Banks seek to offload risk on insurers | FT Alphaville

Banks seek to offload risk on insurers

Now when and where did that last happen…

In Tuesday’s FT, Brooke Masters reported on a rather novel approach that some banks are trying to take in order to reduce their capital requirements. The trick is to reduce the predicted loss that would be experienced if a borrower were to default. This is effectively done by getting an insurer to guarantee the future value of the collateral held as security for the loan.

The collateral in question is, however, no ordinary collateral. It’s intangible, like patents, for example.

If you’re finding it a bit difficult to visualise, don’t worry, we have diagrams! Here goes:

Here we have a tech company that borrowed from a bank. The tech company has gone bankrupt. The bank, in an effort to make itself whole on the loan, seizes collateral. The collateral is, in this case, a patent portfolio that the bank then tries to sell to the market.

Unfortunately it turns out that the tech company going bust was one of a series of such bankruptcies as the economy is in a recession. As a result, the market isn’t feeling that great traders are being attacked by intraday bars OOHHH the humanity!!! so no one is in a mood to buy patents, especially as it’s really difficult to value them.

As patents are generally hard to value, regulators don’t tend to value such intangible collateral very highly. Consequently, the “loss given default” — calculated to determine the amount of regulatory capital that has to be held against a given loan on a bank’s books — is high for loans to companies that mostly have these types of hard-to-value, and potentially hard-to-sell intangible assets.

End result: it can be expensive in regulatory capital terms to lend to tech companies. (That’s if you’re subject to bank regulation of course… Private equity, venture capital, hedge funds, friends/relatives of the founders do not have this problem, hence their strong role in the sector.)

From the banks perspective, having this collateral, even though it is intangible, reduces the risk of the loan. It makes them more comfortable lending to these companies at all. So they are a bit miffed by regulations, especially Basel III, not giving them much credit for it.

The solution banks have come up with, to try to decrease the capital requirement, is to get insurance companies involved. The role of the insurer is to guarantee the amount that can be made on the sale of the patents, and indeed that a sale can be made at all (to the insurance company itself, as it turns out).

In the above, we have the same tech company and its still on its feet for the time being. But now the bank is paying a fee to an insurance company. The fee is in exchange for the insurance company buying the patents if the tech company does go bust, like so:

Rather than be forced to go to the market to get an uncertain sum, the insurance company buys the patents from the bank that was entitled to them as collateral under the loan agreement.

The FT story gives a couple of examples other than patents, like logos and recipes. As for whether regulators will be alright with this:

… Mr Tepper [global head of corporate development at M.Cam, a US finance company that is working on a couple of proposed structures involving intellectual property] said one US deal was close to being ready for submission to the US Federal Reserve for regulatory approval. The Fed declined to comment. Regulators in two other countries have not seen such deals, but they said approval might depend on whether the contracts [between the bank and insurance company] qualify as tangible assets for accounting purposes.

Also, we’d like to point out a parallel that the article draws:

The banks seek deals in which an insurer agrees to buy a borrower’s intellectual property – anything from a mobile phone patent to a logo or recipe – for a fixed price in case of default. That price could then be counted against the expected losses, in the same way the expected proceeds from a credit default swap can be used today.

From this one naturally draws parallels to the monoline insurance companies’ forays into derivatives on US subprime mortgages. It turns out that particular asset class was also rather hard to value correctly — something that only became evident to many in the industry after a systemically risky amount of contracts had been written by the likes of AIG, Ambac, MBIA, and so on.

Indeed FT Alphaville is reminded of the original Fed approval for credit default swaps to reduce regulatory capital — something that the original inventors of the contracts (JPMorgan) had lobbied hard for. That led to many (unforeseen) things…

One positive perspective on the whole thing is expressed in the article itself:

If the structures fly, they could make it cheaper for banks to lend to tech and biotech groups and other start-ups that are valued for ideas more than physical assets. The model for using the value of intellectual property as collateral started as a way of making it easier for small businesses to get loans.

Another perspective is that banks are meant to be in the business of assessing and pricing credit, hence should be able to decide whether or not to make a loan to a company, without the crutch of derivatives there to offload the risk.

Given such a crutch, banks may end up over-levering companies because the part where the borrower goes bust doesn’t affect them any more. If all the banks do that, one ends up with an over-levered sector, and possibly (cough, cough) and over-levered economy. Not having such derivatives crutches therefore acts as a natural handbrake to the amount that businesses can borrow.

In addition to all of that, are insurance companies in a good position to price the value of patents, logos, and recipes? And not just that, but also the probability of default of these companies? Why would anyone expect them to be better at it than banks? Or is it just that insurance companies have an advantage over banks in that they aren’t subject to Basel rules on regulatory capital?

To the insurance companies’ credit, they appear to be ‘overcharging’ from the banks’ perspective:

The discussions have got bogged down over the price banks would pay the insurers for the contract. The banks argue the price should be lower than for a CDS because there is an asset that changes hands.

If the price were to be right one day, what’s to say that borrowers will get the benefit of this anyway? Surely some of the costs of hedging will be passed to borrowers, in the same way that many corporate loans now get priced with reference to credit default swap spreads rather than solely on an independent assessment of creditworthiness by the bank in question?

In short, “Dear Fed, When mulling this over, please don’t think of what this will do to the market in the next month or even the next year. Instead, think of what it will mean for the shape of things to come about 10 to 20 years from now. Also assign a confidence interval to those predictions and proceed with the caution moves like this deserve. Yours, FT Alphaville.”

Related link:
Banks eye intangible assets as collateral – FT