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FTalphaville
1/9/08
Citi sees “terminal decline” for banks’ modern business models
First Moody’s; now Citi. Is everyone losing the faith in their ability to do what it is they’re paid for, and the value of what they produce?
Here’s a snap from a Citi research note looking at the strained condition of all things financial. In a 70-page tome entitled “Testing Times,” the bank’s chief IB watcher in Europe, Jeremy Sigee, makes a convincing case for sector-wide capitulation.
Investment banking business models are, of course, being put to the test. While hedge funds and private equity are still attracting inflows, and emerging markets are still riding high, proprietary risk taking and product innovation are being scaled back. So, having already been bearish on fixed income revenues, which are forecast to fall back to 2004/5 levels this year, the Citi team now see revenues from equities and advisory work falling by 10 and 20 per cent, respectively.
But what’s really got Sigee questioning his very employment is the collapse of securitisation and structured credit.
But the bad news is that securitisation and structured credit seem to have died for the foreseeable future. We can see in Figure 21 (below) that volumes have collapsed nearly to zero since July. Indeed it is these securitisation and structuring products that have been the root cause and the epicentre of the recent market turmoil. Several things were wrong:
– The securitisation model broke up the credit value chain in sub-prime mortgages. Originators had every incentive to maximise volume and little or no incentive to care about the interests of borrowers or the ultimate credit providers. Servicers had no resources or expertise (or, again, much incentive) to talk to borrowers about their financial circumstances, interest rate re-sets or loan restructuring. The holders of the credit risk had little or no awareness of who they had lent to, or on what documentation and terms, and little or no ability to enter dialogue with those borrowers to reschedule or restructure the debt once into difficulties.
– The statistical assumptions about possible losses, underpinning the tranching structures and the creation of AAA debt out of low-quality borrower pools were based on earlier cycles, but then in this present cycle were applied to greatly increased volumes, greatly relaxed criteria and dangerous new product structures, without adjusting the loss assumptions.
– The concept of what “AAA” actually meant — as embedded in the mandates of money market funds, or the risk screens of treasury departments, or even in the control frameworks and capital models of bank risk managers and regulators — became very distorted, without the full realisation of those investors or risk managers.
– The layering of structure upon structure (eg CDOs of mezzanine sub-prime MBS, CDO-squareds, or CDO-cubeds) further removed transparency of what assets (and risks) were underlying securities, further distanced borrowers from credit providers, added leverage upon leverage to the underlying risks, and multiplied the impact of the errors in key statistical loss assumptions.
– The structuring process came to rely heavily upon certain structured (rather than ‘real-money’) investor types to take certain tranches. In particular they relied upon the ABCP-funded SIVs & conduits, and the highly leveraged specialist hedge funds and special purpose funds. Many of these have now been hit by losses, some very large, and have been revealed to be greatly more risk-prone than had been thought. As a result many are being dismantled or scaled back at the present time.
These are fundamental and important flaws, Citi says, that for the time being mean that
very little business is being done.
This is much more than just a “buyers’ strike”, or a matter of hoping/waiting for buyers’ risk appetites to return. In reality many of the key buyers have blown up and others will no longer participate now they know what the risks are.
Also, we suspect that this is more than just a sub-prime problem. It is true that the only significant credit defaults are in sub-prime at the present time, and that there were specific practices unique to sub-prime that have contributed to the defaults and to the problems for related securitisations and structured credit. However, the problems discussed above (integrity of credit value chain, meaning of “AAA”, transparency, reliance on inappropriate / disappearing buyer types) are at least partially shared by other forms of securitisation and structured credit. And finally, even if those structural problems can be solved, it may be that the recalibration of loss assumptions leaves some of these products economically unattractive for investors.
In other words, says Sigee, this is more than just one of those ups and downs to which businesses are prone.
It’s not about how quickly the cap markets can come back after a wobble; or which market participants can muddle through the bad patch.
What is being tested is the “structural soundness” of that which has in recent times underpinned the banks’ business models:
Whole product areas, structuring techniques, risk management practices, economic models and client types are being challenged. Some or all of the big new things that drove growth in capital markets and in investment bank revenues over the past few years, may be in terminal decline.
This entry was posted by Paul Murphy on Wednesday, January 9th, 2008 at 14:26 and is filed under Capital markets. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site. |
