Sunday, 30 September 2007

How bad can the business pages get?

As an exercise, I'd like to take a look at an article in today's Observer and deconstruct the text. The journalists responsible, Heather Stewart and Nick Mathiason, don't come out of it smelling of roses.

Let's begin near the start of their article with:

Britain's banking sector, once a bastion of financial rectitude overseen by cautious pin-striped branch managers, has been swept along in a frenzy of creative accounting, adapting strategies invented by Wall Street's 'masters of the universe' to feed the British public's voracious appetite for cheap loans.

This is just cheap. First we have the parody of 'pin-striped branch managers' - how does what a branch manager wears effect their job? - then emotive language like 'frenzy' and 'voracious' plus a cute little anti-American jibe with no evidentiary support. Perhaps we can tell already that this is not going to be a balanced piece of reporting.

Northern Rock [...] was certainly not the only UK bank to dive headfirst into the murky world of securitised loans, 'special purpose vehicles' and 'collateralised debt obligations' (CDOs).

Again, totally unjustified language: do the authors know that Northern Rock 'dived headlong' into CDOs rather than calmly and maturely took the business decision to use a perfectly reputable instrument? And just because something is 'murky' to what appear to be rather ill-educated journalists doesn't mean that it is murky to a professional banker, risk manager, or regulator.

The article then goes on to talk about off-balance sheet funding and the increasing gap between deposit funding and lending. It isn't long before we get another disingenuous piece of mud-throwing:

The regulators can hardly claim to be shocked about the blossoming of these byzantine arrangements.

Firstly regulators don't claim to be shocked by them, and neither are they byzantine. Just because you don't understand it, Heather and Nick, doesn't mean it is complicated. The article doesn't get any better:

In other words, instead of taking money in from depositors, and then lending it out again (how dull), they have become mere conduits, gathering in willing customers and selling their loans to investors keen to take a slice of the profits.

Deposit funded lending is not just dull, it also, crucially, has a low ROE. Banks have a duty to their shareholders, just like any other corporation. If a different method of doing business improves returns for acceptable risk, they are failing in their duty if they do not use it. And why is a conduit 'mere'? A central lesson of business over the last twenty years is stick to what you are good at and let others do everything else: it is hard to argue banks are necessarily both the best originators of credit risk and the best long term holders of it. You don't call Tesco a 'mere' grocery distributor: why criticise an originate-and-distribute bank?

Next we get something that is either a mis-understanding or a deliberate spin on the truth:

As the credit crunch hit last month, HBOS - the giant UK bank formed by the merger of Halifax and Bank of Scotland - was forced to announce that it would lend money to a so-called 'conduit fund' called Grampian, 'to repay maturing debt as market pricing was unacceptable'. This was code for a bailout: no other institution would lend the facility money.

In all likelihood, HBOS had written a standby letter of credit to the conduit and hence was obliged to provide liquidity since the ABCP market was disrupted. I rather suspect the authors have no evidence no one else would lend Grampian money because I rather suspect Grampian had no need to ask anyone else. Standby LOCs are commonplace for conduits and, while banks are probably not overjoyed about them being triggered, there is no evidence that they have thus far endangered the banking system. In particular, once a conduit's assets come back on balance sheet, the bank has to provide capital against them in the usual way, so the balance sheet relief only lasts as long as the liability belongs to the ABCP holder.

Of course, Heather and Nick can't resist throwing a little more mud:

No mention of Grampian is made in HBOS's 2006 annual report - an indication that the facility was held off-balance sheet. [...]

This complex financial merry-go-round has made a lot of people rich.

Good grief how terrible. HBOS followed accounting standards in not including an off balance sheet vehicle in its accounts and, even worse, some money was made. What a disaster for the financial system.

Heather and Nick continue with a deeply dodgy passage:

But for all their sophisticated risk management models, when defaults on sub-prime borrowing in the US shot up, and demand for CDOs and other asset-backed loans petered out, the banks realised they simply didn't know what their total liabilities were.

Umm, let's see. A liability is something on the balance sheet, like a bond you have issued. The subprime market has nothing to do with a bank's written debt, so they can't mean that, unless they are referring to covered bonds. They might mean the bank's assets because its easy to confuse an asset with a liability when you are writing polemic, but given the banks were mostly sellers rather than buyers of CDO tranches, that doesn't seem likely either. They might mean the value of the protection bought from the securitisation vehicle, but that isn't on balance sheet (although it is difficult to value at the moment) and it definitely isn't a liability so they can't mean that, can they? Perhaps they don't know what they mean.

Having fired off a string of alarmist propaganda, the authors conclude with:

[...] as it becomes clearer just how radically the banking sector has been transformed - and that the ratings agencies, accountants and just about everyone else in the City has been in on the act - it's hardly surprising if public confidence is shaky.

With journalism like that it is hardly surprising that public confidence is shaky. But the fact remains that securitisation has improved bank profitability, allowed banks to focus more on their customers, given investors access to a much wider range of assets, and spread risk in a fashion that has, so far at least, caused distress but no actual bank failures. How bad might the sub-prime crisis have been if risk had not been securitised? I can't suggest that the regulatory, accounting or ratings systems are perfect - far from it in some cases. But no one's interests, apart perhaps for the authors', are served by articles written in the same vein as Heather and Nick's. Mind you, informed balanced reporting of the credit crunch in the mainstream UK press is about as rare as Giraffes in Canary Wharf.

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