Thursday, February 4, 2010

Economics 04/02/2010: Nama - riskier than Anglo?

I just came across a very interesting paper, written back in November 2007 and published by the Bank for International Settlements as a Working Paper No 238.

As a proposition: I will use the study results to argue that Nama is a more risky undertaking than the Anglo Irish Bank.

Authored by Ryan Stever and titled “Bank size, credit and the sources of bank market risk” the paper “…examines bank risk by investigating the equity and loan portfolio characteristics of publicly-traded bank holding companies.” The study is based on the US banks, with sample being a panel of ‘at least 339 publicly trades BHCs at each point in time” for the period of 1986-2003. “These range in size from American Bancorporation at $31 million in book assets (200 employees) to Citigroup at $1.26 trillion (over 280,000 employees).”

“Unlike the pattern for non-financial firms, equity betas of large banks are two to five times greater than those of small banks. In explaining this, we note that regulation imposes an effective cap on banks’ equity volatility. Because the portfolios of small banks are less diversified, this cap has a greater effect on small banks than large banks.”

In other words, there is plenty of evidence that even when effective, regulators can induce some unintended consequences onto the banking system and that these consequences, if unaddressed can lead to systemic failures. Here is how it works:
  • Regulators (and/or shareholders through exercise of their voting rights) place a limit on the total volatility of each bank’s assets regardless of size, which tends to minimize bank risk; however
  • Small banks have more idiosyncratic risk inherent in their loan portfolio “because they cannot diversify away idiosyncratic volatility as well as large bank” (practically – smaller banks are more specialized, making their loans books more exposed to idiosyncratic strategy risk).
  • Smaller banks inability to diversify comes about in “a number of different ways – for example; less total loans held, less diversity in borrower type (they do not have access to large borrowers) and geographic restrictions (small banks tend to be more localized);
  • Because their total equity volatility is limited by regulation smaller banks must then find a way to eliminate their idiosyncratic volatility that is in excess of larger banks’ idiosyncratic volatility.

To do this, small banks do not necessarily pursue higher levels of equity capitalization or lending to different sectors in the economy – in other words, they do not strive to become like larger banks, but instead they either
  • make loans with less credit risk than large banks (Swiss private banks, for example). This has the effect of reducing idiosyncratic volatility (as desired) and also reducing the beta of each loan (and thus the equity beta of small banks); or
  • demand more collateral (e.g. Irish banks).

Of course, the problem with selecting the latter path way (collateral beefing up) as opposed to the penultimate pathway (more conservative, risk-sensitive lending) – as Irish banks should have learned from the current crisis – leads to additional problem, not highlighted in the study. This problem is manifested in the selection bias induced onto collateral – smaller banks opting for higher collateral requirements will take on less diversified collateral that is more likely to be positively correlated with their own (risk-skewed) loans books.

Thus collateral risk becomes positively correlated with loans risk.

Just think of what type of collateral Liam Carroll was supplying for his property development loans? You’ve guessed it – property-based collateral.

In fact, the study does find that small banks did not lower their equity volatility through lower leverage. Instead, “the reduced ability of small banks to diversify forces them to either pick borrowers whose assets have relatively low credit risk or make loans that are backed by relatively more collateral.”

What are the lessons for Nama from all of this? I am afraid not very positive ones. Nama is setting out to purchase loans on the basis of their collateral. Loans that are in distressed with collateral that has breached covenants due to precipitously declining valuations. Guess what – collateral risk is positively correlated with loans risk here from the start. Can this correlation be diversified? Yes, but not within Nama setting.

Remember, Nama promised to take good and bad loans together and mix them to derive cash flow. But these loans are all written against the same types of collateral as in:
  • Same instruments;
  • Same geography;
  • Same vintages;
  • Same currencies and so on.
In language of diversification – which loans returns are orthogonal to each other? Answer: none. Hence, no diversification is possible.

Take this back to the study findings and treat Nama as a sort-of-a-bank undertaking (with no deposits, but plenty of loans, although of course it does not matter, because Nama is not facing market funding constraints, courtesy of the state that is willing to give it your and my money with nothing definitive being asked in return).

Recall the last quote: “the reduced ability of small banks to diversify forces them to either pick borrowers whose assets have relatively low credit risk or make loans that are backed by relatively more collateral.” But in Nama’s case – what borrowers with “lower credit risk” can they select? None.

This leaves only option for Nama – to raise the underlying quantity and quality of collateral. Again – can this be done?

Sure, if Nama can either increase seniority of its claims on the collateral, or if it can swap assets for higher quality assets somehow. Alas, this works in theory, but in practice, Nama is saddled with seniority and quality of assets that banks have. It cannot go out to the market and demand that senior debt holders out there step aside and let residual quality claims that Nama might hold to step forward. Nor can it go to the developers and demand that better or more collateral be pledged for the loans. It is neither legally possible, nor feasible, given the dire state of developers’ finances.

Now, step aside and think of the Anglo. Anglo is a bank that is saddled with exactly the same dilemma – poor loans risk diversification. Can it escape this conundrum, assuming it can get funding (remember – Nama has no funding constraint). Of course it can. It can diversify client base and start attracting clients with lower risk profile by offering cheap loans to selected clients. And of course, Anglo has done so in the past – perhaps not enough, but it did. It can go out and lend outside Ireland, to diversify via change of geographies (it has done so in the past as well). And it can load up on collateral – which, once again, Anglo did. And yet, despite doing all these things, Anglo collapsed.

Anyone still thinks Nama – with much more limited ability to diversify key risks – can succeed?

So here you have it – Nama is the ultimately non-diversifiable risk undertaking that is actually worse off in terms of risk profile than the Anglo Irish Bank…

One would hope their board and risk committee understand this. Not really - the board contains such experienced finance and risk people as town managers, and the risk committee - well, that one will be staffed by who knows who, for it will have no one from outside Nama on it.

And this, of course, is where Nama is so nicely reflective of the Anglo...
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