a variety of structured derivative package in which the
developing country (Mexico was the first) uses foreign exchange reserves as
equity capital to create an investment company. The investment company
vehicle then uses the equity (i.e. the foreign exchange) to buy long-term,
stripped US Treasury bonds [STRIPS are zero-coupon securities created by the
U.S. Treasury by physically separating the principal and interest cash flows].
The investment company also issues its own fixed interest liabilities in the
form of long-term bonds (which came to be called Brady Bonds after the US
Secretary of the Treasury who held office at the time), which carry a
sovereign government guarantee, in an amount equal to the maturity value of
the US Treasury discount bonds. The investment vehicle's bonds are in fact
only issued in exchange for the debtor country's outstanding foreign bank
debt at its current market value (in Mexico's case this represented a
discount to its face value of about 35%). The principal of the bonds issued
by the investment vehicle (the Brady Bonds) is thus guaranteed by the
Treasury bonds held, and repayment in full at maturity is riskless. Additional
short-term Treasury coupon strips (which provide only payment of interest
without principal) were also purchased by the investment vehicle to provide a
guarantee for the interest payments during the first 18 or 24 months of
life of the bonds. After that, interest would have to be paid from
the underlying loans or other government sources. The interest is thus
only partially guaranteed and only riskless for the payments backed
by the US Treasury strips. Banks that exchanged their loans to developing
countries for these "Brady bonds" could then trade them in the open
market, with their values determined by changes in the issuing country's
sovereign credit rating and in US interest rates which affect the current value
of the underlying collateral -- the Treasury bonds.
Although the maturities of the Brady bonds were usually 20 or more years,
in the case of a Brady bond with a two-year rolling interest guarantee, it
was identical to buying a 20-year discount zero coupon bond, a six-month zero
bond, a 12-month zero, an 18-month zero, and a two-year zero. These
streams were default-free, so they could be considered as AAA. It was
only the interest payments to be paid after the second year that
(which could be represented as 36 zero coupon bonds with maturities running
from 30 months to twenty years at six-month intervals) carried foreign
exchange and sovereign credit risk. The Brady structure thus provided
complicated market valuation, it also provided an infinite
number of possibilities for rearranging the various pieces of the
bond into more attractive cash flow structures.
"An example would be transferring Brady bonds into a trust structure,
rearranging the cash flows and swapping them from floating USD into fixed DEM
with a bullet repayment. Investors are thus able to achieve a higher yield
than a Latin American DEM Eurobond with essentially the same counterparty
risk. The bank arranging the issue is left with a contingent default risk
on the underlying Brady bonds. There can be a loss in the case of a
default, as the residual value of the Brady bonds in the trust might not be
sufficient to cover the bank's potential loss from unwinding the cross
currency swap." (Watzinger, p. 49).
Thus, a company set up to buy Brady Bonds could issue its own
two-year bonds that would carry a AAA credit rating since the interest
payments were backed by US Treasury securities, and another series of
bonds with a twenty-year guaranteed principal value at maturity and a lower
credit rating reflecting the risk on the remaining interest payments. If this
second series could be rated investment grade, the final result would
be to transform high risk, impaired, syndicated loans of banks to Latin
American governments into low risk investment grade bonds that could be sold
to institutional investors, with a profit from the credit rating
differential as well as fees and commissions. This is called
credit enhancement, and investment banks quickly extended the
Brady principle to other types of developing country debt. Since the
first Brady issues were in Mexico (JP Morgan had produced a prototype of the
Brady Bond called the Aztec bond in 1988), this extension also appears to
have started in Mexico.
The problem facing investment bankers was thus to find structures that
allowed credit enhancement of these issues at minimal cost. The first
step in this process was the creation of an investment vehicle in the form of
an offshore trust that would buy high interest rate domestic bond (say a
Mexican government issued security, such as Cetes, which carries a AA
domestic credit rating), along with some zero coupon US Treasury bonds.
These purchases would be financed through the issue of its own-dollar
denominated bonds (no longer called Brady's). The bonds could be divided
into two classes, one class would have its principal collateralised by
the Treasury discount bonds in Brady fashion, while the other class,
backed by the domestic bonds, would carry no guarantee. The
interest would be paid by the interest generated by the peso asset. For the
rating agencies, these were credit enhanced peso bonds, and they were
assigned a credit rating equal to the Mexican government rating on its peso
issues in the domestic capital market. Since a government is always the benchmark,
and thus the domestic risk-free rate, it is almost by definition investment
grade in its own market. The enhanced bonds issued by the trust were
thus given an investment grade rating. But, as dollar bonds paying
dollar interest rates they could be sold to US institutional investors. What
the investor was in fact buying was a peso denominated Mexican government
bond, and the exchange rate risk on the interest payments. But, on
their balance sheets these were represented as if they were US investment
grade bonds. Again, the result was that US institutional
investor funds were being invested in emerging market debt, earning above
market interest rates, without their balance sheets necessarily reflecting
the actual risk involved. These structures were offered in various
combinations, but it still remains true that neither the investor nor the
bank intermediary have any direct interest in evaluating either the final use
of the funds nor the risk adjusted returns. For the intermediary there was no
risk, unless the bank was required to guarantee that it could convert the
interest payments into dollars, which only represented a risk if the foreign
currency were to become inconvertible (this is not devaluation risk, but that
it could not be traded at all). This provides one possible explanation of why
so much effort was made to prevent Mexico from suspending convertibility in
1994. Structures similar to these were used in Asia as well as in
Latin America. Thus the structured note and the credit enhanced Brady
structure provide simple examples of how funds were moved from
developed to developing countries despite the existence of prudential
regulatory barriers, and why there was little effort expended in
insuring that the funds were moving to the highest risk adjusted uses. The
buyers were interested in enhancing yield in a low yield environment, while
the intermediaries were interested in producing no risk, no capital using
vehicles that generated fee and commission income. Earnings on
structured vehicles could exceed 2% of principal.
The result of these packages is to change the credit risk characteristics
of the bonds by shifting them to different individuals. They thus allow
access for investors whose activities are limited by the credit risk
classification of they assets they can buy. "Emerging market borrowers
use total return swaps to get access to funding, or reduce the cost of it. The
borrower sells assets to a bank and enters into a total return swap. In this
swap, he receives the total return on the assets sold and pays Libor plus
spread. Consequently, the borrower raises funds while at the same time still
being able to benefit from a price appreciation of the asset sold." "Investors
use total return swaps to get access to their desired emerging market
exposure. In a number of countries, severe restrictions in the cash market
prevail. For instance, cumbersome settlement procedures, withholding taxes or
minimum holding periods. Total return swaps can be an effective means for
investors to structure a way around these restrictions." (ibid., p.49).
…
My reaction: It
was the Brady Bond which provided the recipe for credit enhancement and
Structured Credit Derivatives.
Mr. Brady's Banking Dilemma
1) Banks and other institutions helping to finance the $400 billion federal
budget deficit cannot also lend money to private borrowers.
2) To make new loans to Americans for cars and homes, banks must sell the
Treasury paper now on their books, forcing long-term interest rates higher
3) The Office of Management and Budget reportedly believes that some of the
nation's largest banks are insolvent and likely to fail.
4) at least one money center bank is now on the government's death watch.
5) struggling behemoths such as Chemical Bank, Citicorp, Chase, Wells Fargo
and other banks cannot raise the billions of dollars more in new capital they
need to survive
6) Mr. Brady and other monetary accommodationists grope for the impossible: lower
rates on Treasury debt, increased availability of credit
for the private sector, and all this with stable prices and low
inflation.
7) Fed has already expanded its holdings of Treasury paper apparently in
response to Mr. Brady's public demand for lower long interest rates.
8) Mr. Brady thinks he can provide covert assistance to dying institutions to
prevent a pre-election crisis (what one federal official privately calls a
"managed collapse" of the banking industry).
9) the monetary policy correction necessary to restrain price increases
during even a moderate recovery could exceed the harsh tightening seen during
the early years of former Fed Chairman Paul Volcker (unless the Treasury
manipulates gold and the dollar).
Structured Derivatives
1) Majority of OTC activity involves individually tailored, often highly
complex, combinations of standard financial instruments packaged together
with derivative contracts.
2) They involve very little direct lending by banks to clients, and thus
generate little net interest income.
3) The role of most derivative packages is to mask the actual risk
involved in investment, and to increase the difficulty in assessing
the final return on funds provided.
4) Global financial institutions no longer seek the maximization of profits
through channeling the lowest cost funds to the highest risk-adjusted return
5) The major objective of the active global financial institutions is now the
identification of riskless "trades" that produce large, single
payments, with all residual risks the responsibility of the purchasers of the
package.
Us Institutional Investors
1) Most US institutional investors are restricted to investments in
"investment grade" assets.
2) They can’t invest in emerging markets or in particular asset classes
such as foreign exchange.
3) Structured derivative packages provided the means by which these
restrictions could be overcome.
The Brady Bond Provided The Recipe For Credit Enhancement
1) The Brady structure provided complicated market valuation, with an
infinite number of possibilities for rearranging the various pieces of the
bond into more attractive cash flow structures.
2) The final result of the Brady Bond was to transform high risk, impaired,
syndicated loans of banks to Latin American governments into low risk
investment grade bonds that could be sold to institutional investors
3) The Brady principle was called credit enhancement and was quickly extended
by investment banks to other types of developing country debt.
4) Thanks the efforts of the US treasury, US institutional investor funds
were being invested in emerging market debt, earning above market interest
rates, without their balance sheets necessarily reflecting the actual risk
involved.
Conclusion: Virtually every one of the financial
“innovation” which have wrecked the US financial system have been
spearheaded by the US treasury (OTC derivatives, securitization, credit
enhancements, etc…). These “innovation” were driven by the
need to “prevent the collapse of the financial system through any means
possible (including fraud)”
In 1990 the financial system was insolvent. It didn’t get better. It
got worse.
Eric de Carbonnel
Market Skeptics
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