What not to invest in!

Jul 1, 2019

Hi everyone and welcome to Finance and Fury. If you missed last Monday’s episode on bank bail in laws, you might want to go back and catch up as this week’s episode follows on from that one.

Today we’ll look at what to avoid holding as investment in the future, based around the updates to these laws. Knowing what investments can be taken by banks in the next financial collapse, to allow them to bail themselves out is a great place to start, as these are going to be pretty risky going forward.

According to an IMF paper titled “From Bail-out to Bail-in: Mandatory Debt Restructuring of Systemic Financial Institutions”:

1. Bail ins - a statutory power of a resolution to restructure the liabilities of a distressed financial institution by writing down its unsecured debt and/or converting it to equity
2. The language is a bit obscure, but here are some points to note:
   • What was formerly called a “bankruptcy” is now a “resolution proceeding.”
   • Bank’s insolvency is “resolved” by turning its liabilities into capital. Insolvent ‘too-big-to-fail’ banks are to be “promptly recapitalized” with their “unsecured debt” so that they can go on with business as usual.
   • “Unsecured debt” includes deposits, the largest class of unsecured debt of any bank. The insolvent bank is to be made solvent by turning our money into their equity – bank stock that could become worthless on the market or be tied up for years in resolution proceedings.
     • This power is statutory. Cyprus-style confiscations are to become the law. Some countries can already take funds from depositors – Australia is a bit of a grey zone
   • Rather than closing their doors - “zombie” banks are to be kept alive and open for business at all costs, and the costs are to be to borne by us at some point – even if you don’t hold bank shares, the market would go down
3. A lot of the recommendations have come from the Financial Stability Board (FSB) – Reformed in 2009
   • Mario Draghi – ex Goldman Sachs
     • Current ECB president - member of the ‘Group of Thirty’founded by the Rockefeller Foundation (the Group of Thirty is a private group of lobbyists in the finance sector)
     • His son - Giacomo worked as an interest-rate derivativetrader at investment bank Morgan Stanley until 2017, a time overlapping with Draghi's presidency of the ECB
     • Current Chair is a former partner of Carlyle Group, the last chair had 30 years’ experience at Goldman Sachs
4. FSB – recommended that banks raise a “buffer” of securities to be sacrificed before deposits in a bankruptcy
   • ‘Too-big-to-fail’ banks are required to keep a buffer equal to 16-20% of their risk-weighted assets in the form of equity or bonds convertible to equity in the event of insolvency - Called “contingent capital bonds”, or “bail-in bonds”, or “corporate notes”.
   • The fine print that the bondholders agree contractually (rather than being forced statutorily) that if certain conditions occur (notably the bank’s insolvency), the lender’s money will be turned into bank capital.
5. Just know that most banks alone aren’t able to do that much damage – but when the people working for banks get the authority and executive powers of Governments to socialise the losses and privatise the gains there is a bad outcome for us
   • This system is a socialist policy – not free market economics – technically closest to fascist system of Government and business merging/restricted, but without the central planning
   • Either way the result are recommendations for policy which incentivises risk taking, then privatises profits but socialises losses

Financial Sector Legislation Amendment (Crisis Resolution Powers and Other Measures) Act 2018 (“the Act”) creates a power of bail-in by Australia’s banks of customers’ deposits.

1. The Act empowers APRA to bail in anything that is on the banks’ balance sheet that can be written off or converted
2. Liability limited by a scheme, approved under Professional Standards Legislation
3. Hybrid Securities – special high-interest bonds evidenced by instruments which by their terms can be written off or converted into potentially worthless shares in a crisis
   • Interesting – there was a massive push from APRA to have banks provide funding for capital requirements from Corporate notes – CBA, WBC, NAB, etc.
   • Hybrid Securities issued by banks; “a generic term used to describe a security that combines elements of debt securities and equity securities.” - securities issued by banks which permit the amounts secured by the security to be converted into shares or written off at the option of the bank in certain circumstances
   • Under the Basel Accord, a bank’s capital consists of Tier 1 capital and Tier 2 capital which includes Hybrid Securities - they’ll be bailed in.
   • The big issue with these securities is the risk of being wiped out – there’s no default; just through the stroke of a pen they can be written off. For retail investors in the tier 1 securities – they’re principally retail investors, some investing as little as $50,000 – these are very worrying.
   • The comments of Graeme Thompson of APRA in an address on 10 May 1999 when he said: “… APRA will have powers under proposed Commonwealth legislation to mandate a transfer of assets and liabilities from a weak institution to a healthier one
4. However, even 20% of risk-weighted assets may not be enough to prop up a megabank in a major derivatives collapse.
   • Propping Up the Derivatives Casino: Don’t Count on the FDIC
     • American banks have nearly $280 trillion of derivatives on their books, and they earn some of their biggest profits from trading in them.
     • AUS Banks - $36 trillion in derivatives
   • Kept inviolate and untouched in all this are the banks’ liabilities on their derivative bets, which represent by far the largest exposure of TBTF banks. 
   • Both the Bankruptcy Reform Act of 2005 and the Dodd Frank Act provide special protections for derivative counterparties, giving them the legal right to demand collateral to cover losses in the event of insolvency.
   • They get first dibs, even before the secured deposits of state and local governments; and that first bite could consume the whole apple - Banks are much bigger now than back in 2008 (failure of Washington Mutual in 2008 $307bn was small compared with the $2.5trn at JPMorgan Chase, $2.2 trillion at Bank of America or the $1.9 trillion at Citigroup)
5. Bail ins but also bail outs will still be likely not to cover the total amount

Who holds these types of assets?

1. Banks are specifically excluded as buyers of bail-in bonds, due to the “fear of contagion”
2. Who holds these types of assets? Super funds were struggling with commitments made when returns were good, and getting those high returns now generally means taking on risk.
   • It wouldn’t be the first time “public pension funds were some of the most frequently targeted suckers upon whom Wall Street dumped its fraud-riddled mortgage-backed securities in the pre-crash years.”

Will deposits get taken?

1. Can technically occur without a Government grab through negative interest rates – or real rates
2. What happens in negative interest rate environment? Cash held outside of the banks becomes more valuable
   • Think – If you have $100k sitting in the bank – at 1% rates - $101k in 12 months, but -1% = $99k in 12 months
   • But if you have that cash under the mattress, it’s still $100k, minus inflation (which is still no different if it’s in the bank)
   • What if a society was cashless and we entered this world of negative interest rates? Any cash in the bank would be taken from you
3. The bank is allowed to convert its debt into equity for the purpose of increasing its capital requirements
   • A bank can undergo a bail-in quickly through a resolution proceeding, which provides immediate relief to the bank. The obvious risk to bank depositors is the possibility of losing a portion of their deposits. However, depositors have the protection of the Federal Deposit Insurance Corporation (FDIC), which insures each bank account for up to $250,000. (Banks are required to use only those deposits in excess of the $250,000 protection and there’s no way around it for these assets due to the legislation)
   • As unsecured creditors, depositors and bondholders are subordinated to derivative claims. Derivatives are the investments that banks make among each other, which are supposed to be used to hedge their portfolios. However, the 25 largest banks hold more than $247 trillion in derivatives, which poses a tremendous amount of risk to the financial system – GDP is $20 trillion. To avoid a potential calamity, the Dodd-Frank Act gives preference to derivative claims.
4. Deposits are now “just part of commercial banks’ capital structure.”

What types of assets, instruments are these? Act update includes write-off and conversion powers in respect of “any other instrument”.

1. Government has contended that is doesn’t include deposits – as deposits don’t include a write off provision, however saying “any other instrument” is unnecessary if only applied to instruments with conversion or write-off provisions
2. Also, banks are able to change the terms and conditions of deposit accounts at any time and for any reason, including on directions from APRA to insert conversion or write-off provisions.
   • This could be resolved by Government passing amendment - exclude deposits from a bail in.
   • Something to watch out for – if banks start changing their T&As to include a write off or conversion provision – might be time to start digging holes in the backyard! (This is just a joke, not advice!)
3. The central issue is the wording - “any other instrument”
   • “Instrument” is not defined in the Act but a “financial instrument” is defined by Australian Accounting Standard AASB132 as “any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity.”
   • RBA confirmed - a deposit with an ADI bank comes under such a definition – it is a contract with terms and conditions as to the deposit being set by a bank, accepted by a depositor on making a deposit and creating a financial asset (a right of repayment) and a financial liability in the bank (the obligation to repay).
   • Deposits are created by “instruments” and are governed by the terms and conditions of those instruments.
   • But this can easily change, by their own admission, “leaving room for future changes to APRA’s prudential standards, including changes that might refer to instruments that are not currently considered capital under the prudential standards”. These provisions extend to “any other instrument” by sub-section (b) definition - other than “Additional Tier 1 and Tier 2 capital”
4. APRA already has a power to prohibit the repayment of deposits by ADIs, this verges on the writing off of those deposits. The Banking Act Section 11CA provides for this. They can also limit how much you can withdraw from your cash account every day. It is a relatively small step to then convert or write-off what the ADI has been prohibited from repaying or paying out.

There are a number of unusual and concerning aspects to its introduction, passing and intentions.

1. The issue could be resolved by the Government passing a simple amendment to the Act to explicitly exclude deposits
2. Rather than reining in the massive and risky derivatives market, the new rules prioritize the payment of banks’ derivatives obligations to each other, ahead of everyone else. That includes not only depositors, public and private, but the pension funds that are the target market for the latest bail-in play, called “bail-in-able” bonds.
3. That means they can be “bailed in” or confiscated to save the megabanks from derivative bets gone wrong – Last time was tax payers, now it is depositors
4. Check super fund investment options – most look okay but if they have credit or corporate notes with the banks – if there are held and converted into shares work a fraction of the original value – this is a bad situation
5. Holding large amount of cash in the bank, even in an offset account, this runs the risk of being bailed in by banks in the next financial collapse. Cash is no longer king, especially due to the intangible nature of currency and interest rates heading towards negative rates