Hedge Fund Manager Paul Singer renews call for transparency

Approximately one year ago, this blog carried a post on hege fund manager Paul Singer, who like your humble blogger was publicly recognized as predicting the financial crisis.

At that time, Mr. Singer was critical of the Dodd-Frank Act for its failure to bring transparency to the financial system and its reliance on regulators to effectively monitor the Too Big to Fail banks.

Mr. Singer is back with a letter to investors in his Elliott Management funds which once again sounds themes that are very familiar to regular readers.

In a NY Times Dealbook article on the letter, Mr. Singer observes:

A great deal of stupidity has chipped away at the massive advantages of Western civilization, which could terminally decline if it remains on the current path. But these problems can be solved — and swiftly ....

This observation confirms the long term economic impact of the Japanese model for handling a bank solvency based financial crisis (preserve bank capital and only recognize losses as banks generate earnings to absorb them).  The US, UK and EU policies since the beginning of the financial crisis reflect this model.

As shown by Japan, the impact of the Japanese model and its supporting fiscal and monetary policies is long term economic decline.  In Japan's case, its economy has shrunk over the last 15 years.

This observation also supports the idea that adopting the Swedish model for handling a bank solvency based financial crisis and requiring banks to recognize all of their losses today will bring a quick end to the global financial crisis.

Mr. Singer is generous with his ire, directing it at the United States,  the European Union and Japan, and offering a critical assessment of the sorry state of affairs in the world marketplace. 

Here is a current snapshot of the U.S., Europe and Japan: the financial sector is overleveraged and opaque. Fiscal, tax, and regulatory policies are unsound and not oriented toward growth and efficiency. On a long-term balance sheet basis, these countries are insolvent, with no hope of paying presently promised benefits regardless of the level of growth achieved or tax rates charges. Monetary policy is extreme and experimental. None of these assertions is refutable...

The financial sector is opaque and, with the blessing of regulators, hiding losses.

He goes a step further, too, arguing that “the epoch of investor confidence in money backed by nothing is coming to an end.” 

As he often has in recent letters, Mr. Singer spends pages railing against the Federal Reserve for buying bonds, printing cash and keeping interest rates at or near zero percent. 

“This policy is arrant idiocy and is likely to ultimately lead to serious inflation, a risk that governments continue to ignore at their peril,” he writes.

Whether it leads to serious inflation or not, Mr. Singer joins Bill Gross, Charles Schwab and Walter Bagehot in thinking that the zero bound for monetary policy is at an interest rate greater than zero and more like Mr. Bagehot 2%.

Mr. Singer spells out a clear casualty of pursuing a zero interest rate monetary policy:  investor confidence in money backed by nothing.

The peril he spells out for Europe, meanwhile, is much more immediate. He points out the circle of codependency between the nations and their banks: the nations support the banks to keep them from falling prey to markets, but the banks support the nations, too, by buying their debt. 

In the next global trading crisis, characterized (as it may well be) by the cascading transmission of losses from one opaque, overleveraged institution to another, the survival of any given commercial or investment bank (or group of such institutions) is likely to depend more on the perception of the creditworthiness of the sovereigns which stand behind them (and the sovereigns’ willingness to actually do so) than on any analysis of the fundamentals of the afflicted institutions....

By adopting the Japanese model, nations have to stand behind their banks to inject capital should a bank's book value fall.  As a result, there is a circle of codependency between banks and sovereign.

Under the Japanese model with its emphasis on protecting the level of capital at the banks, opacity is a policy requirement.  For example, regulators have given RBS's Stephen Hester permission to hide the losses on and off the RBS balance sheet and only recognize them as RBS has earnings to absorb them.

If the Swedish model were adopted, nations would only stand behind the bank depositors.  This breaks the circle of codependency.

Under the Swedish model with its emphasis on protecting Main Street and requiring banks to recognize the losses on and off their balance sheet, transparency is a policy requirement.  If banks disclose their current asset, liability and off balance sheet exposure details, market participants could see that all their losses have been recognized.

Back home, a bevy of regulation in the wake of the financial crisis has done little to shelter the system from risk, address leverage or puncture the veil of secrecy at large financial institutions, he writes. 

The argument is context to his real point, however, about impending  regulation of hedge funds: “It is worse than pointless.”...

“We wonder if the Securities and Exchange Commission, the regulatory body tasked with policing hedge funds in the U.S., has the sophistication and resources to sniff out issues related to the myriad of complicated trades, strategies and securities that these firms manage,” he writes, before throwing some salt on a particularly sensitive wound at the agency. “Hopefully this new crop of regulators will be more astute than those who ignored a 15-page detailed analysis of the Madoff fraud that was handed to them on a platter years before his unmasking.”

If every financial institution over a certain size were required to provide ultra transparency, the regulators could enlist the resources of the market to help them understand each firm and the risks it poses to the system.

For example, JP Morgan could help the regulators in their analysis of Citi and BofA.  Likewise, these firms could help in the analysis of JP Morgan.

Just how sizable are the losses being hidden by banks?

Following the confession by RBS's Stephen Hester that with permission from the regulators his bank is hiding losses on and off its balance sheet, the logical follow up questions are:

• How sizable are the losses being hidden at each bank, throughout the UK, Eurozone and global banking system?

• How long will it take to work through the hidden losses?

A Bloomberg article provides some insight for the size of the losses from the European commercial property market and how long it might take for the Eurozone banking system to work its way through these losses.

European landlords have 582.7 billion euros ($779 billion) of commercial property debt maturing by the end of 2013 at the same time regulators are urging banks to shrink their balance sheets. 

The maturing loans could trigger writedowns for banks that need to meet stricter capital standards under international accords and as the region’s sovereign debt crisis threatens to dent lender balance sheets. 

If banks demand repayment, it may lead to a surge in foreclosures and restrain economic growth in Europe. 

That’s why regulators are instead encouraging gradual sales of the loans to private-equity firms including Blackstone Group LP (BX) and Dallas-based Lone Star Funds....

European lenders can both avoid writing down the loans and shrink their balance sheets at the same time.

For non-performing loans that the banks want to continue to hide, they simply rollover the loans at maturity.

For performing loans, the banks either demand repayment or sell the loan.  Either way, the banks' reported risk adjusted assets decline and their Tier 1 capital ratio improves.

As this blog has said before, by not requiring the banks to realize their losses before they increase their capital ratios, the numbers reported by the banks are meaningless.  What is meaningful is that to achieve these meaningless numbers, banks are cutting back on extending credit to the real economy (the regulator driven credit crunch) and restraining economic growth.

Most European real-estate debt originated before markets plunged in 2007 is being held on bank balance sheets at 90 percent or more of face value, according to Conor Downey, a partner specializing in real estate and financial reform at law firm Paul Hastings. Potential buyers value them at 50 percent to 60 percent, he said. 

If we say the value is 50 percent, then, based on the 582.7 billion euro exposure, banks are sitting on roughly 291 billion euros of unrecognized, hidden losses.

A substantial “rebound in capital values appears to be at best delayed with no immediate prospects for any strong growth, so I think the banks are probably feeling fairly uncomfortable at the moment,” said Colin Lizieri, a real estate finance professor at Cambridge University.

So much for the gamble on redemption.

European commercial property prices rose 5.3 percent in 2010, according to data from Investment Property Databank Ltd., the latest available. That followed declines of 15.9 percent in 2008 and 2.2 percent in 2009 that left borrowers struggling to repay loans and banks trying to sell soured assets. 

New regulatory requirements mean banks have to increase core capital to 9 percent by June, which may restrict lending. That’s “not a very fortunate plan,” given current market conditions, European Central Bank Governing Council member Ewald Nowotny said last month....

It is worse than a not very fortunate plan.  It is a deliberate action by regulators that is causing significant damage to the real economy.

While relative yields on European commercial mortgage debt packaged into securities narrowed in the last two months, the spreads are wider than a year ago and five times the level in November 2007, according to JPMorgan Chase & Co. (JPM) data. 

Investors demand 505 basis points, or 5.05 percentage points, above lending benchmarks to hold the securities, down from 575 basis points at the end of 2011. The spread has widened from 365 basis points a year ago, the data show. 

European banks hold most of their loans on their books with just 112 billion euros, or 6 percent, securitized at the end of 2010, according to the latest figures from DTZ Research. 

Banks sold 20 billion euros of real-estate loans across Europe and the Middle East last year and a further 13 billion euros is on the market, CBRE Group Inc. said Feb. 21. A total of 20 billion euros will probably be sold this year, according to the broker.

Most of the property debt owned by European banks is secured against properties in unfavorable condition or unattractive locations. 

Suggesting that a 50% loss rate might be optimistic.

In the U.K., two thirds of the properties financed by banks are secured against non-prime property, according to a Dec. 30 report published by the Bank of England. 

Potential acquirers are instead focusing on prime assets, Natale Giostra, CBRE’s European head of debt advisory, said in December. 

Banks may add to the problem if they foreclose on borrowers because more inferior real estate would come onto the market and push down values, said Lizieri at Cambridge University. 

Banks that historically bundled property debt for sale are being discouraged by new rules that mean securitizations require higher levels of capital. Instead, they’re seeking to team up with other banks to package their loans into funds that can be sold. 

Funds “diversify - and therefore improve - each investors’ risk position,” Simon Gleeson, a lawyer at Clifford Chance LLP in London specializing in markets and regulation, said in an e- mail. “You need quite a large number of banks involved, and they need to trust each other only to put in assets of the specified quality. Building that trust may take time.”

Regulatory arbitrage to try to get rid of non-performing assets.

Banks are being “nudged” by regulators toward recognizing bad real estate loans, “but it’s going to end slowly,” said Bob Penn, a partner at Allen & Overy LLP in London. “Regulators report to their political masters and are sensitive to their wishes. They don’t want to drive economic growth off a cliff and they don’t want to trigger another crisis.”

So the blame for not adopting the Swedish model and requiring banks to recognize all of their losses up front is really on the politicians who were adamant that the banks hide their losses and fiscal and monetary policies be adopted that maximized the destruction of the real economy.

Honestly, the regulators pushed for the banks to hide their losses.  As this blog has previously stated, having financial institutions hide losses is the regulators default position.  Example of this abound including the US Savings and Loans.

Private-equity firms are seeking to pick up some of the slack. Royal Bank of Scotland Group Plc sold 1.36 billion pounds ($2.14 billion) of commercial real-estate loans to a Blackstone fund in December at about 29 percent less than face value, two people with knowledge of the talks said, who declined to be identified because the deal was private.... 

Lloyds Banking Group Plc (LLOY), Britain’s second-biggest government-aided bank, sold more than 900 million pounds of mortgage-backed loans to Lone Star Funds in December. The loans may have been bought at a 40 percent discount, two people familiar with the matter said.

 For assets like non-prime shopping malls in Spain, “there’s virtually no buyers or at least there’s none unless there’s significantly lower prices,” said Harm Meijer, an analyst at JPMorgan in London. The investment bank expects “falling property prices or at best a flattish market for a long time” across Europe, according to a Jan. 11 note to investors.

Banks will put more distressed real estate up for sale in some parts of Europe this year, Meijer said, and Dutch offices and secondary U.K. properties will be among the assets sold. 

U.K. banks would have to write off billions of pounds if they “seriously attacked” their commercial property loan books through sales, Michael Marx, chief executive officer of Development Securities Plc, (DSC) said by e-mail. RBS said yesterday that its non-core division’s commercial real estate assets were impaired by 3.4 billion pounds in 2011.

Germany, the largest economy in Europe, is not immune, based on the performance of commercial mortgage backed securities issued there. Only 22 percent of German CMBS loans were repaid when they matured last year, compared with 74 percent in France and 38 percent in the U.K., Standard & Poor’s said in a January report.... 

PwC said that it will take 10 years for banks to sell up to 3 trillion euros of assets and expect a similar timeframe for their troubled real estate loans. 

That echoes earlier crises, said Meijer of JPMorgan. “We’ve heard from bankers in Germany that they only worked out the last of their problem loans from the 1970s in recent weeks.”

Please re-read the previous two comments about how long it will take to work out from under the commercial property exposure.

There is a reason that Japan has been pursuing the monetary and fiscal policies it has been for the last 2+ decades.  The reason is it takes forever for the banking system to generate enough capital to absorb the losses.

RBS' Stephen Hester ends the myth of bank capital being there to absorb losses

In this blog's discussion of the Japanese model for handling a bank solvency crisis, your humble blogger noted that the central element of this model is banks only recognize losses as they generate the capital to absorb them.

As a result, bank book capital is not available to absorb losses on the excesses in the financial system and save Main Street and the real economy.

Never did I expect to read an article in which a banker confirms a) that regulators have adopted the Japanese model and b) that there are losses hidden on and off his bank's balance sheet.

Mr Hester said [RBS], which is 83pc owned by the state, had been "spooked" by the severity of the eurozone crisis into taking "an extra £1bn" of losses for 2011. 

"We got spooked by the dangers of the eurozone so we deliberately spent an extra £1bn that we hadn't planned on in losses to go even faster than we had planned in reducing risk. 

"You can say to me it's a slight Alice in Wonderland world, where extra losses is a good thing and I completely appreciate the difficulty in the communication of that, but those are the facts," said Mr Hester. 

The RBS chief admitted that since its £45bn bailout in 2008, the lender had taken losses when it could "afford" to and used profits to "finesse" its results. 

"We have to finesse it with our own profits as we go through. Each year we have, in a sense, a budget for making losses for clean-up – and the better or worse our profits are, the better or worse that budget is and the faster or slower that we can go," said Mr Hester, adding that the bank had "never" had sufficient capital to recognise all its losses upfront.

Please re-read Mr. Hester's comments as they confirm the UK's adoption of the Japanese model for handling bank solvency and the simple fact that regulators do not use bank capital to absorb losses.