Perspective on Risk - Oct. 17, 2023

Howard Marks Writes A Follow-up; The FSB Weighs In; OSFI Highlights CRE Risk; Commentary on Office Exposures; Payment Network Outage; Research

Howard Marks Writes A Followup

Howard Marks of Oaktree famously wrote Sea Change last December where he publicly stated what many had been thinking: that the secular decline in inflation and interest rates had ended, and that the investment thesis going forward needed to adapt. If you haven’t read the piece, go back now and read it and it will all seem obvious (with hindsight)

In my 53 years in the investment world, I’ve seen a number of economic cycles, pendulum swings, manias and panics, bubbles and crashes, but I remember only two real sea changes.  I think we may be in the midst of a third one today.

We’ve gone from the low-return world of 2009-21 to a full-return world, and it may become more so in the near term. Investors can now potentially get solid returns from credit instruments, meaning they no longer have to rely as heavily on riskier investments to achieve their overall return targets. Lenders and bargain hunters face much better prospects in this changed environment than they did in 2009-21. And importantly, if you grant that the environment is and may continue to be very different from what it was over the last 13 years – and most of the last 40 years – it should follow that the investment strategies that worked best over those periods may not be the ones that outperform in the years ahead.

He has now published publicly his May followup message: Further Thoughts on Sea Change.

I find it hard to believe the Fed doesn’t think it erred by sticking with ultra-low interest rates for so long. 

… we haven’t had a free market in money in roughly the last two decades, a period of Fed activism. Instead, Fed policy has been accommodative almost the entire time, and interest rates have been kept artificially low. Rather than letting economic and market forces determine the rate of interest, the Fed has been unusually active in setting interest rates, greatly influencing the economy and the markets.

Importantly, this distorts the behavior of economic and market participants.  It causes things to be built that otherwise wouldn’t have been built, investments to be made that otherwise wouldn’t have been made, and risks to be borne that otherwise wouldn’t have been accepted. 

… after a long period when everything was unusually easy in the world of investing, something closer to normalcy is likely to set in.

The overarching theme of my sea-change thinking is that, largely thanks to highly accommodative monetary policy, we went through unusually easy times in a number of important regards over a prolonged period, but that time is over.

I’ll leave it to you to read his article if you want to know how he is investing. I’d also add, from where I sit, the big question will be how rough the process of adapting to “normal” will be, and whether the Fed and the other authorities have the fortitude to bear the inevitable pain. Let’s remember that things like the term premium have not yet fully normalized.

The FSB Weighs In

2023 Bank Failures - Preliminary lessons learnt for resolution (FSB)

The bank failures of the first quarter of 2023 constitute the first real test at a larger scale of the international resolution framework established by the Key Attributes of Effective Resolution Regimes for Financial Institutions (“Key Attributes”) in the aftermath of the Global Financial Crisis.

Credit Suisse

The actions by the Swiss authorities to facilitate a commercial transaction outside of resolution … raises the question why resolution was not the chosen path despite it being an executable alternative at that time in light of preparations made. The Swiss authorities had concerns about the ability of the prepared resolution strategy to address the crisis of confidence at Credit Suisse.

Supervisors Were Proactively Planning For Resolution

Since the summer of 2022, the Swiss Financial Market Supervisory Authority (FINMA) had initiated intensive meetings of the Crisis Management Group (CMG), which included home and key host authorities of Credit Suisse.

Based on the review conducted by the FSB, it appears that the resolution planning work of the past decade … had put authorities in a position to conduct a single point-of-entry (SPE) resolution, if desired.

Early in October 2022, FINMA involved not only Credit Suisse’s Core Supervisory College but also the CMG in its crisis management. It also decided to temporarily extend the CMG’s participating authorities to include the SEC in the planning for bail-in execution and the NYDFS, which has jurisdiction over the firm’s New York branch and had the ability to access the FRB’s discount window facility.

A resolution was ready to be implemented on Sunday 19 March if so decided. Over several months, FINMA had addressed a number of technical issues to prepare for resolution thanks to the cooperation with the BoE, FRB, FDIC and SEC in particular.

Total Loss Absorbing Capital Was Credible

Although resolution was not used in the case of Credit Suisse, the TLAC standard and its full implementation, along with the resolution package that FINMA had prepared for the firm, provided a credible alternative path. The availability of sufficient bail-inable debt would have supported the bank’s post-stabilisation restructuring, which would have been capital intensive.

Planning Gave The Swiss Authorities Optionality in Resolving CS

The Swiss authorities had considered three options: (i) a commercial merger, (ii) restructuring via resolution, and (iii) a bailout/nationalisation. … In the specific situation of the crisis faced by Credit Suisse, the going-concern acquisition of Credit Suisse by UBS was deemed by the Swiss authorities to have the best chances to stabilise the situation in that particular market environment.

Authorities are expected, when choosing the resolution strategy for a particular firm, to have assessed its systemic impact considering a scenario with potential adverse market conditions... At the time of the failure of Credit Suisse, the Swiss authorities had concerns that the application of the bail-in tool in the volatile market conditions following the failures of several US banks in mid-March 2023 could give rise to financial stability issues and could be accompanied by several knock-on effects in Switzerland and globally.

Public Sector Liquidity Backstops Are Required

It is an important reminder that recapitalisation of a bank in resolution is not, by itself, sufficient to ensure the continuity of a firm’s critical functions if the firm cannot maintain access to liquidity to refinance its liabilities as they fall due. In the period following commencement of a resolution process, even a recapitalised bank is likely to experience heightened liquidity needs generated by market volatility.35 Authorities need to have credible liquidity backstops and other frameworks in place that are overt and easily understood by market participants and depositors in order to restore market confidence when a bank is resolved.

Legal Issues

The Credit Suisse case was the first instance where authorities came as close to resolving a GSIB

According to the SEC staff, there would have been legal challenges relating to US securities laws in executing a bail-in; they noted that banks need to prepare sufficiently to comply with US securities laws after an open bank bail-in.

In an open-bank bail-in, the SEC staff considered that it would be difficult for an issuer to compile the disclosures required by securities regulations and anti-fraud laws over a resolution weekend and that ex ante preparations would be necessary to mitigate these challenges.

Oh. Oops. Robin Wigglesworth had something to say about this in The regulatory nightmare of TLAC (FT):

Alphaville still can’t quite grasp how the tens of thousands of lawyers, bankers and government officials across Europe and the US that have spent more than a decade tortuously working through all these rules and coming up with new instruments to fit them somehow missed that they might not play nice with US securities law.

Not to fear though! “Further work will be planned.”

Yes, please do some of this co-operating of which you speak. It sounds like a grand idea.

US bank failures

The three US regional banks were effectively resolved without bailing out shareholders and unsecured creditors.

The failures of the US regional banks have shown that banks that have not been designated as G-SIBs or D-SIBs64 could be systemic in failure.

With the failure of SVB and the impending failure of Signature Bank, concerns began to emerge among US authorities that a least-cost resolution of the banks, absent more immediate assistance for uninsured depositors, could have negative knock-on consequences for depositors and the financial system more broadly.

The use of the systemic risk exception was deemed necessary in order to stem contagion effects to the rest of the banking sector through uninsured deposits and was driven more by the similarity of business models or funding models with other banks than by the size of the failing banks.

SVB, Signature Bank and First Republic Bank would have benefited from having in place loss-absorbing capacity in the form of long-term debt, which is an area of work that was already underway by the FDIC and Federal Reserve before the recent events.66 The US bank failures illustrated that the availability of sufficient loss-absorbing capacity, ranking below uninsured deposits and thus providing an additional layer to absorb losses before uninsured deposits,67 could have forestalled, or largely reduced, deposit runs on these banks or the need for using the systemic risk exception.

OSFI Highlights CRE Risk

OSFI, Canada’s regulator, is quite good; always liked them. Smaller. less chaotic than the US; always listened when they spoke. In their Annual Risk Outlook - Semi-annual update they highlight some risks and developments in commercial real estate,

Negative rating migration seems to be lagging changes to the risk environment. This indicates that risk assessments, risk rating models, and collateral valuations may not appropriately reflect the risk environment.

We have noticed evolving practices in the CRE market. In particular, an increase in the use of “participation” agreements and other co-lending arrangements such as layering in other subordinated debt arrangements whereby the risk is tranched between multiple lenders and entities. These agreements don’t always have standardized contractual language and therefore can present additional risk to lenders based on legal, operational, and structural complexities. They can affect lenders’ rights and remedies thereby impacting the probability of default and level of recovery values. Within this context, we now consider CRE to be a higher risk item than was reflected in the April ARO as conditions remain challenging.

Commentary on Office Exposures

Thought I’d take a minute to look at a few earnings call transcripts to see what is being said about our friend, oCRE ffice.

Goldman Takes Its Marks On CRE

Goldman has always been perceived as being more disciplined in marking down their exposures than some peers. Important to note that the 50% figure includes equity investments, so its not just a mark on the office loan book. They consider their office loan book as Class A space.

On page 10, we provide additional detail on our CRE exposure similar to last quarter. CRE loans continue to represent a relatively small percentage of our overall lending book at 14%. CRE investments are diversified across geographies and positions, with no single position representing more than 1% of the total on-balance sheet alternative investments. Across both equity investments and CIEs, we have marked or impaired office-related exposures by approximately 50% this year.

Ebrahim Poonawala

Good morning. I guess maybe just one first follow-up, Denis. I just want to make sure I heard you correct. Did you say you marked your CRE exposure by 50% in CRE office? And on that, just give us a sense of visibility even beyond office CRE. Clearly, it's a very manageable issue for you, but it remains sort of a source of nuisance and earnings noise. How much more do we have to go before this is kind of pinned down?

Denis Coleman

Sure. So, yes, to clarify, for our CRE and CIE exposure in the office space, we've either marked or impaired that down by about approximately 50% this year. So that's -- I think that's quite significant. We started the year with about $15 billion of CRE alternative investments. That's been reduced now by about $5 billion. 3/4 of that was either through paydowns or dispositions, the balance through marks and impairments. So we're making very, very significant progress against those exposures. If you were to look at the same set of exposures in non-office, the adjustment there through marks, our impairment is about 15% year-to-date. So we feel we've reduced a lot of notional appropriately reflected the valuations in those positions. But as indicated by our targets, we intend to continue to move down those exposures.

Wells Increased Office Allowance

As expected, net charge-offs have continued to increase from historical low levels, and we increased our allowance for credit losses, primarily driven by our office portfolio, as well as growth in our credit card portfolio.

Our allowance for credit losses increased $333 million in the third quarter, primarily for commercial real estate office loans, as well as for higher credit card loan balances

Mike Santomassimo -- Chief Financial Officer

Yeah, sure. When you -- the hard part of office right now is that there aren't a lot of trades happening yet, right? There's a few in certain cities, and they're all a little bit different in their complexion. So you still have somewhat limited information in price discovery in a lot of places.

JPMC Seeing “A Trickle of Chargeoffs”

we are seeing a trickle of charge-offs coming through the office space.

BAC Experienced a Reduction In Office Writeoffs

Commercial net charge-offs declined from the second quarter, driven mostly by a reduction in office write-downs.

Payment Network Outage

Japan payments clearing system glitch impacts 1.4 mil. transactions (Kyodo)

Japan's payments-clearing network suffered a system problem Tuesday, affecting 11 banks including MUFG Bank and disrupting at least 1.4 million transactions, the network's operator said.

Japanese Banks' Payment Clearing Network said it was unclear what went wrong and when the problem would be fixed. It is the first time that bank customers have been impacted by a system problem since the network was launched in 1973.

Most Japanese banks are connected to the key payment network, known as the Zengin system, which processes an average 6.5 million transactions and over 12 trillion yen ($81 billion) a day.

Japan payments clearing network restored after 2-day disruption

Among the banks that were hit, MUFG Bank said the same day that its transaction service had returned to normal following the problem in the system operated by Japanese Banks' Payment Clearing Network that affected over 5 million transactions.

The issue detected Tuesday morning was caused by a problem in the computer system relaying transaction data between financial institutions and the clearing network. During the disruption, financial institutions were forced to take alternative steps to transfer money without using the relay system. The operator had been utilizing backup measures in the meantime to process transactions and attempted to restore the system on Wednesday without success.

Research

Insurer Interest Rate Risk

In Measuring Interest Rate Risk Management by Financial Institutions, Board economists confirm some common wisdom; life insurers are more sensitive to changes in long-term interest rates than property and casualty insurers, life insurers are ‘generally’ well hedged against long interest rate movements (to a first approximation), the term premium helps to explain this difference in sensitivities;

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