How, but why?

How could a AAA product turn into a junk bond risk, especially when held by a Big Four bank? I can only speculate…

How, but why?

Banker of Last Retort

The ANZ Bank’s recent announcement of a $200-odd million provision against an exposure to the “monoline” insurer ACA Capital was sufficiently out of the ordinary to catch your correspondent’s eye.

I wasn’t able to winkle out the story from anyone involved, but I did speak to a couple of chaps at two different banks who believed that they had had similar deals pitched to them.

(If I’m wrong in my assumption that the deals are the same, I’m sure that my charming editor will be only too happy to publish a clarification from the ANZ. In the meantime I will speculate joyfully.)

First though, I’ll explain that “monolines” are specialist insurers of credit risk. They rent out their AAA credit rating to borrowers, who are better off if the premium they pay to the monoline is less than the interest rate reduction resulting from their enhanced credit rating.

Monolines began as a nice safe (but boring) business, enhancing the credit of local government borrowers, but then expanded their business to insure corporate borrowers and CDOs. With chaos in the American home loan market and the prospect of rising corporate defaults, the spectre of large claims has raised concerns about the viability of the monolines. Some monolines recapitalised with cash injections from sovereign wealth funds, but ACA was downgraded to CCC credit rating. At this time it’s too early to know if ACA will survive.

With that out of the way, and bearing in mind this is speculation only, rewind back to a time when ACA was regarded as genuine AAA, and an investment bank was shopping a deal around to other banks.

Apparently the investment bank had reached the maximum amount that Australian Prudential Regulation Authority would allow them to lend to a single counter-party – but still wanted to do more business with ACA. They were looking for other banks to “front the deal” and become an APRA-acceptable intermediary between the investment bank and ACA, in return for a payment of 10 “basis points” (0.10%).

It’s important to understand that every Australian bank has a credit rating below AAA and that a transaction with a triple-A borrower theoretically improves the credit risk. For this reason there was no need for the ANZ to allocate any “prudential capital” to the deal, and a margin that would be wafer thin to a normal corporate looked like money for jam to the ANZ; at the time.

It didn’t quite work out that way. ACA is now rated as junk bond risk, and ANZ has raised a provision (though your correspondent would be astonished if the bank had to write off the whole $200 million).

By now some readers are shaking their heads. “All very interesting, BoLR,” they say, “but no one will ever ask me to act as the intermediary on a $200 million deal.” “You’ve wasted your time this week, BoLR” they add, somewhat uncharitably.

Au contraire, I say: there are lessons for entrepreneurs here.

Should ANZ have stuck to its knitting? Well, maybe. But that stops you from ever trying anything new, and how can you grow if you don’t try new things?

Should ANZ have realised that if it’s too good to be true it probably is? Possibly, there is an argument that 10 points is too fat for a truly risk-free deal but way too thin for anything else – but on the other hand, remember that an expert ratings agency (credibility then still intact) was attesting to the AAA status.

Should ANZ have made sure that it didn’t swim with the sharks? (This cliché says that you are on a hiding to nothing if you think your path to making money is by outsmarting the smart guys). If you believe (as I do) that investment bankers are usually the smartest guys in the room, then you really don’t want to buy anything they want to sell.

However, the lesson which your correspondent thinks is most relevant is the advice that he gives the time-poor small business operator to whom he acts as mentor: Put your energy into relationships, not deals.

One-off propositions can appear attractive, but in the long run you are always better off working on a long term relationship, and it’s hard to see how this was ever going to be anything more than a one night stand – regardless of the sweet blandishments that the investment banker may have whispered to the contrary.


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