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Bank Regulation: The Assets to Capital Multiple

Tuesday, April 15th, 2008

I have been fascinated with the IMF Global Financial Stability Report that was recently reviewed on PrefBlog … particularly Figure 1.17:

imf_117.jpg

The IMF comments:

Some banks have rapidly expanded their balance sheets in recent years, largely by increasing their holdings of highly rated securities that carry low risk weightings for regulatory capital purposes (see Box 1.3 on page 31). Part of the increase in assets reflects banks’ trading and investment activities. Investments grew as a share of total assets, and wholesale markets, including securitizations used to finance such assets, grew as a share of total funding (Figure 1.16). Banks that adopted this strategy aggressively became more vulnerable to illiquidity in the wholesale money markets, earnings volatility from marked-to-market assets, and illiquidity in structured finance markets. Equity markets appear to be penalizing those banks that adopted this strategy most aggressively (Figure 1.17).

The variation in multiple for the banks listed is ENORMOUS. The new derisive nickname for UBS is Union Bank of Singapore … but what are the implications for Canadian banks?

First, let’s gather up the ratios for these banks:

Assets to Risk-Weighted-Assets Ratios for Canadian Banks
  RBC BNS TD BMO CIBC
Risk-Weighted Assets 241,206 234,900 163,230 179,487 128,267
Total Assets 632,761 449,422 435,200 376,825 347,734
Assets:RWA 2.6 1.9 2.7 2.1 2.7

All the numbers are within the range for most banks – as reported by the IMF – but there are some fascinating differences that I might write about at another time.

Clearly, however, these differences can be significant and there is a clear indication that UBS was “gaming the system” by loading up with AAA assets that had no risk weight but – regardless of their investment merit – had, shall we say, considerable mark-to-market risk.

OSFI attempts to control such gaming by the imposition of an Assets-to-Capital multiple:

Institutions are expected to meet an assets to capital multiple test on a continuous basis. The assets to capital multiple is calculated by dividing the institution’s total assets, including specified off-balance sheet items, by the sum of its adjusted net tier 1 capital and adjusted tier 2 capital as defined in section 2.5 of this guideline. All items that are deducted from capital are excluded from total assets. Tier 3 capital is excluded from the test.

Off-balance sheet items for this test are direct credit substitutes1, including letters of credit and guarantees, transaction-related contingencies, trade-related contingencies and sale and repurchase agreements, as described in chapter 3. These are included at their notional principal amount. In the case of derivative contracts, where institutions have legally binding netting agreements (meeting the criteria established in chapter 3, Netting of Forwards, Swaps, Purchased Options and Other Similar Derivatives) the resulting on-balance sheet amounts can be netted for the purpose of calculating the assets to capital multiple.

Under this test, total assets should be no greater than 20 times capital, although this multiple can be exceeded with the Superintendent’s prior approval to an amount no greater than 23 times. Alternatively, the Superintendent may prescribe a lower multiple. In setting the assets to capital multiple for individual institutions, the Superintendent will consider such factors as operating and management experience, strength of parent, earnings, diversification of assets, type of assets and appetite for risk.

BMO is to be commended for disclosing its Asset-to-Capital multiple of 18.39, but I don’t see this number disclosed for any of the others. So … it will have to be done roughly, using the total assets from the table above, over the total regulatory capital:

Assets to Risk-Weighted-Assets Ratios for Canadian Banks
  RBC BNS TD BMO CIBC
Total Assets 632,761 449,422 435,200 376,825 347,734
Total Regulatory Capital
Tier 1 + Tier 2		 27,113 23,874 23,117 20,203 18,713
Very Rough
Assets-to-Capital
Multiple
(internal check)		 23.3
(23.3)		 18.8
(18.6)		 18.8
(19.0)		 18.7
(18.6)		 18.6
(18.5)
Reported
Total Capital
Ratio		 11.2% 10.2% 14.2% 11.3% 14.6%
The internal check on the Assets-to-Capital multiple is the Assets-to-RWA multiple divided by the Total Capital Ratio. Variance will be due to rounding.

Well! This is interesting! According to these very, very rough calculations, RBC has an Assets-to-Capital multiple of 23.3:1, which is both over the limit and well above its competitors. This may be a transient thing … there was a jump in assets in the first quarter:

RBC: Change in Assets
From 4Q07 to 1Q08
Item Change ($-billion)
Securities +6
Repos +12
Loans +8
Derivatives +7
Total +33

I have sent the following message to RBC via their Investor Relations Page:

I would appreciate learning your Assets-to-Capital multiple (as defined by OSFI) as of the end of the first quarter, 2008, and any detail you can provide regarding its calculation.

I have derived a very rough estimate of 23.3:1, based on total assets of 632,761 and total regulatory capital of 27,113

Update, 2008-04-17: RBC has responded:

Thank you for your question about our assets to capital multiple (ACM). In keeping with prior quarter-end practice, we did not disclose our ACM in Q1/08 but were well within the OSFI minimum requirement. Our ACM is disclosed on a quarterly basis (with a 6-7 week lag) on OSFI’s website. We understand this should be available over the next few days. Below is an excerpt from the OSFI guidelines outlining the calculation of the ACM. We hope this helps.

Update, 2008-6-4: From the FDIC publication, Estimating the Capital Impact of Basel II in the United States:

Posted in Primers, Regulation, Regulatory Capital | 14 Comments »

Crosses

Wednesday, March 5th, 2008

The following has been copied from the comments to March 4, 2008. The rule of thumb is: if one person asks, twenty want to know! The question was:

I enjoy your blog but I still have a lot to learn. What do you mean by “crossed” in the Notes section of the volume highlights when you write “RBC crossed 15,000 at 19.07″ or “RBC crossed 100,000 at 23.20, then Nesbitt crossed 50,000 at the same price”? I assume you mean they bought the stock at that price but I am just not sure. Thks

 

A dealer “crosses” a trade when he acts for both the buyer and the seller. In institutional trading, it is very common for large trades not to be posted publicly – showing too much size might scare away counterparties, and lead to other traders playing traders’ games. 

There are other, better reasons: say, for instance that you are the investment manager for 100 clients holding varying numbers of shares. If you were to put it up publicly and only get a partial fill – say, 57,600 shares – you’ve got headaches splitting it up fairly and headaches having all those clients with tiny, virtually untradeable positions.

The best reason for doing this is if the order is contingent: maybe you want to sell PWF.PR.K to buy POW.PR.D and take out $0.45 on the switch. In that case, the dealer’s got two orders to fill. Maybe he can sell the PWF.PR.K, but can’t find any POW.PR.D for you (or he finds some, but he can’t put the deal together in such a way that you take out your $0.45). In that case, nothing will happen – and the next day, maybe you’ll call another dealer.

Whatever your reason, if you want to sell 100,000 shares of PWF.PR.K, you will not get your dealer to put this on the board for you. What you will do is ask him to find a buyer. He then checks his rolodex for people who have shown interest in PWF.PR.K in the past – or managers he’s talked to recently who have expressed a longing to purchase a high quality perpetual discount issue of any nature – and start dealing. Once he’s found a buyer who is willing to pay what you’re willing to sell for, he’s happy.

The exchange requires that this trade be recorded on their books. As long as the price is equal to or higher than the posted bid, and equal to or lower than the posted offer, then everything is OK and the trade gets filled as a cross.

A more specialized type of cross is when the dealer is acting for both the buyer and the seller – and so is the investment manager! This is an internal cross. The investment manager might have two funds: Acme Dividend Fund and Acme Preferred Share Fund. These two funds have differing cash flows, such that Dividend Fund needs to raise $2.5-million, and Preferred Fund needs to invest the same amount. In many cases – not all cases, but many cases – it makes sense according to the mandates of both funds that one sells to other. The investment manager gets the dealer to do it for him, the dealer ensures the price is fair, marks the trade as an “internal cross”, and Bob’s your uncle.

There are other specialized cross types as well.

Posted in Primers, Reader Initiated Comments | 1 Comment »

Icebergs, Retail & RS

Friday, February 22nd, 2008

Assiduous Reader madequota told me in a comment that:

I’ve mentioned the other cloaking device they use as well, the so-called ‘ice-berg” order. Can I strategically advance my cause as a retail investor by using icebergs? NO. Can I mislead other investors by coming into the market anonymously? NO. Does Regulation Services see a conflict in this? NO.

… and later that …

I’ve dealt with a number of different brokers, and all confirm that “iceberg” orders, and the option of listing orders under broker 1 are institution-only tools, and Regulation Services is the body that is responsible for this. Perhaps the people I have spoken too were misinformed, but they are consistent in their explanations, so I tend to buy into it.

OK … I’ve been in the business for a while. On the inside, and I’ve occasionally had to get the absolute truth of some matter or other. I have learned one thing: Don’t Trust What Anybody Claims About The Rules.

Company policy, tradition and wild guesses will often be confused with The Rules. This applies to operations personnel, traders, compliance people … anybody.

So I asked the horse’s mouth:

I have been advised that retail clients are not permitted to enter iceberg orders on the TSX due to rulings of Regulation Services.

Can you confirm this? Are there any documents on your website pertinent to the discussion or communication of such a ruling?

Here’s how Regulation Services responded to my query:

Thank you for your email inquiring about Iceberg orders and retail clients.

Market Regulation Services Inc. (RS) is not aware of any such restriction. UMIR 6.3 Exposure of Client Orders requires a client order that is less than 50 Standard Trading Units and less than $100,000 value to be immediately disclosed.  There is an exception to that rule that if the client requests that the order not be fully disclosed then the rule does
not apply.

Here is a link to UMIR 6.3. I suggest that clients of discount brokerages should write letters to the Big Bosses of these brokerages politely asking for the capability to be added to the software.

Update: “Wait a minute!” mutters the baffled crowd “What’s an iceberg order?”

They were introduced on the TSX in 2002:

Using compliant access technology provided by one of the Toronto Stock Exchange’s and TSX Venture Exchange’s Order Access Partners, a Participating Organization or Member may enter a large order of several thousand shares, but describe a “disclosed” portion, which may be as few as 2,000 shares. Those disclosed shares will be displayed to traders and the public, but all shares, up to the entire balance, are eligible to trade at any time – albeit after any and all disclosed volume at the same price.

If the Iceberg order is filled in portions, its disclosed portion, which fills first because of its disclosure, may eventually be decremented to zero. At this point, the displayed portion of the Iceberg order will automatically refresh to the original disclosed amount, repeating as necessary until the entire balance is traded. When an Iceberg order refreshes, it receives a new time-stamp, allowing other same-price orders an opportunity to move up in the time queue.

You would use them, for instance, if you wanted to sell 20,000 preferred shares and couldn’t find a block buyer (or didn’t want to ask around, for fear of moving the price). If you put in an order to sell the whole block at 21.50 as a regular order, you’d probably scare away the bids … with that kind of size overhanging the market, many traders will figure the market’s going to move down. And maybe they’ll back off on what bids they do have, hoping that you’ll get desperate.

So with an iceberg, you can just show it 2,000 at a time. Assuming that it’s just a straight sell – nothing to be done on the other side – this would be (slightly) superior to instructing a more complex algorithmic software package to do the same thing. Algorithmic software does have a latency factor … trade #1 would get filled, the TSX would notify the seller’s machine, the software figures out it has to put in another order, it transmits it, the order is checked and accepted by the TSX and then gets displayed. This doesn’t take much time, but it does take some time. If somebody had put in, say a market order to buy 5,000 shares, you would miss the last 3,000 of them, which would get filled at prices worse than yours before you’d even received notification of your fill!

And, of course, doing it manually will take even longer than software, by orders of magnitude.

Update, 2008-7-16 The minimum show for an iceberg is the greater of 500 shares or the Minimum Guaranteed Fill.

Posted in Primers, Regulation | 3 Comments »

Seniority of Bankers' Acceptances

Tuesday, February 5th, 2008

This is a question that has bothered me for a long time – and I’ve never been able to get a satisfactory answer.

What is the seniority of Bankers’ Acceptances?

Finally, through the magic of the Internet, I’m a bit further forward with this inquiry and think – think! – I have a good answer with respect to US Law.

According to DRAFT COPY: PRINCIPLES AND CONDITIONS PRECEDENT FOR THE CREATION OF A LATIN AMERICAN BANKERS ACCEPTANCES MARKET, creditted to Matilde Carrau, Constantino Flores and Manuel Renato Martínez Quezada of the University of Arizona College of Law:

To recuperate the funds invested by the bank in the discount of the acceptance, the bank generally rediscounts the facility in the New York bankers acceptance market. To be able to participate in this market the acceptances have to meet the eligibility requirements established by 12 USC § 372 and § 373. The result of compliance with eligibility requirements also causes that the acceptances not to be considered a deposit subject to reserve requirements or FDIC assessment(155) under regulation D. Hence if the bankers acceptance is eligible for discount and purchase the bank will offer a better rate for this facility as compared to what it would offer in a traditional lending since these “savings” will partially be passed on to the customer.(156)

[155] Under FDIC regulation, banks are required to pay a premium over deposits; hence, if the bankers acceptance complies with eligibility requirements and is therefore not considered a deposit, no prime will be paid for said transaction and the operation will be cheaper.

[156] Professor Boris Kozolchyk comments that off balance sheet credit operations will always be preferred by bankers to get involved with. Bankers acceptances are regarded when backed by premium banks in the moneyness scale as one of the private instruments closest to the currency status; and for practical purposes, they may be regarded as money. Negotiable Instruments class, spring 1997 semester, University of Arizona College of Law, Master of Laws In International Trade Law Program (hereinafter NI Class comment).

Which seems to mean, according to these authors’ interpretation of US law (as of 1997!) that BAs are junior to DNs.

It is my (limited!) understanding that BAs in Canada are regulated by the Bills of Exchange Act … the fact that this is not the Bank Act leads me to believe that:

  • BAs are not considered deposits
  • BAs are not insured
  • BAs will be wiped out before insured deposits lose a dollar

But, I’m still trying to get something definitive from the CDIC and OSFI!

There’s more questions, too! Say the recipient of the proceeds of the BA (the issuer, whose note has been accepted by the bank) does, in fact, pay back his money while the bank is going down the drain. Will this repayment lose its identity in the bankruptcy, becoming part of the general assets of the bank and go towards paying its liabilities in order of seniority? Or does the payment retain its identity and be used to honour THE PARTICULAR BA that was issued against this payment?

Update, 2008-2-7: I have explicit confirmation from the CDIC that: “A Bankers’ Acceptance is not an insurable product with CDIC.”

Update, 2008-2-19: I asked the OSFI:

What is the status of Bankers’ Acceptances should the guaranteeing bank become bankrupt?

a) If the original issuer repays the debt, does this payment retain its identity (and become payable to the holder of those particular BAs), or do such repayments lose their identity and become undifferentiated assets of the bank?

b) If the original holder does not repay the loan, and the bank is not able to honour its guarantee, what is the seniority of the BA in the bankruptcy process? Are BAs junior to Deposit Notes, or parri passu?

c) Has the status of dishonoured BAs been tested in court?

and received the following answer:

OSFI does not have the authority over the day-to-day business operations of financial institutions, such as the issue you raise in your e-mail.

As you may know, a Bankers’ Acceptance note is a short-term promissory note issued by major corporations, backed by a Canadian Chartered Bank, and repayable on a specified date.   

Therefore, in order to determine the guarantee behind the note, you may wish to contact the financial institution from which the agreement originates.

Update, 2008-2-20: I have received the following answer from the Bank of Canada:

In response to your inquiry, I wish to inform you that the Bank of Canada, as the country’s Central Bank, does not provide banking services to the public, nor does it legislate the rules and regulations applicable to the activities of commercial banks and other financial institutions in Canada. This responsibility falls upon the jurisdiction of the Office of Superintendent of Financial Institutions, which can be reached at http://www.osfi-bsif.gc.ca/osfi/index_e.aspx?ArticleID=18.

There’s still a few arrows in my quiver, but I’m starting to run out of options!

Update #2, 2008-2-20: I have talked to a money market trader at a major bank – who in turn talked to his liquidity desk (who runs the BA book) – and the answer from there is:

  • (a) Payments from the underlying borrower would go into a BA pool, and
  • (b) BAs are parri passu with deposit notes

He had nothing written down on this matter.

Update, 2008-2-21 I checked Moody’s Guidelines for Rating Bank Junior Securities:

For most unregulated non-financial organizations, it is generally assumed that the probability of default is constant across the various obligations within a typical capital structure.1 (In other words, if the company goes bankrupt, it will default on all of its obligations.) Notching guidelines for these entities are therefore governed solely by differences in the expected severity of loss given default. However, because they are regulated — and their regulators may refuse to support certain junior obligations (or more likely, selectively impose losses on them without placing the entire bank into liquidation) — differences in the probability of default also play a role in bank notching practices.

The interplay between systemic support and selective interference complicates the analysis of banks’ junior obligations.

Moody’s does not notch senior debt issued by banks; they are rated at the same level as deposits. This is because deposits and senior debt have the same probability of default and generally rank pari passu in liquidation.

Here’s what Fitch has to say in its Bank Rating Methodology:

Support ratings are the product of Fitch’s assessment of a potential supporter’s (either a sovereign state’s or an institutional owner’s) propensity to support a bank and of its ability to support it. Its propensity to support is a judgement made by Fitch….

It is assumed that typically the following obligations will be supported: senior debt (secured and unsecured), including insured and uninsured deposits (retail, wholesale and interbank); obligations arising from derivatives transactions and from legally enforceable guarantees and indemnities, letters of credit, acceptances and avals; trade receivables and obligations arising from court judgements.

Update, 2008-2-22: OK, we’re starting to get somewhere! Here’s what a Bank of Canada spokesman had to say on the matter:

I would recommend seeking answers from issuers of these instruments or regulators thereof (securities commissions) or perhaps OSFI.

As for the Bank of Canada: BAs carry the credit risk of the accepting bank and are valued accordingly. If the Bank of Canada were holding (either outright or as collateral) a BA issued or accepted by a bank that becomes insolvent, the market value of the BA would obviously be reduced.

In this situation, the Bank of Canada would demand that the BA it is holding as collateral or in a repo be replaced by other collateral. If the institution that pledged or sold the BA to the Bank of Canada were to default at the same time as the bank that issued or accepted the BA were to become insolvent(a highly unlikely scenario), the Bank would be holding an unsecured claim against the bank, that would rank parri passu with the claims of depositors and other general creditors.

Update, 2008-2-27: Many thanks to the wonderful OSFI, who referred me to Section 369 of the Bank Act:

Insolvency 

369. (1) In the case of the insolvency of a bank, 

(a) the payment of any amount due to Her Majesty in right of Canada, in trust or otherwise, except indebtedness evidenced by subordinated indebtedness, shall be a first charge on the assets of the bank;

(b) the payment of any amount due to Her Majesty in right of a province, in trust or otherwise, except indebtedness evidenced by subordinated indebtedness, shall be a second charge on the assets of the bank;

(c) the payment of the deposit liabilities of the bank and all other liabilities of the bank, except the liabilities referred to in paragraphs (d) and (e), shall be a third charge on the assets of the bank;

(d) subordinated indebtedness of the bank and all other liabilities that by their terms rank equally with or subordinate to such subordinated indebtedness shall be a fourth charge on the assets of the bank; and

(e) the payment of any fines and penalties for which the bank is liable shall be a last charge on the assets of the bank.

(2) Nothing in subsection (1) prejudices or affects the priority of any holder of any security interest in any property of a bank.

(3) Priorities within each of paragraphs (1)(a) to (e) shall be determined in accordance with the laws governing priorities and, where applicable, by the terms of the indebtedness and liabilities referred to therein.

This helps a little … but Paragraph (3) kind of muddles the game, doesn’t it?

Update 2008-3-19: No response at all – not even an acknowledgement – from the thoroughly useless Canadian Bankers Association. I am now contacting the IR departments of the Big 6 Banks individually:

Sirs,

It is my understanding that under Section 369(1)(c) of the Bank Act, your Bankers Acceptances would be considered a third charge on the assets of the bank in the event of insolvency.

Section 369(3) of the Act notes that liabilities within this charge may be further ranked in accordance with terms of the indebtedness and liabilities referred to therein.

I would appreciate receiving information regarding Bankers Acceptances that have been accepted by your firm, regarding their seniority within the third charge.

Sincerely,
HYMAS INVESTMENT MANAGEMENT INC.

James Hymas
President

Update, 2008-03-24: TD is parri passu, according to their IR department:

In the event of the insolvency of The Toronto-Dominion Bank, the obligations of the Bank under any Banker’s Acceptance issued by it would rank against the unencumbered assets of the Bank on a parity with all deposit liabilities of the Bank, other than amounts due to the government of Canada or to a province thereof which shall be a first and second charge on the assets of the Bank. Under the laws of Canada, the obligations of the Bank under any Banker’s Acceptances issued by the Bank are direct liabilities of the Bank and rank at least pari passu with all unsecured, unsubordinated indebtedness of the Bank.

Update, 2008-7-18: Other references

Update, 2008-8-12: Daryl Merrett, Bank of Canada Review, 1981: The Evolution of Bankers’ Acceptances in Canada

Posted in Interesting External Papers, Primers | 5 Comments »

Banks' Capital Structure: Tier 2A and Tier 2B

Friday, January 25th, 2008

Assiduous Readers will be familiar with Banks Subordinated Debt, but perhaps not so much with the difference betwee Tier 2A and Tier 2B Capital.

2.2.1. Hybrid capital instruments (Tier 2A)
Hybrid capital includes instruments that are essentially permanent in nature and that have certain characteristics of both equity and debt, including:
• Cumulative perpetual preferred shares
• Qualifying 99-year debentures
• Qualifying non-controlling interests arising on consolidation from tier 2 hybrid capital instruments
• General allowances (see section 2.2.2.)
Hybrid capital instruments must, at a minimum, have the following characteristics:
• unsecured, subordinated and fully paid up
• not redeemable at the initiative of the holder
• may be redeemable by the issuer after an initial term of five years with the prior consent of the Superintendent
• available to participate in losses without triggering a cessation of ongoing operations or the start of insolvency proceedings
• allow service obligations to be deferred (as with cumulative preferred shares) where the profitability of the institution would not support payment

Limited life instruments (Tier 2B)

Limited life instruments are not permanent and include:
• limited life redeemable preferred shares
• qualifying capital instruments issued in conjunction with a repackaging arrangement
• other debentures and subordinated debt
• qualifying non-controlling interests arising on consolidation from tier 2 limited life instruments
…
Limited life capital instruments must, at a minimum, have the following characteristics:
• subordination to deposit obligations and other senior creditors
• an initial minimum term greater than, or equal to, five years

Limits defined by the OSFI are:

The following limitations will apply to capital elements after the specified deductions and adjustments:
• A strongly capitalized institution should not have innovative instruments and non-cumulative perpetual preferred shares that, in aggregate, exceed 25% of net tier 1 capital.
• Innovative instruments shall not, at the time of issuance, comprise more than 15% of net tier 1 capital. If at any time this limit is breached, the institution must immediately notify OSFI and provide an acceptable plan showing how the institution proposes to quickly eliminate the excess.
• The amount of capital, net of amortization, included in tier 2 and used to meet credit and operational risk capital requirements shall not exceed 100% of net tier 1 capital.
• Limited life instruments, net of amortization, included in tier 2B capital shall not exceed a maximum of 50% of net tier 1 capital.
• Tier 2 and tier 3 capital used to meet the market risk capital requirements must not – in total – exceed 200% of the net tier 1 capital used to meet the market risk capital requirements.
• Tier 2 and tier 3 capital cannot – in total – normally exceed 100% of the institution’s net tier 1 capital. This limit cannot be exceeded without OSFI’s express permission, which will only normally be granted where an institution engages mainly in business that is subject to the market risk capital charge.

As has been noted, the limit on non-common-equity elements of Tier 1 Capital has been raised to 30%.

Update, 2008-2-12: I also note the OSFI July, 2007, Advisory (an “FRE” is a “Federally Regulated Entity”):

The maximum amount of innovative instruments that a FRE can have outstanding is being increased to 20% of net Tier 1 capital. A maximum of 15% of net Tier 1 can be included in the innovative Tier 1 category with the balance, a maximum of 5% of net Tier 1 eligible for inclusion in Tier 2B. Any portion of the innovative Tier 1 instruments permissible within Tier 2B can thereafter be transferred to the innovative Tier 1 category as room becomes available.

In addition, and without limiting the application of the preceding paragraph, subordinated debt issued by Non-Consolidated Financing Entities will be eligible for inclusion in Tier 2B capital provided the conditions set out in Section 5 of this Advisory are met. The sum of this subordinated debt and innovative Tier 1 instruments included in Tier 2B capital of the FRE must not exceed the greater of 5% of net Tier 1 of the FRE or the dollar amount obtained when the 5% limit is calculated at its ultimate controlling FRE (the “innovative overflow”). Any portion of the “innovative overflow” composed of subordinated debt issued by Non-Consolidated Financing Entities permissible within Tier 2B cannot, at any time, be transferred to the innovative Tier 1 category.

Tier 2B capital in aggregate will continue to be limited to 50% of net Tier 1 capital. OSFI’s Interim Appendix to Guideline A-2 (Banks/T&L/Life) states that “[a] strongly capitalized FRE should not have innovative instruments and perpetual non-cumulative preferred shares that, in aggregate, exceed 25% of its net Tier 1 capital.” FREs need not include the amounts of innovative Tier 1 instruments that are included in Tier 2B, in the calculation of the 25% limitation on preferred shares and innovative instruments in Tier 1.

If, at any time after issuance, a FRE’s ratio of innovative instruments (included in a FRE’s innovative Tier 1 category) to net Tier 1 capital exceeds 15%, and/or if the “innovative overflow” exceeds the allowable level as described above, the FRE must immediately notify OSFI. The FRE must also provide a plan, acceptable to OSFI, showing how the FRE proposes to eliminate the excess (or excesses if it breaches both limits) as soon as possible. A FRE will generally be permitted to continue to include such excess(es) in the respective category(ies) until such time as the excess(es) is (are) eliminated in accordance with its plan.

 

Posted in Primers, Regulatory Capital | No Comments »

Banks & Subordinated Debt

Wednesday, November 21st, 2007

I ran across an interesting story today on the Cleveland Fed website: Credit Spreads and Subordinated Debt by by Joseph G. Haubrich and James B. Thomson.

Subordinated debt may be counted as part of Tier 2 capital by the banks, where it is senior to preferred shares (and everything else that’s in Tier 1) but junior to deposits.

One proposed means of injecting more market discipline into the banking sector is a subordinated debt requirement. It would compel banks to issue some debt that the government does not guarantee and that is paid off only after all depositors have been satisfied. A mandatory subordinated debt requirement was one of the reforms recommended in a 1986 study commissioned by the American Bankers Association. In addition, the Financial Modernization Act of 1999 requires that large banking companies have outstanding, at all times, at least one (though not necessarily a subordinated) debt issue rated by a commercial credit-rating agency.

Some experts argue that subordinated debt is unnecessary because equity capital already gives depositors and other bank creditors a layer of protection. But banks’ equity—that is, their stock—rises when their profits increase, so the prospect of higher equity can encourage them to take greater risks. Debt is more sensitive than equity to the loss aspect of risk because it lacks the upside inducement of higher profits. Subordinated debt thus gives a bank’s depositors and general creditors the same protection from losses as equity does, without creating the incentive to assume more risk.
…
Evidence on credit spreads and credit spread curves suggests that these sources of information could one day become useful to bank regulatory agencies. At this time, however, the evidence is too weak to justify imposing a mandatory subordinated debt requirement, especially if its purpose is to increase market discipline on banking companies and give bank supervisors better information about banks’ changing conditions. Before supervisors add credit spreads from subordinated debt to their dashboard of early warning signals of deteriorating bank conditions, much more work must be done on extracting useful, reliable risk indicators. So, despite some encouraging results, we need considerably more evidence on the value of credit spread information to regulators and markets before deciding to impose any new rule on how banks fund themselves.

By way of example, Royal Bank’s 2006 Annual Report shows $21.5-billion in Tier 1 Capital and $8.6-billion in Tier 2 Capital; the latter figure includes $7.1-billion in sub-debt.

Update, 2007-11-22: OFHEO is attempting to use sub-debt as a control feature on the GSEs, but it isn’t working out very well:

Those tests show that the market behavior of sub debt yields has changed as negative information has emerged about the Enterprises’ management and risks. However, the nature of the change has been to link sub debt yields more closely to Treasuries. That paradoxical development is consistent with investors having greater confidence that Fannie Mae and Freddie Mac or their federal regulator would reduce the Enterprises’ default risks, with greater liquidity in the Enterprise sub debt market in recent years, or with greater confidence in the value of the implicit federal guarantee associated with Enterprise debt.

Posted in Interesting External Papers, Primers, Regulatory Capital | 8 Comments »

Covered Bonds

Wednesday, November 7th, 2007

RBC has issued covered bonds – denominated in Euros.

Covered bonds are a financing that offers increased protection to the lender and decreased funding costs for the issuer. The issuer sets up a mortgage pool and securitizes it – so far, this is just an ABS. However, there is full recourse to the issuer in the event that the pool does not cover repayment of the debt. The high regard with which covered bonds’ credit quality is held is reflected in their Basel II risk-weights – there are a number of different options for the calculation, but basically, covered bond holdings are added to risk weighted assets at between 40%-50% of the charge that would be incurred by holding the issuing bank’s senior unsecured debt.

I am advised that RBC was able to sell their issue for “midswaps + 11bp” (a measure with which I am not very familiar), a rate that will can be swapped back into Canadian at Canadas + 65bp for their five year paper. This compares to GoC +88bp for CIBC’s recent five-year deposit note issue.

So, based on the Canadian Curve, and allowing a few bp for the credit differential between CIBC and RBC, 5-year covered bonds can be issued 20bp through deposit notes! This is cheap financing!

These issues have recently been authorized for Canadian Banks, to a limit of 4% of total assets after consideration by the OSFI:

We note that covered bonds — debt obligations issued by a deposit taking institution (DTI) and secured by assets of the DTI or of any of its subsidiaries — provide a number of benefits but also raise concerns. For example, covered bonds can improve funding diversification and lower costs. However, they also create a preferred class of depositors, reducing the residual level of assets available to be used to repay unsecured depositors (including the Canada Deposit Insurance Corporation) or other creditors in the event of insolvency, depending on the amount issued and the nature of credit enhancements.

RBC’s issue has been rated AAA by DBRS:

The rating is based on several factors. First, the Covered Bonds are senior unsecured direct obligations of Royal Bank of Canada (RBC), which is the largest bank in Canada and rated AA and R-1 (high) by DBRS. Second, in addition to a general recourse to RBC’s assets, the Covered Bonds are supported by a diversified collateral pool of first-lien prime conventional residential mortgages in Canada. Third, the Covered Bonds benefit from several structural features, such as a reserve fund, when applicable, and a minimum rating requirement for swap counterparties, servicer and cash manager. Fourth, the underlying collateral originated by RBC is of a high credit quality with a low credit loss historically. And, lastly, the final maturity date on the Covered Bonds can be extended for an additional 12 months, if required, which increases the likelihood the Covered Bonds can be fully repaid.

Despite the above strengths, the Covered Bonds have the following challenges. First, a weakened housing market in Canada could result in higher losses and lower recovery rates than those used for credit enhancement determinations. This is mitigated by the home equity available and conservative underlying asset values. Secondly, RBC may be required to add mortgages to maintain the collateral pool, incurring substitution and potentially credit-deterioration risk. These risks are mitigated by the ongoing monitoring of the pledged assets to ensure the over-collateralization available is commensurate with the AAA-rating assigned. Third, there is a liquidity gap between the scheduled payment of the Covered Bonds and the repayment of underlying mortgage loans over time. This risk is mitigated by the over-collateralized collateral pool and the build-up of a reserve fund if RBC’s rating falls below A (high) or R-1 (middle) and the extendible maturity date for an additional 12 months, if required. And lastly, there is no specific covered bond legislative framework in Canada, unlike in many European countries. This is mitigated by the contractual obligations of the transaction parties, supported by the opinions provided by legal counsel to RBC and a generally creditor-friendly legal environment in Canada.

A Fact Book regarding covered bonds is available from the European Covered Bond Council.

Update: OK, got it. The “midswaps” stuff bothered me because RBC seems so proud of themselves for being to issue 11bp over. Top-Quality banks ARE the interest-rate-swaps rate … bank debt should normally trade AT the swaps rate (except for weak banks, which would trade over); covered debt should therefore trade THROUGH swaps.

I have been advised that due to the credit crunch, market impact costs (or “new issue concession” to be more particular) are such that being able to issue EUR 2-billion at only 11bp over is, indeed, something of an achievement.

Update, 2012-12-21: CMHC has released the Canadian Registered Covered Bond Programs Guide.

Posted in Miscellaneous News, Primers | 5 Comments »

Downgrades Coming in CPDO Market?

Thursday, September 6th, 2007

The agencies are under attack again!

CreditSights, a New York based Credit Research Firm has launched another attack on its Credit Rating Agency competitors with the release of a report “Distressed CPDOs: We’re Doomed!”. It should be noted that by “Credit Research Firm”, I mean that they are paid by their subscribers; as opposed to “Credit Rating Agencies” which are paid by the issuers.

In other words, to make a living they have to convince the buy-side that the CRA ratings are worthless and that the buy-side should therefore pay them for their analysis. Which is not to say they’re wrong, but it’s always a good idea to follow the money.

Anyway, the new battleground is CPDO Ratings. There has been something of a crisis of confidence in these ratings since the recent kerfuffle began.

There may be one or two people in the galaxy who are unaware of just what is meant by CPDO (it’s not a Star Wars character). The Default Risk site has republished a case study, First Generation CPDO: Case Study on Performance and Ratings and a UBS Primer on the topic.

Basically, the idea is … well, we we all know what a CDS is, right?

consider, on one hand, a portfolio composed of (1) a short position (i.e. selling protection) in the CDS of a company and (2) a long position in a risk free bond. On the other, consider an outright long position in the company’s corporate bond, all with the same maturity and par and notional values of $100. These two investments should provide identical returns, resulting in the CDS spread equaling the corporate bond spread.

Essentially, what a CPDO does is (synthetically) purchase a portfolio of five year bonds (5 years is the standard CDS term), lever the hell out of it (with leverage financing at, essentially, the risk-free rate due to the definition of a CDS) and aim to capture the spread on such a portfolio over a ten year term.

The critical point is that the investment horizon is longer than the term of the assets. To a first approximation, therefore, you don’t really care what happens to spreads, since if they increase then you get to reinvest less money (since there’s a capital loss) at the higher spread.

As the UBS primer points out, the three major CPDO risks are:

  • credit events in the underlying portfolio
  • costs of exiting the old off-the-run index
  • low premium on the new on-the-run index

They conclude, after examining a representative hypothetical product, that the CPDO can withstand 7% annual losses, which will result from 0.8% of the underlying portfolio defaulting with 67% severity every year, while leveraged 13X. Such a loss may also result from the old off-the-run index rising in premium by 12.5 bp per year every year.

A low premium on the new index may result from migration … the CDSs in the index are replaced if the credit rating falls below investment grade. Therefore, the old index may include junk credits at a high premium while the new index will not contain these elements. Therefore, there will be a yield give-up when rolling the index. As Fitch says in their review:

This migration historically shows a downward trend for investment grade assets, which means that they are more likely to get downgraded than upgraded. Every quarter, the negative trend in the migration process leads to an increase in the portfolio spread relative to the underlying driving spread. For a CPDO, this idiosyncratic spread widening will cause MtM losses, which are crystallised on each roll date or following a de-leveraging event. The impact on NAV is significant. For instance, a widening of 5bp every six months in a transaction leveraged 15x on a five-year index with 4.3 years of duration equates to 5 x 4.3 x 15 = 322bp or 3.22% NAV decrease.

This post comes about because of a Bloomberg story: CPDOs Rated AAA May Risk Default, CreditSights Says:

To make matters worse, the CPDOs are likely to earn a lower premium on the new CDX Series 9 index because the credit risk will be lower as the downgraded companies drop out. At least five companies in the CDX and iTraxx indexes have lost investment grade ratings and will have to be replaced, according to Watts. Without the downgraded companies, the new CDX index may be priced 11 basis points tighter than the current benchmark, JPMorgan Chase & Co. analysts led by Eric Beinstein in New York said in a report published this week.

which is discussed in the Fitch paper under the heading “Migration Driven Spread Movements”:

The average migration causes around 2.4% of spread widening over a six-month period or around 2bp for a spread of 80bp. Fitch’s model for migration is not constant but stochastic. It also generates extreme migration scenarios that would cause 20 to 30bp of spread widening over six months. The impact of credit migration is also relative and increases when spreads are high in the model.

So, it’s not as if Fitch didn’t consider this risk, anyway! CreditSights is simply claiming that the risk has been miscalculated.

The CreditSights paper is available for 150 USD. Tom Graff wants a free copy. 

Posted in Primers, Sub-Prime! | 5 Comments »

Credit Default Swaps: Links to Primers

Friday, July 20th, 2007

Credit default swaps have been in the news quite a bit lately, so I’m posting some links to articles:

Credit Default Swap (CDS) Primer, Nomura, May 2004

The CDS Market: A Primer, Deutsche Bank, 2004

Bloomberg article on Insider Trading (hat tip Bill Cara) Note: it’s not clear to me why these changes in the CDS levels did not leak into the bond market via arbitrage of the basis.

Update, 2007-7-29: There’s a good introduction at the Accrued Interest blog.

Update, 2007-9-13: There are some good downloadable papers at John Hull’s website. Hull & White, 2000 is the basis for the Bloomberg CDSW screen.

Update, 2008-01-28: Hu & Black discuss the problems inherent in “debt decoupling” – if the owner of a bond is fully, or even more than fully, hedged via CDSs, this block of bonds might be voted in a manner that is predjudicial to the economic interest of that class of creditors.

There are also several sources of qualitative evidence. One is the recent tendency for credit default swap contracts to require the protection buyer, if it is also a creditor, to act in the interests of other creditors. This suggests concern that the protection buyer might not otherwise do so. How this obligation can be enforced, however, without disclosure of either votes or hedges, is anyone’s guess. We have also heard from bankruptcy judges that they sometimes see odd behavior in their courtrooms, which empty crediting might explain. For example, one judge described a case in which a junior creditor complained that the firm’s value was too high, even though a lower value would hurt the class of debt the creditor ostensibly held.

There is some commentary at Naked Capitalism.

Update, 2008-2-6: More warnings via Naked Capitalism: CDSs may not work as advertised due to operational issues, the ascendency of Sales over Risk Management, and the relative amounts of notional vs. deliverable bonds.

Update, 2008-3-30: Another risk with CDSs is a potential disparity between the cash-settlement price and the ultimate recovery price, as has happened with Delphi. See AleaBlog and Felix Salmon.

Update, 2008-4-3: It’s linked in the comments, but I should highlight the February 21 review of some BoC Research into CDS Pricing.

Update, 2008-9-4: See also CDS Recovery Locks.

Update, 2009-3-12: Risk Weight of Credit Default Swaps.

Posted in Interesting External Papers, Primers | 18 Comments »

LBS.PR.A : Financial Statements & Some Comparatives

Thursday, April 5th, 2007

I was asked on an old thread to comment on this issue in the light of the release of the split-share corporations first audited financials through Brompton’s dedicated web page.

LBS Balance Sheet, 2006-12-31 (Simplified by James Hymas)
Assets (thousands)
Good Assets 311,659
Assets only an accountant could love 14
Total Assets 311,673
Liabilities  
Misc. Liabilities 3,010
Preferred Shares 120,000
Total Liabilities 123,010
Shareholders’ Equity 188,663
Total Liabilities & Equity 311,673

OK, so remember from the example of Sixty-Split that the Asset Coverage Ratio is defined as Total Money Available / Total Money Required.

Total Money Required is the redemption value of the preferreds: $120-million.

Total Money available is the Shareholders’ Equity plus the amount already earmarked for the prefs less the miscellaneous liabilities (because they get paid first or, at least, earlier) and also less the ephemeral assets of $14-thousand (because they will evaporate prior to the preferreds coming due AND because if the company gets wound up tomorrow there’s no actual cash to be gained from them), or $188,663 + $120,000 – $3,010 – $14 = $305,639.

Correction, posted 2007-4-11 : There is an error in the above. There is no need to subtract the $3,010 in miscellaneous liabilities because they were never added in the first place, since the positive figures being used come from the liability side of the balance sheet. Thus, the cash available is $188,663 + $120,000 – $14 = $308,649 and the coverage ratio is 2.57:1.

Another way to arrive at this number is consider the total money available to the company on liquidation, less the amounts that have to be paid out before the prefholders get paid: $311,659 – $3,010 = $308,649.

Which just goes to show, you have to be careful with this stuff and, if possible, check it with a different method!

Therefore, the Asset Coverage Ratio is $305,639 / $120,000 = 2.55:1.

Or, to put it in DBRS terms, there’s downside protection of 60.7% … in other words, the assets could lose 60.7% of their value and there would still be enough in the kitty to pay off the preferred shareholders (although the capital unit holders would lose their shirts).

Just how much asset protection one wants is a function, in part, of just what the assets are. If LBS held a portfolio of Junior Uranium explorers I would be more concerned, but I take the view that the LBS portfolio of big Canadian Banks and Insurers isn’t going to drop by that much any time soon. I’m happy with the coverage.

By way of comparison, the recent DBRS rating of CFS.PR.A as Pfd-1 started off the summary with:

The rating of the Preferred Shares is based on the following:

(1) The available downside protection, which is 57% to the principal amount of the outstanding Preferred Shares at closing.

….

A full analysis is more complicated than that, obviously, but it is clear that on an Asset-Coverage basis, LBS.PR.A has nothing to be ashamed of. So now let’s go to the income statement:

LBS Income Statement (thousands) (Simplified by James Hymas)
Income  
Dividends, Interest & Lending 2,038
Expenses  
Fees (547)
Expenses (185)
Brokerage (66)
Total Costs (799)
Preferred Distributions (1,304)
Capital Unit Distributions (2,981)
Realized & Unrealized Capital Gains 26,858
Total Change In Net Assets 23,813

It should be remembered that these figures are derived from operations for the period October 17 (commencement of operations) to December 31. We’re interested in ratios, not absolute numbers, so we’ll assume – for now, for the purposes of this analysis only – that this INITIAL PARTIAL period gives a good indication of what may be expected (in terms of ratios) for FUTURE COMPLETE periods.

An assumption. For now.  

So: we want to find out the income coverage. Total income for the period is $2,038 [thousands throughout] and is of a nature that appears to be sustainable. We’ll cut the boys a little slack, and ignore the $66 transaction costs … they had to invest all their money in the period, their first since inception, and given that the corporation takes a passive stance towards the stock portfolio, it’s not very likely to recur to the same extent. At the end of the period, they held a total of just over six million shares, so their COMMISSSIONS paid amount to just over a penny a share, which is entirely reasonable.

We have no idea, from just these figures, whether their trading was done competently or not. It is entirely possible that these guys are the most reckless idiots in creation and overpaid for their stock big-time, to the amount of $1.00 per share. It is also possible that they’re the smartest, toughest negotiators & traders in the world and UNDERPAID for their stock, to the amount of $1.00 per share. This somewhat vital information, which may usually be relied upon to be a much greater number than piddly little commission expenses, is completely missing from such completely simplistic moronic idiocy as the Trading Expense Ratio, which, for instance, mutual funds are required to report by policy of the Canadian Securities Administrators, in an apparent effort to ensure that the gullible think they understand something.

But one way or another, we’ll exclude commission costs from the expenses, in the belief (hope?) that they were largely a one-time thing.

So to calculate income coverage, we come up with $2,038 – $547 – $185 = $1,306 presumably recurring net income after expenses, to cover preferred share distributions of $1,304.

Not quite an exact match, but close! We’ll say that income coverage is 100%, for purposes of this analysis. That’s pretty good! The figures shown in my article on split shares are even more out of date than they were when I wrote it, but serve as a reasonable benchmark. One Hundred Percent coverage implies that preferred shareholders may expect that there is a reasonable chance that they will get their dividends without the company having to dip into capital, thereby reducing the Asset Coverage Ratio.

All sorts of bad things could happen in the future, of course. What if the company is too generous in its distributions to the Capital Unit holders (there are limits to this under the prospectus; determining whether these limits are good enough is left as an exercise for the student)? What if all the banks cut their dividends to zero in response to taxation changes? You can never predict the future, but you can extrapolate the present … as long as you retain a healthy skepticism towards this and any other extrapolation (and watch the financials to ensure that you like what’s happening!), the income coverage on this issue looks quite good.  

Not quite as good as DBRS noted for CFS.PR.A:

(3) The Interest Coverage Ratio test of 1.5 times for the Preferred Shares, which ensures a high level of protection to the holders of the Preferred Shares.

but good enough for investment grade.

DBRS rates this issue Pfd-2. There’s a chance I might quibble about this rating if I did a very thorough analysis of comparable issues and historical performances … but there’s nothing in these financials that makes me suspect that such a rating is completely out to lunch.

I’m happy with the rating. That does not imply anything at all about whether I think that LBS.PR.A is a good investment at this time at the current price.

Remember the Tech Wreck? Everybody and his shoe-shine boy was telling everybody else that ‘The Internet is going to change all our lives, and therefore Nortel is a fantastic buy at $110!’. Well, yeah. The internet is going to change our lives. And Nortel is a fine company (although perhaps I should have chosen another example, a company that can keep a set of books, for instance). BUT. BUT. BUT. That does not imply it should be bought irregardless of price.

First you determine value. Then you determine price. Then you subtract. Then you make an investment decision.

So, anyway, I’m not going to comment much on the investment characteristics of LBS.PR.A. I’m happy to rant and rave on and on about issues I consider lousy, but for discriminating between “Weak Sell”, “Hold”, “Buy” and “Strong Buy” (which aren’t actually terms I use, but serve as examples), you’ve got to be a client.

Or, soon (very soon!) a subscriber to PrefLetter!

But, out of the kindness of my heart, I’ve uploaded a recent evaluation of the HIMIPref™ Split-Share Index, to give interested readers a place to start.

Posted in Index Construction / Reporting, Issue Comments, Primers | 1 Comment »

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