The move by Barclays to shove more than $12 billion in toxic assets from its own account to a Cayman Island based entity run by Barclays people who promptly quit to join the new firm, Protium, gets slammed again today in the Financial Times.
Gillian Tett points out that the Protium move has more than a passing resemblence to the the SIVs that caused so much trouble when this meltdown began. Those were off-balance sheet entitites that held long term credit assets and funded themselves with short term debt. Banks could take in profits without setting aside capital to meet regulatory reserve requirement because they were pretending they weren’t on the hook if the SIVs collapsed. This was a brilliant strategy, arbitraging the regulatory gaps and what seemed to be a gap in risk tolerance and time preference to earn great returns, until it wasn’t and the whole thing came crashing down and banks had to take the SIVs bank on their balance sheets.
Of course, the new model SIV isn’t repeating the same mistakes as the old model. Some improvements that Tett points out:
- Longer term Capital: The SIVs were funded with short term debt, mostly commercial paper. Protium has a long-term loan from Barclays.
- No Capital Reserve Regulatory Arbitrage: Because the loan is secured by the debt Barclays transferred to Protium, for regulatory purposes the assets will still need to be reserved against.
But there are still quite a few risky and dodgy aspects of the new style SIV.
- Exploding Assets: The loan to Protium doesn’t have to be marked to market. This means that Barclays can carry it as a $12.6 billion asset even while the underlying value of the collateral declines. It has traded a volatile asset for one that is only superficially stable. If the value of Protium’s assets declines to the point where it cannot service the loan, Barclays will find itself hit with a suddenly exploding asset instead of a slowly declining bundle of assets.
- Compensation Cap Arbitrage: The employees of Protium, a Cayman Islands based financial company, likely won’t be subject to the kind of pay caps that politicians want to impose on banks. This kind of gaming of the rules is no doubt a huge part of the motivation for starting Protium.
- Still Dependent On Cheap Money: We’ll leave it to others to decide whether the interest on the Protium loan, which is just 275 basis points above Libor, is cheap. It sounds cheap to us. But what really makes it cheap is that the loan is reportedly subordinated to the equity. Try getting that kind of loan from your bank.
- Built On The Assumption Of Market Failure: The old SIVs were built on the idea that the market wasn’t effeciently pricing debt, so that there were arbitrage opportunities to buy long term debt with short term debt. Protium is built on the assumption that the assets are underpriced by the market. Otherwise why not simply sell them on the open market. Once again we have bankers who think they are clever enough to outsmart the market.
Tett thinks Protium is the future and that there’s little regulators will be able to do to prevent banks for pushing their activities from the bright, regulated sectors of the market into the dark corners.
Yet, in spite of all those benefits, the fact remains that Protium is still the financial equivalent of a cellar: namely a dark place that is outside public scrutiny, but implicitly linked to the main financial “house”. And that points to a crucial challenge which is now dogging regulators – and which goes well beyond Barclays itself.
For the really dirty secret that currently bedevils the whole financial reform debate is that the more that regulators force banks to clean up their “front rooms” (ie regulated activity), the greater the risk that activity will flee to unregulated corners of finance – if nothing else because financiers have little desire to subject their pay to public scrutiny.
In theory, regulators could prevent that outflow, if they were willing to clamp down on the unregulated world in a co-ordinated way. In practice, though, western leaders are finding it so tough to agree on how to reform the front rooms of finance that I seriously doubt they will have the energy to attack the cellars too.
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