Steinhoff, the banks and the bezzle


If you lend against collateral, do you have a credit or market risk position? Both answers can be found in the way banks handled their $1.6 billion loans to the family trust of Christo Wiese, former chief executive of Steinhoff International, the troubled South African retailer.

Some banks (including Goldman, HSBC, Nomura and Bank of America) treated the loans as investment grade credit exposure. Even though the borrower was not Steinhoff itself, the shares in the company that collateralised the loan would have reduced the loss-given-default in the banks’ risk models.

When Steinhoff shares plunged in December on news of accounting irregularities, the collateral vanished, and the banks reported the loans as impaired in their year-end earnings.

Others (notably JP Morgan and Citigroup) treated the Wiese facility as a margin loan or repo trade, taking a long trading position in Steinhoff shares, financed by the facility. When the shares plunged, a margin call would have been made on the Wiese family trust, and if this wasn’t paid, the shares would have been sold. As a result, JP Morgan and Citi each suffered a $130 million trading loss on the collateral held in their equity portfolios.

There is an important philosophical difference between the two approaches. Treating such loans as banking book assets amounts to hiding market risk. If you think the market overreacts then this makes sense. Witness how Nomura refers to its losses as ‘unrealised’, betting that Steinhoff shares will recover, allowing it to recover the full principal amount of the loan.

JP Morgan’s approach seems more honest, but there is a price to be paid in terms of earnings volatility, as every unpaid margin call crystallises a trading loss. But that doesn’t scare JP Morgan, which appears to be doing a lot of this Steinhoff-type margin loan business.

Screenshot of interactive data visualisation tool available to subscribers

Evidence for this comes from two sources. Risky Finance compiles Basel Pillar 3 filings from JP Morgan, and according to this data, the bank’s securities financing exposures reached a record four-year high of $269 billion. [see chart]. Meanwhile, value-at-risk figures published by JP Morgan in its latest 10-K filing shows that the bank experienced 15 VaR backtesting exceptions in 2017, the highest since the financial crisis.

According to the 95% one-day management VaR statistics used by JP Morgan in its 10-K, you should expect between 12-13 such exceptions per year, so 15 of them is not necessarily a sign that something is wrong. When JP Morgan analyses the same trading result using 99% regulatory VaR, it experiences no backtesting exceptions at all.

But the contrast with other US banks is striking. Goldman hasn’t reported a single 95% VaR exception since 2014, similar to Bank of America, while Morgan Stanley has had none since 2013. Remember, you ought to get some exceptions otherwise your VaR model may be deceptive.

Now, Basel III rules make up for flaws in VaR models with additional risk charges such as stress VaR, trading book default (incremental risk) and standardised market risk charges. But that isn’t the point.

The real lesson is that these banks (along with HSBC and Nomura) are putting market risks in their banking books where nobody sees them. Even Goldman, which a few years ago was a purist in marking credit risk to market, recently announced plans to grow its lending business, while cutting its VaR to record lows.

In his book about the Great Crash of 1929, economist JK Galbraith referred to the ‘bezzle’, defined as the unseen loss or fraud in a portfolio at the late stage of an asset bubble. The Steinhoff episode suggests that there may be a substantial bezzle lurking in the credit portfolios and risk models of large banks today.

What the banks said

“Equities revenues were down 23%, mostly driven by an episodic loss in derivatives of roughly $130 million related to a single client event.” (John Gerspach, Citigroup, 16 Jan)

“We took a $130 million loss on a single structured loan and that was Steinhoff. We took full mark on that position.” (Marty Chavez, Goldman, 17 Jan)

“Provision expense was $1 billion, up $227 million, driven by a $333 million impact from the charge-offs and reserve build for a single commercial exposure. Negative news reports on that company caused significant market concerns which affected the credit spreads and stock price of this formerly investment grade credit.” (Paul Donofrio, Bank of America, 17 Jan)

“Loan impairment charges were $658 million in the fourth quarter, or 27 basis points as an annualised percentage of gross loans and advances. This was 218 million dollars higher than the third quarter, due largely to two corporate exposures.” (Ian Mackay, HSBC, 20 Feb)

“Fiscal net earnings includes an unrealized loss related to a margin loan of approximately ¥14 billion ($140m)…This quarter we had the losses from the margin loans, so we feel the need to further strengthen our risk control, make it more thorough.” (Takumi Kitamura, Nomura, 1 Feb)

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