A $4 Trillion Dodd-Frank Loophole

To improve the safety of the financial system, the Dodd-Frank reform law requires that most derivative deals be executed on a clearinghouse that will require traders to post collateral and will provide a central place for regulators to keep an eye on risk in the market.

The idea was to increase transparency in a market that played a key role in the financial crisis and led to the federal $182.3 billion bailout of American International Group (AIG) in 2008.

But for every new rule, there is a frantic search for new loopholes. And sure enough, banks have found a big one.

Our colleague Bradley Keoun at Bloomberg News has a fascinating story about how some of the country’s largest banks are planning to help clients circumvent new requirements in the law. The move lets traders “transform” risky securities into the high-grade bonds that clearinghouses require traders to post as collateral. Traders and investors do this by temporarily swapping out their lower-grade securities for high-grade bonds such as Treasuries, which are in great demand these days as investors and banks shore up their books.

The traders are happy because they have the quality collateral they need, and the banks are happy because they collect fees and interest for lending out their goods. Bank of New York Mellon (BK) estimates that investors will need as much as $4 trillion in good collateral to comply with the new regulations.

If things go well, this scheme would operate smoothly. But if traders go bust, banks could be left holding risky bonds instead of high-grade securities. Also, if the banks themselves originally had borrowed the high-grade bonds, the original lender might set off a domino effect through the market by calling back the collateral.

Banks say swapping out collateral doesn’t hide risk because the banks are regulated, too. Barclays (BCS) says banks have their own new capital requirements, which might limit how much they can lend, and JPMorgan Chase (JPM) spokeswoman Jennifer Zuccarelli told Bloomberg News that collateral transformation isn’t risky because it’s a short-term, established type of lending that is “subject to tight capital and liquidity rules and fully transparent to regulators.”

In July, regulators reached a major milestone when they approved rules specifying which types of derivatives must be traded over clearinghouses, as well as face further requirements. Bart Chilton, a Democratic commissioner at the U.S. Commodities Futures Trading Commission, opposed the rules, saying they provided too many exemptions. The rules excluded insurance and retail transactions and trades by many non-financial companies and small banks. Chilton said he was concerned that the financial industry would take advantage of the loopholes and that exempted trades designed for “legitimate purposes are going to morph, kind of chimerical,” into more complex, riskier financial products.

The CFTC and other regulations still have more rules to finalize, each striving to make markets less risky—and each providing new items for the industry to scour for loopholes.

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Europe’s $39 Trillion Pension Threat Grows as Economies Sputter

January 11, 2012, 1:48 AM EST By Rebecca Christie and Peter Woodifield

(See EXT4 for more on the sovereign debt crisis.)

Jan. 11 (Bloomberg) -- Even before the euro crisis, people were worried about Europe’s pension bomb.

State-funded pension obligations in 19 of the European Union nations were about five times higher than their combined gross debt, according to a study commissioned by the European Central Bank. The countries in the report compiled by the Research Center for Generational Contracts at Freiburg University in 2009 had almost 30 trillion euros ($39.3 trillion) of projected obligations to their existing populations.

Germany accounted for 7.6 trillion euros and France 6.7 trillion euros of the liabilities, authors Christoph Mueller, Bernd Raffelhueschen and Olaf Weddige said in the report.

“This is a totally unsustainable situation that quite clearly has to be reversed,” Jacob Funk Kirkegaard, a research fellow at the Peterson Institute for International Economics in Washington, said in a telephone interview.

A recession threatening the world’s second-biggest economic bloc, along with efforts to reduce debt across Europe, is exacerbating the financial risks. Stable or falling birthrates, plus rising life expectancies, are adding to pressures, with the proportion of economic output devoted to spending on retirement benefits projected to rise by a quarter to 14 percent by 2060, according to the ECB report.

Increased retirement ages and lower benefits must be part of any package to hold the 17-nation euro area together, according to analysts, including Fergal McGuinness, the Zurich- based head of Marsh & McLennan Cos.’s Mercer’s pensions consulting unit for central and eastern Europe.

Ageing Populations

Europe has the highest proportion of people aged over 60 of any region in the world, and that is forecast to rise to almost 35 percent by 2050 from 22 percent in 2009, according to a report from the United Nations. That compares with a global estimate of 22 percent by 2050, up from 11 percent in 2009.

The number of people aged over 65 in the 34 countries in the Organization for Economic Cooperation and Development is forecast to more than quadruple to 350 million in 2050 from 85 million in 1970. Life expectancy in Europe is increasing at the rate of five hours a day, according to Charles Cowling, managing director of JLT Pension Capital Strategies Ltd. in London.

In so-called developed countries, the average lifespan will reach almost 83 by 2050, up from about 75 in 2009, the UN said.

Cutting Costs

Governments and companies have taken steps to reduce future costs with policy makers having increased retirement ages in countries, including France, Germany, Greece, Italy and the U.K.

“Irrespective of whether you’re inside or outside the euro or anything else, raising retirement ages is one of the structural reforms that all of Europe has to do,” Kirkegaard said. “The crisis has forced them to address this. This is actually a positive thing in many ways.”

By 2060, the average French pension benefit will be 48 percent of the national average wage, compared with 63 percent now, said Stefan Moog, a researcher at Freiburg University in Freiburg, Germany.

Pension managers and governments are relying on economic growth to safeguard the promises they make. If the euro zone grows too slowly to bolster public and private coffers, the retirement plans may become unaffordable, according to Mercer’s McGuinness.

Benefits’ Squeeze

“The amount of money countries are going to spend on social security and long-term care is going to go up,” McGuinness said in an interview. “Governments with more generous social-security systems will have difficulty affording them. They will have to recognize these costs will impact their ability to reduce borrowings.”

State pension obligations in France and Germany are three times the size of their economies, according to data compiled by Mercer. It’s more sustainable in France than Germany because of France’s higher birthrate.

Last year, there were 4.2 people of working age for every pensioner in France. The ratio will fall to 1.9 by 2050, according to a report by Economist magazine in March. In Germany, the proportion will decline to 1.6 from 4.1 in the same period.

“That is going to put a lot of pressure on Germany’s ability to meet their promises,” McGuinness said. “What they are more likely to do is cut back benefits. Governments face a lot of longevity risks.”

Private pension funds are under pressure too with benchmark euro-area interest rates at the lowest level since the 13-year- old currency was introduced. Low rates mean pension plans have to hold more assets to back their long-term payout projections.

Add to Risks

Unless growth returns, fund managers will effectively be forced to take on more risk, said Phil Suttle, chief economist of the Washington-based Institute of International Finance.

“That creates problems because they all head into sectors that seem a great idea now, and then they blow up, whether it’s commodities or equities or whatever,” Suttle said. “You’re going to intensify the boom-bust cycle.”

The growing doubts facing the euro area is another planning hurdle as companies reconsider investment strategies amid concerns that Greece may default on its debt and spark a broader euro breakup.

The implied probability of one country leaving the euro by the end of 2013 rose to 53 percent on Jan. 9 from 45 percent a week earlier, based on wagers at InTrade.com, an Internet betting market. The probability of one country departing by the end of 2014 is 59 percent.

Pension plans in countries such as Greece or Portugal may benefit from exiting the euro as higher interest rates that would likely accompany a return to their national currencies would cut the cost of liabilities, while assets invested abroad would almost certainly gain in value, according to Mercer, a unit of Marsh & McLennan Cos.

U.K. Plan

In Britain, which has refused to join the euro, occupational pension funds have moved the risk of ensuring adequate retirement income to the employee from the employer in the past decade to curb pension-fund shortfalls.

Unfunded public-sector U.K. pension obligations across 1,500 public bodies totaled 1 trillion pounds ($1.57 trillion) in March 2010, the Treasury said Nov. 29 in the first set of audited Whole of Government Accounts. That compares with a total of 808 billion pounds of outstanding U.K. government bonds and accounts for 90 percent of all public-sector pension liabilities.

Royal Dutch Shell Plc, Europe’s largest oil company, was the last member of the benchmark FTSE 100 Index to close its defined-benefit pension plan to new entrants when it made the decision last month to do so. The company plans to introduce a fund for new employees next year that makes them responsible for ensuring they have enough to live on in old age.

Governments may have to follow the same path for their own employees as well as increasing the retirement age to at least 70 and possibly 75 to make the pensions affordable, Cowling wrote in an article published in July by Public Service Europe.

--Editors: James Hertling, Tim Quinson

To contact the reporters on this story: Rebecca Christie in Brussels at rchristie4@bloomberg.net; Peter Woodifield in Edinburgh at pwoodifield@bloomberg.net

To contact the editor responsible for this story: James Hertling at jhertling@bloomberg.net

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Banks Have Record $1.45 Trillion to Buy Treasuries on Savings

June 19, 2011, 12:05 PM EDT By Masaki Kondo, Yoshiaki Nohara and Saburo Funabiki

June 20 (Bloomberg) -- Japan’s biggest bond investors see increasing parallels between the nation’s government debt market and Treasuries, indicating that historically low yields in the U.S. have room to fall.

Just as in Japan, deposits at U.S. banks exceed loans, reaching a record $1.45 trillion last month, Federal Reserve data show. As recently as 2008, there were more loans than deposits. The gap is also at an all-time high in Japan, where banks use the money to buy bonds, helping keep yields the lowest in the world even though the country has more debt outstanding than America and a lower credit rating.

While none of the more than 40 economists surveyed by Bloomberg expect the U.S. will see two decades of stagnation like Japan, they are paring growth estimates as unemployment remains above 9 percent and the housing market struggles to recover. The International Monetary Fund cut its forecast for U.S. growth in 2011 for the second time in two months on June 17, bolstering the appeal of fixed-income assets.

“I’ve seen what happened in Japan, so when looking at the U.S. now, I think, ‘Ah, the same thing is going on,’” said Akira Takei, the Tokyo-based general manager of the international fixed-income investment department at Mizuho Asset Management Co., which oversees about $41 billion.

Savings Increase

In the decade before credit markets seized up in 2008, U.S. deposits exceeded loans by an average of about $100 billion, Fed data show. The worst recession since the 1930s led consumers to trim household debt to $13.3 trillion from the peak of $13.9 trillion in 2008, and increase savings to 4.9 percent of incomes from 1.7 percent in 2007, Fed and government data show.

Banks pared lending amid more than $2 trillion in losses and writedowns, according to data compiled by Bloomberg. Instead of making loans, financial institutions have put more cash into Treasuries and government-related debt, boosting holdings to $1.68 trillion from $1.08 trillion in early 2008, Fed data show.

Yields on 10-year Treasuries -- the benchmark for everything from corporate bonds to mortgage rates -- have fallen to less than 3 percent from the average of 6.79 percent over the past 30 years even though the amount of marketable U.S. government debt outstanding has risen to $9.26 trillion from $4.34 trillion in 2007, Treasury Department data show.

Ten-year yields fell 2.5 basis points, or 0.025 percentage point, last week to 2.94 percent in New York, the fifth straight weekly decline, according to Bloomberg Bond Trader prices. The price of the 3.125 percent security due in May 2021 rose 7/32, or $2.19 per $1,000 face amount, to 101 17/32.

Lending Drop

Loans dropped and savings rose in Japan, too. Lending has declined 27 percent from the peak in March 1996, while bank holdings of government debt surged more than fivefold to a record 158.8 trillion yen ($1.98 trillion) in April, according to the Bank of Japan. The difference in deposits and loans, known domestically as the yotai gap, is 165 trillion yen, or more than Spain’s annual economic output.

Yields on Japanese bonds due in 10 years dropped to 1.115 percent last week from 3.46 percent in 1996 and have remained at about 2 percent or lower since 2000.

The U.S. and Japan are “beginning to look similar because of the fact that we’ve had very low interest rates for a very long time now” Charles Comiskey, the head of Treasury trading at Bank of Nova Scotia in New York, said in an interview. “This is going to be 10 years of pain to de-lever ourselves from the mess of a debt-ridden society that we’ve become.”

Rates Outlook

Futures traded on the Chicago Board of Exchange indicated in January that the Fed would raise its target rate for overnight loans between banks from a record low of zero to 0.25 percent in 2011. After reports this month showed that the jobless rate rose back above 9 percent, consumer confidence fell, the housing market weakened and manufacturing slowed, traders now see no increase until late 2012 at the earliest.

The IMF said the U.S. economy will grow 2.5 percent this year and 2.7 percent in 2012, down from the 2.8 percent and 2.9 percent projected in April.

Further declines in Treasury yields may be limited because the inflation rate is higher than in Japan, where consumer price changes have been mostly negative since 2000.

U.S. prices rose 3.6 percent in May from a year earlier, according to the Labor Department. That means 10-year Treasuries yield 62 basis points less than the inflation rate. So-called real yields in Japan, where consumer prices rose 0.3 percent in April, are a positive 82 basis points.

Pimco Avoids

“Treasury bonds at the current valuation would likely disappoint long-term investors with low or even negative real returns,” Tomoya Masanao, the head of portfolio management for Japan at Pacific Investment Management Co., wrote in an e-mail to Bloomberg News. “The global economy seems more tilted to inflation than deflation over the next three to five years.”

Pimco, based in Newport Beach, California, had $1.28 trillion under management as of March 31, including the world’s biggest bond fund, the Total Return Fund. Bill Gross, the firm’s co-chief investment officer, has said mortgages, corporate bonds and sovereign debt of nations such as Canada are more attractive.

The median estimate of more than 50 economists and strategists surveyed by Bloomberg is for 10-year Treasury yields to rise to 4 percent over the next 12 months.

Those forecasts fail to take into account the weak U.S. housing market, which makes up the bulk of Americans’ net worth, according to Akio Kato, the team leader for Japanese debt in Tokyo at Kokusai Asset Management Co., which runs the $31.1 billion Global Sovereign Open fund.

Housing Tumble

“U.S. home prices won’t rebound unless household debt” is reduced, Kato said. “As long as the situation remains the same, bank lending won’t grow. U.S. banks will tighten criteria for borrowers."

House prices in 20 U.S. cities are 14 percent below the average of the past decade, according to the S&P/Case-Shiller index of property values. The gauge dropped in March to the lowest level since 2003. Japan’s land prices are still at less than half the level of two decades ago.

Japan has endured two decades of economic stagnation with nominal gross domestic product about the same as it was in 1991. Government debt is projected to reach 219 percent of GDP next year, the Organization for Economic Cooperation and Development estimates. That compares with about 59 percent in the U.S., government data show.

BOJ Nullified

The economy has struggled to recover even though the BOJ buys government securities monthly to lower borrowing costs and stimulate the economy. The efforts have been nullified as banks use BOJ funds to buy bonds rather than lend.

‘‘With no prospects for Japan’s economic growth, funds from the widening loan-deposit gap flow to bonds rather than stocks,” said Katsutoshi Inadome, a strategist in Tokyo at Mitsubishi UFJ Morgan Stanley Securities Co., a unit of the nation’s largest listed-bank.

That’s similar to the U.S., where economists are cutting growth forecasts even though the Fed has pumped almost $600 billion into the financial system since November by purchasing Treasuries under a policy known as quantitative easing. The program is due to end this week.

Mizuho’s Takei said there is a “very high chance” that lenders will continue to funnel deposits to the bond market, helping to push Treasury 10-year yields toward 2.4 percent within a few months. Takei said he favors longer-maturity securities.

“Eventually, yields in Japan and the U.S. will converge,” said Mizuho’s Takei. “This is just the beginning.”

--Editors: Philip Revzin, Rocky Swift

To contact the reporters on this story: Masaki Kondo in Singapore at mkondo3@bloomberg.net; Yoshiaki Nohara in Tokyo at ynohara1@bloomberg.net; Saburo Funabiki in Tokyo at sfunabiki@bloomberg.net

To contact the editor responsible for this story: Rocky Swift at rswift5@bloomberg.net

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