Transaction proposals for collateralised finance trades are still not acknowledging the appropriate risks, says Jeroen Wilbrink. Pension funds should only make their balance sheet available at the right price
During the recent credit crisis, many banks have seen their balance sheet deteriorate dramatically. In addition to the recapitalisation offered by the various national governments, these institutions have also been trying to raise funding through many new, structured transactions. Some of these transactions also aim to achieve other beneficial goals, such as moving illiquid assets off their balance sheet. Most of these structures have the same basic concept - pledging these assets as collateral to pension funds and insurance companies in secured lending transactions.
It is our opinion that in some cases the interest paid on these transactions is based on misguided risk-models and the real risks are misrepresented or misunderstood. However, if modelled and structured correctly, institutional investors can still expect decent returns, while banks receive their much needed funding.
Liquidity is by far the number one concern for financial institutions these days. Both Bear Stearns and Lehman, as well as Fortis and AIG - and many others - lost their footing because short-term financing became scarce and inter-bank lending unavailable.
Although in some cases, bad investments had a large impact on the balance sheet of these institutions, it was the so called ‘credit crunch’ that had effectively driven investors and other lenders away. As a result, lenders were prevented from providing funds to many of the banks and this resulted in a further drying up of liquidity in bank balance sheet financing.
Realising the risk with short-term funding, banks have been actively soliciting long-term financing from real money managers such as insurance companies and pension funds, and more recently we have seen a steady increase in the number of offerings of secured lending transactions. Many are variations of asset-backed commercial paper (ABCP) or various forms of repurchase agreements (REPOs) and total return swaps (TRS).
These types of collateralised finance become more and more important, with breakdown of ‘structured investment vehicles (SIVs), ABCP and other financing structures, which were used to finance assets off-balance sheet.
Among the potential lenders are some of the largest insurance companies and pension funds, and we understand that many transactions have already been closed.
The financing proposals being touted are generally based on a transfer or sale of assets by the bank to the investor, with the agreement to buy or transfer them back after a certain time period has elapsed. The funds received from this sale can under some structures be used as normal working capital.
If the assets - which are in effect held as collateral against the future buy back or transfer back - drop in value, the bank generally has the obligation to transfer more assets to the lender. This mechanism ensures that at all times the value of the assets held as collateral are equal to the loan amount.
However, if the borrower fails in its obligation to buy back or transfer back the assets, defaults on interest payments or even fails to transfer more assets to the lender under the agreement, the lender then can sell the assets in the market to receive its money back.
In short, the lender is selling securities, which under the agreement should go back to the borrower at the end of the term. This way the lender can make good any losses of the borrower defaulting on the loan.
Unfortunately the risks of these transactions are often not fully understood by the lenders or investors, or even by the borrowing bank.
Many of the banks present the risk as what they call a ‘joint default risk probability’, a term formerly associated with the pricing of structured credit instruments such as collateralised debt obligations (CDOs) and ‘first to default’ baskets.
What this is meant to explain is that a lender only loses money when both the collateral (read the illiquid securities transferred to the balance sheet of the pension fund or insurance company) and the borrowing bank default. Using historic default probabilities and correlations, many product proposals conclude that the risk is negligent and the spreads offered to lenders are accordingly low.
Unfortunately, three mistakes are being made in this reasoning. First, you do not need both bank and collateral to default to make a loss. The real risk is the bank defaulting on the loan or the interest, and if the collateral held turns out to be insufficient to make up for any losses incurred. So the securities you hold do not need to be impaired, they only need to be worth less.
This sounds pretty straightforward. However, combined with the second misinterpretation of the risk, the expected resulting losses from a default are in actual fact much higher. This second mistake as mentioned earlier, is that the correlations used in the modelling of these transactions, are based on historic observed correlations.
Many pricing models and asset allocation models assume that correlation is a constant. In reality, correlation changes over time. The very reason correlation can change is what causes systemic risk in the financial market.
For many assets such as equities and credits, or asset-backed securities such as residential mortgages or credit card loans, the correlation will move up rather rapidly if defaults occur, especially if the default occurs in the financial sector. We have witnessed such rises in correlation time many times, for example during the crisis surrounding Lehman, Enron, Parmalat and LTCM.
It is therefore quite possible that in case of a default of the borrowing bank, the resale value of the various securities held as collateral are no longer sufficient to pay for any losses the lender incurs, due to adverse market moves related to the default. One recent example which illustrates this point are the mark to market losses on ‘safe’, triple-A CDOs, investors had to endure this year.
In some cases these losses had as much to with defaults as with misjudging the moves in correlations under stressed scenarios. This assumption of using historic correlations to estimate risk has also partly led to the demise of LTCM in the 1990s, and Barings.
The third risk many lenders fail to observe and some banks fail to mention, is that the assets banks tend to pledge as collateral are very illiquid. The simple truth is that banks would not need to find long-term financing if the assets they are looking to finance are liquid and easily sold for cash. To give the banks some credit, illiquid investments are also often long-term investments, and the fact that banks look to finance them with term liquidity should be applauded.
However, illiquid assets become even more so during periods of financial sector stress, which makes them both difficult to value and impossible to sell. In the many proposals that we have seen, securities suggested as suitable collateral also included bank loans, real estate loans, CDOs tranches and even hedge fund shares. These assets are among the least liquid around, and their use as security in case of a default of the borrowing bank should be considered carefully.
When financial markets hit uncertainty, all securities will drop sharply, with possibly the exception of government issued bonds that might have a safe haven status. We are still in the midst of the current crisis, but the transaction proposals we see are still not acknowledging the appropriate risks. One other danger is that, considering the borrowing requirements of many banks, there is little incentive to educate investors on the real risks.
We do think there are opportunities in these collateralised finance trades. However, modelling the risks and analysing the collateral on offer is a difficult exercise.
To benefit from the current liquidity crunch, a pension fund or insurance company would be wise to make sure they model the risks correctly, or involve a professional counterparty to help model the risks and advise and negotiate on the pricing. Banks are willing to pay for liquidity, but investors need to make sure that when they make their balance sheet available, it is at the right price.
Jeroen Wilbrink is director of structured solutions in the asset liability management and insurance team at F&C Investments. The views expressed in this article are those of the author and not necessarily those of F&C