Credit investing is hard enough without having to read presidential tweets and central bank transcripts. But that has been the story this year, as bond markets ebbed and flowed around perceptions of rising and falling rates. And we mean everything about the bonds – their issuance, yields and spreads.
Bank pillar 3 disclosures show that the French banking giant more than doubled its securitisation exposure over the last 12 months.
‘Securitisation is back’ was our sub-headline when we last reviewed bank pillar 3 filings from the end of 2018, observing that total exposures had increased by $48 billion during the year. Half a year on, the trend has accelerated, with $120 billion of new exposures added in the last twelve months to the balance sheets of the 11 systemically important banks we monitor.
The last 12 months have been remarkable for changes at UK councils hobbled by lender option borrower option (LOBO) loans.
After years of denying the problem, attitudes at councils are changing, typified by the toppling of Newham’s long-standing mayor last year in favour of a transformative candidate, Rokhsana Fiaz. Multiple lawsuits have been filed by councils against the biggest LOBO lender, Barclays.
Portfolio optimisers often give results that are extreme and unstable. With so many variables involved, it can be hard to decipher why. This article presents a simplified formula for a two-asset optimisation which will bolster your intuitive understanding of how a portfolio optimiser behaves and why it may behave badly.
Thomas Smith specialises in quantitative investing. He currently works in the Quantitative Analytics division of Barclays plc. Previously, he was Lead Quant Researcher and partner at Brooksbridge Capital LLP, and a member of the fixed income research team at AHL, a division of Man Group plc. Thomas holds degrees in economics from the University of Toronto and the University of Oxford.
Over the past 60 years, a rich history of quantitative research has emerged aimed at the investing community. None has had as much influence as the concept of portfolio optimisation.
According to research, portfolios do better when optimised for low risk and high returns. This has prompted the growth of passive index funds, because the idiosyncratic risks of individual stocks aren’t compensated enough, limiting the alpha that stock pickers can generate.
More recently, the idea of smart beta has become fashionable. If you divide the universe of stocks by factors such as size, momentum or value and optimise your exposure, you can outperform the index and demonstrate this using a backtest. Analytics provided by MSCI Barra or Bloomberg make this as easy as pushing a button. Today, hundreds of billions of investment dollars are being allocated to smart beta products.
In reality, the theory behind this fashion is shakier than many investors realise. When applied naively to input data, optimisation models can lead to extreme or unstable trading strategies.
Rising trade tensions with the US haven’t dampened the pace of dollar-denominated bond issuance by Chinese companies, particularly in the highly-leveraged property sector. In the last 12 months, real estate issuers in China have increased their outstanding debt by $38 billion, half of that in this year alone.
The biggest names here include Evergrande Group, Sunac and Country Garden, with most issuance done via Caribbean tax havens. Let’s look at them in more detail.
According to Evergrande’s annual report, it owns property inventory with floor area covering about 50 square kilometres in mainland China, an area the size of Chicago, as well as land held in reserve. Country Garden has about 24 square km, while Sunac boasts 150 square km of floor area, the size of Liechtenstein.
These three are just the tip of the iceberg – there are dozens more of Chinese developers whose bonds feature in iBoxx’s emerging markets corporate bond index. According to Chinese government statistics, there are about 1,200 square km of uncompleted properties in China – a floor area that if laid out flat would be almost the size of Greater London.
To pay coupons on their bonds, the property developers have to complete these buildings and then sell these properties at high prices to China’s growing middle class. While rating agencies categorise most of this as junk debt, investors such as Pimco’s emerging markets bond fund have snapped it up.
Total outstanding Chinese corporate borrowing tracked by iBoxx is now approaching the half trillion dollar mark, with $120bn in real estate alone. Shanghai property prices, measured in dollars per square foot, are now similar to London and New York. Even so, average credit spreads for the sector have tightened by 145 basis points this year. Things worked out well for Evergrande chairman Hui Ka Yan, who spent $1 billion of his own money buying his company’s bonds last October.
In June 2007, then-Citigroup CEO Chuck Prince famously talked about having to “keep dancing until the music stops”. That remark came just before the global financial crisis. In June 2019, the music may be still playing, but the notes are growing more discordant by the day.
Warning signals multiplied in the first half of June – the US treasury curve inverted, the US-China trade war intensified, and the prospect of a very real war in the Persian Gulf pushed up oil prices. Central banks have reversed the tightening rhetoric of a few months ago, and markets are now anticipating a rate cut later this year.
That sparked a remarkable rally in stocks as investors bet that Fed chairman Jerome Powell will bail them out.
The picture of S&P 500 cumulative performance this year is almost identical to a year ago, with the difference that Microsoft has replaced Amazon as the ‘tentpole’ holding up the index. Once again, holding the four biggest market cap stocks at the start of the year outperform the index itself, with a 23% return vs 16% 1)note that our capitalisation weighting is different to the free-float weighting used by S&P.
The $420bn increase in Microsoft and Facebook’s market caps this year is equal to the entire market cap of the smallest 60 S&P 500 members (the world of Mattel, Harley-Davidson and Foot Locker). The gigantism arguments we have written about before seem truer than ever: the incumbent power of tech giants makes them unstoppable, their huge R&D budgets goose their shares with option value, and regulatory threats are perceived as impotent.
For companies that lack the same dominance or R&D optionality, the alternative is to buy it in, using cheap borrowed money. In the long term, the strategy is rife with execution risks, but in the short term, investors love it.
It pays to be acquisitive in 2019
To see how, let’s filter our cumulative return chart for stocks that at the beginning of the year were in the midst of the process of acquiring others. These 76 M&A acquirers in the S&P 500, when ordered by cumulative cap-weighted return, converge on 21%, five percentage points more than the entire index.
Acquiring R&D expertise or market dominance seems to increase stock returns whether you are a media giant like Walt Disney, or a tech company like IBM or Fiserv. The only sector where investors are sceptical of M&A is healthcare, where companies such as Eli Lilly or Bristol Myers Squibb have lost ground this year.
If the market is so kind to the idea of M&A, then it makes sense to use leverage to do it. Indeed, two thirds of the $460bn of M&A deals in progress at the start of this year used cash, or a mixture of stock and cash.
Paying for M&A deals is what drove US corporates to increase their total bonds outstanding by $170 billion in the first five months of 2019 according to iBoxx data. This increase was led by the technology sector which contributed $34 bn, followed by health care and industrial goods at $24 bn and $21 bn respectively.
Although things were less frenzied than in the equity market, by their own sober standard, credit investors were fine about the new borrowing. Credit spreads for US corporates declined across the board. It’s telling that spreads of companies that borrowed the most, such as IBM or Bristol Myers Squibb, declined more than companies that didn’t increase debt.
As with equities, perhaps the M&A deals that drove the borrowing seduced investors, offering them a more compelling growth narrative than the alternative of sitting on the sidelines doing nothing. And they can ignore all the worrying recessionary and geopolitical signals because they know that the Fed has their back.
Risky Finance has crunched the year-end regulatory filings for the biggest 11 global banks. For those who aren’t subscribers to the full database, here are some of the key trends we noticed.
1) Is reducing risk increasing it?
Troubled Deutsche Bank is on a mission to cut its complex balance sheet and reduce risk, and at first sight, the numbers bear that out. The bank shrank its derivative assets by more than 15 per cent in 2018, and its total assets by more than 12 per cent.
However, Deutsche’s regulatory capital requirement or risk-weighted assets barely went down despite credit and operational RWA reductions of five per cent apiece. The culprit? An unexpected 15 per cent increase in market RWAs that was caused by the balance sheet reduction.
It sounds like a contradiction but a paragraph buried in the bank’s annual report explains why.
“The increase was primarily driven by stressed value-at-risk”, Deutsche said, “coming from a reduction in diversification benefit due to changes in the composition of interest rate and equity related exposures”.
So according to Deutsche’s calculations, that bloated, complex derivatives portfolio would actually be helpful in a 2008-style crisis when correlations all went to one, because the exposures offset one another. The idea is not totally far-fetched: remember how Gregg Lippmann’s famous ‘big short’ helped save Deutsche in 2008?
It’s a bit like saying that nuclear power stations don’t melt down when all the components are aligned properly. But what happens when things go wrong? As Deutsche Bank is telling us, when the portfolio is being dismantled, it becomes even more dangerous.
2) Steinhoff really spooked JP Morgan
It was the big story at the beginning of last year, how a South African retailer came unstuck with accounting irregularities, ensnaring the global banks like Bank of America and HSBC that extended margin loans to its largest shareholder. It was that rare thing these days: sudden hefty impairments on investment grade corporate loans.
When we published a story about it in March, we noticed how JP Morgan and Citigroup did things a bit differently, booking the loans through their securities financing business, incurring mark to market losses when the value of the equity collateral plunged in value.
A few months later, JP Morgan did something quite dramatic: it reduced its securities financing exposure by $130 billion. This wasn’t reported by any news organisation, perhaps because the disclosure to the Federal Financial Institutions Examination Council never appeared in an SEC filing.
In this disclosure, there are two types of securities financing exposure reported, and the second one in which margin loan collateral is reflected in JP Morgan’s loss-given default (LGD) model saw the $130 billion decrease. The other type of exposure stayed constant, but saw an equally dramatic rise in its capital requirement.
One might detect the hand of the New York Fed here. Until Steinhoff, JP Morgan appears to have run its collateralised margin lending on the tiniest sliver of capital. Without that advantage, the bank saw no point in operating in this market, and made a quiet exit.
3) Securitisation is back
Of course it never completely went away – the 11 banks in the Risky Finance database have $800 billion of securitisation exposure between them. But after years of slow decline after the financial crisis, 2018 was the year that securitisation bounced back.
$48 billion of new exposures appeared on the balance sheets of BNP Paribas, Barclays, Citigroup and Deutsche Bank, offset by about $20 billion of reductions at the likes of Goldman, HSBC and Wells Fargo, where legacy portfolios continue to run off.
When you look at the contribution of new securitisation to credit RWAs at the banks, you can see why they are doing it – the impact on capital requirements is tiny. And that’s the whole reason for securitisation in the first place: the tranching of exposures in a waterfall of losses which gives huge risk transfer benefits to originating or sponsoring banks.
The financial crisis cast a long shadow over this market. The most toxic parts of it, like correlation trading or asset-backed CDOs, have all but disappeared. But collateralised loan obligations are in rude health, with BNP Paribas having done $20 billion of them last year, while Barclays structured $6.7 billion of synthetic CLOs. Mortgage-backed securities origination also saw a comeback, with Barclays doing $11.5 billion of European MBS, while Citi ramped up its private label MBS and asset-backed financing to the tune of $16 billion.
These are modest numbers compared with pre-2008 but are significant nonetheless.
Goldman Sachs’ 4th quarter earnings call on 16 January was unusual, and not just because of the new management team that was present. What was notable was that the new CEO, David Solomon, devoted time to issuing an apology from Goldman to the Malaysian people.
The 1MDB fraud scandal, in which Goldman bankers paid bribes to secure Malaysian bond deals whose proceeds were stolen by corrupt officials, has become a major burden on the firm. One Goldman partner behind the scheme, Tim Leissner, has already pleaded guilty to fraud. Another, former co-head of Asian investment banking Andrea Vella, is currently a focus of investigations.
Malaysia’s government immediately dismissed Solomon’s apology; instead it wants $7.5 billion in compensation. Goldman is fighting that claim; the explanation that accompanied the apology sought to portray the bank itself as a victim of Leissner’s fraud.
Shareholders know better – the bank’s compliance failures are likely to cost it billions, whether directly to Malaysia or in US government fines (the bank is also facing class action lawsuits from investors). So how painful could this get?
Risky Finance has taken Malaysia’s $7.5 billion claim and used it as a hypothetical figure in its database of bank operational risk losses since 2008. We have no idea if and when such a claim would be paid. Just for the purpose of comparison, let’s assume that the money will have to be paid in the second quarter of 2019.
Our first chart shows the history of bank losses attributable to poor controls and fraud since 2008. The losses include the major post-crisis mortgage settlements, rogue trading losses, Libor and FX rigging fines and penalties for money laundering and consumer mis-selling. When expressed as a percentage of common equity tier one capital, we can see that a $7.5 billion Goldman settlement would amount to more than 10.3 % of today’s capital.
As a single payment that looks big, but there have been plenty of payments in the past ten years that would outrank it. To get a better idea of the scale, we’ve created a cumulative ranking of all the losses incurred by the banks since 2008. With the potential $7.5 billion 1MDB payment included, Goldman ranks in sixth place, just behind Credit Suisse and ahead of UBS.
It’s a dubious honour for the UK that the top three banks are all British, but this is a result of the multi-year payment protection insurance redress that the banks paid. Deutsche Bank is currently in fourth place, but is likely to go higher if fined for its role helping Danske Bank’s Estonian money laundering operation.
And remember that our $7.5 billion estimate for Goldman is just a baseline. Given the egregious nature of the 1MDB case, the Department of Justice might take an exemplary approach in punishing the bank. If you look at the firm’s fixed income, currencies and commodities unit you can understand why.
This was the unit that hatched the Greek swaps in 2001. It created the Abacus CDOs in 2006-7. It sold derivatives to Libya. Finally, it got to 1MDB. These aren’t a series of one-offs, but a way of doing business that no-one except a regulator appears to be capable of stopping.
A big settlement is definitely coming. The lesson is that Goldman is likely in the not-too-distant future to enter the club of permanently tainted banks, defined as those whose total operational risk losses over the past decade exceed 25 per cent of capital.
Banks in this club get change forced upon them. If their experience is anything to go by, Goldman may end up having to raise capital or sell part of its business, such as the FICC unit, in order to rebuild its reputation. David Solomon might learn that ‘sorry’ is never enough.
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