Thursday, March 10, 2011

US banks don't need borrowers in order to 'lend'

Who says that a bank needs to find a willing and creditworthy borrower for it to be able to lend out money? Only incompetent unimaginative putzes will insist that a willing borrower be at the other end of a profitable banking transaction. This is what separates the men from the boys; the masters of the universe form the masters of the basement.

All you ever need, to have a profitable ‘lender’-like arrangement, is a willing credit default insurer. And with the environment the way it is nowadays, willing parties for this arrangement practically fall from the sky. Opportunity abounds to create synthetic junk bonds. Here is a list of some of the things bankers are most thankful for, that make this unbelievable wealthmaking opportunity possible for those willing to go for gold:

The CDS market Where would we all be without this wonderful market? Probably just sitting around all day, staring into the ceiling whilst we drink endless pitchers of kool-aid. Because of the so-called credit default swap market – anyone - regardless whether he’s an actual lender or not, can enter into an insurance protection program with a willing seller of insurance a.k.a. CDS counterparty. Don’t have an existing relationship with some debt-hungry junk debt, oops, sort, high-yield corporate debt issuers you wish you had on your rolodex? No problem, you can still get a potential payout, as if you were a lender, in the event that they go into default, courtesy of the CDS counterparty/insurer you have a payout arrangement with.

Yield-hungry chumps insurers Why would anyone be willing to give a payout to a non-lender in the event of a credit default by a borrower who probably doesn’t know said non-lender from adam? Simple. How much is in it for him? Promise to pay the insurer high enough premiums, and he’ll give you protection from the boogieman himself. After all, it’s not everyday that a big corporate issuer suddenly declares bankruptcy, right? In all likelihood, he’s thinking… since issuer A has never defaulted before, there’s likely a small probability of him ever doing so. Who are you to argue with history?

Fed interest rates Still, why would anyone want to enter into an insurance arrangement where they could end up paying out debt obligations of a defaulting issuer to any ‘JP Morgan wannabe’ in exchange for some premium payments? Well, you’ve got the current low interest rate environment to thank for that. Correction, you’ve got the current negative interest rate environment to thank for that. Large institutional investors are going out of their wits looking for that high yielding instrument that could help them attain those rosy blue sky returns they’ve promised to their retail Joe Schmoe investors, when they were still busy collecting those assets from Joe. Today’s current interest rate environment was designed specifically to push investors to take on more risk. There are never enough high yield debt, so you synthesize it.

US Government Hey, we’ve got history on our side here. What happens when the unthinkable happens, when the underlying issuer defaults and the insurer ends up having to pay out its obligations to Mr. Morgan wannabe? Uncle Sam will come in, of course. After all, when all the Joe Schmoe investors in the chump insurer stands to lose all of their pension and retirement funds because of said insurer’s decision to be the stupidest guy around the table when dealing with more sophisticated parties, you can bet that the Uncle will be thinking of his beloved voters, and of the implications of non-action to the entire financial system.

Why do banks get into derivative swaps? This is practically a no-brainer.

Capital arbitrage Oh, come on. You’re getting credit protection from a known default risk. At the worst case, this has got lead to capital improvement for you somehow. You just have to be crafty. Chuck Norris kick to you, Basel II.

Derivatives holders are actually paid ahead of unsecured creditors. ‘Nuf said.

When you take insurance from a protection seller, you are effectively selling short such underlying security. More short selling puts more stress on the issuer/borrower, by increasing issuer’s cost of borrowing. This leads to greater likelihood that your hoped-for payday comes much sooner. Know what's cooler than a million dollars in CDS payouts? A billion dollars in CDS payouts! Ka-ching!

related post: US banks are not capital-constrained

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