Be Very Careful in Your Search for Yield/Income

Have you ever been tempted to blindly look for “treasure” without knowing what you were really doing or what risks you really faced?

This kid’s game is played all the time on Wall Street, and investors need to be very careful not to get trapped in the process. How so?

With the Federal Reserve and other global central banks implementing serious financial repression, investors everywhere are searching far and wide in pursuit of yield/income. This setting is perfect for issuers and/or sellers of financial products to hang a juicy yield out there in hopes of luring investors to bite.

I see this very scenario at play this morning in reading how banks are searching for capital. I caution investors not to blindly bite on these offerings. Let’s navigate as the Financial Times addresses, Yield Hunters Look to Tier Two Debt:

Banks are taking advantage of strong investor demand for high-yielding assets to issue large quantities of a form of riskier debt as lenders race to meet new regulatory requirements on capital.

The boom is particularly noticeable in Europe, where last month $7.9bn of so-called tier two debt was issued by banks including Erste Bank, Danske and Rabobank, making it the busiest month for the region since May 2008, according to data from Dealogic. European banks have issued more than $25bn of tier two debt so far this year, surpassing the amount raised for the whole of last year and taking it close to 2010 levels.

With share prices still quite low and regulators still working out the rules for tier one capital, many banks are opting to fill their holes with tier two capital.

Since the start of the eurozone crisis, many bankers have worried that they would be unable to sell tier two capital, because it ranks below senior debt in a bank’s capital structure. In a default or insolvency situation, tier two bondholders would be near the bottom of the list of creditors to be paid back.

However, investors are being tempted back into the market by the promise of higher returns and the dearth of other investment options.

Kapil Damani of the capital markets structuring group at BNP Paribas said recent transactions had seen strong demand from wealthy Asians as well as European institutional investors.

While a “high” coupon, say 5% perhaps, “may” look attractive in a world of interest rates near zero, do investors know and appreciate what they are buying? By moving down the capital structure of the banks balance sheet, investors are being tempted but do they appreciate the risks?

To connect the dots between how banks are “tempting” investors and what those investors may really be getting, let’s navigate elsewhere and see what former FDIC Chair Sheila Bair has to say about the banks balance sheets.

In The Sunday New York Times, Ms. Bair points out:

In the meantime, Ms. Bair says, she is discouraged by a lack of will among regulators to protect the nation from future financial crises. “I wish that the regulators had a more singular focus on making sure the bailouts never happen again,” she told me. “Yet, outside the F.D.I.C., I don’t sense a real commitment to making sure the government will never have to step in.”

That failure is having a genuine impact on our economy, in Ms. Bair’s view.

“Our bailout strategies didn’t clean out bad mortgage assets, and we didn’t force banks to take losses,” she says. “We imposed no accountability and did no fundamental restructuring. We were Japan, and I think we have a Japan-like recovery because of it.”

Focus specifically on the statement that the banks have not cleaned out bad mortgage assets and did not take losses. Do you think there is a very real chance that the capital being raised by banks currently is being utilized to offset the losses that banks still need to take on these assets?

You think?? Duh…??!!

Might investors care to know where these bad mortgage assets are marked, that is, at what prices are the banks carrying these assets on their books? What might happen to that “tempting” coupon when these assets are written down if not totally written off? That is when investors get bitten.

If this all looks and feels like a continuation of a Ponzi-scheme, you would be right, it is.

Navigate accordingly.

Larry Doyle

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I have no affiliation or business interest with any entity referenced in this commentary. The opinions expressed are my own. I am a proponent of real transparency within our markets so that investor confidence and investor protection can be achieved.