Managing the great deleveraging

Photo Dominique Sénéquier / CEO of AXA Private Equity / October 27th, 2011

Till 2007, a large part of the global growth was fueled by leveraging and debt creation. With governments and central banks struggling to save the banks, the private debt crisis has evolved into a public debt crisis. The next ten years could be brutal. Will governments and financial institutions be able to manage the great deleveraging?

ParisTech Review – The global financial crisis started in 2008 and we experienced a severe relapse last summer. How long will this crisis last?

Dominique Sénéquier – In fact, we entered a major financial crisis as early as 2007 and today, as we near the end of 2011, it is still far from over. If we are to fully understand its scale, we need to go back a little. The crisis erupted in the United States because there had been excessive accumulation of debt in all areas, including consumer debt through credit cards and student debt through student loans. This debt, once issued, was securitized (cut into pieces and reassembled in the form of securities with homogeneous risk) as CDOs (Collateralized Debt Obligations) and CMOs (Collateralized Mortgage Obligations). However, the most significant debt build up was in real estate, especially in the United States, Spain and Ireland. This real estate debt was securitized through other financial products, CMBS (Commercial Mortgage-Backed Securities) and RMBS (Residential Mortgage-Backed Securities).

By July 2007, the financial world noticed that all these financial products were invading so-called SIVs (Special Investment Vehicles), which was all the more worrying considering the fact that these SIVs, absent from bank balance sheets, were not subject to any regulation. In July 2007, SIVs were exposed, opening up a Pandora’s Box. This terrible financial crisis immediately emerged. For the United States alone, these SIVs contained several hundred billion dollars of debt which had been more or less hidden, as they had not been consolidated by the banks. It was indeed the banks that had agreed ??these loans, but they had transferred them immediately off their balance sheets by financing them through simple commercial paper. The first reaction of the market was to stop the funding of SIVs. The result of this was that bad loans began to creep back onto banks’ balance sheets. As they were now back within the scope of the regulators, they thus became visible and banks had to make provisions for the corresponding losses, which explains the holes in bank balance sheets in 2008. But this was merely the first unpleasant surprise.

If we had acted at this stage, could the rest of the crisis have been avoided?

Who can say? Next, it was discovered that due to the vast quantity of “toxic” assets (often covered by CDS, Credit Default Swaps), banks would activate their anti-default insurance, the CDS. These CDS thus began to be called upon as collateral. But at the time, there were no clearing houses and one could sell a CDS to a bank without any collateral in place to back the CDS. The first culprit and victim of this was the insurer, AIG (American International Group). In the autumn of 2008, AIG suddenly found itself called upon for $ 80 billion of claims for CDS cover. These CDS had been purchased earlier in the decade by financial institutions such as Goldman Sachs and Société Générale, who activated them when the rating agencies began to downgrade some of their assets. It was then discovered that AIG, called upon to find the cash immediately, had promised US$80 billion in assets, representing mathematical life insurance liabilities in collateral for its subsidiary, AIG Financial Services. AIG thus transferred this sum into an unregulated structure, AIG Financial, which did not have enough capital because it had received CDS premiums but had never envisaged it would suffer losses on these CDS at the level of claims received in 2008.

Finally, the third step was the crisis in interbank funding, which resurfaced in the summer of 2011. The problem occurs when banks, unaware of the exact amount of toxic assets on the balance sheets of other banks, suddenly refuse to lend to them. Each bank then tries to collect its debt from troubled banks. The situation reached a climax when, over a weekend in mid-September 2008, three possible bankruptcies emerged: AIG, Merrill Lynch and Lehman Brothers. It was crucial to bail out AIG (the number of policyholders was too large to take the risk), disaster was averted by Bank of America acquiring Merrill Lynch, but Lehman Brothers was left to its fate, especially since its president, Dick Fuld, had annoyed the American financial system by refusing a recapitalization solution proposed by Korean banks a few months earlier.

Looking back, was abandoning Lehman Brothers a good idea?

I’m not sure that U.S. authorities really had a choice. I’m not surprised that it was impossible to bail out all three institutions over this disastrous weekend. Besides, to be precise, Merrill Lynch was not exactly saved, it was just backed – similar to when Gordon Brown ordered the president of Lloyds to buy HBOS, and the British group was sent into bankruptcy.

Public opinion is showing a real resentment, more or less pronounced depending on the country, against the banks and the States that supported them. What is this support really?

In the United States, hearings were held to determine whether the federal government put pressure on Bank of America to buy Merrill Lynch. We now know that Bank of America bought it without assistance from the federal government, since the TARP program (Troubled Assets Relief Program), passed by Congress, only became operational a year later. As for AIG, Washington had no choice. US$80 billion could not be taken from policyholders. The money had to be found somewhere and fast. So the Fed provided the funds, even though its statutes absolutely do not provide for such actions. Its function is to provide liquidity to the banking system, not to bail out insurers. It was therefore necessary to urgently summon highly specialized lawyers and identify, in just one night, convoluted paragraphs that could somehow justify the operation in the Fed’s statutes. At the end of this weekend, Henry Paulson, Treasury Secretary, realized that the whole system was contaminated and launched the political process that would become the TARP: US$700 billion to save American finance. The system was replicated in the United Kingdom. Lloyds and Royal Bank of Scotland received between them more than GBP80 billion of public money.

Did all the countries react in the same way?

In the Netherlands, the government had to buy the Dutch part of ABN Amro, which was in bankruptcy, after an epic battle. Barclays wanted to buy it, but failed. So, a consortium comprising the Royal Bank of Scotland (RBS), Fortis and Banco Santander carried out the operation. They divided up ABN Amro between them. Santander did well, but Fortis and RBS went bankrupt in the process because off-balance sheet, ABN Amro housed a SIV of 200 billion euro. That’s how BNP Paribas won Fortis. As for Greece, in order to save its banks, it guaranteed 100% of deposits and this explains, in large part, its excessive debt in 2011.

So when will the crisis be over?

We still have a long way to go. I never thought that the crisis would be resolved in three years. It will take ten years for the crisis to end and everyone involved will come out worse off. The toxic assets – all these loans provided to insolvent borrowers – had created a fictitious growth, inflated by the explosion of credit in the years leading up to 2007. From now on, this false growth will have to be compensated for, meaning real growth will be stunted, especially since credit is no longer available at the same levels.

How did the banking crisis become a State crisis?

States became indebted because they launched recovery plans, they bailed out banks and their tax revenues were used to plug the holes created by the toxic assets. They came out weakened. Now, we have a Sovereign crisis. In retrospect, the political choices faced are now clear. Either savers pay the price directly, for example by letting AIG collapse, or losses are nationalized. But today, States have to spread the burden of this nationalization among households, who have to make savings. Barrack Obama has just launched a program to save US$2.5 trillion over ten years, US$250 billion per year. Europe should do the same and make the duration clear instead of creating national plans of two or three years. Europeans pretend to believe that everything will be settled in 2013, that they can bring their deficits below 3%. Not only is this not credible, but it could bring Europe to its knees.

The governments of the Euro area refuse to acknowledge the blindingly obvious: Greece will not pay its debt. Why this denial of reality?

What European leaders do not want is contamination through the intervention of the CDS (Credit Default Swaps) market, as happened in the case of AIG. The Greek loans are largely insured by CDS held by hedge funds and banks, but it is not known with any certainty whether these CDS are backed by solid counterparties with hard cash. Only some of these CDS were placed in clearing houses. States are therefore asking banks and insurers to “voluntarily” waive 50% of their Greek assets (even though these investors paid insurance premiums for their CDS), and carry on as if there was no Greek default. They will no doubt be asked to re-lend this 50% to Greece for 25 years. All current backroom negotiations involve this stagecraft. It is absolutely essential to avoid a formal default of Greece, as it would trigger a CDS issue, opening another Pandora’s Box of a deregulated insurance market without capital.

Wouldn’t triggering the CDS be a way to definitively purge the errors of the past?

When it became apparent in 2008 that the global CDS market was worth a minimum of US$6 trillion, politicians made their calculations. When a bank lends 100 Euros, it must have 10 euro in equity. So to put these US$6x trillion dollars back on the right path, a bank with US$600 billion of capital would need to be created from scratch, which is impossible. It will take twenty years to put this situation right.

Have lessons been learned?

It is unfortunate that after 2008, new issues of CDS were not banned or placed in properly regulated financial institutions. Today, we have finally created a platform for “clearing” where each CDS must be supported by collateral, as is the case for an ordinary insurer.

Is the Greek crisis a hint of what awaits Europe and its banks?

As far as Greece is concerned, Europe has a choice. Either the European States take on more debt to bail out Greece, or – as Germany wants – private creditors are asked to make sacrifices. The July 2011 plan amounted to writing off 21% of Greek loans, but we now know that this will be more like 50%. Is this serious? It’s not the end of the world. French banks can safely withstand a drop of 50% on their Greek assets. Banks and insurance companies will make additional provisions and strengthen their capital to meet Basel III rules, which require that the core tier 1 ratio is at least equal to 4.5% (this is the ratio of their highest quality capital, corresponding to common shares and retained earnings, to their total assets weighted according to their risk). An additional “conservation” cushion of 2.5% is added to this ratio, bringing the total to 7%. That’s all. It would not be the end of the world.

You mean to say that the debt crisis isn’t the most serious threat for the banks?

It is important to maintain perspective. Banks are sitting on time bombs that are much more dangerous than sovereign debt such as irresponsible traders, for example. Losses of 2.5 billion euro caused by the trader at UBS correspond to half of the bank’s commitment to Greece. Do not forget that Société Générale lost 5 billion euro with the Kerviel affair without incurring any real shock to the bank, which speaks volumes about its solidity.

If despite everything, a bank is in danger because of its Greek commitments, what should it do?

It can always issue equity to the market, doing so is not degrading. Obviously, given current share prices, this would significantly dilute the current shareholders, which they will seek to avoid at all costs. Another option would be to tighten belts, i.e. reduce its balance sheet. That is why BNP is selling 70 billion euros in assets and Société Générale 25 billion euros. With a more compact balance sheet, they will need less capital, and will be able to avoid going to the market or to the State. Naturally they will then issue fewer loans. This is the time of the great deleveraging.

So we can stop the contagion?

We can solve the Greek problem. It will be expensive, but it is possible. And more widespread contamination is not necessarily inevitable. Spain and Portugal are making very serious budgetary efforts and Italy, meanwhile, is a much stronger country. Italian families have huge real estate holdings: US$8 trillion – nearly three times the GDP. They do not sell because there is no inheritance tax for primary residences. It’s not visible money that flows and fuels the economy, but it is a considerable strength.

Does the French government have to intervene to help the banks?

If the State lends 10 billion euro for 20 years to Société Générale, this is better than a recapitalization carried out at the wrong time. The example of the United Kingdom demonstrates this. The British state lost more than GBP20 billion as a result of recapitalizing RBS and Lloyds too early. Even if France were to lose 20 or 30 billion euro in three years on some banks, it would not be the end of the world in comparison to our GDP of 2 trillion euro. That’s why French banks are in some ways envied by American, British or Dutch banks: they are without doubt stronger.

What if the French government nationalized a bank?

Why not? It is an option like any other. That would mean one fewer company on the black list and suddenly, everyone would lend to it. If markets suddenly attack a French bank and if this bank can no longer refinance itself in the interbank market, it may be necessary to nationalize or consolidate with a long term loan.

IMF chief Christine Lagarde is less optimistic. She asserts that we must recapitalize European banks for an amount up to 200 billion.

When you want to kill your dog, you accuse it of having rabies! Let’s not be naive. Some have an interest in leaking alarmist reports about Europe. Of course, if all the fragile countries went under at the same time, it probably would cost 200 billion, but there is no reason for that to happen – for example, Ireland, which was very fragile in 2008, recently saw its rates decline as a result of confidence in its recovery.

The French are very enthusiastic followers of the theory of an American plot against the Euro. What about you?

The current atmosphere is probably exacerbated by the Anglo-Saxon press. America is clearly seeking to maintain the dollar’s status as the sole reserve currency. It is the main objective of the United States, supported very effectively by the Anglo-Saxon press. They cover the Eurozone failings widely and not always objectively – they arguably focus too much on the countries of southern Europe, while the finances of the United Kingdom are also in very poor condition, not to mention the finances of the United States. It is a campaign of influence. For if the dollar dominates the world, it is not because America has no problems, it is because there is no real competing currency. Casting doubt on the European banks and on the euro is therefore fair game. If tomorrow, the rich countries began to spread their reserves: half in dollars, half in euros, it would displease the Americans greatly.

In short, you think the United States fears the Euro zone?

In their view, the Eurozone mustn’t emerge as too great a monetary power, because it is already a major economic power. Let us not forget that the Eurozone GDP is twice that of China, 12 trillion dollars compared to 6 trillion. The combined GDP of France, Germany and Italy alone is greater than that of China.

What is the real challenge for the United States?

Certainly not the trade deficit with China, which is much talked about but is actually quite low: US$170 billion. The U.S. debt ceiling of US$16 trillion is far more serious. Of the half of this debt held by foreigners, 40% is in China – potentially US$3.2 trillion which is huge. Americans absolutely need China and other countries to continue to buy their debt.

You manage Ardian (ex Axa Private Equity). Your business, specifically, is debt. How will you survive in the era of deleveraging?

The crisis has affected our business. From September 2008 to September 2009, the private equity market virtually stopped. In late summer 2011, this is again the case. There are no direct LBOs (Leveraged Buy Outs). At Ardian, we are therefore active in our secondary business, which consists of buying private equity portfolios from banks. Ardian has made acquisitions from Citigroup, Barclays and HSH. Due to the fact that banks are currently lending very little, our Mezzanine business, halfway between senior debt and capital, is growing. In this deleveraged world, all private funding instruments that can replace senior debt are very useful for the economy. In short, in the future, there will be fewer players in Private Equity, but those who remain will always have access to debt.

The LBO (Leveraged Buy Out), which is your preferred mode of intervention, has bad press in France. It is sometimes accused of strangling companies instead of developing them.

This criticism reflects above all the lack of economic culture in France. When Vivendi and France Telecom derailed the stock market in 2002, they were not under LBO but were too leveraged, with excessive debts. At one point, they accounted for 25% of the capitalization of the CAC 40. The whole world was accumulating huge debts. Many companies went bankrupt that were not under LBO: Merrill Lynch was not under LBO. You see, there is nothing wrong with an LBO when it is carried out properly. What is important is the balance that a company maintains between the long-term capital provided by shareholders, and the debt. This gearing consists of making the best use of its capital, so, not borrowing at all would be mismanagement. It would be defrauding shareholders, even employees, to not use all the financial capacity of the company to grow it.

Private Equity therefore has a future in Europe. Though in emerging markets?

In emerging countries, we encounter immense fortunes, but this wealth must first diffuse down into the population if it is to have a real economic value. Redistribution, taxation and democracy are prerequisites for the practice of private equity. Legal certainty must also be guaranteed. Private equity requires that rights can be asserted and shareholders’ agreements enforced. So there are few countries where it can be practiced safely. In China, large asset managers have taken substantial losses in recent years. Large managers who moved from London to Hong Kong have not always found success. You see, before Western economies are completely replaced by the emerging economies, water will flow under the bridge. This will not prevent the Russians or the Qataris from buying property on Place Vendome, but emerging economies are not going to save the world. At AXA Private Equity, we manage 28 billion US dollars: we will certainly not put half in China and half in Brazil, based on the notion that this will be the future. It would not be rational. In China, we must go very slowly and very cautiously, but we can succeed there.

More on paristech review

By the author

  • What’s up in Private Equity?on April 19th, 2012
  • Managing the great deleveragingon October 27th, 2011
  • Does Private Equity have a future?on June 3rd, 2010
  • Gaelle Olivier

    Very interesting article and a lot of straight talk – refreshing in those days of circumvular discussions

  • Philippe Silberzahn

    Thank you for this remarkable analysis of the current crisis. I wish all articles would be that clear. One question is regarding the consequences of the deleveraging. One could say that the disappearance of debt will change the system forever. It seems, as you suggest, that the economic system essentially was fueled by debt. Hence growth really was artificial. If you remove debt, then there will be no growth. Can the system survive or shouldn’t that change how the system works? Put otherwise, is the impact structural?

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