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UKAR – the biggest mortgage lender you’ve never heard of

U.K. Asset Resolution (UKAR) was established in late 2010 as a holding company for Bradford & Bingley (B&B) and the part of Northern Rock that was to remain in public ownership (NRAM).  Unlike other rescued institutions – RBS and Lloyds – whose progress we are kept well abreast of in the media, UKAR has flown under the radar somewhat. To give an idea of scale of the rescue; despite neither entity issuing a mortgage since 2008, UKAR is still the 7th largest mortgage lender in the UK today with a balance sheet of £74bn. About a third of assets on UKARs balance sheet are the legacy securitised RMBS deals of the two firms; B&B’s Aire Valley and the Granite complex from Northern Rock. A further 26% and 22% of assets are unencumbered mortgages and covered bonds respectively.

So, how well have they been using our tax money? And, are we likely to receive a return on our cash?

We met with management last week and they laid out their broad strategy going forward. They told us they are very focused on trying to help those able to refinance their mortgages elsewhere at a better rate. They also detailed how processes for collections and dealing with arrears have improved. This trend can be observed below, as the number of borrowers in the two securitised deals who haven’t made a mortgage payment for over 3 months has decreased significantly.

UKAR – borrowers in 3+ months arrears have declined significantly

More specifically, UKAR has a three pronged strategy for dealing with each of the three groups of assets (RMBS, unencumbered mortgages and covered bonds):

  • RMBS deals – has a strategy of tendering for notes that represent expensive financing
  • Unencumbered mortgages – sell off loan portfolios to third parties who wish to securitise them
  • Covered bonds – shortening the maturities through liability management exercises

Along with lowering arrears, UKAR has been successful in achieving these objectives whilst turning a decent profit. Clearly this profit is where we as tax payers (or the government) extracts value. Unlike the cases of RBS and Lloyds in which the government took an equity position, here they fully nationalised the institutions and extended a loan. Last tax year UKAR paid back £5.1bn of debt and £1.1bn in interest, fees and taxes to the government.

One further, slightly more technical point to note is the RMBS structures have hit a non-asset trigger. The trigger specifies that the notes issued out of UKAR have to be paid back sequentially – in order of seniority – until the whole deal is paid off. At this point there will be a slice of equity that will become available to the Treasury, roughly £8bn in total.

So, yes, I do think that they are doing a good job of looking after the tax payers’ investment. I also think commercial liability management exercises and portfolio whole loan sales will continue to maximise value. And of course, helping to keep people in their houses is a pretty good deal as well.


A new source of supply in the ABS market

One of the features of the ABS market this year has been the lower levels of primary issuance. That, coupled with increased comfort in the asset class and higher risk/yield appetite has caused spreads to tighten.


We have had a few new deals, but 10 months in and new issuance volume is only about half the amount seen in 2012, and just a third of 2011 issuance.


What we’ve seen of late, despite the subdued new issuance, is an increase in the number of these securities available in the market. In the not-so-distant past, banks would structure a securitised deal, place some with the market and keep some to pledge to their central bank as collateral for cheap cash.

Now spreads have tightened, and the market feels healthier, some of these issuers are taking the opportunity to wean themselves off the emergency central bank liquidity and are offering the previously retained securities to the public market.

Another dynamic in ABS at the moment is that ratings agency Standard and Poor’s is considering changing its rating methodology for structured securities in the periphery. S&P is considering tightening the six notch universal ratings cap – countries rated AA or above will not be affected, but bonds issued from countries with a rating below AA could be downgraded as they won’t be allowed to be rated as many notches above their sovereign as they were before.

The implication is that securities that get downgraded will become less attractive for banks to pledge as collateral because of the haircuts central banks apply to more risky (lower rated) securities. Our thinking is that southern European issuers will be hit hardest by this change. So unless the ECB loosens its collateral criteria (which it can and has done previously), one would expect to see more of those previously retained deals coming to the market as well.

So whilst we haven’t seen too much in the way of new issuance, it looks like we could be about to see an increasing number of opportunities in the secondary market.



Funding for Lending – has the scheme achieved its goals?

As has been widely reported, last week the Bank of England and HM Treasury extended their Funding for Lending Scheme (FLS). The FLS was originally launched in July last year with the intention of stimulating lending in the real (non-financial) economy. Under this scheme a bank or building society borrows UK Treasury Bills and hands over eligible assets as collateral. The fee they are charged (effectively the interest rate) and the amount they can borrow are determined by how much they have increased their lending. The bank or building society can then either repo their T-Bills for cash or, more cheaply/likely, just use them to replace cash in their liquidity buffer. The more they lend the more they can borrow at the lower rate.

The BoE and HM Treasury have hailed the scheme as a success. But on what measure?

Today we received news that mortgage approvals had another weak month in March, increasing only slightly to 53,500. Mortgage approvals have been flat at around 50,000 per month since early 2010 and, considering last week’s extension to the programme incentivises SME lending more, it doesn’t look like the cheaper funding has spurred the desired increase in lending.

UK mortgage approvals chart

Further, with the average mortgage rate in the UK at around 4% and banks able to borrow at what the Bank of England estimates to be 0.75%, the lower rates clearly aren’t being passed on to the man on the street either. Assuming banks’ net interest margins aren’t the measure on which this programme is judged I think it’s fair to say it hasn’t been a huge success.

Unless that is, you happen to be an investor in asset backed securities. The UK Residential Mortgage Backed Securities (RMBS) market has rallied significantly since the FLS was first announced. Granted, most risk assets have rallied since last summer – partly down to Mario Draghi’s now famous speech – but I think that the UK RMBS sector has had an extra boost from the FLS.

Rather than issue RMBS, the banks and building societies have preferred to pledge their mortgage stock with the FLS which has provided a technical support for the market. The graph below shows the spread on an index of short dated, AAA, UK prime mortgage deals. As you can see they began their rally last summer and have been hovering around 50bps since the autumn. The lack of supply – we haven’t had a new public deal since last November – has certainly been supportive for spreads.

UK Prime RMBS chart

The Bank of England and the Treasury claim that the scheme has been a success mainly on the grounds that things would have been worse without it. Clearly we’ll never know. Whether things are better or not the FLS appears to have done almost exactly the opposite of what it set out to do. It was established to provide support to the non-financial sector, but as far as I can tell, to date it has actually made the financial sector marginally healthier and better off.


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RBS – The Goodwin Lottery?

Vince Cable has suggested that the government’s shareholding in Royal Bank of Scotland should be parcelled off to UK citizens. The UK government’s ordinary shareholding in RBS Group (A shares) today stands at 65.29%, which goes up to  81.15% including B shares (shares with priority over dividends).

Assuming the UK government would distribute A shares only, this would give us roughly 63 shares each that would be worth £222 based on yesterday’s closing share price of £3.54. This very simplistic way to dispose of the government’s ordinary stake could well be described as fair, though it would leave lots of individual holders and create administration and system chaos. Is there a better way? How can you reduce this administrative nightmare, make the give away more popular, or improve RBS’s future prospects?

How about simply having a lottery, as opposed to the shares being split? We could have a lottery based on the electoral roll for example. However, winners would get substantially more shares each, say 300,000, which at £3.54 a share would be worth just over a million pounds each. We could in effect create more than 13,000 new millionaires. It could maybe even be marketed as the Goodwin Lottery!

A second alternative would be to actually embrace free choice and the market economy via selling tickets for the lottery. This could not only create the same amount of millionaires, but would raise extra revenue for the government. The use of the existing Camelot lottery network would make that relatively efficient.

A third alternative would be to basically “de-mutualise” it. This would involve an open offer for sale of the government’s share holding to individuals, with all proceeds raised contributing to new equity for a new invigorated bank. This would act as a deeply discounted rights issue with the government stake being 100% diluted, and their huge loss being the new investors’ gains.

The ideal solution for the UK economy is to have a thriving competitive banking sector, at a minimum cost to the taxpayer. If the politicians decide the best way to do this is to simply give the shares away then hopefully they may improve their plan to get some of the potential benefits outlined above.

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Going Dutch – SNS nationalisation

We have been talking about the emergence of, and the effects of, the financial crisis in our blogs for a number of years now. However, more than 5 years into the crisis even we can be surprised. On Friday the Dutch government nationalised SNS, as capital injections from the private sector failed to appear. This action was undertaken to maintain the stability of the Dutch financial system.

This legal manoeuvre involved a confiscation of all SNS equity and group and bank level subordinated debt by the authorities, and an injection of cash into the bank. The holders of the aforementioned equities and bonds quite simply no longer have these securities. To paraphrase Monty Python, they are ex securities. Investors have lost all legal rights. Instead, they have been offered potential compensation based on the value that the Dutch government ascribes to the securities. However, their judgement of what that amount may be is highly likely to be zero.

We have examined many times the potential weakness embedded currently in financial issuers and how the tiering of debt is becoming more significant for investors. Before the financial crisis, senior and subordinated debt from the same bank were seen as equal under all circumstances except an event of default, in which case the senior bonds would see better recovery values. The fact that for systemic reasons the authorities wouldn’t want the bank to stop operating meant that subordinated debt benefitted from the halo effect of the perceived need to sustain the bank for the benefit of the financial system. However, since 2008, countries all over Europe have been putting in place legislation, in the form of so called “resolution regimes”, to allow them to deal with failing banks, without necessarily having to keep the whole bank going. This use of these recently introduced new laws in the Netherlands allowed the authorities to separate the claims of subordinated bond holders from those of other, more senior, bond holders. This is something we have not encountered before in this form (for example, while the UK government did nationalise the preference shares as well as the equity of Northern Rock, it didn’t actually nationalise the subordinated debt, whereas in Denmark a different approach was followed, leaving bondholders on the wrong side of a good bank/bad bank split). This Dutch approach allows for the quick and efficient bailing in (writing off) of subordinated debt and allows the bank to continue operating, thereby protecting the financial system.

‘Going Dutch’ is an expression used when you agree to share a restaurant bill. However, going Dutch SNS style means subordinated bond holders pick up the tab, as they have been eliminated, losing all the capital value of their investment. They have explicitly provided 1 billion euros of capital to help the ongoing health of the Dutch financial system.

Early intervention of this sort to protect the financial system is obviously bad news for subordinated bond holders, with their status becoming more equity and less bond like. It will be interesting to see what the market and the rating agencies think of this new approach in the ongoing battle to support the financial system. Is it a one off, or something we are going to come to see as common practice?


Contingent capital notes – bank equity’s best friend?

As investors, the majority of our time is spent pricing risk with an increasing amount of that spent trying to value optionality. We’ve always had to price the optionality inherent in owning certain bonds. For instance what’s the likelihood of a call option sold to a bond issuer being exercised? What’s the likelihood of an early refinancing, or perhaps a change of control? These and other options are both risks and opportunities that credit investors will regularly have to consider and reconsider.

Some of the more recent options that credit investors have been forced to consider are those embedded within contingent capital notes or CoCos. These aren’t entirely new securities with Lloyds having exchanged bonds for CoCos back in 2009. Simplistically these ‘first generation’ CoCos are designed to behave like a traditional bond until a pre-defined trigger is breached. When triggered, first generation CoCo holders are forcibly converted into equity at pre-determined pricing, aiding the bank with its recapitalisation efforts. These instruments have found favour with the regulator not least because traditional subordinate capital instruments proved themselves almost entirely ineffective in providing loss absorbing capital.

However, since the issuance in 2009 the market has moved on somewhat and a new breed of CoCo has since emerged. Many of these newer instruments (see chart above) are designed to be written off entirely in the event of a trigger without the conversion into equity discussed above. This optionality has two obvious implications. Firstly, given that investors are written down to zero without equity conversion, any prospect of participating in a future recovery becomes null and void. Secondly (with the caveat that the quantum of issuance remains small for now), the prospect of a bond essentially performing the role of a non dilutive emergency rights issue has to be positive for all other stakeholders in the bank, not least common shareholders. And don’t forget that the majority of these instruments will see their coupons paid before tax, further enhancing the relative value of said issuance.

Selling all this optionality does have its price, as do most things in life, but the current exuberance in credit markets may yet see CoCo investors fail to exact an adequate premium.


Don’t call us we’ll call you

We have opined on many occasions about the call features on bank debt and have long argued that investors and issuers should price these securities on economic rather than emotional grounds (for more detail, see Jim’s blog on Deutsche Bank being the first not to call a Lower Tier 2 bond in 2008).

However, even we were surprised late last week when Intesa SanPaolo decided to amend the terms of some of its callable subordinated debt by removing the call option for each of the bonds.

The terms of a security are sacrosanct to bond investors. We obviously fear the terms of a contract being amended as this reduces our legal rights and the value of our securities. Therefore bond documents are carefully written, and a trustee generally acts as an arbiter to protect both the issuer and the investors’ interests. How can Intesa be allowed by the trustee to unilaterally change the terms of the bond?

The simple removing of the call option from the bond terms and conditions is not detrimental to bond holders. If someone has an option against you and cancels that option the text books and simple logic states that you can be no worse off, and the only party whose position is weakened is the one who has cancelled the option they had against the other party. So in theory as a bond investor you’re better off, so why complain?

The reason investors in these types of securities are concerned is that they were hoping that for reputational reasons the bonds would be called to keep them happy.  In many cases that long term care of reputation with regard to funding has been deemed an appropriate call (excuse the pun) for the bank issuer of these callable securities to make.

The companies that have generally not called securities in the past have been led by the likes of JP Morgan, Deutsche Bank, and US Bancorp. But none of them decided to remove the call option as that would be potentially detrimental to them. Indeed this week US Bancorp’s subordinated bonds matured due to them exercising an economically efficient call.  These non-callers continue to be able to fund and interact with the investors whose expectations were not met regarding their bond holdings.

In these difficult times it appears that banks are now more willing to act on a purely economic basis, which takes some of the hope out of the valuation of callable securities. The investor relations department of banks used to have a mantra of ‘don’t call us we’ll call you’. That is looking increasingly out of fashion.


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Bail-ins: Damned if we do; damned if we don’t

We have written on numerous occasions about the hitherto inseparable links between sovereigns and banks, and we have also written about the benefits of writing down bonds to create capital  (see The New Era for Bank Bonds: Send In The Clowns? and Equitisation of bank capital bonds) . In 2007 the global markets woke up to the fact that the US subprime market was blowing up, and in 2008 realised that due to financial engineering and securitisation, both of which were preposterously known at the time as ‘risk dissemination and minimisation’, banks the world over had major solvency issues as vast quantities of investments plummeted in value. This, in turn, led to a liquidity crisis as the investment markets shunned investment in banks and the interbank market froze over.

The crisis we are in today is the same crisis we were in 5 years ago. Sovereigns had to step in to guarantee their banking systems, so as to enable debt to be rolled over and confidence to return. In the short term the most important thing was to provide liquidity, which we saw through government guaranteed debt issuance and secured funding directly with central banks in the UK, US and more recently Europe. Next, sovereigns had to buy huge volumes of illiquid assets from their banks (US), or provide direct capital injections to support their solvency (US and UK), as the perception dawned that the liquidity crisis was caused by a solvency crisis.

All this time, the inevitable link between sovereigns and banks was becoming more and more deeply intertwined. And whilst it may feel that the Great Recession has metamorphosed from a banking crisis to a sovereign one, it hasn’t really: sovereigns took on increased liabilities to protect their banking systems and now find themselves in the ‘limelight’. It’s the same crisis, with a different focus.

Many European banks, though, remain substantially undercapitalised. Hence, the system is still overwhelmingly dependent on central banks to provide them with liquidity at an affordable cost. All the time the sovereigns providing liquidity are becoming more and more tied to the health or otherwise of their banks and the assets they are taking from them as collateral.

Has the time come for this cycle to end? Might the severance of this link bring the beginning of the end of the sovereign crisis? Many European banks are still on 24 hour life support, saddled by enormous levels of liabilities that are cutting off new lending and suffocating new investment through the multi-year crisis in confidence in lending to and investing in banks.

So how will this occur? Well my sense is that there’s abundant liquidity at the moment after all the LTROs, inter-central bank funding lines, secured lending facilities and covered bond new issuance. The problem is far more one of solvency and capital adequacy in Europe, where the very worst of the banking crisis continues today. For sovereigns to provide their national banks with the recapitalisations they need, via wholesale nationalisations, would only see a worsening of the sovereign debt crisis, as the funds would have to come from somewhere. So this approach doesn’t really work. And is it really desirable from the perspective of the taxpayer?

The solution? We need new capital, in substantial scale, and fast. The time may have come to sever a significant part of the link between a sovereign and its banks. Unsecured bank bonds in peripheral Europe where the sovereigns are struggling under high borrowing costs, and so where the cost of providing guarantees and funds to their banks are painful, should now be written down in certain cases. Both subordinated debt and senior unsecured bonds would see defaults, in some cases even to zero. This would generate huge amounts of capital (which writing down only subordinated debt would not achieve on its own), and does not involve the troubled sovereign having to borrow more from the markets or seeing debt / GDP levels spiralling. Yes this is painful for investors and to risk-taking savers who are exposed to bank bonds in their pensions and so who suffer losses there. But the write downs are taken. Capital is generated. Deleveraging of the system occurs quickly and substantially (at last!). And the severance of this part of the sovereign-bank link (deposit guarantees must remain in place)  means that the banks might just stop dragging the sovereigns down with them.

Policymakers and politicians must be aware (and I’m assuming they are already) of the benefits of this first step towards cleansing the system. If this doesn’t work, then nationalisation is the last resort, and the taxpayer must step in one last time. But this situation of creeping nationalisation where taxpayers provide 24 hour life support in European banks through emergency policy response after emergency policy response, at the expense of much higher tax and lower quality of life across all citizens for a very long time feels wrong, at least before the risk-takers have suffered. Could now be the time for bank bondholders to see defaults, where they are needed? There are countries where these dramatic measures aren’t needed, as well as individual banks where they won’t be needed within troubled systems. The process will be painful for bearers of risk (investors and savers), but it might, more importantly, provide the capital the system so needs to start restoring confidence in the banks, and the sovereigns would benefit from cutting the tie with the non-deposit banking system. So policymakers have to work out whether society overall would be better off with this new approach than the current one. They may very well conclude that the present situation of taxpayers being subordinate to bank bond holders, rather than vice versa, is a morally repugnant system.

Some of us are damned if we change tack and take this approach. All of us are damned if we don’t.


Debunking myths in the financial system- an annual review

Last week saw Citigroup’s credit conference & an opportunity for investors to catch up with a number of European high yield issuers. For a number of companies the message continues to be one of uncertainty, not least with regard to their banking relationships.

Back in 2008 Richard & I blogged about companies drawing down on bank lines (see here). Companies like CIT were doing so as they were finding it increasingly difficult to fund, whilst the likes of Porsche saw an opportunity borrow cheaply and then deposit the funds at a higher rate.

It seems once again companies are looking to draw down committed facilities. However, rather than being born out of an individual company’s distress, the catalyst seems to be the waning confidence in the banking system. At the very point in time when banks are finding it more difficult to fund their balance sheets and to deleverage, they risk seeing companies call on committed lines, which by their nature are not fully funded.

Which leads nicely into the Tuesday’s annual Sovereign and Financial System Review conducted by our financials team. The meeting focussed on the debunking of myths we feel broadly remain common place amongst investors.

Whilst the substance of the meeting is outside the scope of any one blog, and merely listing the myths taken out of context, I figured  it was a worthwhile exercise anyhow to list those myths that have been debunked over the last 12 months or so, as well as those that continue to circulate:

The myths that are being debunked:

  • No more banks will be allowed to go bust
  • Banks have deleveraged already
  • Banks have already restructured
  • National champion banks will be fine
  • Covered bonds are bullet proof
  • Supra and agency bonds are ‘guaranteed’
  • It’s ok, there’s a bail out fund
  • Germany’s fine- they’ll bail us out
  • Governments will abide by EU treaties
  • Insurance Sector is a ’safe haven’
  • You don’t need to do sovereign analysis
  • Credit analysts can’t do sovereign analysis

The myths that are still believed to varying degrees in the market, or that have appeared recently, and give rise to the most discussion around here at the moment, :

  • It’s easy, just look at the debt/GDP ratio (for sovereigns)
  • It’s ok if you have commodity exports
  • It’s ok if most debt held domestically
  • Just look at net external debt
  • Just look at current account deficit
  • Sovereign debt doesn’t need documentation
  • Eurozone breakup is unthinkable
  • Docs or English law prevents redenomination
  • Foreign bonds are in some way better
  • You can work out impact of Eurozone break up
  • Bond lawyers can tell you what you need to know
  • As long as the bank is profitable, it’s ok
  • XYZ bank is highly profitable based on its net interest margin
  • Capital ratios or non-performing loan ratios are an indicator of solvency
  • Leverage ratio (equity/assets) will be the most useful
  • The yield curve determines how banks do
  • Household leverage is an indicator of problems or a lack thereof
  • Some banking sectors are ‘safe havens’
  • Banks have improved their funding profile
  • Banks have increased their deposit bases
  • Banks have lots of collateral available
  • Banks can always raise secured funding or repo
  • Banks have successfully prefunded maturities
  • National champion banks will be fine
  • Government bad bank structures are working
  • Central counterparties eliminate risk of financial defaults
  • Repo market can value corporate bond collateral
  • Repo market increases transparency
  • Collateralisation has reduced counterparty risk
  • “Too big to fail banks” will still get some sort of support
  • Secured debt will be fine
  • Agencies/supranationals are implicitly guaranteed
  • It’s ok, the banks can just go to the ECB for repo
  • National central banks can’t create credit
  • A crisis is a buying opportunity
  • We’re at the bottom, things will rally now
  • Export/investment will recover quickly
  • Asia/rest of the world will bail us all out
  • Countries with own currencies recover quicker

Congratulations to those of you who made it to the end of that list. I imagine you are an elite few!

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Banking Sector Myths Exposed

The financial sector has understandably been a hot topic over the past few years and is a subject we’ve blogged about at great length. Given the constant newsflow around the sector, and of course due to popular demand, Ben Lord and Stefan Isaacs recently joined forces with Jeffrey Spencer, a senior member of our financial institutions credit research team, to share our current views.

We thought these two teleconferences would be of interest for our readers as Jeffrey uncovers the truth behind some common misconceptions about the state of the banking system.

From a fundamental research perspective, Jeffrey analyses a range of issues, including the extent to which banks have de-levered, their reliance on wholesale funding as well as the challenges they are facing in raising capital.

Our fund managers took this opportunity to restate their views about financials from a more macroeconomic and sector allocation perspective.

There are two versions, similar to each other, but one is aimed at a more European audience, whilst the other is slightly more UK focused.


Financial Teleconference: UK Call:

Financial Teleconference: Euro Call:

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