Shadow banks’ unknown unknowns

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Good morning. Gold prices fell more than 6 per cent yesterday, the biggest sell-off since 2013. Among the proposed reasons for the decline: thawing US-China trade tensions; the dollar’s recent uptick; the lack of US economic data. None of the explanations for the rise in the gold price made loads of sense to us. Why should the explanations for the decline be any different? Send us your thoughts: unhedged@ft.com

Lending to non-bank lenders revisited, again

A few weeks ago, after we heard the scurrying of the credit cockroaches known as First Brands and Tricolor, Unhedged wrote a couple of pieces about banks lending to non-banks lenders — “shadow banks” informally, or “non-depository financial institutions” in the US regulatory argot. Three takeaways:

1. The reason to expect problems — or rather, more problems — in NDFI lending is that it has grown so quickly. NDFI lending accounts for all of the growth in US bank lending this year. And when a credit cycle contracts, the worst problems show up where there was most growth during the expansion.

2. It is not bad news that some lending is leaving the banking system. The problem is when lending leaves the system and takes regulatory capital with it, but risk remains.

3. Banks, which have depositors and regulatory backstops, are better at raising and holding liquidity than non-banks. So the banks rent this liquidity to non-banks, as credit lines and other forms of short-ish term lending. Rental liquidity is the umbilical cord connecting shadow banking to banking.

The stresses and strains we have in the banking system since we last wrote have confirmed that these are the points to watch, and added some supplemental points, as well. The biggest news has been losses at Western Alliance and Zions Bancorp stemming from loans to a group of distressed real estate funds. Fitch Ratings issued a note this week entitled “Rapid US non-bank loan growth raises risk of wider losses for banks.” Here is a bit of it:

Recent incidents point to losses linked to borrowers in consumer credit or commercial real estate (CRE) mortgage warehouse lending . . .  Western Alliance’s exposure to a CRE mortgage warehouse loan is $100mn . . . Western Alliance also faces exposure from a separate warehouse loan to First Brands. Additionally, JPMorgan Chase [and] Fifth Third have recorded losses on a warehouse loan tied to Tricolor’s bankruptcy, and Barclays reportedly has exposure as well.

“Warehouse” is the key term here. A warehouse loan is (typically) short-term finance for loans that the borrower plans to sell in the secondary market. It is rental liquidity as described in point three above. In theory, this should be quite safe: warehouse loans tend to be both generously collateralised and short term. But neither of those things help if the collateral isn’t really there or has been pledged multiple times. “The way you lose money in warehouse lending is fraud,” says Christopher Wolfe of Fitch, a co-author of the report. This is the classic problem of indirect lending: you think you have laid off credit risk, but really you have exchanged it for counterparty risk. “The banks are not exiting the risk, they are still sponsoring it — counterparty risk is important even if you are in a senior [credit] position” says Julie Solar, another co-author.

So when thinking about NDFI risk at banks, you can’t just think about what, you think about who. The problem for investors is they don’t get to know who. Under the FDIC current disclosure scheme, we know the volume of NDFI loans at each bank, and how it breaks down to very broad categories: mortgage, business, consumer and private equity. Banks’ controls for counterparty risk, and the concentration of their exposure to specific counterparties — these investors have to take on faith. Loan performance is not broken out by the subcategories, either.

A report from the banking team at JPMorgan’s European Banking Team, led by Kian Abouhossein, argues NDFI disclosures in European are even worse than in the US, and that “very poor disclosure in relation to non-depository financial institutions (NDFIs) globally” is driving up banks cost of capital. It is understandable that investors might want to be paid more for investing in banks when the banks’ loan books have a big and growing blind spot. And now that attention is focused squarely on that blind spot — NDFI loans — there is no going back. Everyone sees the problem now. When fourth-quarter reporting season rolls around, expect some NDFI slides to be added to banks’ presentations, or more selling by investors.

One good read

Variation upon a theme.

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