To raise capital, Unicredit proposes selling stock at 43% discount

Italy's Unicredit is the first Eurozone bank to test the equity markets to try to raise capital to meet the 9% Tier I capital ratio.  To attract buyers, Unicredit is offering current shareholders the opportunity to buy more shares at a 43% discount to yesterday's closing stock price.

If the offering is going to be successful, Unicredit is going to have to provide significantly more disclosure on its exposures.

Investors have learned not to buy financial 'black boxes', and Unicredit is a giant black box loaded with unknown exposures, as a result of their experience buying sub-prime mortgage backed structured finance securities.

According to a Guardian article,

Stephen Hester, the chief executive of Royal Bank of Scotland, remarked last year that investors thought it was "dumb" to invest in banks.  

Over the next few months, it will become clearer if his remarks are correct as banks across Europe race to plug the €106bn (£88.2bn) shortfall that regulators believe they need to survive the eurozone crisis. 

UniCredit is the first big test. 

Embarking upon its third capital hike since the 2008 banking crisis, the Italian bank is currently enduring significant pain on the markets. Its shares have fallen 10%, and been suspended, after it priced its €7.5bn cash call at a 43% discount – larger than expected – to Tuesday night's share price.... 

Not all of the banks across Europe deemed to have shortfalls (all UK banks were given a clean bill of health) will embark on such cash calls. Others are selling off businesses and reducing their risky loans, but the plight of UniCredit is regarded as important. 

Louise Cooper, markets analyst at BGC Capital, said. "This will be a key test for investors' appetite for bank share offerings and will be closely watched by corporate brokers whose banking clients desperately need to raise new equity."

It takes disclosure to hold bankers' worst instincts in check

In his Bloomberg column, William Cohan laments that our financial system is not set up to hold individuals like Jon Corzine in check so that they do not recklessly bet their firms.

Mr. Cohan, since before the financial crisis began on August 9, 2007, I have been saying that the only way to stop this behavior is disclosure.  Detailed disclosure.  Disclosure that is updated every day.

Regular readers know that it is only with this disclosure that market participants have the information necessary to assess the risk of the firm.  It is only with this risk assessment that investors can accurately adjust both the amount and pricing of their exposure to the firm.

As a firm's risk increases so does its cost of funds.  As a result, with net income essentially flat, the stock price of the firm gets hammered as future earnings need to be discounted at a higher rate to reflect the increased riskiness of the firm.

This is what is meant by market discipline.

Until we have this type of disclosure, we are going to let bankers' worst instincts run wild.

In the end, Jon Corzine was little more than an unsupervised rogue trader.... 

In any case, it’s incredible how little Corzine and his associates learned from the collapses of Bear Stearns Cos., Merrill Lynch, Lehman Brothers Holdings Inc. and American International Group Inc. three years ago.... 

It didn’t have to be this way. The tragic element of Corzine’s MF Global is that Monday’s bankruptcy filing could have easily been avoided if Corzine’s ego and ambition had been held in check by someone -- anyone -- willing to stand up to the former New Jersey governor, senator and senior partner at Goldman Sachs Group Inc. (GS) 

Where, for example, was J. Christopher Flowers, the billionaire founder of J.C. Flowers & Co.? According to MF Global’s most recentproxy statement, Flowers’s firm owned 6.8 percent of MF. But then Flowers had reasons to have blind faith in Corzine: It was Flowers who recruited the former governor to MF in 2010, and also made Corzine a partner in his private- equity fund.... 

Where were MF Global’s other institutional shareholders, such as Fidelity Investments (which held a 14.8 percent stake, according to the proxy), Guardian Life Insurance Co. (7.4 percent), TIAA-CREF Investment Management LLC (6.6 percent) and Piper Jaffray Cos. (PJC)(6.3 percent)? Were they too dazzled by Corzine’s resume to take a serious look at how he intended to transform MF Global from a backwater to a major player on Wall Street? 

Where was MF Global’s auditor, PriceWaterhouseCoopers LLP, which managed to pocket almost $25 million in fees from the company over the past two years? 

And where, for heaven’s sake, was MF Global’s eight-member board of directors -- a ragtag collection of mostly unknown Wall Street types who had the fiduciary responsibility on behalf of creditors, shareholders, counterparties and employees to make sure Corzine wasn’t taking irresponsible risks? Is it too much to ask a board of directors to take this responsibility seriously? Apparently it was at MF Global....

The collapse of MF Global points once again, in the strongest possible terms, to the importance of having a substantive, teeth-bearing regulatory regime charged with overseeing the kind of asynchronous risk-taking that gives people like Corzine the incentive to gamble with other people’s money in hopes of reaping financial windfalls. 

And yet, more than three years after the collapse of Lehman Brothers and the onset of the financial crisis, we don’t have in place anything close to necessary regulations to try to prevent companies like MF Global from exploding. 

There is little question that from the outset of his tenure at MF Global, Corzine was swinging for the fences. He told me at the time that he saw MF Global as sleepy and risk-averse; he was determined to ratchet up exponentially the amount of risk the firm took using its creditors and shareholder money. Corzine himself had only a tiny fraction of his fortune invested in MF Global. His option-oriented compensation package encouraged him to take outsize risks in order to move MF Global’s stock price into “in-the-money” territory.... 

While the denouement of MF Global is still being written, one thing is crystalline: Behind Jon Corzine’s bearded, avuncular facade lies the soul of a stubborn, ambitious and aggressive risk-taking trader who in the end drove MF Global into the financial abyss. If only someone had had the guts to stop him.

Opacity has a high price: EU response to sovereign debt and bank solvency crisis shows it

Opacity has a very high price.

First, there were the losses on the opaque securities sold before the solvency crisis began on August 9, 2007.  This includes the opaque toxic structured finance securities loaded with fraudulently underwritten sub-prime mortgages as well as CDOs like Abacus that were designed so that Wall Street could profit from the collapse in the sub-prime market.

The Bank of England's Andy Haldane estimated the losses from the opaque securities exceeded $4 trillion globally.

Second, there is the on-going cost of bailing out the banking system.  The banks themselves hid risk both on and off their opaque balance sheets.

Based on a chart showing actual US Debt versus its pre-crisis trend line by Diapason's Sean Corrigan, Zero Hedge suggests that this cost is $3.5 trillion.

Third, we have the EU's sovereign debt crisis which to a significant extent is the result of attempting to bail out the banks in 2008/2009.

Based on the tentative agreement reached by EU policy makers, it appears that the cost is at least 440 million euros - the "equity" that the EU is putting into the European Financial Stability Fund.

This tally of costs only looks at the direct costs of opacity.

Hidden are the indirect costs like zero interest rate policies that transfer wealth from savers to bankers (banks pay nothing for the deposits and can park them at central banks and earn a risk free spread).

In short, opacity has a very high price.

Unfortunately, so long as we have pockets of the financial system that remain opaque, the cost of opacity will keep increasing.

For example, in the Eurozone, bank balance sheets are opaque.  What this means is that no one, including the regulators, knows how much exposure any bank has to any other bank, to any sovereign or how the bank might be trying to hedge the risk of this exposure.

As a result, the options available to Eurozone policy makers and financial regulators in how to respond to the sovereign debt and bank solvency crisis are limited.

For example, how many times did the policy makers express fear of causing contagion.  This "fear" clearly influenced the negotiations over the size of the haircut on Greek debt.  The banks knew that the policy makers would not be willing to risk a blow-up of the Eurozone banking system.  Hence, banks could negotiate to minimize the haircut and receive a 30 billion euro credit enhancement.

Imagine how differently the negotiations would have gone if all market participants knew the intimate details of each bank's assets, liabilities and off-balance sheet exposures.  With this information, policy makers could have seen if it fact a 100% write down of the Greek debt would have triggered contagion.

[This blog has suggested on several occasions that disclosure is the cure for contagion.  I have argued that   as soon as the data is made available to the market, it is in each bank's best interest to adjust their exposures to the other banks so that their exposures are not more than they can afford to lose.]

However, the EU policy makers and financial regulators did not have disclosure.

• This is despite the fact that all of the assets, liabilities and off-balance sheet exposures are knowable facts since they are in each bank's information systems.  

• This is despite the fact that the EU policy makers and financial regulators had gone through the first stage of the financial crisis in 2008/2009 and seen that the the financial markets broke down everywhere that there was opacity and that the policies that they adopted then had failed to provide disclosure - actually, they bought time in which disclosure could have been implemented and the current round of the financial crisis avoided.

Instead, the EU policy makers and financial regulators were faced with opacity and the fear of the unknown.

The results were predictable.  Once again opacity extracted its high price.

Now the question is will the Eurozone policy makers end opacity by setting up a data warehouse to collect the current asset, liability and off-balance sheet exposures from each bank and providing this data for free to market participants.

The Financial Times would like to "eradicate the fear in Europe's banks"

A column by the editors of the Financial Times looks at efforts to eradicate the fear in Europe's banks.

It is one thing if your humble blogger says that investor fear is a direct result of the opacity of bank balance sheets.  I have been saying this since the beginning of the financial crisis on August 9, 2007.

It is entirely another when the Financial Times directly and permanently links investor fear to the opacity of bank balance sheets.

As investors again fear to tread amid the holes of unknown depth that riddle Europe’s banking system, policymakers have finally regained their resolve. Better late than never: the efforts now being made to probe and fill the capital needs of banks are welcome news....

Now, across the European Union, banks are under strain, with a particularly vicious dynamic in the eurozone. Troubled sovereign debt weighs on banks’ balance sheets and lending, which in turn threatens growth and sovereign creditworthiness. 

Everyone knows that there are unrealised losses in European banks, but nobody knows how big they are and who will bear them. Investors rightly fear about their potential exposure – not a good incentive to ensure uninterrupted funding for banks’ credit to households and businesses. 

The [European Banking Authority] must therefore carry out its plans for new stress tests without delay. This can only be the first step. Once holes are found and measured, they must be promptly filled in a co-ordinated EU-wide action: contagion is now European if not global. A mooted 9 per cent tier one capital threshold makes sense. While there is nothing magic about that number, it ensures a sufficient common minimum.... 

This prescription for action works only if you assume that investors will trust the results of the European Banking Authority's stress test.  Why should they given that earlier tests saw banks pass (Dexia, Bank of Ireland Plc and Allied Irish Bank Plc) that were subsequently nationalized within 90 days?

The only way that investors are going to trust that all the holes have been found and properly measured is if each bank's current asset and liability-level data is disclosed and the investors can do the analysis for themselves.

The crisis is also an opportunity to undo the EU’s mistake of treating private banks’ bondholders with more respect than taxpayers.

This mistake is the result of each country's financial regulators having access to information that is not made available to all market participants. The financial regulators have access to each bank's current asset and liability-level data.  Other market participants do not.

As a result, the other market participants are dependent on the financial regulators to analyse this data and properly assess and communicate to the market the risk of each bank.  This dependency on the financial regulators creates a moral obligation to bail out private bondholders.  After all, why should they incur losses when the financial regulators are saying the bank is solvent?

If we are going to make private bondholders responsible for losses on their investments, we have an obligation to provide them with the current asset and liability-level data so they can assess the risk of their exposure.

Most banks should be able to raise capital privately or by limiting dividends and bonuses....

Ireland, Spain and Greece have shown that banks are not able to raise capital privately when there is doubt about their solvency.

The only way banks are going to be able to tap the capital markets is if they disclose their current asset and liability-level data.  With this data, market participants can assess whether the bank is solvent or insolvent (where solvency is a function of the relationship between the market value of a bank's assets and the book value of its liabilities).

If solvent, private investors will rush to invest.

If insolvent, private investors will look to see if the bank's franchise provides it with the capacity to earn its way back to solvency - Security Pacific is an example of this as it was insolvent from loans made to less developed countries.  Where the banking franchise has earning capability, private investors will invest.

The other insolvent banks can be recapitalized through payment of dividends and bonuses in stock or bailouts by the host government.  Alternatively, the host government might decide to close the banks down and sell off their assets.

The collapse of Lehman Brothers in 2008 brought the world’s financial system close to meltdown. It is time to show the right lessons were learnt.

The right lesson in particular is the way to eradicate market participants' fear in banks is to require each bank to disclose its current asset and liability-level data.

Your humble blogger looks forward to working with the EU financial regulators and setting up a data warehouse that will provide all market participants access for free to each bank's current asset and liability-level data.

Fed seeks to end buyers' strike

With its announcement that it was going to pursue zero interest rate policies for a minimum of two more years, the Fed upped the stakes in its effort to end the buyers' strike.  The buyers' strike applies to all forms of investment.  This includes everything from risky assets like stocks and long term bonds to business expansion.

The question is will the knowledge that interest rates will be artificially held at zero forever change buyers' behavior?

If the experience of Japan for the last two decades is any indication, the answer is a resounding NO!

Why should the Fed or any other central bank pursuing similar policies expect zero interest rates to end the buyers' strike?

Investors are acting according to Mark Twains' observation that he was more interested in the return of his capital than the return on his capital.  Given what has happened since the start of the Great Contraction this makes sense.

What has happened since the start of the Great Contraction?

Investors learned two lessons from blindly chasing yield.

First, they learned the difference between investing and blindly betting.  Investing requires access to all the useful, relevant information in an appropriate, timely manner and evaluating this information so that the risk and return can be assessed.  Blindly betting is buying opaque financial innovations like CDOs cubed.

Second, they learned that return of their principal is more important than capturing a 1 - 3% higher return on their principal.  When the focus is on return, significant losses of capital result.

What has not happened since the start of the Great Contraction?

Policymakers and economists have not followed the advice that they freely gave to Japan when its bubble burst.  Their advice was that the most important thing Japanese policymakers could do to restart their markets and economy was to publicly recognize the size of the losses related to the bubble and who was holding them.

Why did they give this advice?

They knew that until the losses are recognized buyers will stay on strike.   Buyers know that the losses exist, but without the disclosure of how big the losses are and who holds them, they do not know how the losses will impact them.  So, rather than take a risk - which is what investing is - buyers go on strike and "invest" where they can get their principal back.

By not recognizing the losses, policymakers are perpetuating uncertainty in the economy that undermines buyers' willingness to invest.  In essence, until the losses are recognized, the losses are the elephant in the room that crowds out everything else.

I am not going to speculate about why western policymakers and economists did not act on their own advice since the start of the Great Contraction.  I will just note that they have not acted and the resulting economic malaise and related buyers' strike has been extremely predictable.

How can France's banks restore confidence?

A Telegraph article asked the question of how can Soc Gen [and all of France's banks] restore confidence. Regular readers know the answer is not to ban short selling, but rather for the banks to disclose to all market participants their current asset and liability-level data.

By announcing that they are going to disclose this information, the French banks are sending a message to the market that they have nothing to hide and any problems that they have are manageable.

By actually providing the information, the French banks would be providing market participants with the ability to confirm or deny this message (trust, but verify).  Confirmation of the message would fully restore confidence.

In addition, the French banks would be setting the global standard for disclosure.

"I mean, why would I as a corporate treasurer want to take the risk?" asked one investor of analysts at Nomura on a conference call yesterday to discuss fears over the funding of European banks. 

John Peace, head of banks research at Nomura, took up the question and gave a lengthy explanation of why he thought the bank was safe, but it was his colleague Alison Miller, head of European credit strategy, who gave a more pithy response. 

"I think the answer is simple, it's about confidence. If something doesn't transpire, that could restore some confidence." 

Confidence in Société Générale, one of France's largest banks, has been lacking this week. 

The bank's shares lost more than 20pc of their value at times and at yesterday's close the lender had seen its market value reduced by about a quarter as rumours swirled the market that it could be in trouble. 

Even a statement from the bank written in bold capitals saying that rumours over its financial health were "COMPLETELY UNFOUNDED" did little to ease fears that something might not be quite right at the bank. 

What is striking is that the suspicions come despite investors having access to far more information on the exposures of European Union banks than they have had before. 

Stress test data published last month by the European Banking Authority provided the market with a detailed breakdown of the exposures of the region's 90 largest banks. 

Analysts at independent research firm CreditSights have even created their own "Stressometer" allowing clients to play around with the numbers and work out the writedowns and losses they think banks could face. 

This is exactly as predicted under the FDR Framework.  Market participants who know how to turn the disclosed data into information do so in a way that makes it easy for other market participants to benefit.

For example, take the fear of the French banking sector's exposure to French government debt, a major source of the collateral used by the banks to fund their day-to-day operations. 

Using CreditSights' database, in just two minutes you can work out that this amounted to €118.73bn (£105bn) at the end of last year. 

Break the figure down and you discover that Société Générale's net exposure to the French government is €16.1bn, about €10bn less than the larger BNP Paribas and about half that of Crédit Agricole. 

Notes sent to clients by Credit Suisse, Goldman Sachs and Nomura, all expressed themselves comfortable with the exposures of France's banks and their funding. 

The question, then, is why are the share prices of European banks being hit so hard? 

Current sector valuations show European banks trade at just 0.8 times their tangible book value and a price earnings multiple of less than six times 2012 forecast earnings. 

"I think there is a really worrying trend here," said one senior London-based credit analyst. 

"What you could be seeing is counter-parties to the French banks asking them to replace French government debt with other assets. What this means is that the market does not want any more exposure to France because of its own worries over its economic outlook." 

Since the eurozone crisis began, there has been the constant fear of contagion to the currency union's larger members and the concurrent worry that it could also lead to a new bank crisis.... 

Unlike in 2008, the banks have a lot more capital and larger liquidity reserves. Dollar funding, one of the main issues in the last crisis, is less of an issue and the banks have about $900bn (£554bn) of funds on deposit with the Federal Reserve, against $50bn in 2008. 

Their funding is also more diversified and banks have made efforts to tap every available investor base, from the Australian bond market to exchange traded funds. 

This is not to say there are not serious problems. European Central Bank lending figures for May showed that more than half of eurozone deposits were being lent out to the region's weaker banks to keep them afloat, a higher proportion than in the previous crisis. 

For all the unknowns made known by the July stress tests, investors still think their are more unknown unknowns out there. 

Actually, the investors know that there are more unknown unknowns out there.  What investors have been clearly communicating since the beginning of the credit crisis is that they do not want facts that are readily knowable included in the unknown unknown category because of a lack of disclosure.