Regulatory Arbitrage 2.0

Gillian Tett has the latest perspective on a curious deal that Barclays did earlier this week (hat tip Brad DeLong). The deal goes something like this. Two former Barclays execs are starting a fund called Protium Finance. Protium has two equity investors who are putting in $450 million. Barclays is lending Protium $12.6 billion. Protium is using the cash to buy $12.3 billion in what we used to call toxic assets from Barclays. Protium’s 45 staff members get a management fee of $40 million per year (presumably from the equity investors, although that seems steep). Returns from the investments will be paid as follows, in this order (and this is important): (1) fund management fees; (2) a guaranteed 7% return to investors; (3) repayment of the Barclays loan; and (4) residual cash flows to the investors.

Barclays emphasized that it was not participating in regulatory arbitrage, because it is keeping the toxic assets on its balance sheet for regulatory purposes. That is, because it has a lot of exposure to those assets through its huge loan, it will continue to hold capital against those assets. So far so good.

But regulatory capital arbitrage is only one kind of arbitrage. For ordinary accounting purposes, the toxic assets are not on its balance sheet. So if they fall in value, Barclays will not have to recognize a loss – at least not until Protium defaults on its loan, which could be as far as ten years in the future. So the bank has the same true economic exposure, but can pretend it isn’t there for a long time.

Or does it have the same true economic exposure? If things go badly, yes, since Protium will default on the loan. If things go well, however, Protium’s investors get all the upside since they get the residual cash flows after the loan is paid off. So Barclays is left with all the downside and none of the upside. In return for giving away the upside, they should have gotten a good interest rate on the loan. The interest rate is LIBOR + 275 bp, and I have no way of calculating if that’s a good rate or not. But even assuming it is a good interest rate, this is what Nassim Taleb calls a nickels strategy – picking up nickels (the nice interest rate) in front of a steamroller (the risk of the assets falling in value).

Finally, we have the other kind of arbitrage. Although Barclays is recognizing its exposure to Protium, Protium is a different company, and it’s not a bank. That’s important these days, and this is Tett’s main point. In particular, because it’s not a bank, British regulators can’t do anything to it. In particular, they can’t prevent Protium from paying its managers whatever they want to pay it, and they probably can’t force Protium to even tell them what its managers are making.

So here we have the ultimate form of regulatory arbitrage. If you’re a bank exec worried about public exposure or, even worse, regulation of your compensation, go create a new special-purpose vehicle to manage bank assets, entice the equity investors in with a sweetheart deal, and pay yourself whatever you want. Given the size of Barclays, the shareholders won’t notice $40 million here or there, especially if it looks like it’s coming from someone else. Everyone wins.

By James Kwak

54 responses to “Regulatory Arbitrage 2.0

  1. Smoke & Mirrors; plain and simple. If it’s not one scam it’s another. See http://tinyurl.com/mdgyap for additional insight.

  2. maybe scamming should become something that is taught as part of the humanities
    after all one can’t leave all these people with all that social stigma alone – they might get depressed and therefore need preventive help!

  3. What’s in a name???—protium is the stable and most commonly occuring isotope of the element hydrogen. However, hydrogen in its molecular form, H2, is highly flammable and explosive when mixed with air even in low concentrations. I guess time will tell whether we have the stable isotope or the explosive molecule.

  4. Why do I get the distinct impression that Jessica is one of the sharper females inhabiting our planet???

  5. Five bucks says explosive molecule.

  6. The question is, when will the realization that the games continue convince shareholders to lose interest?

  7. This is just nuts. Seems to be a way for fund managers to skim a lot of money off the top and leave the bank holding the bag at the end of the day.

  8. Since when is spam allowed here ???

  9. See the NY Times this morning! China is sending workers back into the factories to make things (that we will buy) while on our side we shift paper and debt around to make the room look clean.

  10. I don’t believe most shareholders pay much attention to methodology for profit. It appears its “the bottom line” that matters most. So, if their stock goes up, dividends increase- “why look at the methods?”

    With means to legally avoid regulation, profits are maintained- whether this is in the form of compensation for management or smaller bones thrown to the shareholders is not of consequence to either party. There is always a better mouse trap just waiting to be sprung.

  11. The trick is to build a system that is flexible enough to adapt along with the finance guys and staff the agencies with smart people. I dont suppose any of the financial reform types will be proposing anything like increased salaries for SEC employees, though.

  12. Shareholders have long since ceased to care about the underlying business, or even if there is any business at all.

  13. I don’t know if it has been covered in this forum, but the guys at Planet Money made me lose all hope.

    http://www.npr.org/templates/story/story.php?storyId=112752133

    The idea that a very powerful members of Congress (both Frank and Oxley) admit that combining any oversight is a nonstarter even though it is the right solution makes me think that we are all doomed. How do you get to comprehensive oversight if everybody is just worrying about their little piece of the puzzle?

  14. Not a single item of real value is being created by this scheme, while untold amounts of currency is being put into circulation. This is not an investment; it is a gambling scheme using dollars as casino chips.

  15. Select the GS level of the hypothetical SEC employee whom you suggest is deserving of a pay increase. GS5 to GS7 represents entry level with a baccalaureate degree and GS 11 entry level with a master’s degree. Moreover, executives make up to 186,000/yr. as far as I can determine. http://www.govcentral.com/benefits/articles/2374

    In addition, as reported by the Cato Institute:
    In 2008, the average wage for 1.9 million federal civilian workers was $79,197, which compared to an average $49,935 for the nation’s 108 million private sector workers. The federal advantage is even more pronounced when worker benefits are included. In 2008, federal worker compensation averaged a remarkable $119,982, which was more than double the private sector average of $59,909. http://www.investors.com/NewsAndAnalysis/Article.aspx?id=504639
    Can one buy honesty and integrity with higher wages? A recent look at the private sector would indicate otherwise. Bernie Madoff was a successful criminal, not because the SEC investigators were not smart enough to catch him, but, for the most part, because higher ups in the regulatory agencies refused to investigate charges repeatedly leveled at Madoff by smart people.

  16. Unless Wall Street salaries come down, you’re going to need $800,000 a year salaries just to keep them honest.

  17. Dan, you say that like it’s a bad thing.

  18. But at the end of the day, it’s our room that will be clean, and theirs that will be cluttered.

  19. Don’t worry, they live to scam. Nothing makes them happier.

  20. > this is what Nassim Taleb calls a nickels strategy – picking up nickels (the nice interest rate) in front of a steamroller (the risk of the assets falling in value)

    then pretty much all money lending is a ‘nickels’ strategy — or what am i missing here?

    if i lend you money to buy a house or build a factory, you pay me back over time and i take the risk that you will fail to do so. is this not the same thing?

    from my point of view the potentially troubling piece of this is not the regulatory arb (minimal) or the accounting balance sheet games (bank investors do not appreciate banks holding large amounts of high volatility assets, so this was a problem they wanted to solve). someone stepped in and volunteered to take the first loss; this lowers the risk to barclays and this helps stabilize their balance sheet.

    no, the real problem with this is that there is a conflict of interest. i don’t have any inside information on this, but on the surface it looks like the people who were managing and pricing the assets at barclays before the sale are going to be in line for the upside at protium should the assets appreciate in value. that means that someone could see a big payday by pricing assets improperly (with low marks) at barclays, having the assets be transferred from barc to protium at an artificially low price, and then having them ‘suddenly’ be worth more later.

    again, i have no information, but it’s a troublesome setup.

  21. Oxley brings to mind some other high profile names from same period—Lay, Skilling, Ebbers, Koslowski etc. As I recall these men were convicted and sentenced. Despite these successful prosecutions, I hadn’t heard a wimper about serious criminal investigations into the financial crisis (a.k.a Goldman Sachs) until Cuomo recently announced his investigation and Judge Raskoff overturned B of A’s $33million sweetheart deal with the SEC. (I do not include here the farcical hearings chaired by the illustrious Barney (cya)Frank.)
    What does it matter who regulates whom if the regs are toothless? or if the regulators are gutless?

  22. I am betting Barclays loaned the equity holders the $450 million, or got it from a friendly correspondent. Can anyone see the resemblance to Enron?

    I like the nice touch: equity investors get a 7% return before the loan gets serviced. Doesn’t sound like a sale to me. Wonder what the income tax consequences to Barclays are?

  23. The advantage is even more pronounced when you consider the hours (3 to 5 per day, not counting lunch) and the job security (go ahead, try getting fired for incompetence). Of course, you need a very high tolerance for boredom, which anyone who has ever worked in government knows but few will admit. Yes, let’s go ahead and pay them even more money. I’m sure Mary Shapiro will find a way to spend it.

  24. Rogier Swierstra

    This is shadow banking under Basel II.

    Say the portfolio is investment grade. Barclays would have to keep about 4% of the assets in capital, or about $500 million. When they sell a cushion that makes their portfolio AAA, they only have to keep ±0.6% in capital, or about $60 million. They “get back” the difference.

    What Protium is investing, $450 million, is pure bank capital. Barclays can go out and make another $12 billion worth of loans. Protium’s investors can expect to make the bank’s return-on-capital. Barclays hedges credit risk, grows its balance sheet in interesting times, and won’t have to write down the loans any time soon. This is probably a very good deal for Barclays.

    What surprises me, though, is how much Protium is getting in management fee for doing essentially nothing: Barclays will do all the work, and investors are putting up the capital at risk.

    (Libor+275 is probably a bit less than what the portfolio is making now. Say the portfolio makes Libor+300, the 25bps difference all go to the investors, but they have 28x leverage so get 7% – voila!)

  25. Why? It is hard to answer without all the details. It can push forward loss recognition to times that are more favorable for raising equity. Then again, if some of these securitization tranches are or were to be rated between BB+ and BB- then they would be risk-weighted at 350 percent which means the bank would have to hold 28 percent equity against them, compared to the 8 percent equity requirement on the loan given to Protium, and who by the way they most certainly will NOT want to see rated. So who knows? Barclays can be freeing itself from a lot of capital requirements. When things are good you go for the AAA rating, when times are bad you are happier with the unrated… and whether you want to call this regulatory arbitrage or not is a matter of taste.

  26. Rogier Swierstra

    Oops … the FT piece says “no capital relief”. Then I don’t get it. Does Barclays really only want to get rid of mark-to-market risk, at the cost of all the upside? Do they know something investors don’t? (Protium’s management still get their $40 million no matter what…)

  27. No. That is not how it goes. “Barclays is lending Protium $12.6 billion.” and that comes with an 8% equity requirement.

  28. how much protium is ‘doing’ depends on what the parameters are — is protium hedging these positions? do they have to maintain computer systems, risk systems, legal infrastructure, etc? are they doing this work for other entities or just barc? i agree that 2% seems high though.

  29. Very little is created now. Most was created before and now someone is just rearranging the chairs so as to make the voyage less painful for the unwilling passengers.

  30. Isn’t the point of regulatory arbitrage that the actors will structure to exploit any variations between regulators? So instead of making one set of good laws/incentives/enforcement, you now have to make sure that all 106 have good laws/incentives/enforcement to cover all of the various fiefdoms.

    It just seems that fixing the toothless/gutless problem exponentially harder.

    Besides, can we really prosecute ourselves into a clean financial system? I know it certainly feels good to throw someone in jail, but poor management of risk is hard to prosecute. Does fraud cause bubbles, or is fraud just a symptom of froth when people are too busy swimming in money to care?

  31. What I don’t get: who are these equity investors ponying up $450 million? It seems like a dumb move if they turn out to be overpaying — unless I’m missing something. If this investment craps out, they get their 7% a year until it craters, then they’re in line behind barclays for the table scraps aka residual cash flows — which they won’t get. So why do they want to play with these toxic assets? 7% yearly isn’t that much if your principal stands a decent chance of getting wiped out. Of course the alternative is that they’re getting a fair price on the toxic crap and (in the theme of this post) Barclays just wants to get this junk off its books. So they bought $12.3 billion to buy how much face value in assets? That would be an interesting question to answer. If the investors are walking into a probable losing proposition, why even gamble unless Barclay’s is fronting/supporting them somehow?

  32. It sounds like Barclays might need to hold 28% equity on the $12.6 billion (although only Barclays knows the risk-rating) but arbitraged an 8% equity requirement. Which nearly begs the question: Why should there be any equity requirement?

  33. Okay, forget it — went back to the original story (lesson learned). The $450 mill isn’t at risk of suffering first loss. Not clear on how the losses get eaten, but looks like the investors are protected somewhat. Strange deal: a lot of fees and fuss and no real value produced at all by this transaction. It’s completely senseless, except perhaps as regulatory arbitrage, as James says. Weird times.

  34. For the next week, its all G-20, all the time.

    http://www.pewfr.org/task_force_reports_detail?id=0019

  35. Yakkis, For me it is a bad thing. I am a working class person who earns money through physical labor. Creating gambling dollars out of the blue has, for the psst 30 years, been taking an increasing toll out of the life style of we persons who earn our money through physical labor.

    If SEC is going to let banks create new dollars in a gambling operation those dollars ought to be taxed at a level commensurate with the risk that gambling places on the greater culture, like a 50% rate or higher. The tax revenues then ought to be returned to the greater culture in a public service way.

  36. Per, when you say that “Very little is created now.” I assume that you mean that very little real value is being created now. I agree, but to me that is what is wrong about bank gambling operations. As long as easy money gambling is available to today’s “to big to fail banking system” there is less and less effort put into investing in real value. And that is the problem. When things get tight, real value is more apt to be supported by its community of users, while highly leveraged gaming gets cashed in at the slightest glimmer of fear. We The People then pick up the AIG type waste when the game blows up.

  37. I don’t disagree with what you said, but why were the regulators “gutless”? The regulators were gutless for 2 reasons.

    For years and years Senator Phil Gramm of Texas had threatened the SEC (Arthur Levitt) that if they dared to enforce the laws the SEC was there to enforce, Senator Gramm would take away their funding.

    Also for 8 years they were told by George “W” Bush to go take an 8 year long lunch break.

    Let’s take a hypothetical:
    You are policemen of a city, and every time as a policeman you gave someone a ticket or threw them in jail the Mayor of the city (Bush and Phil Gramm) smacked you violently in the side of the head, and threatened to take away the Police Dept. funds. How many tickets would you hand out?? How many would you put in jail? And what would happen to crime in the city?? Should we then blame the policemen?? Do you think it’s wrong to blame the policemen of the city?? That’s what happened to Arthur Levitt and the SEC.

  38. I’m sorry, but I disagree with your first assumption that “the portfolio is investment grade”. I have a difficult time believing that anyone involved Barklay’s, the investors, management or, and I can’t tell from the story if their services will be necessary, any of the three credit ratings agencies.

  39. It wasn’t so long ago that the FED was talking about putting together a “bad bank” to absorb toxic assets. I imagined this bank being staffed by professionals who would take on the arduous task of balancing risk and profit. They would buy up the knots of CDOs, MBOs and other distressed assets, sell what they could accurately assess as AAA and take write-downs on the rest. This bank would allow the other banks get back to lending without the constant threat of “mark to market” that foreclosure brings.

    Can someone explain how this is not a privatized version of a “bad bank”?

  40. Seems like a natural outcrop of (1) the overblown panic over “toxic” assets, and (2) the questionable decision to make banks account for fixed income securities on a mark-to-market basis instead at a volume reflecting their probably payoffs.

  41. Exactly, although I suspect some think the problem here is that management will get paid “too much.”

  42. Yound Economist

    FED is going to create the speculative bubble in the economy and financial market by using too low interest rate and this bubble will be like subprime crisis. We will have bubble that is from wrong resource allocation from too low interest rate and we also will have the crisis that will cause the shock on economy and labor market.

    I think it is very wrong policy is the main reason for the higher unemployment rate and higher cost of living currently. FED support speculators on Wall Street, mainly financial institution, to push up asset price and inflation too high and then FED have very slow reaction on the speculation; therefore, we have big bubble and speculation and big crash and crisis.

    This policy still goes on by Bernanke and it will cause the bigger crash and crisis but we have the same result that is the higher unemployment. Now FED lie everyone about inflation trend and the effect of monetary policy on the welfare (lower cost of living (low inflation) and lower unemployment). The inflation is currently low due to the base effect that oil price was too high last year but the current inflation trend is too high. The monthly inflation show the growth at 6% , ISM price paid show the jump in core inflation, and if we pass this October, the inflation will go to around 3-6% in the next six months (oil price is at this level) and core inflation will move up to 2-4%. Therefore, we are going to have higher inflation than the past cycle and inflation will move up more quickly than the past cycle.

    Another FED’s lie is the monetary policy can improve the unemployment rate. Greenspan and Bernanke used too low interest rate after Tech bubble and create short term speculative economy with high property and asset prices, higher consumption but we have no real economy, no real employment and our businesses have no competitiveness. Frankly, GDP can grow but we have the worst employment in the every cycle because when we use too low interest rate, it will push up price higher and more quickly. Business can have more profit from higher margin and they have no need for new investment because there is no real demand increase. I call the Monopoly support by FED. Then, when speculators get too cheap funds from FED, they put into asset speculation, surely, it makes people believe that we had the good economy because stock prices went up, real estate price went up. But we were just in the speculative economy that FED created.

    All FED policy that keep interest rate too low and unrealistic and the more FED try to push economy to Monopoly and Speculative economy, the more severe effect of crisis and crash will occur and surely we all know that this policy create more volatile economy and less people going to real investment that need long term return rather than short term return in financial markets. It is going to create the less real economy and the less real employment.

    I think, after this October, inflation will go up uncontrollably to 6% in six months and we will have big bubble and big crash by itself and surely, unemployment rate will move up more than anyone expects. So, FED should stop the speculation and stop lying on their policy and economic and inflation forecast.

    I think before regulating the bank, we should have the law to regulate FED and government to use monetary and fiscal policies for long term and sustaining growth rather than for speculators like this.

  43. What you seem to be missing, at least in terms of the FT article, is who is in line behind whom. Protium’s 7% return appears to be senior to Barclays’ interest distribution. Why assume the liquidation preference is {all outstanding Barclays THEN all remaining to Protium}?

    7% compounded for ten years is 97%. That’s Protium’s cumulative interest claim. If the deal is structured as {all unpaid interest Protium THEN all outstanding Barclays THEN all remaining Protium}, Protium has almost no chance of losing, even though it is technically in the most subordinated tranche (“equity”); it just so happens to also have a senior claim.

    That is the cynical view.

    The optimist would say that even with vanilla documents, hell, you have 28:1 non-recourse leverage, Barclays is going to be damned if they push you into default (that would be a hell of a mark-to-market grenade on the balance sheet – they’ll work something out), what are the odds these things are underwater for a decade continuously (first sign of life along the way and you sell the underlying)?

  44. Rogier Swierstra

    I thought this would be done as a swap: Barclays pays “total return” on the assets (including getting money back in case of default) and receives 275bp.

    But you’re right, we don’t have the details. A cute puzzle, though.

  45. While I am probably more of a cynic about government than you are—no doubt because I have lived longer and still have a good memory—Simon Johnson’s online lectures on the financial crisis outline the dynamic nature of the crisis and several reasons for ineffective regulation and/or regulatory failure. These include Global Banks vs. National (and State) Regulators, too many regulators which resulted in non-responsiveness akin to a regulatory version of the Genovese Syndrome (hence “gutless”), off balance sheet obligations, reliance on the determinations of rating agencies, and general inability of the regulators to “keep up” with the fast paced international movement of currency and securities.

    Surely, risk/leverage mismanagement of a number of global European banks that apparently held half of the toxic assets cannot be placed at the feet of one POTUS and one U. S. Senator.

  46. I remember from one of Simon Johnson’s lectures a telling comment from a regulator to SJ that supports your argument. It went something like this: I am one of 54[regulators]. What do you expect me to do?

    This admission of non-responsiveness by one regulator in a “crowd of regulators” definitely supports your argument for “making one set of good laws/incentives/enforcement.”

  47. cool stuff – Betya 5 bucks they thought it out… If stable = normal rate of profit / If explosive it = taking advantage of a profit bubble (rent) somewhere, sometime… Or maybe they really hope it’s some function of the two in space-time?

  48. I think this little story is about how one sort of financial machination can work to re-distribute assets and wealth from losers (likely, mostly families who lost their homes because they got sucked into sub-prime mortgage deals?) to the 40 friends of friends (or whatever) and all their friends, acquaintances and contacts (even if made through spam) who end up purchasing the ‘risky assets’. All just a mechanistic post-modern societal effort at making a little money from some wealth re-distribution – nothing for us to be surprised about!

    Clans, fiefdoms, villages, empires etc used to go to war to re-distribute food, property and wealth… Come on – why bother with war just to re-distribute a little wealth to ‘the deserving’ when you can just take advantage of bubbles comin’ and goin’! It’s just ‘rational decision making’ dressed up in ‘sophisticated’ garb (language) – just some guys trying to do a little ‘innovative’ business!

  49. , inflation will go up uncontrollably to 6% in six months and we will have big bubble

    If inflation goes up uncontrollably to 6%, I don’t see how we can get a bubble.

  50. Antonio Freitas

    Well, Brad is gone, we miss him.

    There are others, of course.

    But let me make the register, pay tribute, to our friends here, including the commentators. It is great to know that The Baseline Scenario is fully operational, so that when we reach this page there certainly comes clever and sharp analysis on the central and most important issues of the political economy of the crisis.

    Congratulations everyone.

  51. I have to rush off to the theater, so I’ll be brief, for once.

    Someone somewhere needs MUST alter the fancyaccountingwords and pain them in the truest light.

    For example: How can assets, toxic or not be unaccounted for, or NOT ON THE BOOKS. Is this legal?

    Toxic assets = 20 cents on the dollar, and must be appreciated or accounted for, or the entire system is foul polluted, and USELESS!!!

    Derivatives = irredeemable debt PONZI schemes!!!

    Arbitrage = predatorclass insiders and oligarchs gaming the captured system in their favor!!, to the wild and grotesque deleterious impact on markets and other investors.

    TBTF = FAILED institutions, run by FAILED management, bruting and pimping FAILED products!!!

    Until and unless we as a nation, or as collective humanity defines these crimes and abuses in their true light – we are all doomed to an unending cycle of boom/bust/collapse/bailout processes. And these processes cause massive harm to the greater society.

    We swim in an ocean of LIES!!!

  52. Blues for Dante

    You would think they would stop coming up with these dumb names for their shadow funds and just be frank with us. Perhaps Suck On This Capital or I’m Rich B*tch Finance would be more appropriate.

  53. well, yet another rule to regulatory legal knowledgebase