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2003.07.17
About High Yield Investment |
Forewords:
The following article originates from a Swiss financial web site which seems to have disappeared from the net. Unfortunately, we don't know the name and references of its author.
While we don't usually publish anonymous statements, we decided for once to reproduce it in these columns, partly because of its informational interest and its clarity,
partly because we would like to know the said name/references.
If the real author of this parcel comes to read here and would like to give us his own claim, we would be pleased to publish it under his responsibility provided - of course -
that the claim comes with reasonable proof of reality. Contact can be done through e-mail with the webmaster.
Everything or near by (and often stupidities) has been said about High Yield Investment. We hope that the following technical paper (reported here only for informational purposes) will give a general idea about what it is, why it exists, and how it works.
Indeed, there is a lot more to say about it... It is only a "fly-over" which is only intended to clear a little bit the usual mystification about this matter.
We strongly suggest to interested people to take advice from professional specialists before trying to involve themselves in this field.
AFBnetwork Webmaster.
Background about High Yield Investment
Management of the US dollars in circulation
The US dollar is the basis of the world's liquidity system and many other currencies base their exchange rate on it.
In practice, the USA acts as the world's central banker. Management of the dollars in circulation, both in the US and abroad, is the responsibility of the Federal Reserve system, founded in 1913 by an act of the US Congress.
The four areas of FED responsibility are:
1)- Conducting the USA's monetary policy,
2)- Supervising, regulating banking institutions & protecting the credit rights of consumers,
3)- Maintaining the stability of the financial system, and
4)- Providing certain financial services to the US Government, the public, financial institutions and foreign official institutions.
The Federal Reserve's domestic tools to achieve these targets, including the FED's central responsibility of management of money supply and credit, are
interest rate policy, open market operations, reserve ratio policy and moral persuasion.
These tools are not always as effective as the Federal Reserve would like them to be. Part of the reason for the less than perfect effectiveness is due to the substantial stock of dollars in foreign jurisdictions.
Several of the Federal Reserve's domestic tools cannot be used in other countries; for example, the Federal Reserve cannot change foreign reserve ratios. Furthermore, a significant amount of credit creation occurs in dollars in foreign countries, particularly in the Eurodollar market.
As the world's central banker, the USA has the key responsibility to maintain stability in the world's monetary system. Internationally, the currency of choice is often the dollar as it is considered the safest currency, especially in times of political crisis. Consequently, those holding the dollar do so for reasons which are less sensitive to economic stimuli.
Because foreign banks readily accept dollar deposits, those funds, which in the domestic context are the basis of M1 money supply, act in a foreign context more like the near money features of M3. This means they are infinitely more difficult to control. The offshore market has grown substantially in the last two decades for a number of reasons.
First, huge quantities of dollars associated with the drug trade slosh around the international monetary system, and second, wealthy individuals concerned about high taxes and preserving their wealth opt to keep their assets in offshore tax havens. This significant stock of dollars cannot be effectively controlled by the USA with its normal domestic policy tools.
Finally, currency futures markets can be another difficult area to control because of the substantial amount of leverage that is available. For example, for as little as $10,000, it is possible to short or go long $1,000,000 versus D-Mark. All other major currencies have a similar leverage vis-a-vis the dollar. This means that even speculators with limited means can take the other side in a Federal Reserve move to stabilize the currency. Since the currency does not have to be delivered as the contracts are rolled near the expiry date, it is possible to create substantial pressure on the dollar in either direction (the Hunts learned this the hard way when they tried to corner the world silver market).
The Federal Reserve uses different financial instruments to control and utilize the amount of dollars in circulation internationally and works with well known international money center banks to issue the related paper.
The institutional structure of the system
A number of problems must be overcome to make the structure work. Inevitably, the offshore dollars find their way into the international banking system by way of deposits. Therefore, banks must be the main buyers of any financial instruments that the Federal Reserve causes to be issued.
However, the rules of the Bank for International Settlements (BIS), the Central Banker's bank in Basle, Switzerland, prohibit banks from buying the newly issued debt instruments from each other directly. This prohibition exists for obvious reasons. If banks were allowed to fund each other, the probability of system-wide bank failure would be increased. This system of funding is not intended to support weak banks; in fact, the opposite objective is the goal.
Therefore, a methodology has been constructed that allows banks to buy each other's newly issued paper. BIS rules do not prohibit banks from owning other banks' financial obligations as long as they are not purchased from another bank directly, but instead are purchased in the secondary market.
The Federal Reserve supports a group of intermediaries that have substantial available cash reserves. These intermediaries purchase paper from issuing banks and almost always immediately resell it to other buyers. These intermediaries are called commitment holders or providers.
The Federal Reserve licenses its commitment holders to participate in quiet international monetary policy. These commitment holders are identified by confidential, Federal Reserve issued registration numbers. The commitment holders are few in number and it has been reported that there is only about a dozen of commitment holders in the world. They are however essential to the smooth functioning of the process of bringing the debentures to the market. Commitment holders often forge relationships with other sources of funds. These relationships are called sub-commitments holders.
Holding a commitment entails a number of conditions which are extremely important to maintain. First, the commitment holder must be able to quickly produce large sums of dollars, generally in the billions. This explains why commitment holders are prepared to take on sub-licensees to ensure a large supply of readily available funds. Second, there is a demand for utter secrecy.
And finally, this is a "funds first" business. No one can buy issued paper on credit. To ensure that this happens without wasting anybody's time, a commitment holder will not initiate a discussion with anyone unless they can prove cash funds or good quality security.
The Federal Reserve has identified a tier of high quality banks, usually the top 100, which it authorizes to deal in the paper. Criteria for being on the Federal Reserve's list includes strength in the basic banking ratios, sound management, long term stability as well as being in a country in which the Federal Reserve desires to be active. It is evident that the largest supply of international dollars resides in Europe, which explains the dominance of European banks on the Federal Reserve's list.
Another aspect of this fund raising process is the fact that it is conducted entirely off the balance sheets of the issuing banks. The instruments issued are guarantees and as such, represent contingent liabilities. As contingent liabilities, they are not recorded on the balance sheet.
However, they do require a risk-adjusted amount of capital reserve as prescribed by BIS rules. By keeping the funding instruments off balance sheets, there is little, if any, disruption of normal financing activities of the banks.
Issuing paper
The Federal Reserve decides which banks will issue paper, what kind and how much at what point in time. A commitment holder and a bank work together to operate a trading program. The commitment holder is the source of funds and establishes a list of banks from which he will accept instruments. The list reflects the preferences of the owners of the funds. Obviously, the strongest banks will appear most frequently on the commitment holders lists. This causes them to benefit the most from this activity. The strongest banks attract most commitment holders to operate trading programs within their establishments.Banks do the actual trading. They inquire through the Federal Reserve to determine what instruments are available. They are also informed about the banks that wish to acquire paper. They arrange the trades, verify and confirm the securities and clear the trades. The commitment holder is an integral part of the process although it does not have to be present to make it function. The commitment holder simply must leave the required amount of funds at the trading bank in a custody account until the procedures have been properly executed. The commitment holder provides the funds that are used to purchase the initial issue of paper, immediately resold to another bank. There is no room in the system for anyone without funds. This is a principal to principal (bank to bank) business only. The trading bank executes the trades and finds buyers for the issued paper. Outsiders can access the system only by finding a commitment holder and lodging funds with him or with one of his sub-commitment holders. The commitment holder spends most of its time finding investors.
Why the yields are so high
As the investment does not appear intrinsically risky, how are the extraordinary returns of High-Yield programs obtained ?
There are several factors contributing to this phenomenon. The international market for US funds is extremely competitive. For example, there are several countries whose desire for dollars is so high that they will pay annual yields of 20% to 25%, make monthly interest payments in dollars and issue debentures whose terms do not exceed one year. These are countries whose risk profile is high even though there is no record of default on their obligations. These borrowers set the benchmark at the high end of the yield spectrum.
At the other end of the spectrum are very low risk sovereign issuers which are able to attract funds at rates competitive with US treasuries. Earlier it was explained how the institutional side of this process functions. It was pointed out that when an SLC is issued by a foreign bank on behalf of the Federal Reserve, the foreign bank has to establish a capital reserve.
Recent changes to BIS rules require off balance sheet entries to be included in the computation of bank capital adequacy ratios.
Furthermore, these assets and all other bank assets must be weighted to reflect their overall risk. Capital adequacy ratios are now all risk adjusted. SLC's fall into the 100% credit conversion factor rating to convert the off balance sheet item to an on balance sheet equivalent. If banking guidelines require the ratio of total risk weighted assets not to fall below 8%, the bank would have to reserve capital of 8 cents for every dollar of SLC exposure. If a SLC of $100 million is issued, $8 million of capital must be set aside.
In reality, the capital requirements are not so onerous because there are a number of other factors at work that lower the marginal cost of capital utilization. The issuing bank will also load in a charge for providing the service which could be up to 2%. As we shall see, the banks are paid their fee at maturity or redemption. Next, there need to be a yield spread which will motivate large sums of capital to sit in a custody account in dollars. The spread earned by the owners of capital and the commitment holder could equal another 4%. This 4% spread would reflect the costs of fund raising and the economic rent of the capital.
The next question is: Why would the Federal Reserve be interested in paying these yields ? First, it is not as expensive as it might appear. As noted, when the SLC matures, the capital reserve is released. More importantly, the value of the process to the Federal Reserve should be clearly understood. Any country which is attempting to stabilize its currency implements one or both of the following policies. The first line of attack is to manipulate interest rates to increase or decrease the flow of its currency by altering final demand. If speculation becomes too powerful, which it often does, the next line of attack is to intervene in the currency market to remove excess supply or demand.
Changing interest rates can be disruptive enough but once the speculators smell a weakening or strengthening currency, it becomes very expensive to rapidly correct the situation. The dollar is the base currency of global commerce. Dollar speculation could develop at a rate that would be mind boggling. The cost to the global economy would be significant, let alone the cost to the Federal Reserve of intervention. From this perspective, the manner in which the Federal Reserve conducts its activities probably is not so expensive. There are countless examples where a central bank has announced it will defend its currency and $15 billion later it gives up as Britain did when it pulled out of the ERM in 1993. That $15 billion goes straight into the pockets of the speculators.
The only perhaps negative aspect of this system is that the Federal Reserve is reliant on a group of fund raisers called commitment holders who grew very rich from the service they provide. But this is the only way the Federal Reserve can keep the process confidential and highly selective.
There is an analog in the public markets. NYSE market makers or specialists are a very select club which is extremely difficult to reach. Market makers are charged with the responsibility of making a market in their particular stock by managing the balance between supply and demand. Market makers bear risk but it is a risk that most of the time is easily managed. Market making firms have the highest return on capital of any firms involved in the market.
Commitment holders are market makers as well, though of a slightly different sort. They do not bear much risk in making a market. Their risk lies in their ability to gather huge amounts of dollars because, unlike equity market makers , they cannot leverage their capital.
The final question is: Why does the Federal Reserve not issue securities directly to these banks to attract their dollar holdings ? First, the Federal Reserve is not empowered to issue securities; only the US Treasury Department and other agencies guaranteed by the US government can do that. Secondly, selling bonds would be negatively perceived since they are generally used for deficit financing. This process works as well as it does because it is not visible to persons that are not insiders. The issuance of an SLC has the effect that it bids up the price of the dollar as dollars are removed from the huge pool of Eurodollars. And if the Federal Reserve is interested in injecting liquidity into an economy, it simply repurchases outstanding SLC's in the countries where it desires to lower the exchange value of the dollar. We could call it a closed market operation.
The domestic analog of this foreign monetary policy is an open market operation.
Entry into a trading program
High-Yield programs are a most difficult area for investors. There are many people around who know certain elements of the marketplace, but very, very few know the entire process. Because enough people know something and the fact that there is significant money to be made, this market attracts many bad players and scammers. From time to time these pretenders attempt to pull off a major fraud with a significant investor. This prompts warnings issued by the Federal Reserve, the Controller of the Currency, the SEC or the ICC. These pretenders almost always attempt to setup their fund raising efforts inside the USA. The Federal Reserve, of course, will not have any part of that since the process is designed to control and utilize expatriate dollars, not domestic dollars. Banks routinely deny the existence of these programs, even the ones operating them, as they do not want to discuss publicly private investment or damage their CD business (disintermediation). The only way into the system is to be able to certify substantial assets to a commitment holder or one of its sub-licensees. Finding either is no trivial task because there are more pretenders around than legitimate commitment holders. If an investor cannot certify at least $10 million, in the form of cash or liquid collateral, the chances of getting attention from anyone genuine are remote. The 2 key elements for successful investing in the High-Yield field are knowing and developing a strong working relationship with the insiders, and the availability of clean funds under full investor control, without any liens attached.
End of parcel
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Last update : 17/07/2003 @ 09:15
Category : Economy
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