Financial Innovation Continues To Advance - Watch Out, Fed

Includes: JPM, MS
by: John M. Mason

A sign of the growing health of financial markets is the continued development of financial innovation and the renewal of some financial innovation that went dormant during the recent financial crisis, but now seems to be re-emerging around the world.

The banking world continues to adjust to the post-crisis, new regulatory environment with new debt products. In this case, JPMorgan (NYSE:JPM) and others are "offering a new type of debt product that will help them to skirt new rules requiring them to hold war chests of liquid assets." (See "Banks Offer Debt Product to Help Skirt New Liquidity Rules")

This new product is called callable commercial paper, and is sold by banks on behalf of municipalities who use it as a type of short-term financing. In essence, commercial banks buy commercial paper issued by municipal issuers.

Previously, the maturity of the paper was 30 days or less. When the financial crisis hit, the municipalities found that many traditional buyers of their debt stayed on the sidelines, resulting in banks stepping in as a backstop to pick up the paper.

New proposed regulation will require banks to hold a portfolio of liquid assets against such credit commitments. The paper now being offered is "callable" for municipal issuers, coming with a maturity of up to 200 days, although it is redeemable by the issuer before 30 days. This allows the banks to avoid the liquidity rules.

Having to act according to the liquidity rules raises the cost of the paper, lessening its usefulness. Also, municipalities are happy with the innovation because it allows them to spread their maturities, thereby reducing their funding risk.

JPMorgan has already done two issues of this callable commercial paper, and is playing a third in partnership with Morgan Stanley (NYSE:MS).

Moving into the "shadow" side of banking, we are hearing more and more about "peer-to-peer" lending. Here, we find a whole growing network of financial advisors that can connect their wealthy clients directly with several kinds of investment products. There are even peer-to-peer lending platforms, like the Prosper Club and the Lending Club.

"Peer-to-peer lending platforms seek to match would-be borrowers with lenders directly, thereby avoiding the complex web of infrastructure and regulation that rules over traditional banks." (See "Peer-to-peer Lenders Look to Rival Traditional Banks")

The article continues by saying that "Loans made on the P2P platforms are generally unsecured and investors must rely on the P2P platform to weed out fraudsters accurately."

Peer-to-peer lending can also provide the lenders returns of 10 percent or more.

A signal that these lenders have arrived is the people being attracted to their companies. Just last week, Prosper announced that Stephan Vermut would be its new chief executive. Vermut is a leader in both prime brokerage and information technology. The former founder and managing partner of Merlin Securities is a seasoned entrepreneur, corporate executive and technologist with more than 25 years of experience in financial services.

The Lending Club counts former Morgan Stanley chief executive John Mack; Mary Meeker, former Morgan Stanley internet analyst; and Larry Summers, former Treasury Secretary, as board members.

Now, moving into the renewal of earlier "shadow" banking endeavors, we see a pickup of activity in the area of structured loan products. The market for Collateralized Loan Obligations (CLOs) is showing some signs that it is not completely moribund.

Last year in the United States, about $55 billion in CLOs were issued. Expectations are for this market to more than double in 2013. The market in the U.S. almost died during the financial crisis, but is seemingly returning to active status as the financial environment improves.

The structured CLOs are bundled packages of corporate loans that have generally been generated to fund leveraged buyouts into one package that investors can invest in.

In the United States, there is an ample supply of liquid leveraged loans. Furthermore, issuers of these securities don't have to retain an equity interest in the packages.

This is not true in Europe. Although the leveraged loan market in Europe exceeded 200 billion euros in 2008, activity has been almost nil because of the slowdown of the European economy. A problem facing the European financial markets, however, is that many of the earlier deals are maturing now, and there is a great need for new funds to replace the CLOs that are maturing over the next two to three years.

A looming problem, however, is the new European regulations requiring that CLO managers must now retain a slice of the action by holding onto some of the equity in each deal. This raises the cost of making deals to the larger participants, and makes it hard for the smaller ones to assemble sufficiently large packages.

There are ways to get around this, as managers can "farm out" this equity portion to parent companies, or to associated "groups" of investment managers.

Still, the market in Europe seems to be gearing up. Pramerica and Cairn Capital are moving to arrange the first European CLO deals since 2007. (See "Race to Revive Pre-crisis Loan Deals in Europe") According to sources close to the deals, the new CLOs will be presented next month.

The point is that there is a momentum building up in financial markets. As the European crisis seems to be receding into the background, more and more effort is being made to "normalize" financial activity. Not only are we seeing a revival of financial instruments like CLOs and asset-backed securities, but we are seeing more and more financial innovations seeking to use the advances coming in the field of information technology, as well as more and more financial innovations seeking to get around the new financial regulations that have been put into place since 2008.

This is healthy, and it should be taken as a sign that the actions of the Federal Reserve and the European Central Bank are achieving some kind of return to more "normal" financial market activity. "Normal" in this case relates back to the decade or two before August 2007.

As mentioned in my last post ("Don't Fight the Fed - The Continuing Saga"), maybe this is just what the Federal Reserve is looking for, since achieving this "normal" may be a necessary prelude to more robust economic growth.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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