The previous excerpt for Chapter 5 discussed the Risks of High Leverage and Funding Mismatch.
Critical Role of the Quality and Transparency of Assets
GIVEN THE HIGH leverage typical of banks, we’ve noted earlier that the level of certainty of asset valuation is critical to credit assessment. We cited Lehman’s balance sheet and “Level 3” assets as an example of low certainty of asset value in this chapter. Also earlier in this chapter and in chapter 4 we noted that the high consistency of cash flow of a company like Clorox can assuage investors’ anxiety regarding high leverage. In this case the certainty of cash flow is the surrogate for certainty of asset value for the ability to repay debt.
Yet another example is that of JPMorgan and its fiasco of 2012 in which events apparently proved that bank employees in one particular unit had reported incorrect values for certain complex derivative transactions. The estimated misstatement of $6.2 billion is much less than the $204 billion of JPMorgan equity (see the JPMorgan 10-K for the fiscal year 2012). Thus one might consider the loss to be “small,” but the market value of equity fell by roughly $50 billion in the aftermath of all the news. One reasonable interpretation of this amplified market reaction is that investors updated negatively their view of JPMorgan asset value uncertainty.
Though a reasonable example, we must add some caveats to this story. First, it’s not truly possible to observe a market move and state with high confidence why it happened. While our interpretation is plausible, it’s likely an additional contributor is market concern that governments or regulators would punish JPMorgan in some way and therefore diminish its future earnings. Second, the JPMorgan stock price did recoup its losses in the ensuing eight months. Third, we use stock price here as a proxy for the lender concern for asset value uncertainty. While negative reaction of the equity to these events is a fair indicator of negative reaction of lenders, the indicator is indirect and not readily quantified.
As a qualitative summary of this JPMorgan saga, the market learned that this bank’s asset values were more uncertain than previously understood. Much of the reporting focused on the exotic nature of the disputed assets and the convoluted and subjective valuation techniques. The message to investors was “almost nobody understands these trades.” This absence of “transparency” aggravates lender discomfort with high leverage.
Asset quality and transparency also impact directly the funding of banks. Short-term repurchase (“repo”) transactions are critical to bank funding – especially to the investment banks such as (pre-bankruptcy) Lehman, Goldman Sachs, and Morgan Stanley. In effect, the borrower in a repo transaction pledges collateral. See figure 5-3 in which we make it clear that repo trades are, contractually, sales and repurchases of the underlying collateral. The “best” collateral for U.S. dollar repo funding is U.S. Treasury debt securities (also known as “Treasuries”). Treasuries have very high quality (i.e., very low default risk) and are extremely understandable (“transparency”) with universal high confidence that there will be an active market in Treasuries in any conceivable distress situation.
Figure 5‑3 Diagram of repo transaction
While banks do employ Treasury collateral in repo funding, they also borrow through repo with other collateral types. When markets are stressed, there is no assurance that borrowers will be able to find repo lenders for any collateral other than Treasuries. The most notorious form of questionable collateral falls under the heading of “ABS” (“asset-backed securities”). Both the quality and transparency of ABS as collateral are suspect regardless of the credit rating. Hence, ABS collateral is unreliable for funding purposes.
As we noted earlier, the flow of this chapter follows the typical logic of banking credit analysis in which the analyst first reviews the “stand-alone” credit risk of a bank and then considers the benefit of government support. Dominant forms of such support are deposit insurance, the Central Bank “lender of last resort” capacity, and equity injection (or seizure) with the intent to honor debt payments to some or all creditors. Deposit insurance, as we discussed, is already present. Thus, standard analysis of banks assumes deposit insurance remains unaltered.
The CB “lender of last resort” is in the middle ground between “already present” and “potentially available.” Normal, “already present,” procedure for CBs is to stand ready to lend to banks at a moderately high interest rate in exchange for high-quality collateral. We discuss this and other practices of central banking in a later chapter. But CBs can and do relax either or both of these criteria (interest rate and collateral quality) on occasion. One example is the European Central Bank’s (ECB’s) establishment of the Long-Term Refinancing Operation (LTRO) in late 2011. The ECB made approximately €1 trillion available to Eurozone (also known as “euro area”) banks at a low interest rate and with collateral including ABS with valuation of this collateral arguably skewed in favor of the banks. This relaxation of criteria is a form of support that creditors may hope will be available to repay their loans.
Government bailout (or “capital injection”) is the clearest expression of support for banks. When a third-party such as a government guarantees a borrower’s debt obligation, credit analysts generally assign the guarantor’s credit quality to that of the guaranteed obligation. A challenge of incorporating “bailout” into banking credit analysis is that there is no written guarantee. The government may “save” the creditors of a failing bank or it may choose not to do so. To form judgments of the likelihood of bailout support, credit analysts consider the history of action of the relevant government as well as recent statements of politicians and central bankers.
One fascinating example from recent times is the failure of Icelandic banks in 2008. The largest banks (Glitnir Banki hf, Landsbanki Islands hf, and Kaupthing Bank hf) all failed in September-October of that year due to runs on bank deposits and failure to roll other short-term debt. More than a year earlier, Moody’s (Moody’s Investors Service – one of the large credit rating agencies) raised its ratings of the default risk of the banks to its highest (i.e., “lowest risk”) level of Aaa. Moody’s reasoned that the Icelandic government had made it very clear that it would support these banks to prevent their failure. Since this government enjoyed a debt rating of Aaa, Moody’s gave the banks the same rating.
In the world of credit ratings, experts declare a rating failure when a rated entity defaults on its debt if this entity had an investment-grade rating a year or less prior to the default. For Moody’s, “investment-grade” means a rating of Baa3 or higher. To default from the Aaa level is the worst imaginable outcome and a much greater error than moving from Baa3 to default. The most evident flaw in the Moody’s 2007 Aaa assessment was that all of these banks were arguably too large for the government to save. (The assets of the three banks were more than ten times greater than Iceland’s annual gross domestic product – GDP. It is difficult for a sovereign to manage its own debt when it reaches just one times its GDP level.) To save all three simultaneously was out of the question. Thus, the Icelandic government “guarantee” had far less value than Moody’s realized.
Government support in the forms of deposit insurance, CB “lender of last resort,” and bailout potential certainly does reduce the default risk to bank lenders. But the support is weaker than a guarantee. To address more quantitatively the benefit of typical government support for banks, a study by Fitch (FitchRatings) – another large credit rating agency – finds that the five-year bank failure likelihood falls from nearly 7% to just over 1% due to this support. This “unsupported” 7% default likelihood is typical of a non-investment-grade, BB credit rating.
This historical finding of Fitch that the observed credit quality of large banks is below investment-grade in the absence of government support is the only study of this kind of which we are aware. It is desirable to have similar studies from other sources that also cover different time periods. Yet the conclusion of this single study is critically important and we shall emphasize the result. With the high-leverage structure and managements’ choice of short-term funding for long-term assets, banks are inherently risky (below investment-grade credit quality) and deliberately rely on government support to run their businesses. Reliance on support necessarily implies that the banks are “risky” from the perspective of the support provider (i.e., the taxpayers of the host country). If governments or bank regulators wish to put an end to bailouts while maintaining some reasonable level of bank safety, the leverage and funding mismatch of banks must change substantially.
The next and final excerpt for Chapter 5 will ask “Who Understands Banking Risk?”
 See “JPMorgan Chase Whale Trades: A Cash History of Derivatives Risks and Abuses,” Staff Report, United States Senate Permanent Subcommittee on Investigations, March 2013.
 In an accounting rather than legal perspective, repo transactions are collateralized loans. Contractually and legally, the same transactions are purchases and re-sales.
 J. M. Pimbley, “The ECB should stop taking counterfeit collateral,” Creditflux, February 2012.
 See, for example, “Moody’s Blasted for Giving Icelandic Banks Top Rating,” Bloomberg, February 26, 2007.
 See “The Evolving Dynamics of Support for Banks”, FitchRatings Special Report, September 11, 2013. This study covered the limited period of 1990-2012. Also see “Sovereign Support for Banks,” FitchRatings Special Report, March 27, 2014.
 See “Fitch Ratings Global Corporate Finance 2012 Transition and Default Study,” FitchRatings Special Report, March 15, 2013.