Category: Credit risk

Public Pensions: Double-Check Those ‘Shadow Banker’ Investments

Mary Pat Campbell

Link:https://www.governing.com/finance/public-pensions-double-check-those-shadow-banker-investments

Excerpt:

For almost a decade leading up to 2021, bond yields were suppressed by low inflation and central bank stimulus. To make up for scanty interest rates on their bond investments, many public pension funds followed the lead of their consultants and shifted some of their portfolios into private credit funds. These “shadow bankers” have taken market share from traditional lenders, seeking higher interest rates by lending to non-prime borrowers.

Even during the pandemic, this strategy worked pretty well, but now skeptics are warning that a tipping point may be coming if double-digit borrowing costs trigger defaults. It’s time for pension trustees and staff to double-check what’s under the hood.

For the most part, the worst that many will find is some headline risk with private lending funds that underwrite the riskiest loans in this industry. Even for the weakest of those, however, the problem will not likely be as severe as the underwater mortgages that got sliced, diced and rolled up into worthless paper going into the global financial crisis of 2008. And until and unless the economy actually enters a full-blown recession, many of the underwater players will still have time to work out their positions.

The point here is not to sound a false alarm or besmirch the private credit industry. Rather, it’s highlighting what could eventually become soft spots in some pension portfolios in time to avoid doubling down into higher risks and to encourage pre-emptive staff work to demonstrate and document vigilant portfolio oversight.

Author(s):Girard Miller

Publication Date: 8 Aug 2023

Publication Site: Governing

Tweets of the Day on Bonds, Jobs, Leverage, China, Oil, and Artificial Intelligence

Mary Pat Campbell

Link:https://mishtalk.com/economics/tweets-of-the-day-on-bonds-jobs-leverage-china-oil-and-artificial-intelligence/

Graphic:

Excerpt:

Everyone knows, or at least should know, that the “Big 3” rating agencies that rate about 98 percent of all debt all issue trash ratings. Here’s the background on how that happened.

Rating agencies used to get paid by investors on the basis of how well they did at estimating the likelihood of default. The better your ratings, the more sought out your opinions.

In the mid 1970s, the SEC created nationally recognized statistical ratings organizations (NRSROs). Following that idiotic regulation, the rating agencies got paid on the basis of how much debt they rated, not how accurate their ratings were. Fees come from corporations issuing debt, not investors seeking true default risk.

The more stuff you rate AAA, the more business you get from companies who want their debt rated. The new model is ass backward, and why ratings are trash. A genuine fiasco happened with ratings during the Great Financial Crisis with tons of garbage rated AAA went to zero.

There should not be NRSROs. The SEC made matters much worse, except of course for the Big 3 who have a a captured, mandated audience, coupled with massive conflicts of interest.

Author(s): Mike Shedlock

Publication Date: 5 Aug 2023

Publication Site: Mish Talk

Fitch Downgrades U.S. Credit Rating

Mary Pat Campbell

Link: https://www.wsj.com/articles/fitch-downgrades-u-s-credit-rating-56c73b89?mod=hp_lead_pos1

Excerpt:

Fitch Ratings downgraded the U.S. government’s credit rating weeks after President Biden and congressional Republicans came to the brink of a historic default, warning about the growing debt burden and political dysfunction in Washington.

The downgrade, the first by a major ratings firm in more than a decade, is evidence that increasingly frequent political skirmishes over the U.S. government’s finances are clouding the outlook for the $25 trillion global market for Treasurys. Fitch’s rating on the U.S. now stands at “AA+”, or one notch below the top “AAA” grade.

….

Few investors believe that Fitch’s downgrade will immediately challenge that role. Still, it is the first time a ratings firm lowered its headline assessment of the U.S. government’s propensity to pay its bills on time since Standard & Poor’s in 2011 lowered its rating one notch below the top grade. That decision followed another tense debt-ceiling standoff in Congress.

Moody’s, the other member of the three big U.S. ratings firms, continues to give the U.S. its strongest assessment.

Fitch said Tuesday that the downgrade reflects an “erosion of governance” in the U.S. relative to other top-tier economies over the last two decades.

“The repeated debt-limit political standoffs and last-minute resolutions have eroded confidence in fiscal management,” Fitch said.

Author(s): Matt Grossman and Andrew Duehren

Publication Date: 1 Aug 2023

Publication Site: WSJ

Canadian legislation aimed at protecting pension plans may mean significant changes for lenders, borrowers and employees

Mary Pat Campbell

Link: https://www.nortonrosefulbright.com/en-us/knowledge/publications/e91814ee/canadian-legislation-aimed-at-protecting-pension-plans-may-mean-significant-changes

Excerpt:

On February 3, 2022, Bill C-228 was introduced as a private members bill and has now made its way to the third reading in Canada’s Senate. The purpose of Bill C-228 is to greatly expand the pension liabilities that are afforded super priority status by amending bankruptcy and insolvency legislation. As currently drafted, the Bill will grant priority for a pension plan’s unfunded liability or solvency deficiency claims over the claims of the majority of creditors — including secured creditors — unless specifically enumerated otherwise in the statutes.

The “unfunded liability” is the amount necessary to enable the fund to continuously pay member benefits as they come due, on the assumption that the fund will operate for an indefinite period of time. The “solvency deficiency” includes the amount necessary to ensure the fund meets its obligations if wound up. As these amounts are constantly fluctuating, a fixed value cannot be ascribed to either of these requirements other than through a single point in time calculation by an actuary.

What does this mean for borrowers with pension plans?

Clearly, Bill C-228 would substantially increase the opportunity for recovery of pension entitlements within insolvency proceedings by way of super priority. The issue is whether it remains viable for lenders to provide capital to borrowers with defined benefit pension plans given the increased risk profile that may be created by Bill C-228 expanding the pension claims that take priority over a secured creditor in an insolvency case.

In all likelihood, Bill C-228 will minimally effect borrowers that have defined-contribution pension plans as the employer’s liability is restricted to predefined contributions. As this type of plan is subject only to ordinary course known contribution requirements, and given that the employer does not guarantee a certain amount of income in retirement, the liability afforded super priority in insolvency proceedings should be predictable in most circumstances.

Conversely, Bill C-228 will significantly impact defined-benefit pension plans. These types of plans commit to providing a specified level of income in retirement based on a variety of factors. As such, an employer must diligently manage the pension fund to ensure it is in a position to pay the benefit to the employee for the remainder of their life, once retired. The inherent challenge with these plans is the uncertainty of the liability of the employer at any given time and the potentially large scope of that liability based in part on external factors such as interest rate fluctuations.

Bill C-228 has therefore created a conundrum. Although the intention of the Bill is to protect pension plans, it may potentially cause a shift that results in even more employers moving from a defined-benefit pension plan to a defined-contribution pension plan. Plainly, this shift may be caused by lenders’ concerns regarding the uncertainty surrounding the amount necessary to liquidate an unfunded liability or solvency deficiency at any given time. In other words, a lender will not be able to determine prior to the lending decision, with any great certainty, the amount of the unfunded liability or solvency deficiency in a future insolvency proceeding. At a minimum, a secured creditor wants to know the quantum of obligations that will take priority over their interests. This is essential information in deciding the quantum of a loan, the terms of such loan, any reserves and whether the creditor will agree to loan any money to the borrower.

Author(s): Candace Formosa

Publication Date: 2023Q2

Publication Site: Norton Rose Fulbright

NYC pension funds lose $2M in failed First Republic, Signature banks

Mary Pat Campbell

Link: https://nypost.com/2023/05/20/nyc-pension-funds-lose-2m-in-first-republic-signature-banks/

Excerpt:

City pension funds had almost $2 million invested with First Republic and Signature banks — losing it all when both banks failed this year.

The losses were contained in new data The Post obtained from the city Comptroller’s office under a Freedom of Information Law request.

Though a federal bailout rescued bank depositors, the city’s pension cash had been invested in bank stocks and bonds.

“The overall loss is negligible in the context of the daily market motions of our $240 billion pension funds,” said Chloe Chik, spokesperson for Comptroller Brad Lander.

All five city pensions funds were hit in the bank failures.

Author(s): Jon Levine

Publication Date: 20 May 2023

Publication Site: NY Post

Statement of CFPB Director Rohit Chopra, Member, FDIC Board of Directors, on the Proposed Special Deposit Insurance Assessment on Large Banks

Mary Pat Campbell

Link: https://www.consumerfinance.gov/about-us/newsroom/statement-of-cfpb-director-rohit-chopra-member-fdic-board-of-directors-on-the-proposed-special-deposit-insurance-assessment-on-large-banks/

Graphic:

Excerpt:

First, we need to simplify our rules while strengthening them. Too many areas of regulation across our economy have become so complicated with weird formulas, dizzying methodologies, and endless loopholes and carveouts. We need simpler rules to prevent future disasters. A better alternative is to create bright line limits, with clear sanctions, including size caps and growth restrictions. Clearly observable metrics make it easier to monitor and increase consistency.

Second, we need to stop subsidizing the largest and riskiest banks by giving out free deposit insurance. When small banks fail, they rarely lead to much cost to the FDIC’s Deposit Insurance Fund, since they can be fairly easily wound down or sold. But when large banks fail, the costs to the Deposit Insurance Fund and broader economy can be steep. To make matters worse, those institutional clients with the biggest deposits feel they can get around insurance limits by going to the biggest banks. In other words, people perceive that the biggest banks get free deposit insurance over the legal limits by way of their too-big-to-fail status.

Fixing our deposit insurance pricing structure is just one small step that could help address this problem. Large, riskier banks should pay more and small, simpler banks should pay less. We should also make the framework countercyclical, so that we aren’t in the position of raising rates when banking conditions are weak.

While today’s proposed special assessment will not fall on small, local banks, the failure of First Republic Bank will be a direct hit to the Deposit Insurance Fund that is not being recouped through this special assessment. It’s a reminder that we need to fix the fund’s pricing over the long term.

Finally, as Swiss policymakers made clear regarding the recent turmoil involving Credit Suisse, more people are saying the quiet part out loud: the current resolution plans filed by the largest financial institutions in the world, which purport to show how the firms could fail without a government bailout or economic chaos, are essentially a fairy tale.5

The latest failures are another reminder that we must work to eliminate the unfair advantages bestowed upon too-big-to-fail banks. New laws and old laws alike provide a roadmap to end too-big-to-fail and the resulting risks to financial stability, fair competition, and the rule of law.6

Author(s): Rohit Chopra

Publication Date: 11 May 2023

Publication Site: Consumer Finance Protection Bureau

The New Mortgage Fee Structure

Mary Pat Campbell

Link: https://rajivsethi.substack.com/p/the-new-mortgage-fee-structure

Graphic:

Excerpt:

Notice that credit scores below 639 have been consolidated into a single row, and those above 740 have been split into three. In addition, loan-to-value ratios at 60% and below are now in two separate columns rather than one. This makes direct visual comparisons a little difficult, but one thing is clear—at no level of the loan-to-value ratio does someone with a lower credit score pay less than someone with a higher score. That is, one cannot gain by sabotaging one’s own credit rating.

In general, there are two types of borrowers who stand to gain under the new fee structure: those with low credit scores, and those with low down payments. In fact, those at the top of the credit score distribution gain under the new structure if they have down payments less than 5% of the value of the home. The following table shows gains and losses relative to the old structure, with reduced fees in green and elevated ones in red (a comparable color-coded chart with somewhat different cells may be found here):

What might the rationale be for rewarding those making especially low down payments? Perhaps the goal is to make housing more affordable for people without substantial accumulated savings or inherited wealth. But there will be an unintended consequence as those with reasonably high credit scores and substantial wealth choose to lower their down payments strategically in order to benefit from lower fees. They may do so by simply borrowing more for any given property, or buying more expensive properties relative to their accumulated savings. The incentive to do so will be strongest for those hit hardest by the changes, with credit scores in the 720-760 range and down payments between 15% and 20%.

Author(s): Rajiv Sethi

Publication Date: 23 Apr 2023

Publication Site: Imperfect Information at Substack

Debt ceiling fears push the cost of insuring against a US government default to highest level since 2008 crash

Mary Pat Campbell

Link: https://finance.yahoo.com/news/debt-ceiling-fears-push-cost-184617316.html

Excerpt:

The cost of insurance against the US failing to repay its debts rose to its highest level since the financial crisis last week, as traders worried that political deadlock in Washington might lead to a default.

One-year government credit default swaps traded at 106 basis points Saturday – the most expensive they’ve been since 2008, according to a Financial Times report that cited Bloomberg data.

Credit default swaps – or CDSs – are a form of insurance against a borrower not making scheduled payments on their debt.

The price of one-year government CDSs has spiked 15 basis points in 2023 with traders spooked by the looming threat of a debt-ceiling crisis, the FT reported.

The debt ceiling is a limit on how much the government can borrow, set by Congress. The US hit its $31.4 trillion debt limit in January – and that means it could run out of money to pay its bills as soon as July if lawmakers don’t vote to raise the ceiling, according to the Congressional Budget Office.

Author(s): George Glover

Publication Date: 24 Apr 2023

Publication Site: Yahoo Finance

Wall Street Boosts States’ Credit Scores as Recession Worries Cloud Outlook

Mary Pat Campbell

Link: https://www.bloomberg.com/news/articles/2023-04-19/wall-street-boosts-states-credit-scores-as-recession-woes-cloud-outlook

Graphic:

Excerpt:

Illinois, Massachusetts and New Jersey this year have garnered higher credit scores from rating companies, including brighter outlooks for the states as well. The upgrades also helped shrink bond yield spreads in the primary and secondary municipal markets, signaling investor perception of state debt is improving.

The better state ratings are due in part to the positive effect of federal pandemic aid, which some states used for one-time expenses while others set cash aside for the future. State treasuries also saw an influx of tax revenue from residents — bolstered by US stimulus money sent to individuals — who spent on services at home at the height of the pandemic, and on travel after Covid lockdowns were eased. 

Still, a slowdown in the US economy this year is causing concern that states can no longer expect a cash haul. The likelihood that the economy in the next 12 months will slide into a recession is greater now than a month earlier, according to a March 20-27 Bloomberg survey of 48 economists.

The poll, conducted after several bank closures roiled financial markets, put the odds of a contraction at 65%, up from 60% in February, amid interest-rate hikes by the Federal Reserve and growing risks of tighter credit conditions. 

Author(s): Skylar Woodhouse

Publication Date: 19 Apr 2023

Publication Site: Bloomberg

Federal Financial Watchdog Aims to Expand Its Reach

Mary Pat Campbell

Link: https://www.thinkadvisor.com/2023/04/24/federal-financial-watchdog-aims-to-expand-its-reach/

Excerpt:

The Financial Stability Oversight Council — the federal agency in charge of keeping the U.S. financial system upright — wants to change a 2019 document that limits how it tries to keep problems at life insurers, money market funds, cryptocurrency firms and other nonbank financial companies from destroying the economy.

FSOC announced Friday that it’s proposing a new version of the document that would free it from the 2019 restrictions.

….

FSOC started a fight with life insurers and their regulators by designating companies such as MetLife and Prudential Financial as “systemically important financial institutions,” or companies needing extra oversight.

Life insurers argued that the SIFI designation process was unclear, arbitrary and unfair.

MetLife sued FSOC over its SIFI designation. A federal appeals court threw out MetLife’s designation in 2018.

FSOC withdrew the last designation of a nonbank company — Prudential Financial — in October 2018.

…..

FSOC says it needs more flexibility to address potential risks as early and as quickly as possible, and that comparing the potential benefits of focusing attention on a nonbank company to the potential impact on the company is not useful.

“This is in part because it is not feasible to estimate with any certainty the likelihood, magnitude or timing of a future financial crisis,” FSOC said. FSOC argued that, if it does prevent a financial crisis, it would save the country trillions of dollars.

FSOC noted that it consults with state regulators and federal regulatory agencies regularly, and that its own members are made up mostly of state and federal agency heads.

“The council expects that most potential risks to financial stability will continue to be addressed by existing regulators rather than by use of the council’s nonbank financial company designation authority,” FSOC said.

Author(s): Allison Bell

Publication Date: 24 Apr 2023

Publication Site: Think Advisor

Credit Default Swaps Imply a Two Percent Chance the US Defaults

Mary Pat Campbell

Link: https://mishtalk.com/economics/credit-default-swaps-imply-a-two-percent-chance-the-us-defaults

Graphic:

Excerpt:

The implied odds are two percent but contract trading is very thin. And some of the protection is mandatory.  If regulators raise risk flags, some banks feel compelled to buy insurance. 

So most likely the true odds of default are much lower.

There is also a three day grace period. We could have a default, but if it is rectified within three days, those betting on a default will be technically correct yet receive no payout.

I believe the odds of a payout on these contracts is essentially zero. But yeah, if there is a default for a couple of days, there will be “chaos” as several people on Twitter have commented. 

Author(s): Mike Shedlock

Publication Date: 21 Apr 2023

Publication Site: Mish Talk