Client versus counter-party: RBS sells interest rate swaps to 19 year old

The Telegraph ran an article on a 19 year old who purchased interest rate swaps from RBS.

At a minimum, this example highlights how the distinction between client and counter-party has been lost as banks have combined lending products (mortgages) with capital market products (interest rate swaps).

This example also raises a series of interesting questions.   Did other universal banks in the UK offer this type of product?  Were similar products offered and sold in the US?  What disclosure is needed so that even a 19 year old has enough information to assess the riskiness of the product before they buy it?

One budding investor – Jessica Naraghi, 23, from Bolton – ended up with an amortising base rate collar swap even though she did not take out the loan it was meant to protect. 

Her decision, aged 19, to say ‘yes’ to Royal Bank of Scotland’s Global Banking and Markets salesman over the telephone has cost Ms Naraghi £73,000 and left her £36,000 in the red. 

Loan documents show that NatWest, owned by RBS, required Miss Naraghi to purchase the capital markets product as a condition of securing her £472,000 loan in June 2008. It said a precondition of any agreement was that the bank was “satisfied with the customer’s interest rate hedging arrangements”. 

“I wanted to purchase a commercial property,” said Ms Naraghi, who was advised by her property owning father about the merits of buying commercial real estate to generate a profitable return. “They agreed to give me a large loan but it did not go through. But they activated the swap two days before.” 

The swap taken out on June 4 capped her interest rate payments at 5.5pc but only allowed them to fall to 4.5pc and meant that she paid more interest as Bank base rates fell in 0.5pc. The £16,755 fee was paid upfront. 

When Miss Naraghi complained, she said she was told to keep paying because failing to do so would harm her credit rating. Later, in June 2009, when she instructed a solicitors firm, NatWest insisted that RBS was “in no doubt that the correct paperwork has been obtained, the correct procedures followed and a clear instruction given by Miss Naraghi to proceed with the transaction”. 

Ian Settle, NatWest’s commercial banking director in Bolton, added: “Miss Naraghi chose to enter into a hedging instrument prior to drawing on the loan and it was also our customer’s choice not to drawn down on the loan.” 

Letters from RBS Global Banking and Markets, however, suggest the paperwork was not complete. The bank wrote in October 2008 requesting “the formal trade confirmation” that it sent in June be signed and returned. 

The bank said if it did not receive the paperwork “we will assume that you have approved the terms of the transaction as set out in the formal confirmation, unless you notify us of any objections that you might have with the next five London business days.” 

Ms Naraghi said: “I never saw the man from RBS and he never explained to me that if rate goes down I have to pay a lot of money. He was ringing me constantly to take the swap. He had me under pressure to take it. But I never signed anything. It was all verbally, on the phone.” 

As the interest payments increased she called a stop last year and paid a break fee to terminate the agreement. “I refused to pay any more and they terminated the agreement and took another £36,000 from my account for termination of agreement. My account is now £36,000 overdrawn and they are intending to take legal action against me,” she said. 

RBS said it was invesitgating the complaint. “RBS has strict policies in place to ensure that interest rate swaps are sold properly,” a spokesman said. “We regularly carry out audits of our businesses to ensure our policies and procedures are robust, meet the relevant regulatory guidelines, and are followed by staff.”

Banks tighten loan terms amid property-price fears

The Irish Independent ran an article on banks tightening loan terms that could have appeared in any EU country or the US and been equally valid.

As this blog has repeatedly pointed out, it is very difficult for banks to lend money when they see the value of the collateral that would secure their loan declining.

In addition, the effect of banks tightening loan terms exacerbates the impact on credit availability caused by the frozen structured finance market.

With the structured finance market unavailable, banks have to hold onto the mortgages they originate.  With the financial regulators pushing for higher capital ratios, banks have an incentive to limit their loan portfolios.  Combining long term credit risk with limited capacity naturally leads to a focus on only highly qualified borrowers.

BANKS are making it harder for people to get mortgages because they believe house prices will keep falling and fear the economy will continue to slow down. 

The lenders are imposing tougher conditions before they will grant mortgages, a Central Bank survey on lending has found. 

Regulators said banks would continue to turn down applications for mortgages despite the Government boosting the tax reliefs it will pay new buyers this year, and banks claiming to be willing to lend. 

Although banks have cut the interest rates they charge on mortgages, at the same time they are demanding larger deposits, the Central Bank said. 

But it is not just a reluctance to lend that is keeping the property market in a price-fall spiral. Demand for home loans weakened in the last three months of last year due to economic uncertainty. 

House prices have fallen by half since the peak of the property bubble in 2007, with an international study last month concluding that prices in Ireland were now among the most affordable in the world. 

But the Central Bank survey found that lenders were being put off by the likelihood that prices would keep falling and have responded to this by making it harder to get approved for a mortgage. 

"The tightening of credit standards in respect of mortgage lending was attributed to less favourable expectations regarding economic activity, along with diminished prospects for the housing market," the survey stated. 

Hopes of an uplift in the property market have been dashed by a comment in the survey that "credit standards are expected to tighten on loans to households with loan demand anticipated to remain unchanged".

The availability of finance was the biggest stumbling block for the property market, the Royal Society of Chartered Surveyors Ireland (RSCSI), whose members include estate agents, said in a report this week. 

A lack of banking funding means up to a quarter of house purchases are now made by cash buyers. 

The RSCSI said: "On the residential side, only those in secure roles either in the public service or from high-profile, international firms are being offered mortgages, despite claims to the contrary from the banks themselves."...

A spokesman for the Irish Banking Federation said banks were engaged in prudent lending to prudent borrowers.

Despite ECB's efforts, Europe heads into credit crunch created by the bank regulators

According to a Bloomberg article, Eurozone banks are now depositing almost all of the money borrowed under the ECB's 3 year financing program back with the ECB.

For regular readers, this is no surprise as it was predicted on this blog.

• The Eurozone interbank lending market is frozen.  No banks trusts in the solvency of any other bank.

• At the same time, Eurozone banks are shrinking so they can meet the 9% Tier I capital ratio target set by the regulators.  One look at what happened to UniCredit, off 60+% when it raised capital, is more than enough to encourage management to find other alternatives, including shrinking the loan portfolio, for hitting the capital ratio.  The result is a credit crunch.

In Europe, we have a situation where not only is monetary and regulatory policy not coordinated, but it is actively working against each other.  Monetary policy is trying to promote growth while regulatory policy is limiting access to the loans needed for that growth.

I don't want to single Europe out as somehow unique.  In the US, the Fed oversees both monetary and regulatory policy.  

The Fed could require banks to provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details (no ultra transparency, no access to myriad Fed programs).  The requirement of ultra transparency would trigger banks realizing the losses currently hidden on their balance sheets.  

This includes their losses on residential real estate.  Once the losses are recognized, the banks then have an incentive to pursue one of the courses of action laid out in the White Paper on the housing industry Chairman Bernanke sent to Congress.

As Chairman Bernanke pointed out, until the housing industry is addressed, the full benefits of current monetary policy will not be achieved.

Banks are hoarding the European Central Bank’s record 489 billion-euro ($625 billion) injection into the banking system, thwarting attempts by policy makers to avert a credit crunch in the region. 

Almost all of the money loaned to 523 euro-area lenders last month wound up back on deposit at the Frankfurt-based central bank instead of pouring into the financial system, ECB data show. 

Banks will use most of the three-year loans to meet their refinancing needs for this year and next, analysts at Morgan Stanley and Royal Bank of Scotland Group Plc estimate. 

“It’s illusory to think that the measure will translate into credit generation,” Philippe Waechter, chief economist at Natixis Asset Management in Paris, said in an interview. “It will assuage some of the anxiety banks have regarding their liquidity needs. But they’ve engaged into a massive overhaul of their strategy and shrinkage of their balance sheets, which is, coupled with the deteriorating economy, not compatible with increasing credit.”...

Governments are urging European banks to keep lending to companies and individuals while requiring them to raise an additional 114.7 billion euros of core capital by June to weather a deepening sovereign-debt crisis. 

Instead of raising equity, most lenders across Europe have vowed to meet capital rules by trimming at least 950 billion euros from their balance sheets over the next two years, either by selling assets or not renewing credit lines, according to data compiled by Bloomberg.... 

Banks account for about 80 percent of lending to the euro area, making them “crucial to the supply of credit,” according to recently installed ECB President Mario Draghi. By contrast, U.S. companies rely more on capital markets for financing, selling bonds to investors.

The ECB lending, and a follow-up loan offering on Feb. 28, won’t ease the pressure on banks to shrink, say analysts including Huw van Steenis at Morgan Stanley in London. 

“The ECB loans will largely be used to pre-fund 2012 and some of 2013’s bank refinancing needs, but it will not stimulate lending,” Van Steenis said. They will “just stop it falling off precipitously.”... 

With the ECB’s injection, “deleveraging may happen in a more orderly way, but it doesn’t mean it will be painless,” said Alberto Gallo, head of European credit strategy at RBS. Banks are faced with high long-term financing costs, a deteriorating economy and difficulties raising capital, he said. “It’s what I call the double punch: A combination of negative growth and banks’ deleveraging will affect lending activity.” 

Even the ECB’s Draghi, who has made it one of his priorities is to keep credit flowing into the economy, said the central bank’s loan offerings may fail to achieve that goal. 

“Monetary policy cannot do everything, but we’re trying to do our best to avoid a credit crunch that might come from a lack of funding,” Draghi said Dec. 19 at the European Parliament in Brussels. “We have to be extremely careful here, because there may be other reasons that create a credit crunch.”...

“The ECB loans are a kick-the-can measure that doesn’t fix the banks’ structural problems,” Gallo said. “Deleveraging needs to happen.”

Wall Street analysts agree: recapitalizing Eurozone banks will not restore confidence

According to a Telegraph article by Harry Wilson, Wall Street banking analysts argue that recapitalizing the Eurozone banks will not restore confidence.

This blog has made this point repeatedly and it is nice that the Wall Street banking analysts are confirming it!

Hopefully, the global policymakers and financial regulators are listening.

The article makes another important point.  Specifically, that banks are having a difficult time funding loans.

It is this point that has driven a considerable amount of the policymakers' and financial regulators' response to the financial crisis.  They have tried to provide the liquidity and capital (think bailouts) so that the banks can keep lending.

Unfortunately, the policymakers and financial regulators mis-interpret what it takes to keep the bank lending channel open.

Yes, we need banks to continue making loans.  But, we do not need banks to hold those loans on their balance sheets.

There is a better, easier solution.  Fix structured finance.

Ironically, the fix for structured finance is the same fix for restoring confidence in the banks:  detailed disclosure.

If market participants had access for each structured finance security to detailed disclosure on the underlying assets' current performance, they would be able to assess the risk of and value the security.  This in turn would lead to both an active primary and secondary market for these securities.

If banks can distribute the loans they make into the structured finance market, then their balance sheet is no longer a constraint on their lending.

Without spending a pfennig on recapitalizing the banks, by simply bringing detailed disclosure on the underlying assets' current performance, confidence is restored and the credit markets are re-opened.

Like UBS, Morgan Stanley argues that the European Union-led recapitalisation of banks will not improve confidence in the sector and that what is needed is a new government-guaranteed funding scheme to back longer-term bonds. 

Without this support, Morgan Stanley said small business lending and trade finance loans could all be at risk of cut backs.

UK Chancellor looking to by-pass the banks to get credit to small businesses

According to a Telegraph article, George Osborne, the UK's Chancellor, has directed the UK's Treasury to look into how the government could directly lend money to small businesses and then package these loans so they could be sold in the capital markets.

The UK government would not need to do this if the securitization markets were functioning.  If they were, there would be private firms that would make the loans and sell them into the capital markets.

Regular readers know that the securitization market is not functioning because the buyers are on strike.  They went on strike at the beginning of the credit crisis and are not coming back until they have access to current performance information on the underlying assets.

The UK government could restart loans flowing to small business simply by requiring current performance disclosure on the underlying assets.

Of course, the UK government could also elect to retain the credit risk of the loans as an enticement to attract buyers.  But by doing so, it is no longer really "selling" the loans.  Instead, it is setting up the equivalent of Fannie Mae and Freddie Mac in the US - an agency where private investors do well and taxpayers are stuck with the losses.

George Osborne used his speech at the Conservative Party Conference to announce plans for "credit easing" - which is a form of quantitative easing for businesses. 

The Chancellor said: "I have set the Treasury to work on ways to inject money directly into parts of the economy that need it such as small business. It is known as credit easing. It is another form of monetary activism," he said. "It is similar to the national loan guarantee scheme we talked about in opposition." ...

However the Government could deploy public to buy corporate bonds either directly through the Treasury or via the Bank of England's asset purchase facility. This facility was set up in 2009 during the apex of the financial crisis but has hardly been used since. 

The Treasury wants to create packages of small business loans that could then be traded. 

In this way the Government support would not add to the national debt for accounting purposes because they would be a tradable asset. 

The plans also include setting up a Small Business Bank that could handle the new policy. At the Liberal Democrat Conference two weeks ago, Vince Cable used his speech to back plans for a new state-backed bank as a way of tackling the failure of banks to lend to small firms.... 

The chancellor also repeated that he would give the Bank of England the green light to engage in further quantitative easing if it decided to go for more asset purchases. 

John walker, National Chairman, Federation of Small Businesses, said: We also welcome steps to help inject money into small firms, but need to see more detail so look forward to working with the Government on this."

Insights from the FDR Framework on why banks are not lending

Four years after the beginning of the credit crisis, policy makers, economists and other market participants are asking the question of "why are banks not lending".

Historically, banks are senior secured lenders.  This role implies that they only make loans that have the following characteristics:

• The borrower has the proven financial capacity to perform on the terms of the loan; and

• The value of the collateral pledged to back the loan exceeds the amount of the loan.

If either of these two characteristics is not present, then banks are not suppose to make the loan.

Clearly, banks demonstrated in the years leading up to the credit crisis that they were willing to make loans that did not satisfy both of these criteria.  No Income, No Job loans stand out as an example of this willingness.

However, and this is a major caveat, in the years leading up to the crisis, banks viewed their balance sheet as a place to "park" the loan for a short interval prior to repackaging and selling the loan to the capital markets.  Bankers were originating loans that conformed to what could be distributed to investors.

This was different than originating loans that would be held to maturity on the bank's balance sheet.

The simple fact is that there are investors who are willing to take more "risk" than banks.  Hedge funds come to mind.

With the collapse of the securitization market and the ability to distribute credit risk, knowing that they were going to have to hold the loans on their balance sheets, banks had to make an adjustment in their lending practices so that only loans that have both characteristics are made.  In the best of times, this would have reduced bank willingness to lend.

Looked at through the prism of the FDR Framework, the lack of disclosure by financial institutions and structured finance securities of all useful, relevant information further reduces bank willingness to lend.

The mechanism by which the lack of disclosure reduces bank willingness to lend is the feedback loop between the requirement that the borrower pledge collateral in excess of the loan amount and the bank's ability to value the pledged collateral.  The lack of disclosure negatively impacts a bank's ability to value the collateral and as a result reduces bank willingness to lend.

How does a lack of disclosure impact a bank's ability to value the collateral?

The largest source of collateral is real estate and there are significant doubts about what residential or commercial real estate is worth.

Bankers know by looking at their own balance sheet that they have a sizable number of loans secured by real estate that are experiencing performance problems.  To date, these loans have received regulatory forbearance in the form of extend and pretend.

The question that bankers have to ask themselves is what would happen to the price of real estate should regulatory forbearance end and they and all of their competitors needed to sell all the underlying real estate collateral to repay the loans.  Would real estate prices drop 10%? 30%? More?

If the bank thinks prices would drop 30%, then the maximum loan amount against the real estate collateral is going to be less than 70% of current valuation.  This represents a substantial reduction from pre-credit crisis lending standards that were closer to 100% loan to value.

Most of this guesswork by the bank could be eliminated with disclosure under the FDR Framework.  With disclosure, market participants could help in the valuation of the collateral by valuing similar properties and establishing market clearing prices that are not artificially distorted by government policies.