Perspective on Risk - July 12, 2024

Untethered Private Credit; Closing The Barn Door On Interest Rate Risk; Supervisory Stress Tests (Should Be Ended); Unwritten Deals; More Glastonbury; Trivia

Jul 12, 2024

Hope you’re all enjoying summer. Just remember, they’re likely to get even hotter in the future.

Private Credit

Untethered From Reality?

A borrower’s struggles highlight risk lurking in a surging corner of finance (FT)

Wall Street’s new titans have differed significantly in valuing the $1.7bn of debts they provided to workforce technology company Pluralsight, highlighting the risk that some private credit marks are untethered from reality.

The seven lenders to Pluralsight who report their marks publicly disclosed a broad range of valuations for the debt, with a Financial Times analysis showing the gulf widened as the company ran into trouble over the past year. The firms disclose the marks to US securities regulators within their publicly traded funds, known as BDCs, which offers a window into how their private funds may be valuing the debt.
Ares and Blue Owl marked the debt down to 84.9 cents and 83.5 cents on the dollar, respectively, as of the end of March. Golub had valued the loan just below par, at 97 cents on the dollar. The other four lenders, Benefit Street Partners, BlackRock, Goldman Sachs and Oaktree, marked within that range.

Line chart of Fair value of Pluralsight's term loan, maturing in April 2027 (cents on the dollar) showing How much is Pluralsight's debt worth? Funds take different views

The most conservative mark implies a loss across the lenders of nearly $280mn on the $1.7bn debt package. But Golub’s mark would imply a loss of just $50mn for the private lenders.

There are several ways for the bank regulators to handle this - they could read and classify the loans as Shared National Credits, or they could develop a program similar to ICERC, which was used in the LDC crisis.

The Private Equity Bubble Is About to Deflate (Bloomberg)

You gotta love this following line:

Technically, private markets can’t be in a bubble if there are no prices. Valuations can neither collapse nor be bid up by investors.

Interest Rate Risk

Closing The Barn Door After The Cow Has Escaped

Are Regulators Cracking Down on Interest Rate Risk? (UponFurtherAnalysis)

This blogger reports the obvious; that after the SVB failure regulators issued more supervisory actions (MRIAs and MRAs) and enforcement action than before SVB.

IRR-related enforcement actions have more than tripled overall

However, none of the enforcement actions relate to banks with more than $100Bn in assets.

Supervision by WSJ headlines is the worst kind of supervision.

Supervisory Stress Tests

Greg Feldberg, formerly of Fed Board and OFR, and now Director of Research, Yale Program on Financial Stability has authored Should the Federal Reserve Reveal More about Its Stress Test Models?

I mean, sure.

I’ve known Greg a long time, respect him, but must disagree with some points he makes. Well, really only the fundamental assumption that the Fed should continue the supervisory stress tests.

Greg writes:

I worked on the first stress test as a member of the staff of the Federal Reserve during the Global Financial Crisis. I believe we’re all very proud about how that turned out back in 2009.

Yup. Me too. But the 2009 stress tests were done for a very specific reason back then that doesn’t exist today, and frankly hasn’t existed for a decade. More in a moment.

He concludes:

In short, supervisory stress tests are very important for bank risk management. I’m concerned, as are many others, that the tests have become too routinized and that further disclosures from regulators will simply make them more so.

Not sure how important they are for the bank’s risk management. Stress tests, yes, but “supervisory stress tests” are useful to the extent they keep the regulators off your back.

And this is again part of the problem.

See, the 2009 SCAP stress test was done for a very fundamental reason. There was a distinct lack of market confidence in the capitalization of the largest banks. Investors were hesitant to fund the banks for fear that the regulators could close, dilute or nationalize the bank after their investment. Adding to this, there was a strong incentive for banks to cut back on lending and market-making as a way to improve their capital ratios, but this incentive was at odds with what was needed for “main street” - namely to keep funds available to solvent borrowers.

The 2009 stress test gave each of the firms a target level of capital that they needed to raise, and it was implicit that if they raised this capital they would not be shut by the regulators.

There was considerable debate about the degree of transparency that was needed, but ultimately an unprecedented level of transparency was given. This was not the Fed’s DNA. Details of the stress test parameters were published so that market participants could 1) judge the credibility of the supervisory stress test, and 2) adjust the parameters if they thought we were wrong.

Over the subsequent years, the stress test has morphed into a tool whereby the regulators are now determining a floor for the minimum about of “buffer” capital that a firm must hold. Regulators have taken the decision on the probability that a firm will breach the regulatory minima out of managements hands.

It is time to do away with the existing supervisory stress test and return that responsibility to bank management.

Further, while I do believe that the regulatory emphasis on stress testing has improved the quality of the analysis, stress testing has become a compliance exercise. In a world of finite resources, regulatory stress testing has likely crowded out other risk management initiatives.

I’d further add that in 2009, the stress tests employed the best and brightest staff (the author excluded) that the Fed had. Now, however, it is likely that the staff assigned to stress testing, while I’m sure are still talented, are not of the same caliber. Not a criticism, but just something that naturally happens as other priorities rise in importance. We can see this in the fact that at least two of the largest banks have found errors in the Fed’s stress tests.

JPMorgan Chase says its stress test losses should be higher than what the Fed disclosed (CNBC)

Bank of America Says it Started Talks With Fed After Stress Test Results (Bloomberg)

As discussed most recently in the Perspective on Risk - August 17, 2023, if anything, the Fed should move towards financial sector wide macro-prudential scenario analysis in a way the UK is pursuing. This could be useful if done in a timely manner.

Unwritten Deals

How UBS fell out with Switzerland’s establishment after rescuing Credit Suisse (FT)

“Fourteen months after the Credit Suisse rescue, we are in the midst of an intense and often superficial debate over whether UBS is too big for Switzerland,” Ermotti said during a speech at the University of Zurich. “To be honest, it’s quite surprising how quickly UBS went from being perceived as a saviour to a potential future problem for the country.”

Much of the recent disagreement [between UBS leadership and Swiss regulators] centres around plans to bolster the country’s financial system after the body blow of losing its second-biggest bank, in a public spat playing out between a group of newly hired leaders who are trying to make their mark on the future of Swiss banking.

The truce among the four biggest institutions in Swiss banking [UBS, the finance ministry, central bank and regulator Finma] broke spectacularly in April when Keller-Sutter unveiled a set of 22 measures to improve the country’s too-big-to-fail regulations.

While most … were widely accepted, a recommendation to increase capital requirements caught UBS off guard. … While the finance ministry has provided little detail on how the capital requirements would be calculated, analysts have estimated it could be an additional $15bn to $25bn for UBS.

That’s a lot of background to get to the main point I wanted to make.

“UBS got this incredible gift — the deal of the century,” said one adviser to banks. “Now the government is coming under pressure from the Swiss public to make it look like it wasn’t such a great deal.

This is the nub of the issue, and to me it harkens back to the Deutsche Bank acquisition on Bankers Trust, which I had some familiarity.

When banks need to be acquired, regulators typically find ways to grease the skids, to make the deal happen, and to make the first-order loss to the sovereign lower than it would otherwise be.

In the US, some failed bank acquisitions come along with risk-weighted-asset calculation relief. In the DB/BT case, there was a decision that the US-based intermediate-tier holding company did not have to hold capital. This led to this entity actually reporting negative capital ratios for a number of years.

Now as I remember it, and I could be wrong, when this determination was initially made, it was agreed that this would be for a limited period of time, and that this was not carte blanche to acquire other firms under the same structure.

But memories get short, some who had the initial understanding on both sides move on, and something that was crafted as a temporary one-off relief somehow lingers and gets established as normal practice.

In the UBS/CS case, I wouldn’t doubt that there were some “assurances” given, but again, people change, the environment changes. In this case, I’m sympathetic to both sides. UBS is too big for the Swiss economy to bail out; UBS however did a good thing in finally putting CS out of our misery.