How sustainable finance is becoming the next sub prime

“If you want to see where you are taking the most risk, look where you are making the most money.” ― Paul Gibbons, business adviser

Much in the way that people in the inter-war period referred to World War I as “the war” or “the great war,” most financiers in the years between the global financial crisis and Covid-19 called the former simply “the crisis”.

Now, we have to be more specific.

Since the early crisis years, almost every financial regulator has been tasked with making sure something like 2008 never happened again. This involved mostly putting higher capital requirements on banks — meaning the amount of money they need to hold back in proportion to how much they lend out — which reduces the bank’s ability to make as much money as it did when those rules weren’t in place.

Most people don’t realise in fact that banks make relatively little cash compared with what they used to make twenty years ago. Now, that all goes to the funds: Private equity, hedge funds and even larger entities called asset managers.

By over-regulating the banks the authorities simply created new financial entities which are less regulated than ever. This is the intractable problem of regulators, who are often staffed by people looking to stay only a year or two and then go on to score better-paying job at said banks, always ensuring they stay one step ahead.

This has also contributed to the slow strangulation of the stock market, where the amount of publicly listed companies has shrunk from 7,000 to 4,000 over the last twenty years as money creeps back, just as day traders are starting to creep in.

It is no coincidence that the moment the stock market is becoming accessible to millions of people instead of just thousands is the point that money begins to creep away from public sight. We’ve talked before about the theory of how language devolution is more pronounced in finance than in other areas of language. It’s like semantic bleaching, only much faster.

For the most part, though, the new rules have stopped further bank runs like we saw from Lehman Brothers or Northern Rock in 2008.

But it’s presented another issue by limiting the amount which can be lent out. How do you kick start your economy when banks aren’t allowed to make any more loans?

One of the main takeaways from 2008 was the notion of risk. New regulation ensured financial institutions would have to keep “skin in the game”, reflecting how the banks had learned the dangers of misallocating risk. Or at least, it was supposed to.

All that work is now being undermined by the combination of two things: sustainable finance, better known by its acronym ESG (environmental, social and corporate governance) and securitisation.

With these two ideas, the European Commission risks undermining both its unsustainability project and the past thirteen years of reform. As coronavirus piles more and more pressure on the financial regulators to look for easier ways out, history might sooner become repeated than learnt.

Shadow banking

Securitisation is what some people like to call shadow banking, which is a name nobody in finance takes seriously because lots of banks you’d recognise on the high street also technically do “shadow banking”. Is HSBC a shadow bank? You can go into HSBC and have a look around and walk up to the staff and ask “are you guys doing shadow banking?” and they’ll ask you what you mean and you’ll feel silly, because you’re confusing the retail part of the bank with the investment part of the bank — which lives in Canary Warf and can’t be entered without an shadowy and (probably) equally nefarious back-door appointment.

That’s the part that does the shadow banking, but you can also get a mortgage and an overdraft with them which makes the whole thing seem perfectly normal and fine, which, it, mostly is.

But are Blackstone, Cerberus and Apollo shadow banks? Well, they certainly sound shadow-banky, right? Except they’re private equity firms, which we mentioned before have started doing a lot of bank-like things that banks used to make a lot of money doing before they were more heavily regulated after the 2008 crisis.

But anyway, the question of how a bank (or whatever institution that manages other people’s money) should be allowed to manage its capital is a big and complex one, and warrants a lot more attention than I have room to give it here. But suffice it to say that shadow banking is a (mostly) well-regulated and accepted part of investment banking, which is what allows banks to say, offer mortgages or personal loans or credit cards, the utility of which can all be debated in other more erudite articles.

You can have a different discussion when you’re talking about the US. America isn’t as reliant on its banking sector as Europe. Over in god’s own country, only about 40% of loans come from the banks, whereas in Europe it’s more like 80%. European banks like Deutsche Bank (which is treated internationally like a US bank for all intents and purposes) even say that Europe needs to depend less on its banks. Look.

But what exactly are the banks doing when they securitise? They’re essentially getting a pile of loans they made which they think people might have trouble paying back — say, for example, loans it made to businesses the government is currently forcing to close — and splitting them into different pieces, selling them on at a profit.

This allows them to move the risk on to someone else while simultaneously avoid taking an outright loss for the loans they made which have now gone bad.

The securitisation market never really died out after 2008. After the implosion of collateralised debt obligations (CDOs) and their derivatives, which fooled investors into thinking they were making safe investments, securitisation bankers still found work in other corners of the market, like packaging leveraged loans, pubs and even music royalties.

So here is the idea: With securitisation, banks can recycle the capital they have tied up in loans which aren’t being paid back, allowing them to deploy more money into struggling businesses trying to recover from chronic lock-downs.

Except, an even better idea, what if they were doing that, but with green and social financial things? So thought the European Parliament, anyway.

Some in the EU who were around during the crisis think this is bad, but lots of other people think it’s fine and should even be encouraged because then banks will be able to lend more money to businesses like they’re supposed to.

This would be okay in principal, if it weren’t for the European Parliament shoe-horning the letters ESG on to the project. (I find it helps to point fingers at a specific European institution rather than say “the EU did this or that”. The EU has many, many tentacles and they all have their own faults and features.)

As well as forgetting the risks of the last crisis, the Commission is in fact promoting the very same activity it sought to curtail with the reforms it spent the last twelve years fighting for. Combining the technology of securitisation with “green” sustainable finance is proving to be potent mix.

Recycling

The problem with risk is not that it’s bad to sell something risky. The problem comes when systemically important institutions buy the risky thing thinking they understand the risks when they in fact don’t. That’s what happened in 2008, in a very convoluted and drawn out way.

Even after years of trying to define sustainability criteria, ESG is still a fairly amorphous concept. It’s pretty easy when it comes to things like coal or wind farms etc., but it gets trickier the further up the supply chain you go.

It doesn’t take many examples to figure out why. One case is of investors who prevented their funds from investing in casinos or gambling companies. But look a little closer, and you found they invested wholesale in companies that produced gambling machines. They still got to call themselves ESG, though.

Finance is full of this, and everyone is the industry is looking around to see which part of their business they can give a makeover and call ESG to get a government grant or bonus or just a slight discount on their next investment.

One of the biggest and less talked-about issues in 2008 was the rating agencies. Rating agencies are not public companies (mostly because they also rate countries, who complain when their sovereign rating is downgraded and often try to reverse the process). They are private institutions which give a credit rating (AAA, BB, etc.) to companies, bonds, loans and just about anything financial to signal to investors how risky something is.

Except twenty years ago that’s not what they were doing exactly. Before then a bank like Goldman would go to a rating agency like Moody’s and say “can you give us this rating to say this is safe?” and if Fitch said “no” then Goldman would go down the road give the deal to another less well-known rating agency, which would give it the rating they wanted because that’s how they get paid.

This still goes on today, but it’s much more heavily frowned upon and you can’t do it as blatantly. The big rating agencies actually call each other out when they would have rated something differently, even when no one is paying them to. That never would have happened a few decades ago.

This dialogue never took place with the ESG rating agencies though. These are new institutions, all having sprung up in the last few years and all looking to get paid to lend their credibility to a “green” deal.

These are the ratings which are slowly becoming more important. What’s more is they are slowly replacing criteria around understanding risk, with the argument following that green assets are cheaper because of rising fuel costs and government subsidies.

Proponents of this theory argue, for example, that a person in an energy-efficient green home is in a better position to pay back their mortgage than someone living in a non-green home.

But that’s not how risk works, or ever has worked. A home owner who loses his job is unlikely to have saved up a substantial buffer from the $30 saved over energy bills. The Parliament and Commission are inflating the idea of financial safety with social good.

What’s more, lobby groups like the French Banking Authority are actually suggesting in the European Parliament that banks be required to hold less capital against green loans as opposed to non-green loans, assuming green means pristine as far as credit is concerned.

ESG is not an indicator of risk, only of social desirability. And calling a loan socially desirable doesn’t have any bearing on whether the person can actually pay it back.

But this, I fear, the Commission has forgotten. Or at least chosen to ignore.

Two to Tango

The new class of ratings agencies, just like the new class of banks, are more than happy to put their stamp on “green” or even “social” securitizations to win more money from investors.

With their help, firms backed by private equity are able to make profit margins that put even the banks to shame. They do this by accessing what are called the capital markets, which is in a sense how any kind of corporate entity like a bank or a firm is able to borrow money.

This can be in the form of bonds, loans, equities, or securitisations. Normally, it involves one entity from the “sell-side” looking to borrow money (i.e. they are “selling” a financial product like a loan) and someone from the “buy-side” is looking to lend them the money, or exchange for getting paid back with interest at a later date.

There’s a lot more to go into about the capital markets – how they’re effectively banned under Islamic law etc. – but for out purposes it is enough to know that, starting probably back in 2017, people on the sell-side realised you could make a lot more money by calling your loan or bond or securitization an “ESG deal”, especially when it came with a rating agency stamp of approval.

Enter private equity, which has bought a bunch of companies that offer mortgages to people as a means of getting more funding for their own businesses.

Kensington Mortgages, a specialist mortgage lender, which was fined £1.2m in 2010 for treating its customers unfairly, issued the first ever “social” securitisation in February.

Kensington is funded by Blackstone, a private equity firm which rose to power after the financial crisis. The United Nations Working Group on human rights sent the group’s CEO a letter in 2019 holding the finance chief’s firm as partly responsible for the housing crisis.

Other private equity groups tunnelling into the UK housing market (already being well-entrenched in the US) include Texas Pacific Group, (whose CEO was caught bribing his children’s way into college), Fortress Investment Group (lost $125 million in a Ponzi scheme in 2009), Tiger Global (which previously went insolvent after shorting tech stocks whose combined value then rose past the $6.5 billion value of the fund), and the Elliot Management Corporation (a vulture fund which specialises in looking for scraps in the remains of dead companies.)

It is worth remembering that in the years before the financial crisis banks were rarely directly involved as sub-prime lenders: the predatory mortgage middle-men who gave out million-dollar homes to people with no job, only to step back when the financial instruments backing them imploded.

Now, private equity firms are taking on similar roles. Only in 2008 no one made money off ESG.

According to Kensington, the lender is actually doing the world a social good by giving a mortgage to people who were turned down by banks because they couldn’t afford one or fell outside the normal criteria.

This allows it to get an ESG rating from ISS ESG, which allows Kensington (and by extension, Blackstone) to make money by selling the mortgages to investors like pension funds, who are being pushed into purchasing ESG products via government invectives.

See the problem yet?

One might remember how one of the biggest reasons the financial world started to collapse in 2008 was because of the unprecedented surge in mortgage defaults.

This was a consequence of people not being able to pay their mortgages. Why? Because lenders were not incentivised to check if they could actually afford it, they simply gave them a mortgage anyway.

With the new ESG directive, the EU would effectively be subsiding mortgage lenders who loosen up their lending criteria and push as many people as possible into accepting a mortgage loan.

As time goes on, more and more money will go into these “non-bank” lenders (funded by the new banks, the private equity groups) who can make far more money off “ESG securitisations” then they can funding boring old bank mortgages.

So far, this hasn’t gone on long enough to blow up like CDOs did in 2007 and 2008. Those contracts had already packaged billions of dollars’ worth of mortgages before Michael Burry and the rest of The Big Short gang started betting against them.

But it won’t take long for the debt to pile up. If lending criteria loosens, as it always does when there is money to be made, and the European Commission continues down the same road with ESG which it seems bent on travelling, then the next financial crisis could be an environmental crisis, too.