20 January 2009
The UK Treasury says it has avoided setting up a ‘bad bank’ to buy up toxic or hard-to-value assets from banks. Instead it has come up with the asset protection scheme (APS), an insurance mechanism intended to jump start the UK’s moribund loan markets without the need to bulk up the national balance sheet.
The details remain sketchy, especially the all-important valuation of the assets that the Treasury agrees to insure. There are also the far from minor details of the amount of first loss (or attachment point) above which the Treasury will be exposed, and the premium (payable in scrip) that it will charge banks for the service.
Something immediately apparent, however, is the irony of the Brown government riding to the rescue of Britain’s stricken banking system using some of the tools and concepts that helped to destroy it. Because the APS is, despite Treasury protests to the contrary, a bad bank—or rather it is a synthetic bad bank, analogous to a SIV-lite or a synthetic CDO.
Consider the Treasury’s offer of ‘protection against future credit losses’ on bank assets. Back in the halcyon days of the bubble, credit default swaps (CDS) were the protection writing mechanism of choice. A portfolio of CDS contracts was in turn the building block for synthetic CDOs, which enabled financial institutions to get paid for taking risks without the inconvenience of bank regulation or accounting.
CDSs and CDOs were touted as offering ‘diversification’ for unsophisticated investors. Ironically, a portfolio of APS contracts will similarly give the UK taxpayer synthetic exposure to all sorts of unfamiliar markets. Consider the Royal Bank of Scotland, which the Treasury envisages as the star experimental rabbit for its innovations. Surely the Treasury will have to write synthetic protection on US subprime mortgage assets that RBS is sitting on.
The word ‘synthetic’ may imply that things aren’t quite real but the credit crunch brought all of these mechanisms onto the balance sheet. But shouldn’t the taxpayer be protected by the first-loss piece of the assets that gets wiped out first?
Here it’s worth remembering that much of the banks’ synthetic credit exposures were ‘super senior’ or ‘lender of last resort’ in character. There had to be enormous writedowns on a mark-to-market basis before such guarantees were in the money, but such safeguards didn’t protect large chunks of AIG, UBS and IKB from turning into bad banks.
The Treasury is hoping that forcing APS customers to retain 10% of super-senior risks will prevent the dumping of toxic assets by banks. One hopes it is right, because requiring banks to take first loss risk on the assets it insures does not really protect the taxpayer from being exposed to some £1 trillion of loans.
If the assets are not valued at rock-bottom prices ““ and the Treasury might be pressured to go easy in this respect—any first-loss layer risks becoming a valuation fudge factor, and will be quickly burnt through. As many synthetic CDO investors discovered, subordination is meaningless when the portfolio melts down.
One final irony hinges on how the Treasury’s APS portfolio is funded. In the bad old days of the bubble, the synthetic CDO served as a water-into-wine mechanism, turning low-rated assets into high-rated tranches. These tranches could be assembled into SIVs or conduits, where the high rating could be arbitraged against low funding costs in the asset-backed commercial paper (ABCP) market.
The APS will turn toxic bank assets into high-rated securities that should attract a credit rating—and funding cost—similar to the UK government. Like an ABCP investor, the Bank of England is providing 364-day funding for such securities. The Bank gets funding from the Treasury which in turn is selling short-term government paper to the same kind of private investors that used to buy ABCP.
The UK government expects banks to turn this state-endorsed capital arbitrage into additional lending. But if the beautified bank assets burn through their subordination, the Bank of England funding will dry up. At this point the UK government would be like the sponsor of a SIV or conduit forced to take the assets onto its balance sheet. We know what happened to banks in that scenario—their short term investors disappeared. At this point the ironies become a little too ominous for comfort.
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