RBS - NOT TOXIC BUT TAINTED ASSETS?

Background: To better secure the solvency (practically and for regulatory compliance) of major banks, The Bank of England and HM Treasury conceived the APS Scheme (successor to the SLS Scheme). This takes 'assets' (i.e. loans) of banks bundled up and evaluated as an interest-bearing bond based on revenue streams over time (interest plus repayments of principal) generated by the loans. RBS, three quarters owned by the UK Government, agreed with the Treasury to offer 5 million loans worth an estimated £282bn (13% or £43bn down from the value at January 2009 of £325bn) and a very considerable % of RBS's total loanbook. The operation involves BoE taking these assets as collateral to swap for interest-bearing Treasury Bills (gilts maturing within a year) or an equivalent i.e. the novel idea of a zero-interest BoE cheque left at the central bank and only encashable by it. The gain by RBS is that asset value writedowns (market risk), which would hit its capital reserve, of these loans are off balance sheet while any credit risk losses up to 21% of the total are not off balance sheet. The swap is renewable and further assets may be demanded to maintain the collateral value. There is a swingeing fee and a considerable discount and haircut so that RBS does not gain treasury bills or a cheque made out to the full value of the assets, only about 75-80%. RBS continues to manage the loans for a fee. It gains a partial reduction in its risk weighted assets, but more importantly closes its funding gap between deposits and loans considerably and therefore much reduces its own borrowing when interbank borrowing is expensive. The government will take its fee for this swap transaction in terms of more shares in RBS raising its stake to 84% and should also see a better prospect of the bank recording a profit sooner plus a rise in the value of its shareholding.
The whole transaction does not strictly involve taxpayers' money; it is a swap. The financing support totalling over one £ trillion is not in the government's i.e. taxpayers' budget, notwithstanding that it is equivalent in size to half of GDP, but then UK banks' assets totasl more than 4 times GDP as a ratio. It is equivalent however to all of UK banks' capital reserves and then some. The media comment on this point is quite wrong, including by the FT who whould know better, which stated on 17th, "Taxpayers who have stumped up billions of pounds to bail out Royal Bank of Scotland". Taxpayers so far have not been taxed or in any way directly required to 'stump up' billions. All of this, as noted by several BoE public speeches, is not only off-budget in terms of the Government's fiscal budget, but also off-balance-sheet of said (media comment again) that these loans are impaired (also called 'toxic'), but that is mere presumption that has never been based on any factual foundation. The loans may be no worse than any other and merely performing in a manne typical of any such a large number of loans i.e. 5 million loans of which say 125,000 may have some defaults - after all the total has to be of high grade aggregate risk quality, but cannot be risk-free. In any case, default risk to a generous amount is at RBS's risk (and government's only via its shareholding) and there is no repayment risk to government since the paper it has issued may be swapped back for the collateral in whatever condition the latter is, and the collateral assets are off-balance sheet and do not generate any kind of paper or other loss for government or central bank accounts. There is insurance cover too, for which RBS has to pay the premium. The media's fixation on the idea that government is insuring or guaranteeing the assets is quite wrong! The overriding purpose of the whole exercise is to close RBS's funding gap to balance its books more cost effectively and remove credit crunch insolvency fears. Furthermore, given that the bank is nationalised, legally if so desired, the bank is technically free of regulatory compliance.
Just consider, before RBS can call on BoE for asset protection to recover losses (and only credit losses are referred to in the APS scheme, not market value asset losses) above £60bn after typically 50% debt recovery from underlying collateral such as property, the assets would have lost more than 42% in credit defaults, and yet could still have generated the equivalent of much of that to BoE in interest payments. But, anyway, if that happened, given also the more than half foreign element, there would have to have been an almighty global economic and financial system crash and whatever cockroaches came out of RBS there would be many more in all other banks. Therefore, to imagine a significant risk to government or 'taxpayers' is ludicrous - yet everyone maintains such a fictional scenario? I suppose people think someone somewhere is impressed?
All this makes the very precise current market value or longer run real economic value of the pledged assets academic, notwithstanding the European Commission's concerns on this point (including its insistence on first loss from over £40bn to £60bn, which again is mere pouch-posing) to prove that the bank is not being uncompetitively favoured.
The commercial hardness and headroom safety in the deal both would suggest that this is not the case. The bank is not gaining funds that it can speculate with or grow its loanbooks, merely reducing its funding gap borrowing requirement, if by a considerable extent of about half. The bank is in any case in other areas deleveraging i.e. reducing rather than growing its assets, especially in derivateives, but also under European Commission pressure reducing its small firms and SME loan books, albeit that this is directly opposing government's requests that the banks maintain their pre-crisis lending levels especially to small firms.
Alistair Darling overrode a warning from the Treasury’s top civil servant that a government-funded plan to insure Royal Bank of Scotland’s survival by underwriting £282bn of toxic loans could cover legally tainted assets.
The media comment would have us think that this gigantic sum of £282 billions is to be viewed as something more akin to siezures of criminal earnings like black market or forged money or heroin? The toxicity of the assets is not a financial or legal problem, not at all really. So, HMT experts have instead wondered about legal risk, at 'tainted' assets, and as another time-delay or make-work concern, Sir Nicholas Macpherson, permanent secretary at the Treasury, wrote to the chancellor in November saying, “It will be impossible to make the scheme work without providing insurance for some tainted assets – that is, assets whose legality may not be certain.” This is an interesting angle whose reasons for being raised may be obscure and of very remote risks, or merely a deal-making leverage (even if it is in effect between government-owned entities). "Some assets on which the APS [asset protection scheme] will pay out may well not fulfil the standard requirements for commitment and payment of public funds,” Sir Nicholas warned (in an official letter seen by the FT). “These include acting within the law, not tolerating fraud, illegality or corruption and operating controls to ensure these things.”
In RBS's interim report in 7 August '09, the CEO Steven Hester wrote plaintively in his letter to shareholders (page 11): "The APS itself, while conceptually straightforward, has enormous operational complexity which is taking time to resolve. For example, HMG has requested regular reporting on up to one billion lines of data covering assets in the scheme and our own systems and data quality are not well designed for the APS purpose." Given that 5 million loans are involved, this suggests 200 lines of code per loan? It probably really reflects the difficulty of precisely cutting and slicing the loans out of the accounts in a multitude of ledgers since not all detail and types fit into the general ledger - all major banks have similar problems. But, what make this complaint fascinating is why such complexity of reporting should be required and what in any case would be the cost or value to HMT, the FSA, or the BoE, to seek to examine all of that periodically?
Now perhaps we have a clue - government want to check for any legal shenanigans?
The APS deal was agreed in late November by which RBS became 84% state-owned. Technically RBS employees are all now public sector employees - why the analysis cannot be conducted within RBS is therefore puzzling.
This deal is not exactly between arm's length parties even if third party scrutineers are involved.
The FT commented that "Taxpayers who have stumped up billions of pounds to bail out Royal Bank of Scotland might be alarmed to discover that a proportion of the assets they are supporting may have been exposed to legal irregularities such as fraud." This makes two wrongheaded presumptions that taxpayers not only stumped up money but are supporting the assets, but suggests there is nevertheless a scandalous view that could very well emerge - perhaps I would think as a result of legal actions and investigations current in the USA by SEC and class action suits over RBS's board statements about its financial solvency and market conditions preparatory to capital raisings i.e. that collateral values, funding gap, default risk, expected writedowns or even underwriting risk and financial enhancement costs to the bank's own and third-party securitisation issues, or perhaps somthing about assurances or loan ontracts related to property or dealings with non-bank financial institutions or some aspects of its economic capital model accounting treatment, or the risks of gaming associated with inability to cleanly define the 5 million loans precisely? We do not know - the above list is mere speculation? There may be nothing at all to worry the deal or any of its hidden associated codicils.
What is perhaps worrying is that HMT was raising a major concern at the last minute that might have scuppered or long delayed the whole deal - why? Is this another case of mandarins playing party politics ahead of an election the government is widely expected to lose, and this is why the letter has now been leaked to the FT? Perhaps HMT senior mandarins had conceptual problems in understanding the nature of the off-balance sheet off-budget deal and were worried that moves in the USA to bring Treasury Bills formally on balance sheet of US Federal Debt if applied here would blow the UK's national debt ratio totally out of the Maastrict water! This was and is a real concern - similar to that of treating all of RBS's deposits and borrowings as part of national debt, a game that some commentators play rather than accept that the bank's balance sheet is precisely that - in balance.
The FT gamely or casually state, "It is well known that the toxic loans and investments RBS siphoned off into a government-backed insurance scheme carry a higher risk of default." Actually, not so! FT added, "But it was the possibility that they may have also been subject to criminal conduct that caused consternation in Westminster as the final details of the scheme were thrashed out late last year." This can mean either criminality by the bank or by its customers, which so far is merely libellous. But we are not talking about insuring the Titanic here; it is not a ship that with one hole under the water line the whole ship sinks. Sir Nick wrote to the chancellor in November to say he was unable to satisfy himself that the risk posed to the Treasury by insuring the assets would be ­negligible. This appeared to be a fear based merely on the bank's technical system difficulty in precisely defining the 5 million loans. The bank’s systems “could not confidently distinguish assets which it is unsuitable for the public sector to deal with”. Did this mean only that US or other foreign assets were involved that on some legal interpretation are outwith public sector support? The problem of the international assets of major banks is an item on the G20 agenda - how to wind up or divorce the domestic part of a bank from its foreign parts? Citicorp could not be made insolvent or nationalised in the US for the very reason that it was too complicated and would involve too many other countries - according to the FDIC. This view is supported by the FT's comment that "However, people familiar with RBS’s asset book claim that the legal issue came to the fore because of the extensive government assistance given to the bank, rather than its being a signal that a big problem was lurking in the shadows." The FT found an industry expert who surmised, "It was reviewed whether it was right and proper for the government to be insuring assets that potentially could have fraud in them.” but adding sensibly, "However, it was an entirely theoretical exercise.” This suggests to me that there are as yet no actual grounds for such suspiion, merely abstract speculation. It is all too easy to raise what may be red herrings simply because the assets involved come from RBS's retail, commercial and investment banking divisions. These should be separated, in my view, into 3 separate deals, and indeed should be so because the analysis to determine asset values (current, over the cycle, and the European Commission's Real Economic Value) each involve very different modeling and detailed analysis in each case. If the assets involve US assets including from Citizen Bank's retail loans, then again there should be more separate deals.
But, this defeats the overall purpose and the safeguard margins built-in plus the off-balance sheet nature of how it is all being accomplished without drawing on taxpayers' money. Therefore, the chancellor was absolutely right to override Sir Nick's concern and claim a wider public interest. He is aware that just as US government support for its banks involve support for foreign including UK loans, so too does UK government support for its banks - and this is also accommodated for by currency swap agreements between the central banks. Trying to disentangle that is not worth the effort.
This, however is spectacularly so in the case of RBS. The FT reports that of the assets to be placed in the APS 60% are held outside the UK, mainly in continental Europe and the US. We immediately think of ABN AMRO's investment banking and its baroque structured products that doubked RBS's exposure to toxic assets, Citizen Bank's retail banking and RBS Greenwich's involvement in about $1 trillion of relatively low quality securitisations many of which may be subject to class action law suits or suits by othet financial firms! But, whatever the risks are, can they exceed the £60bn first loss to be borned by RBS - the most plausible answer is NO!
Therefore, what else is afoot. It may be that what is of concern here are losses that could hit the bank directly and be of such scale that they would have to count on budget of the government because of its 84% ownership and also of such significance that the prospect of selling off RBS in whole or piece by piece suddenly becomes hard to work out, even remote.
In the case of Northern Rock, the bank was split between good bank and bad bank, so as to be able to sell-off the good bank. The problems of dividing up the general ledger and the operating units of RBS appears now to be much more problematic.
The FT says that Treasury insiders say the potential legal problems highlighted by Sir Nicholas stemmed from the lack of knowledge among the big banks about exactly what risks they had taken on during the lending boom – a central cause of the banking crisis. “The nature and complexity of the RBS balance sheet meant it would be impossible to go through every single asset. We did due diligence for eight months and, as part of that process, (and) excluded £43bn of assets from the scheme.” I interpret that as plain silly. There was no point in such detailed assessment given the structure of APS. Moreover, the £43bn looks to me more like amortisation of assets over a year rather than exclusion of assets for any particular reasons, though could be a mix of both, mainly the former. I suspect this 'insider' is just another speculatiing with lesss than expert intuition.
The government stresses there is no evidence of any illegal assets on the RBS books. But, of course, what is being demanded is positive not negative assurance, i.e. full audit - but how rediculous that 8 months auditing cannot provide surety - what does that say for quarterly and annual audits? Also, the scheme would not cover assets where there is any sign of “material or systematic criminal conduct on the part of RBS or any of its representatives”. This comment by an 'insider' places the criminality fear directly on the bank's side? FT comments The Treasury stands by its assessment that losses on the assets were not expected to exceed £60bn – the amount RBS would have to absorb itself before the scheme pays out - but pays out to whom, to government, it's 8% or whatever the assets as a bond pays. Therefore, “the direct cost to the taxpayer is expected to be nil”, it said. This is nonsensical. The government's risk in an asset repo swap is limited really only to its expected income while it holds the assets before handing them back in exchange for the return of its paper. The repo deal cannot mean the government has to make good the value of the pledged collateral or the underlying since it is merely a temporary investor on a swap basis in the bond - therefore the talk of £ billions at risk makes no sense unless there is truly an insurance scheme involved to compensate for loss in value of the assets (beyond their amortisation - i.e. as loans are paid off presumbly pro-rata between the first £60bn at the bank's risk and remaining £222bn, supposedly at the government's risk, for which it could seek thirdy party cover, probably quite inexpensively without excessive further due diligence?)
RBS said due diligence on the insured assets had been exhaustive and there was no information or evidence to suggest that any of the assets were irregular, legally-wise. Banking analysts (that breed who rarely see beyond what is in the published accounts) said that the fact that those assets had been insured at a high cost to the bank meant they clearly all posed a risk of default. Not so, if the premium is dictated by BoE and given that European Commission insists the premium has to curry no favour. It is therefore further nonsense to deduce the quality of the assets merely from the premium charged.
According to published accounts in 2009, RBS made its largest loss provisions on the investment banking side, for structured products such as asset-backed securities and derivatives i.e. the £10bn that wiped out the purchase price for ABN AMRO, in a sign that this is where it expects the brunt of the losses might arise. Again, not so. The provisions had to reflect market values that have since recovered for assets that may be held to maturity i.e. these are paper not economic losses and are not strictly an estimate of future losses, merely current paper losses as yet unrealised and that may never be so realised!The FT provides an interesting potted profile of Sir Nicholas Macpherson. He is a cerebral mandarin, 25 years a civil service, and close ally of the prime minister with his hand on the tiller of Number 11 under Gordon Brown during boom and bust. Hang on a second, there was no boom and bust under Brown's helmanship of the Treasury? His one great feat was avoiding going into recession with the USA in 2001/2, a feat unprecedented for over a century! In fact Sir Nick was only appointed as Treasury permanent secretary in '05 albeit at the height of the lending boom, and knighted in '09 for overseeing the banking bail-out, including nationalisation of Northern Rock, Bradford & Bingley, RBS and almost too LBG.
The 50-year-old worked with both Tory (Clarke) and Labour chancellors (Brown & Darling) – and in FT's words is a stickler for civil service protocol. His e-mails reminding colleagues not to leak to the press are a regular feature of the run-up to each Budget - that's not being a stickler, that's routine. Popular with Treasury officials, Sir Nick’s elusiveness can irritate the more down-to-earth MPs on the Commons’ Treasury committee. That says little - it is axiomatic that civil servants should cover themselves in fish-slime in any public fora sufficient for any human hands to fail to grab onto.
His salary is £161,000. He is an Old Etonian, ex-CBI and Peat Marwick economist before joining HMT in '85, including working on EU economic & monetary union, and played a sterling role in negotiating the Maastricht treaty in '91.
In response to his letter of concern, he got a formal “direction” from chancellor Darling to override the question of potential misuse of public money in the APS.
The FT says this is only the 2nd such direction since '97, which I very much doubt. There was a similar direction in late '08 over the reference of the Lloyds and HBOS merger. Eching this latter one precisely, Darling asserted the “wider public interest” in maintaining confidence in the banking sector meant it was “right to live with the residual risks” the Treasury highlighted - quite right too.
The FT goes on to mention recent mortgage frauds, where criminal gangs have worked together to obtain credit using false data - but that is surely not at all the issue, and in any case the property remains as security. The Treasury on Wednesday declined to be drawn on the nature or estimated maximum amount of the potentially tainted assets - of course not, it's not possible. HMT stressed it had “no specific information that shows any of the assets are irregular or tainted”.
In evidence of Opposition playing honest daft laddy, Lord Oakeshott, Liberal Democrat Treasury spokesman, said of the letter it “must be the most shocking a Treasury permanent secretary has ever had to write as accounting officer – he could not satisfy himself on the risk to taxpayers from underwriting RBS’s wild loans ... taxpayers cannot condone, never mind reward, fraud and corruption.”
To digress, this is kneejerk ignorance of the kind that George Osborne and some others including Vince Cable reserve for claiming government finances are in a mess or, sadly in my view, Ken Clarke recently, who said that public spending cuts will have to be the most severe in British history. He is an ex-Chancellor I much admire for talking right while walking left, who is merely happy now to be dishing back the same unfounded accusations at New Labour that New Labour levelled at him in the '97 General Election campaign, despite the fact that Brown on assuming office kept to Clarke's budget projections for two years - something Clarke himself would not have done and sensibly never did do when in office. New Labour accused Clarke of having over-borrowed and he mysreiously never responded with the telling question "what would you have done different to get us out of recession?"