Shadow Banks and Secret Insurance

Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.
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Specific Electric.

A lot has been written, some of it by me, about General Electric's announcement on Friday that it will get rid of most of its GE Capital business. One theme is that Dodd-Frank is working: Regulations intended to limit and shrink and de-risk big interconnected financial institutions are doing that. Mike Konczal argues that GE's move shows that Dodd-Frank successfully cut off the regulatory arbitrage that formerly encouraged the growth of shadow banks, and that status as a "systemically important financial institution" is not, as some argue, a gift to banks or a permanent promise of bailouts, but rather something that banks and shadow banks want to get out of. Here is Paul Krugman on GE Capital as shadow bank. Peter Eavis points out that GE Capital's weakness was its reliance on wholesale funding, and here at Bloomberg View, Justin Fox argues that "If it’s going to be increasingly difficult for large, wholesale-funded financial companies to generate acceptable returns, then it's not just GE that will be under pressure to divest and shrink." On the other hand, Antony Currie says that it would be very difficult for a big actual bank to follow in GE's de-SIFI-ing footsteps; that path is really only available for shadow banks.

Here is a look at GE's decision-making and deal process, which, it goes almost without saying, involved JPMorgan's Jimmy Lee, who advised GE along with Blair Effron of Centerview. GE's sale of much of its real estate portfolio to the Blackstone Group was done without an auction: GE's advisers on the real estate sale -- who, in this fee-splitting world, were not JPMorgan and Centerview but rather Bank of America and Kimberlite Advisors -- "called the head of Blackstone’s team, Jonathan D. Gray, and offered him the opportunity to buy exclusively, as long as he was willing to move fast and pay up." He did. Here are the New York Times and the Wall Street Journal on Blackstone's (and Gray's) increasing prominence in real estate, highlighted by this deal.

Other takeaways: "The conglomerate’s so-called repatriation of its foreign earnings, which will mean taking a $6 billion tax hit, is notable in an era when corporate America has bellowed loudly for an overhaul of the tax code." "GE could retake throne as king of all dividend stocks." Oh and I guess now it has to run an industrial business.

Captive reinsurance.

Here's a big fun New York Times article about captive reinsurance. Here's how I understand captive reinsurance:

  • Life insurers have reserve requirements that are either appropriately conservative or way too high, depending on whom you ask.
  • Life insurers can reduce their reserve requirements by buying reinsurance.
  • If the reinsurer has lower reserve requirements than the original insurer (as it often does), then this transaction reduces overall reserve requirements.
  • That's just classic regulatory arbitrage.
  • What makes it "captive," and delightful, is that the original insurer owns the reinsurer, and can reduce its own capital requirements just by shifting papers around.

What is fascinating about this is that it's not just insurance companies who think that the reserve requirements are too high; it's many insurance regulators, too, which is why they knowingly allow this. The Iowa insurance commissioner is a big fan, and he tells the Times that captive reinsurance is "a pragmatic approach to address the nationally recognized problem of redundant reserves." But I mean no, it's a crazy approach. The pragmatic approach would be to have reserve requirements that you think are appropriate, and then enforce them. Setting reserve requirements too high and then arbitraging them away is ... look, obviously I find it delightful, but it's really no way to run a railroad.

Bank mutual funds are bad.

Or might be bad, one story of this story is that there is a measurement problem. "Most of the funds run by each of the four largest banks in the business -- Goldman Sachs, Morgan Stanley, JPMorgan Chase and Wells Fargo -- have underperformed their basic benchmarks over the last 10 years, according to analysis of industry data done for The New York Times by Morningstar." That's just an unweighted list of funds, so if you have a tiny underperforming fund, that cancels out a giant outperforming fund. But "When Goldman and other banks discuss the performance of their funds, they tend to use statistics that are weighted by how much money is in each of the funds at the time of measurement," which look better for their funds, but which "skews the figures to where money is now, even if the money just entered top-performing funds and did not experience recent gains." I am not an expert on measuring mutual fund performance but it feels like the right way would be to weight performance by the amount of client money that actually experienced that performance? 

Anyway, assuming that bank mutual funds underperform non-bank mutual funds, what is the takeaway? You could tell a couple of overlapping stories:

  • Asset management is an actual business, and companies that specialize in it are better than big banks that just drop in on it casually.
  • If you run an independent asset management business, you have to compete on price and/or performance. If you run a bank, you compete by cross-selling unwitting banking/brokerage/whatever clients on your overpriced and underperforming asset-management products.
  • People worry about banks (1) being too risky and (2) swindling customers, but those worries are in tension with each other. Overpriced asset management is a great business to be in, from the standpoint of recurring revenue, low capital intensity, limited risk, etc. But, y'know.

“It’s a good business for them -- but that doesn’t mean it is a good investment,” said Larry Swedroe, director of research at Buckingham Asset Management. 

(Disclosure: I used to work at Goldman Sachs and have a couple of bank-run mutual funds in my 401(k), though, as we've discussed, I'm mostly a Vanguard index fund kind of guy.)

Regulation and skew.

Two broad stories of modern finance are:

  • Post-crisis regulations on banks -- capital requirements, limits on proprietary trading -- have cut down on market making in fixed-income markets and reduced liquidity.
  • None of this affects equity markets at all, because equity market-making is not capital intensive and is dominated by non-banks.

But here is a story about how bank regulations seem to have increased options skew in equity markets, because options market-making is still dominated by banks, and is still capital-intensive, so banks are taking on less risk than they used to and that is showing up in market prices.

Sovereign debt.

Mark Weidemaier and Mitu Gulati write at Credit Slips about Russia's potential veto over the International Monetary Fund financial aid package for Ukraine. The concern is that "IMF policy forbids 'lending into arrears' to official bilateral creditors," and Ukraine owes Russia money and hasn't paid it, so Russia might be able to block IMF aid to Ukraine. Weidemaier and Gulati take the other side of this, arguing that Russia may not be an "official bilateral creditor" because of the structure of its debt, that Ukraine has offsetting claims against Russia that may cancel the arrears, and that anyway "It would be quite extraordinary for the Fund to allow one of its members to block a rescue package when the member is involved in armed conflict with the recipient government." It seems to me that letting Russia block a Ukraine IMF bailout can't really be the right answer, so it's encouraging that actual sovereign-debt experts think the IMF will get to a different answer

Elsewhere, here is Felix Salmon's interview with Arturo Porzecanski, who is unimpressed by Argentina's negotiations with its creditors. And here's a New York Fed blog post whose headline includes the phrase "the Most Fantastic Financial Swindle of All Time," so, you know, click:

As happens, the lax underwriting, poor information, and general speculative fever invited fraud. The starkest example was Gregor MacGregor, a Scottish adventurer who had fought for Venezuela in its war of independence against Spain. Upon his return to England, MacGregor toured the wealthiest drawing rooms of London touting the vast resources, civil service, and army of the entirely fictional Central American principality of Poyais (see map above). So convincing was MacGregor that he was able to float a large bond issue on the London Stock Exchange in 1822. As evidence of the information gaps during the bubble, Neal notes that mythical Poyais was able to borrow at yields barely higher than those charged real countries like Peru, Chile, and Colombia.

I read that and thought, I mean, there are probably some real countries today whose spreads should be wider than a fictional country. The fictional-country 10-year would be a good benchmark for distressed sovereign debt.

Things happen.

People are worried about bond market liquidity. Jana Partners wants to break up Qualcomm. Marty Lipton still doesn't like activist hedge funds. Wells Fargo is getting more investment-bank-y. Almost half of Harvard economics majors go into finance, laments a Harvard economics professor. Financial services employees are miserable. The IMF on Islamic finance. "Man accidentally wears polo shirt to surprise meeting with Obama." Oxford Cambridge Goat Race.

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(Corrects spelling of Antony Currie's name in first paragraph.)

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Matt Levine at mlevine51@bloomberg.net

To contact the editor on this story:
Zara Kessler at zkessler@bloomberg.net