The basic thing about investing in big banks' unsecured debt is that once upon a time it was a pseudo-risk-free proposition because, like, it's a bank, what could possibly go wrong,1 and now it's like,2 hi, you are buying the mezzanine (call it 10-to-30%-loss3) tranche in an actively traded and extremely opaque CDO full of goofy stuff and, hey, put a price on that.
I don't know who'll be good at putting a price on that but it stands to reason that Jes Staley, the former head of JPMorgan's investment bank who left for BlueMountain shortly after several billion dollars of JPMorgan's money made the same voyage, would. He thinks so anyway:
On a panel at the Bloomberg Hedge Funds Summit in New York, Mr. Staley discussed what is known as resolution authority, in which regulators help wind down failing banks. The process of adapting to these new rules, he said, would give banks a “more clearly defined capital structure,” and thereby create opportunities for investors.
“There’s going to be tremendous mis-pricing between the different levels of the capital structure in these banks,” Mr. Staley, who is known as Jes, said on the panel.
One imagines that, if all goes according to plan, then at some point between now and the end of time:
- There will be some bank debt (deposits!) that is bail-outable and more or less government guaranteed;
- There will be some other bank debt (repo!) that is collateralized and more or less money-good, ish;
- There will be some other other bank debt that is bail-inable and more or less clearly mezzaniney and going to be toasted in any bank failure; and
- People will believe that.
And the money-making opportunity is more or less that some people will transition to believing that more slowly than other people.4 The existence of debates about the current existence / size / sign of the too-big-to-fail premium suggests that that opportunity is pretty large; the ratings agencies, for instance, still give US banks' unsecured long-term debt several notches of uplift for assumed governmental support. Possibly a lagging indicator.
Meanwhile, on the other side of town, I am utterly flummoxed by Bruce Berkowitz:
Investor Bruce Berkowitz said Monday that the giant bet5 his Fairholme Capital Management has taken in the government-backed mortgage guarantors Fannie Mae and Freddie Mac amounts to a wager Congress will restore dividends on the companies’ preferred shares. ... “The tough work is over,” Berkowitz said. “I don’t understand the politics involved but it seems obvious to me what needs to take place.”
Umm! We've talked before about how I don't understand the Fannie/Freddie preferred trade at all and this makes me understand it less. The gist of it is that:
- the U.S. government owns and controls Fannie and Freddie after a Treasury bailout and FHFA conservatorship,
- everyone in Congress, Treasury, the FHFA, and any other instrumentality of the U.S. government that has had any contact with Fannie and Freddie has sworn on a stack of bibles that no common or preferred shareholder of Fannie or Freddie will ever see a dime from those companies ever again, and
- loads of people, now including Bruce Berkowitz, are like "naah, you're kidding, you'll totally give Fannie and Freddie back to us, turn the preferred dividends back on, and let us make a few billion dollars on the government-supported but shareholder-owned mortgage-buying businesses that worked out so well last time."
I do not get it though perhaps I am just insufficiently cynical about the likelihood of governmental lying?6 I mean, stacks and stacks and stacks of bibles.
It's a neat illustration of ... something. Perhaps the something is that, even after governments move to more clearly define expectations of what will happen to various parts of the capital structure of systemically important financial institutions, some people will misprice those instruments out of nostalgia or foolishness or an overdeveloped sense of how they should be treated, and smart clear-eyed people like Jes Staley will eat those people's lunches. Or perhaps it's that whatever governments and regulators say about how systemically important financial institutions will be treated is bullshit, and you might as well gamble on finding (or creating) sympathy and getting the rules changed after the fact. We might have to wait until the next crisis to find out which it is though.
Regulatory Tussle over Bail-Ins, Depositors Highlights Complexity of Bank Debt [Nick Dunbar]
After JPMorgan, Staley Sizes Up Banks for Hedge Funds [DealBook]
Bruce Berkowitz Places Bet on Fannie, Freddie [WSJ MoneyBeat]
Fairholme Issues Statement on Fannie Mae and Freddie Mac Preferred Stock [Fairholme Funds]
1.Ooh here is John Carney on the Goldman TBTF-premium-is-negative paper we talked about a while ago. And generally there is a mass of argumentation about the extent to which bank debt was viewed as safer than it should have been, because of bailouts, before or during or after the crisis, and whatever.
2.That Nick Dunbar post: recommended. Also this BIS paper he cites, on bank asset encumbrance etc.
3.What? Well, figure banks are supposed to have capital ratios north of 8%, ish, though that's 8% of RWAs and in fact you get like 3% or whatever leverage ratios (just equity:assets). So the attachment point for unsecured debt is like 3-10% or whatever. The detachment point ... this BIS paper says "Assuming all retail deposits were to receive depositor preference, this would raise the median asset encumbrance ratio for European banks to about 69.5%." Meanwhile US banks are facing noises about long-term-debt-plus-capital requirements of like 15-25%, though probably "of RWAs." So, whatever, if you're a term unsecured lender to a bank you've got like 5-10% of the capital structure below you and like 70-85% above you, give or take.
4.And/or will overshoot? I don't know what side of the trade Staley is on; from his quotes and my priors I mostly assume he's betting on divergence between parts of the capital structure that Europe/etc. plan to leave to their own devices and parts of the capital structure that will be more formally protected. But for all I know he's betting on convergence, because his experience at JPM taught him, naaaaah, banks really are too big to fail and their unsecured creditors will always get government help.
5.Like $2.4bn of par though he bought it recently and it trades at like 20-25 cents on the dollar.
6.So, Berkowitz's statement on the matter: cynical? naïve? so naïve-sounding it's got to be cynical? Take a look:
Taxpayer dollars expended by the government during a time of national crisis will be fully repaid. And equitable treatment of taxpaying shareholders, including community banks, insurance companies, and mutual funds holding Preferred Stock, must be restored with dividends reinstated. Repaying taxpayer investments, restructuring government guarantees, and restoring shareholder property are not mutually exclusive. This is the American way.
The time to restructure Fannie and Freddie is upon us. Sustaining our nation’s economic recovery requires it.
On behalf of the hundreds of thousands of Fairholme Funds shareholders who helped to rebuild American International Group, Bank of America, CIT Group, General Growth Properties, MBIA Inc., and others after the Great Recession – we stand ready to do our part.
Their part is of course "make a billion dollars." I TOO STAND READY TO DO MY PART, where do I sign up?