U.S. fi­nan­cial ti­tans of­fer up a way to bet on the next bank­ing cri­sis

The Globe and Mail Metro (Ontario Edition) - - Report On Business - ALASTAIR MARSH TOM BEARDSWORTH

Less than a decade af­ter the most re­cent ma­jor bank­ing cri­sis, Gold­man Sachs Group Inc. and JPMor­gan Chase & Co. are of­fer­ing in­vestors a new way to bet on the next one.

The two fi­nan­cial gi­ants are now mak­ing mar­kets in de­riv­a­tives that al­low in­vestors to bet on or against high-risk bank bonds that fi­nan­cial reg­u­la­tors can wipe out if a lender runs into trou­ble. Oth­ers are also plan­ning to start trad­ing the con­tracts, known as to­tal-re­turn swaps, in the com­ing weeks, ac­cord­ing to Max Ruscher, the Lon­don-based di­rec­tor of credit in­dexes at IHS Markit Ltd., which ad­min­is­ters the bench­marks that the swaps are linked to.

At a time when fi­nan­cial mar­kets are rac­ing from one high to an­other, and even the new No­bel lau­re­ate in eco­nomics is won­der­ing aloud about in­vestor be­hav­iour, the de­vel­op­ment is at once a sign of the head­long global race for in­vest­ment re­turns and nag­ging wor­ries that the in­vestors may be get­ting ahead of them­selves.

Un­der­ly­ing th­ese trades are se­cu­ri­ties known as ad­di­tional Tier 1 notes, which banks started is­su­ing af­ter the Euro­pean debt cri­sis. They seek to pro­tect tax­pay­ers from bear­ing the cost of govern­ment bailouts, bring­ing with them rel­a­tively high yields. In an era of near-zero in­ter­est rates, they’ve be­come sought af­ter by debt in­vestors around the world, bal­loon­ing into a $150-bil­lion (U.S.) mar­ket.

The av­er­age yield on the debt is about 4.7 per cent, or around 10 times that for se­nior bank bonds, based on Bank of Amer­ica Mer­rill Lynch in­dex data.

Tier 1 cap­i­tal is a “shock ab­sorber” that banks can use to boost their bal­ance sheets in an emer­gency, while im­pos­ing losses on cred­i­tors, Jim McCaughan, chief ex­ec­u­tive of­fi­cer at Prin­ci­pal Global In­vestors, said in an in­ter­view. That could cre­ate a neg­a­tive “feed­back loop” for traders, he said.

“I don’t be­lieve it’s a dan­ger yet be­cause I don’t think there’s that spec­u­la­tion go­ing on in a big way,” he said. “But watch this space and be very wary of this.”

At least some of the de­mand for the new de­riv­a­tives is com­ing from in­vestors look­ing to pro­tect them­selves should prices of the debt drop – or should an­other bank­ing cri­sis erupt. Those risks emerged in June, when AT1s is­sued by Banco Pop­u­lar Es­panol SA were wiped out as part of a bank res­cue.

“Some par­tic­i­pants are look­ing to get exposure to an as­set class while oth­ers are hedg­ing their po­si­tions,” ac­cord­ing to a re­port on IHS Markit’s web­site. “On one side of the TRS trade, the in­dex buyer an­tic­i­pates that the to­tal re­turn of the in­dex will rise. The in­dex seller on the other side takes the op­po­site view.” Credit-de­fault swaps

Wall Street and City of Lon­don banks have a long track record of cre­at­ing de­riv­a­tives around debt mar­kets as in­vestors grow ner­vous that they’re be­com­ing too ex­posed. Be­fore the fi­nan­cial cri­sis a decade ago, they cre­ated credit-de­fault swaps tied to sub­prime mort­gages, en­abling the trade that Michael Lewis made fa­mous in his book The Big Short. Other swaps cre­ated around the same time have since be­come used to bet against com­mer­cial mort­gages that are heav­ily ex­posed to shop­ping malls.

AT1 notes can’t be hedged with credit-de­fault swaps be­cause banks can skip coupon pay­ments on the bonds with­out trig­ger­ing a de­fault.

The to­tal-re­turn swaps al­low in­vestors to hedge a bas­ket of AT1s, and traders can make am­pli­fied gains – or po­ten­tially out­sized losses – with­out hav­ing to own the un­der­ly­ing notes or tie up large amounts of col­lat­eral.

Gold­man Sachs is mak­ing mar­kets in swaps tied to an iBoxx in­dex of U.S. dol­lar-de­nom­i­nated bank-cap­i­tal notes and a gauge of sim­i­lar euro bonds, Mr. Ruscher said. The two in­dexes in­clude AT1s is­sued by lenders such as Banco San­tander SA, Deutsche Bank AG and HSBC Hold­ings PLC. New tool

The swaps on bank-cap­i­tal note in­dexes “will be a very use­ful ad­di­tion to the tool­kit that our clients use in man­ag­ing risk and tak­ing broad-based exposure to the AT1 mar­ket,” said Manav Gupta, Gold­man’s co-head of Euro­pean credit flow trad­ing, who con­firmed that the bank is mak­ing mar­kets for the trades.

A spokesman for JPMor­gan con­firmed the bank is also of­fer­ing swaps on iBoxx in­dexes. Deutsche Bank started trad­ing to­tal-re­turn swaps ref­er­enc­ing Bloomberg Bar­clays in­dexes last month and plans to trade on iBoxx gauges, a spokesman said.

To­tal-re­turn swaps are be­ing in­tro­duced now be­cause of the growth of the AT1 mar­ket and in­vestor de­mand, Mr. Ruscher said. Still, the in­dex swaps may be more use­ful for in­vestors look­ing to re­duce exposure to the mar­ket than those seek­ing to gain. BlueBay As­set Man­age­ment, for ex­am­ple, prefers to select in­di­vid­ual bonds and avoid weaker is­suers that may en­ter in­dexes.

In a to­tal-re­turn swap, buy­ers usu­ally pay sell­ers the Lon­don in­ter­bank-of­fered rate. If the in­dex goes up over the pe­riod of the con­tract, the buyer gets money from the seller; if there’s a de­cline, the buyer pays an ex­tra sum to the seller. Ei­ther way, larger in­dex changes lead to larger pay­ments.

Gold­man Sachs (GS) Close: $239.80 (U.S.), down $2.60 JPMor­gan Chase (JPM) Close: $95.99 (U.S.), down 85¢

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