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Level 3 assets at large American investment banks may have “bottomed out”, according to a new report by Moody’s. The stores of these illiquid, difficult-to-value assets often housed many of the most toxic securities that battered banks’ balance sheets during the credit crunch. Any decline in Level 3 assets is considered positive for banks’ credit profiles, Moody’s claims. (For previous coverage of Level 3 assets, click here.)
Somewhat ominously, the ratings agency adds that further falls in Level 3 inventories are unlikely. Although risky and illiquid, these securities feature “attractive yields and wide bid-offer spreads.” Under pressure to boost shareholder returns, it will be difficult for bankers to shun them completely.
Given banks’ recent travails, their boards have come in for plenty of criticism. In a new report, Moody’s wonders whether boards at large banks featured enough financial industry experts to “ask the right questions and appropriately challenge management.”
The ratings agency looks at the boards of 20 large American and European banks before and after the credit crunch. In Moody’s mind, the more independent non-executive directors with financial-industry experience, the better. On average, boards have added four new members since the crisis began. These additions bring more financial experience than their predecessors; around half of independent board members now boast financial experience, up from a third in 2007.
This is a good thing according to Moody’s, but in itself it is unlikely to make banks sounder at a stroke. After all, as Lex points out, sometimes non-experts ask the most pertinent questions. More plumbers on boards, for example, might have asked, “Hey, what happens if house prices actually fall?”
In a “noteworthy sign of returning liquidity to capital markets,” a report from Moody’s highlights a drop in Level 3 assets (L3) at the biggest American investment banks in 2009.
These assets cannot be valued easily because they are generally illiquid. Many of the credit boom’s newfangled financial instruments—subprime-linked securities, collateralised debt obligations and the like—were classified as L3 and marked to internal models when reporting their values on balance sheets. Subsequent write-downs of these assets called into question the judgment and competence of bank executives.
In general, creditors now prefer banks to hold less L3, with outright disposals preferable to transfers into the Level 2 or 1 categories. As a percentage of tangible common equity, cash L3 at five lenders with large investment-banking operations fell sharply in 2009; “good news for creditors,” according to Moody’s. (L3 derivative positions were excluded from the analysis due to inconsistent disclosure practices.)
Despite the decline as a share of equity, the absolute value of L3 at Bank of America and JPMorgan remained relatively flat in 2009. Bank of America reported the largest increase in value of L3 (US$9.4bn) in the sample, while JPMorgan was the only bank to disclose a net transfer into the L3 category. Morgan Stanley reported the largest absolute decline in L3, trimming its balance by some 38% during the year, largely through disposals.
Traders love volatility. Traders at hedge funds should particularly enjoy volatility, given the leeway they have to invest in a wide variety of securities and take both long and short positions. And although not all funds state it explicitly, “market neutral” performance—that is, growth in both good times and bad—is often used to justify hefty fees.
A recent study by ratings agency Moody’s compared monthly changes in a global index of hedge fund performance to the VIX index, a measure of volatility, going back to 1994. Large, sudden spikes in volatility tend to coincide with large losses for funds. “This stands to reason,” Moody’s writes, because a “sudden re-pricing of risk across the board can catch [hedge fund] managers off guard, in the same way as other market participants.” Is this yet more fodder that investors can use to renegotiate fees?
Even though some of the big investment banks are raking in profits, a new report from Moody’s questions whether “reliable repairs” have been made to these companies’ business models. The ratings agency then runs through some of the key ratios it will be following to gauge the health of the wholesale investment banking units at the largest financial firms.
One of the simplest metrics, gross leverage, is also the most telling. The scale of deleveraging at the pure-play investment banks is striking, as is the fact that high-flying Goldman Sachs and Morgan Stanley (the green line in the chart) were once practically indistinguishable from credit crunch casualties Bear Stearns, Lehman Brothers and Merrill Lynch (yellow line) as far as gross leverage was concerned.
Among the investment banking survivors, “few managers have been willing to reset promises to shareholders for a less free-wheeling environment,” Moody’s warns. “As a result, some firms may be tempted to again increase risk and leverage to meet shareholder demands as the crisis recedes.”
A new report from Moody’s is testing the mettle of banking bulls (admittedly, already a small club). The ratings agency estimates that the average maturity of new debt issued by banks has fallen sharply in recent years, from 7.2 years in 2005 to 4.7 years so far in 2009. Some US$10trn in debt will come due between now and 2015 for the banks that Moody’s rates; the true figure for all banks is even higher.
A shorter maturity profile leaves lenders more “vulnerable to a sudden increase in interest rates and/or to swings in investor confidence,” Moody’s says. This problem is particularly acute in the US and UK, where the average maturity over the past five years has fallen from 7.8 to 3.2 years and from 8.2 to 4.3 years, respectively. (Moody’s chart for the US is below.)
As rates rise from historic lows and governments pare back support to the financial sector, borrowers looking to extend debt maturities will face steeper funding costs. The banks that cannot pass these costs on to customers will either take a hit to margins or be forced to shrink their assets.