Is COVID-19 about to trigger 2008-type banking collapse?
In June, Atlantic published “The Looming Bank Collapse,” an article by University of California, Berkeley law professor and former Morgan Stanley derivatives structurer Frank Partnoy, which sparked significant debate over whether a crisis banking in the same mold as that seen during the global financial crisis (GFC) is just around the corner.
In fact, the article suggests that this time around things could be even more dire than the disaster that unfolded in 2008. “You may think that such a crisis is unlikely, memories of the 2008 crash still being so fresh. But the banks have learned few lessons from this calamity, and new laws designed to prevent them from taking too much risk have failed to do so, ”Partnoy said. “As a result, we could be on the brink of another accident, different from 2008 less in nature than in degree. This one could be worse.
But why worse, one might ask? After all, didn’t the banks learn the lessons from the last time? Haven’t the regulations been severely tightened since? And don’t banks currently have sufficient capital and liquidity reserves? Well, according to Partnoy, the problem lies with secured loan obligations (CLOs). They are similar to Secured Debt Securities (CDOs) – those notorious mortgage pool instruments issued to low risk home buyers with low creditworthiness but falsely assigned to blue chip ratings by rating agencies; However, instead of going to troubled home buyers, CLOs are given to struggling businesses.
“The CLO market has exploded over the past decade…. It’s a byproduct of the private equity boom, which accumulates tons of debt on its acquisitions, ”said Whitney Tilson, a former hedge fund manager recently. “CLOs should work well for banks, unless, like mortgage loans in 2008, all loans go bad at the same time. “
CLOs are similar to CDOs in that their purpose is to purchase loans using packaged money from various investors, who receive a rate of return for their participation. CDOs were generally sold according to their risk levels, called tranches, with senior tranches considered the safest because they held the first claim on CDO assets in the event of default of these subprime loans, and junior tranches. being the riskiest but offering the highest rates. back to ostensibly reflect this risk.
But during the financial crisis, CDOs that ended up suffering substantial losses were known as squared CDOs; they did not buy risky real estate loans but rather tranches of other CDOs and credit default swaps (CDS) referring to other CDOs. These products dramatically increased the risks for investors and ultimately caused huge losses. Indeed, it is worth remembering how questionable the data on which loans were made to these risky homeowners turned out to be at the time, and the critical role that falsely rated debt played in generating such horrific losses. .
CLOs, which pool business loans in a similar way for different tranches of investors, do not suffer from this problem. “The typical CLO holds hundreds of diverse loans in dozens of industries,” observed a recent article from the Wharton School at the University of Pennsylvania. “Exposure to any industry is contractually limited to 15% of the loan pool, while maximum exposure to a single company is 2%. Thus, defaults must be ubiquitous in all sectors of the economy to materially affect the collateral pools of the CLOs. “
As such, corporate bonds that support CLOs will typically come from a much greater diversity of industries. This explains why senior CDO tranches sold before the 2008 crisis resulted in losses of several hundred billion in subsequent years, but similarly rated CLO tranches ended up without losses. Since the maximum exposure to a single industry or company is necessarily low, defaults would have to occur in a number of industries for the CLO’s guarantee pools to be significantly affected. But if the losses reach the banking sector, which largely represents the senior tranche, they constitute such a small fraction of their Tier 1 capital that they would not pose serious problems.
In a recent speech, Randal K. Quarles, vice chairman of oversight of the US Federal Reserve Board of Governors (Fed), reiterated the strong position in which the US banking sector currently finds itself. “The big US banks entered this crisis on good terms, and the Federal Reserve has taken a number of important steps to help build bank resilience,” he noted. He also highlighted the steps taken by the Fed to ban third-quarter share buybacks for big banks, while capping dividends and forcing banks to reassess their capital needs amid continued uncertainty and resubmit their capital plans. Quarles also confirmed that the Fed recently released a baseline scenario and two hypothetical recession scenarios that it can use to assess the resilience of the banking sector, and that it will release the bank-specific results of that assessment before the end of the year. the year.
And in May, the Bank of England (BoE) confirmed that banks should be able to withstand a 30% contraction in the economy. “Will everything be alright?” We don’t know, ”said Stephen Jones, former managing director of UK Finance, the professional banking association, adding that Bank of England modeling suggests the system as a whole is sound. “Banks are not the problem in this crisis; the impact of the pandemic on the wider economy is the problem. “
But while banks’ capital and liquidity positions are generally more solid vis à vis 2008, it remains decidedly difficult to determine at what point they will end up racking up toxic debts as the coronavirus continues to block economic activity. Thus, the liquidity phase of the crisis will soon give way to the solvency phase as liabilities begin to ignite. As Mr. Hyun Song Shin, economic adviser and head of research at the Bank for International Settlements (BIS), recently acknowledged in an editorial, “The banks will undoubtedly bear the brunt of the surge in bad debts and insolvencies affecting the weakest companies, especially in the sectors where the pandemic has hit the hardest. “
And while the banking systems in some parts of the world exhibit admirable resilience, there is no guarantee that the banking systems in every part of the world will survive this global shock. Those who were already under stress before the pandemic will undoubtedly feel an existential threat given the scale of the ongoing economic contraction. Lebanon, a country that has suffered from a deep economic and financial crisis since last year, is one of the clearest examples in this regard. Banks had already exercised capital controls on depositors before the pandemic took hold, freezing savers on their dollar deposits and blocking most overseas transfers. And the country is now suffering under the weight of an indebted state that defaulted on its foreign currency debt obligations in March as well as a level of poverty that has exceeded 50% in recent times.
As such, banks are now potentially looking down the barrel of a wave of collapses if conditions continue to deteriorate. Indeed, Riad Salameh, governor of the central bank of Lebanon, warned at the end of August that banks must increase their capital by at least 20% by the end of February 2021 or leave the market. Salameh, however, confirmed that deposits would be preserved in such a scenario, as the outgoing bank would not go bankrupt, but rather its shares would be turned over to the central bank.
However, as the coronavirus continues to wreak havoc across much of the world, it is still too early to tell whether banks are in existential danger. According to JPMorgan Chase, global gross domestic product (GDP) fell more than 15% in the first half of the year, four times more than in 2008. The International Monetary Fund (IMF) estimates that SMEs ( small and medium-sized businesses) bankruptcies “could triple from an average of 4% before the pandemic to 12% in 2020, threatening to worsen unemployment and damage bank balance sheets.” And concerns continue to mount over the number of people who will be permanently sacked. “Some companies believe their business model has been permanently damaged by this,” noted John Wraith, UBS economist and head of rate strategy in the UK and Europe. “Many casualties will not bounce back even if there is a medical breakthrough.”
All of this means that at some point the level of banks’ NPLs could very well reach a critical stage that will force them to cut back on their lending and induce a credit crunch, similar to 2008. And while regulators continue to push back. trusting the resilience of the world’s largest banks, small lenders are on much more fragile ground.
“I fear that there is indeed a deceleration in the supply of credit, which alone will contribute to a very weak recovery,” warned Vítor Constâncio, former vice-president of the European Central Bank (ECB), who believes that the European Union (EU) may even need to lift its rules preventing taxpayer money from being used to finance bank bailouts and that a credit crunch could end up appearing in the second half of 2021. Observed in 2008, banks remain vulnerable to a sharp deterioration in their overall health. And with no end in sight for the coronavirus, just how pronounced this deterioration will ultimately be remains far from certain at this point.