July ’17

The BAN Report: Bye, Bye LIBOR / The GSE Profit Sweep / Margin Loans Spike / The Downside of High Rents-7/27/17

Bye, Bye LIBOR

This week, the UK’s Financial Conduct Authority announced a plan to phase out LIBOR by the end of 2021, causing massive disruption in loans tied to this index.

On Thursday a top U.K. regulator said it would phase out the London interbank offered rate, a scandal-plagued benchmark that is used to set the price of trillions of dollars of loans and derivatives across the world.

Andrew Bailey, the chief executive of the U.K.’s Financial Conduct Authority, which regulates Libor, said that work would begin to plan for a transition to alternate benchmarks by the end of 2021. “We do not think markets can rely on Libor continuing to be available indefinitely,” he said.

Libor is calculated every working day by polling major banks on their estimated borrowing costs. Its integrity was called into question following a rate-rigging scandal where traders at numerous banks were able to nudge it up or down by submitting false data. Banks were fined billions of dollars and several traders were sent to jail.

Over the last five years regulators have tried to find ways to tie Libor submissions to actual trades, as opposed to estimations. But in several cases that proved impossible because interbank lending has hugely diminished, Mr. Bailey said.

The push to ditch Libor creates a headache for authorities who should drum up alternative benchmarks and banks that face having to rewrite trillions of dollars’ worth of contacts. In financial markets Libor is ubiquitous, being used to price financial products ranging from mortgages to complex derivatives. Industry bodies have yet to agree on fall back rates that can be inserted into existing contracts if Libor suddenly ceases to exist.

This is a big problem for loans that are priced off LIBOR.   Here’s what many standard loan documents say:

“If the 5-Year LIBOR SWAP Rate becomes unavailable at any time, Lender shall select a new index or other appropriate measure as a basis for setting the Interest Rate.”

Jason Kuwayama of Godfrey and Kahn said, ““A great number of lenders switched away from using LIBOR as an interest index after the price manipulation scandal in 2012.  I don’t see this as a huge issue for commercial loans because most will mature before LIBOR is phased out.  But for those that still use LIBOR, the bigger issue arises with longer term loans for which the bank entered into an interest rate swap or a similar derivative instrument that was indexed to LIBOR.    Lenders who have hedged themselves into that position should look to amend their documents sooner rather than later.”

The GSE Profit Sweep

The New York Times had a great article about how the US Treasury opportunistically changed the terms of the bailout of Fannie and Freddie in 2012, so that they could seize the expected spike in profits from the GSEs.

In August 2012, the federal government abruptly changed the terms of the bailout provided to Fannie Mae and Freddie Mac, the mortgage finance giants that had been devastated by the financial crisis. Instead of continuing to receive payments on the taxpayer assistance, Treasury officials decided to begin seizing all the profits both companies generated every quarter.

It was an unusual move, given that the companies still had public shareholders. But it was necessary, the Treasury said, to protect taxpayers from likely future losses in their operations. Justice Department lawyers have reiterated this view in court, saying that the bailout terms were modified because the companies were in a death spiral.

But newly unsealed documents show that as early as December 2011, high-level Treasury officials knew that Fannie and Freddie would soon become profitable again. The materials also show that government officials involved in the decision to divert the profits knew the change would most likely generate more money for Treasury than the original rescue terms, which required the companies to pay taxpayers 10 percent annually on the bailout assistance they had received.

The US government advanced 187.5 billion to bail out Fannie and Freddie, but they have since returned 270.9 billion to the government, 83.4 billion more than their investment.     This is all coming out because Fannie and Freddie shareholders are claiming that many of these profits belong to them, and the government essentially took private property without compensation.

Margin Loans Spike

Fueled by a boom in asset values, Wall Street has been pushing consumers to borrow against their stock and bonds.

Executives at Morgan Stanley earlier this month highlighted these loans to individuals as a big growth area and revenue driver, saying the loans helped expand the bank’s overall wealth lending by about $3.5 billion, or 6%, in the second quarter. On Thursday, Goldman Sachs Group Inc. took a step toward growing its securities-based lending business through a new partnership with Fidelity Investments.

For brokerages, these so-called securities-backed loans have become a reliable source of revenue in the years since the financial crisis as firms have begun moving away from a business model of charging commissions for trading to a system of fees based on assets under management. The loans themselves help brokers retain these assets because customers don’t have to sell stocks and other securities when they need cash. These loans have also become a big factor in brokers’ compensation.

Clients, in turn, are able to borrow money at relatively low interest rates because the loans are secured.

Margin loans are usually fairly low-risk for the lender, as the leverage is limited to 50% at the time of purchase.   The problem with a spike in margin loans is it can accelerate a downturn in asset prices, as securities firms must liquidate assets if margin calls cannot be met.   It can also be expensive to the borrower, as most margin loans are priced in the high single digits.

The Downside of High Rents

Bloomberg had a great story about how independent restaurants in trendy neighborhoods are being pushed out by higher rents.    The irony is the very reason many of these neighborhoods became popular was due to their unique restaurants, which are being replaced in many cases by bland corporate tenants.

In 1995, the restaurateur Jonathan Morr opened a 3,800-square-foot noodle shop called Republic on Union Square West in New York City, paying an annual rent of $220,000. “The rent was relatively inexpensive for what it was,” he said. “But remember, when I opened, Union Square was very different than it is today. There was very little there along with the drugs in the park. At the time we were taking a risk.”   

Twenty-two years later, Union Square has been gentrified beyond recognition. It’s home to a Whole Foods supermarket and an apartment building whose penthouse sold for more than $16 million. And now Republic is on its way out. Morr said he expects to close the space by the end of 2017, three and a half years before the lease expires. “It’s just a fact of life—there’s no way that we’re staying there after the lease is up,” he said. Taking advantage of an impatient landlord, Morr plans to leave the space early and will “split the difference between what [the landlord] gets from us and what he’ll get from the next tenant, and call it a day,” he said.

Republic is joining a slow but distinct restaurant exodus from the area, following in the footsteps of Danny Meyer’s Union Square Cafe, whose prohibitively high rent forced it to search for a new space in 2015.  “There’s no such thing as a New York restaurant that’s immune to real estate,” said Richard Coraine, the chief of staff for Union Square Hospitality Group. He noted that the original, 1985 rent for USQ was $4,500 a month. A roughly fivefold increase over 30 years is what prompted Meyer to move his beloved restaurant to its current home, on a corner a few blocks northeast of Union Square.

This phenomenon is pushing out many tenants that were vital to the fabric of these neighborhoods.   Diners, pizza shops, and high-end restaurants are being replaced by Starbucks and other corporate tenants.    The rent for Blue Water Grill was raised to over $2MM a year, which means the restaurant might have to generate $20MM a year in sales just to break even.   According to Restaurant Business, only 19 independent restaurants in the country generated $20MM in sales in 2016.    Moreover, in expensive cities, very few restaurants own their own real estate, which would allow them to maintain some cost certainty.

The BAN Report: What’s Eating the Examiners? / Banks Stay Stingy on Deposits / CFPB Curbs Arbitration / Fed to Slow Rate Increases? / After Walmart Leaves-7/13/17

What’s Eating the Examiners?

The Office of the Comptroller of the Currency, the primary regulator for most of the US banks by assets, published its “Semiannual Risk Perspective for Spring 2017” last week.   This important publication tells industry participants what issues are most at the forefront of bank examiners concerns today.   A few concerns of note:

  • Strategic risk remains elevated as banks make decisions to expand into new products or services or consider new delivery channels and continue merger and acquisition (M&A) activity. Banks face competition from nonfinancial firms, including financial technology (fintech) companies entering the traditional banking industry. This competition is causing changes in the way customers and financial institutions approach banking.
  • Credit underwriting standards and practices across commercial and retail portfolios remain an area of OCC emphasis. Over the past two years, commercial and retail credit underwriting has loosened, showing a transition from a conservative to an increasing risk appetite as banks strive to achieve loan growth and maintain or grow market share.
  • Strong CRE loan growth has resulted in increasing credit concentrations. Results from recent supervisory activities raise concern over the quality of CRE risk management, particularly as it relates to managing concentration risk.
  • Operational risk continues to challenge banks because of increasing cyber threats, reliance on concentrations in significant third-party service providers, and the need for sound governance over product service and delivery.
  • Some banks continue to face challenges complying with Bank Secrecy Act (BSA) requirements as money laundering and terrorism financing methods evolve.
  • Multiple new or amended regulations are posing challenges to change management processes and increasing operational, compliance, and other risks.

These concerns are basically unchanged from the last report in Fall of 2016.    However, a few larger macro risks were added:

  • Heavy reliance on third-party service providers for critical activities and the increasing changes driven by new products offered by emerging fintech companies create increased risk relating to third-party risk management.
  • Credit risk in banks with high concentrations in agricultural lending is increasing. Commodity prices for grain crops have declined over the past three years and livestock, and dairy prices have declined over the last two years, resulting in lower income and cash flow for agriculture industry borrowers.
  • Changes in interest rates and the yield curve are raising interest rate risk. This increased risk is evident in changes in unrealized gains and losses in bank investment portfolios with long duration assets

Sometimes, one gets the impression that the OCC does not know what to do with fintech.    They are very worried about banks relying on third-party service providers to offer additional products to their customers, while they are still considering a fintech charter.

The concern about agricultural lending is a new concern, as lower commodity prices could cause problems through agricultural portfolios.   Fortunately, a large portion of agricultural lending involves government support.    The worry about interest rate risk has been elevated as well.

Banks Stay Stingy on Deposits

Still flush with deposits, banks have not budged on increasing deposit yields despite four rate increases.    So far, consumers have stood pat, perhaps conditioned for low yields for nearly a decade.

Banks have been dealing with interest-rate cycles and depositors for decades, but a number of factors, both psychological and technological, make this time of rising rates different. A decade of near-zero rates, more competition from online firms, less loyalty from customers and new capital rules, among other factors, are making preparations more difficult.

Of course, banks don’t want to raise deposit rates until they have to. Though they tend to raise certain loan rates as soon as the Fed makes a move, they prefer to let deposit rates lag, bolstering profits.

And when they do raise rates, it is often because competition has forced them. “Nobody wants to be first,” said Greg Carmichael, chief executive of Fifth Third Bancorp. “But nobody wants to lose deposits.”

Bank of America is a case in point. Its cost for U.S. interest-bearing deposits in the first quarter was just 0.09%—unchanged from the prior quarter and the lowest among its peers.

Talking with analysts recently, finance chief Paul Donofrio said it seemed unlikely that customers would leave the bank to chase rates because many had their primary checking accounts there.

Or at least they used to care. A complicating factor is that depositors haven’t thought of bank accounts as income-producing instruments in nearly a decade, thanks to the Fed’s near-zero interest-rate policies.

Given that, many customers have come to view banks in terms of the services they offer, such as mobile banking, rather than the rates they pay.

How long will this continue?    With lagging loan growth this year, banks are not lacking in funding, so it makes little sense to pay up for more deposits.    We suspect that someone will eventually go first and other banks will have to follow.   But, in the meantime, this is great for bank earnings as banks can continue to increase loan yields while funding costs are flat, thus boosting net interest margins.

CFPB Curbs Arbitration

This week, the Consumer Financial Protection Bureau adopted a rule that would make it easier for consumers to sue financial firms by  breaking up mandatory arbitration clauses common in consumer loans.

The nation’s consumer watchdog adopted a rule on Monday that would pry open the courtroom doors for millions of Americans, by prohibiting financial firms from forcing them into arbitration in disputes over their bank and credit card accounts.

The action, by the Consumer Financial Protection Bureau, would deal a serious blow to banks and other financial firms, freeing consumers to band together in class-action lawsuits that could cost the institutions billions of dollars.

“A cherished tenet of our justice system is that no one, no matter how big or how powerful, should escape accountability if they break the law,” Richard Cordray, the director of the consumer agency, said in a statement.

The new rule, which could take effect next year, is almost certain to set off a political firestorm in Washington. Both the Trump administration and House Republicans have pushed to rein in the consumer finance agency as part of a broader effort to lighten regulation on the financial industry.

Lawmakers have 60 legislative days to overturn this rule, and there will undoubtedly be lots of pressure from the banking industry, which had worked for a decade to move consumer disputes from the courts to arbitration.

Rob Nicholas, ABA President and CEO, said “We’re disappointed that the CFPB has chosen to put class action lawyers – rather than consumers – first with today’s final rule.  Banks resolve the overwhelming majority of disputes quickly and amicably, long before they get to court or arbitration.  The Bureau’s own study found that arbitration has significant benefits over litigation in general and class actions in particular.  Arbitration is a convenient, efficient and fair method of resolving disputes at a fraction of the cost of expensive litigation, which helps keep costs down for all consumers.”

From a practical standpoint, this rule would dramatically increase the number of class action lawsuits, as the arbitration clauses have made class action suits very difficult.    Consumer lending has already been viewed as toxic by many banks, and this ruling, if it stands, will not make it any easier.

Fed to Slow Rate Increases?

Traders often hear what they want to hear to support their market view, and yesterday’s hearing by Janet Yellen was no exception.

Ms. Yellen added, however, that the Fed was paying close attention to the recent weakness of inflation. While emphasizing that she expected prices to start rising more quickly, she said persistent weakness could lead the Fed to raise interest rates more slowly.

“It’s premature to reach the judgment that we’re not on the path to 2 percent inflation over the next couple of years,” she said. “We’re watching this very closely and stand ready to adjust our policy if it appears the inflation undershoot will be persistent.”

Ms. Yellen’s testimony before the House Financial Services Committee lifted stock prices and lowered bond yields on Wednesday. Investors tend to celebrate any sign that the Fed might slow the pace of its interest-rate increases.

So, rates will probably continue to go up, unless inflation is not as bad as we thought.

After Walmart Leaves

While there are better sources for one’s sympathy, Walmart, the nation’s largest retailer, gets blamed for destroying communities when it opens a store, and then destroying them when they leave.

Much has been written about what happens when the corporate giant opens up in an area,with numerous studies recording how it sucks the energy out of a locality, overpowering the competition through sheer scale and forcing the closure of mom-and-pop stores for up to 20 miles around. A more pressing, and much less-well-understood, question is what are the consequences when Walmart screeches into reverse: when it ups and quits, leaving behind a trail of lost jobs and broken promises.

The subject is gathering increasing urgency as the megacorporation rethinks its business strategy. Rural areas like McDowell County, where Walmart focused its expansion plans in the 1990s, are experiencing accelerating depopulation that is putting a strain on the firm’s boundless ambitions.

When you combine the county’s economic malaise with Walmart’s increasingly ferocious battle against Amazon for dominance over online retailing, you can see why outsized physical presences could seem surplus to requirements. “There has been a wave of closings across the US, most acutely in small towns and rural communities that have had heavy population loss,” said Michael Hicks, an economics professor at Ball State University who is an authority on Walmart’s local impact.

On 15 January 2016, those winds of change swept across the country with a fury. Walmart announced that it was closing 269 stores worldwide, 154 of them in the US. Of those, 14 were supercenters, the gargantuan “big boxes” that have become the familiar face of the company since the first opened in Missouri in 1988.

While these stories are unfortunate, towns with shrinking populations in a tough retail environment are going to continue to see loss of large retailers.

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