Give up now? 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 strainedcondition of all things financial. In a 70-page tome entitled “TestingTimes,” the bank’s chief IB watcher in Europe, Jeremy Sigee, makes aconvincing case for sector-wide capitulation.
Investment banking business models are, of course, being put to thetest. While hedge funds and private equity are still attractinginflows, and emerging markets are still riding high, proprietary risktaking and product innovation are being scaled back. So, having alreadybeen bearish on fixed income revenues, which are forecast to fall backto 2004/5 levels this year, the Citi team now see revenues fromequities 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 securitisationand structured credit seem to have died for the foreseeable future. Wecan see in Figure 21 (below) that volumes have collapsed nearly to zerosince July. Indeed it is these securitisation and structuring productsthat have been the root cause and the epicentre of the recent marketturmoil. Several things were wrong:
– The securitisation model broke up thecredit value chain in sub-prime mortgages. Originators had everyincentive to maximise volume and little or no incentive to care aboutthe interests of borrowers or the ultimate credit providers. Servicershad no resources or expertise (or, again, much incentive) to talk toborrowers about their financial circumstances, interest rate re-sets orloan restructuring. The holders of the credit risk had little or noawareness of who they had lent to, or on what documentation and terms,and little or no ability to enter dialogue with those borrowers toreschedule or restructure the debt once into difficulties.
– The statistical assumptions aboutpossible losses, underpinning the tranching structures and the creationof AAA debt out of low-quality borrower pools were based on earliercycles, but then in this present cycle were applied to greatlyincreased volumes, greatly relaxed criteria and dangerous new productstructures, without adjusting the loss assumptions.
– The concept of what “AAA” actually meant— as embedded in the mandates of money market funds, or the riskscreens of treasury departments, or even in the control frameworks andcapital models of bank risk managers and regulators — became verydistorted, without the full realisation of those investors or riskmanagers.
– 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 underlyingsecurities, further distanced borrowers from credit providers, addedleverage upon leverage to the underlying risks, and multiplied theimpact of the errors in key statistical loss assumptions.
– The structuring process came to relyheavily upon certain structured (rather than ‘real-money’) investortypes to take certain tranches. In particular they relied upon theABCP-funded SIVs & conduits, and the highly leveraged specialisthedge funds and special purpose funds. Many of these have now been hitby losses, some very large, and have been revealed to be greatly morerisk-prone than had been thought. As a result many are being dismantledor 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 toreturn. In reality many of the key buyers have blown up and others willno longer participate now they know what the risks are.
Also, we suspect that this is more thanjust a sub-prime problem. It is true that the only significant creditdefaults are in sub-prime at the present time, and that there werespecific practices unique to sub-prime that have contributed to thedefaults and to the problems for related securitisations and structuredcredit. However, the problems discussed above (integrity of creditvalue chain, meaning of “AAA”, transparency, reliance on inappropriate/ disappearing buyer types) are at least partially shared by otherforms of securitisation and structured credit. And finally, even ifthose structural problems can be solved, it may be that therecalibration of loss assumptions leaves some of these productseconomically 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 awobble; 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, structuringtechniques, risk management practices, economic models and client typesare being challenged. Some or all of the big new things that drovegrowth in capital markets and in investment bank revenues over the pastfew years, may be in terminal decline.
