Wednesday, January 30, 2008

Prepare for return of a direct lending world

(John Dizard in the FT) At the beginning of the year I floated a deliberately heretical thought: that it would be impossible to recapitalise adequately the US banking system with new investments of actual cash. Instead, I suggested, it would be necessary to return to a discarded 1980s concept. Not padded shoulders for power suits, though that might help as well, but "supervisory goodwill". That was an accounting tool used by US regulators to allow weak and reorganising depository institutions to meet their capital requirements by using a sort of pretend equity. By the end of the decade, supervisory goodwill, at least under that name, was prohibited by an act of Congress.

I was hoping for a blast of angry mail from readers, particularly those at regulatory agencies and central banks. It never appeared, since it turned out that there was a lot of re-thinking about bank capital adequacy being done by the official and semi-official world. Heresy and irresponsible suggestions were, at least for a moment, allowed.

In the space of just three weeks, though, forced writedowns of asset values, surprising disclosures and the consequent market reactions are forcing a new consensus within the central banking world. There isn't a lot of time to play with what-if's. The "ifs" happened.

Wall Street and the City have been waiting for a series of magical events that will allow the securitisation machine to re-start. Recapitalising the monoline insurers, one-time injections of new equity for banks from sovereign wealth funds, a revival of stock market confidence; all those were, collectively, supposed to revive off-balance-sheet lending.

That's not what the central banking world is thinking. The official world, and those close to it, are anticipating that we're going back to an on-balance-sheet financial industry. That is, the extension of credit will be done, to a much greater degree, through direct lending by depository institutions rather than through the securitisation of structured products. The frenetic expansion of securitised and, it was supposed wisely distributed, risk turned out to be not quite so wise after all.

The problem with putting credit on bank balance sheets is that those balance sheets aren't big enough to cover the losses from past practices and to continue to expand credit at an adequate pace. Shareholders' equity and reserves aren't there, at least in the necessary size.

Very true, the central bankers will say. So we'll just have to get some new shareholders. The "real money investors" are there, and not just the sovereign wealth funds. What about the present shareholders, I ask, my face turning white? As Colbert memorably said: "A banker is a soldier in the service of the state." So perhaps the rally in bank shares might be a little premature. The central banking world is expecting a serious shake-out of individual and perhaps institutional participants.

New money will come in to recapitalise US banks, and perhaps eventually the European banks, but it will demand seniority to existing shareholders. And it will get it. The central banks do care about the capital adequacy of the institutions they oversee and to whom they grant cheap funding. But if mistakes were made under an old regime, then the people who bet their money on that regime are just out of luck.

It won't be enough, of course, to simply assign existing bank shareholders to the role of cannon fodder. The new shareholders have to be given some assurance that there will be sufficient operating cash flow to take care of them, and to finance any further write-offs for, say, losses on leveraged buy-outs or credit cards.

What follows, I believe, will be steep yield curves for some time. Net interest margin, not deal fees, is in the end what the banking business is all about. The central bankers are less comfortable talking about this implication, but it would seem inescapable. The steepness of the yield curve has to come more from low rates at the short end than high rates at the long end, or those McMansions will be underwater for a lot longer than the political system can bear.

During the transition to a new set of shareholders, who will profit from the on-balance-sheet world, the central banks will probably be willing to have case-by-case exceptions to the rules on capital adequacy. They are opposed to black-letter, across the board, permanent changes in capital adequacy rules. Write-offs can be stretched out a bit, or ratios allowed to run a bit thin, but there is not the intent to adopt the let's-pretend style adopted by the Japanese banking system in the early 1990s.

As for the rating agencies . . . there will be a quiet demotion, rather than a purge. Central bankers believe the agencies will not have the same significance in an on-balance-sheet world. During securitisation's heyday, they enabled the other participants in the obscuring of risks. Structured finance isn't over, but the lack of transparency effectively allowed by the abuse of the ratings system has been noted. We're not going back to the pre-structured finance world, but it will be much simpler, and subject to much better disclosure.

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