For me, one of the largest red flags in the market has been the continued poor health of the Financials. The reason, of course, is that they are struggling to shrink their balance sheets, “extend and pretend” on their loan books and earn their way out of impending Japanization. I’m not sure where I got this little piece of wisdom from (and if you can prove it wrong please let me know); There has never been a bull market in history that hasn’t been lead by financial stocks. A sobering thought.
Banks are, despite all their crimes, still the veins and arteries that pump credit around the body of the economy which acts as a lifeblood to economic activity.
It seems easy to say as someone who entered the industry in 2008 but I can’t understand why people want to bother with financials. Buffett says he puts Technology stocks in the “Too Hard Pile”, well given that banking is no longer a “3-6-3” Game (take deposits at 3%, lend at 6%, be on the Golf Course by 3pm), I think banks fall into that pile for me. I like businesses I can understand, it’s not even possible that the CEOs understand all that goes on within these large banks.
They are so incredibly complex and their balance sheets so huge and opaque that they are completely impossible to analyse. RBS at one stage had a balance sheet larger than the entire UK economy, talk about too big to fail! I also find the economics entirely underwhelming – let’s say a bank can achieve an ROE of 15%, which is in excess of where most banks are currently aiming for. Is that so impressive when you consider that they are leveraged somewhere between 10 and 50x!? That means their unlevered return is only 1.5% at most.
It is my personal opinion that banks on the whole are run not for shareholders or even for clients, but instead for employees. Banker remuneration is a much maligned topic but it’s perhaps most succinctly described by the old Wall Street book “Where Are the Customers Yachts?” I’d rather own businesses where my interests were better aligned with the staff.
The obsession with complicated ratios and “Stress Tests”! The most recent set of European Stress Tests modelled how banks would react in negative tail risk scenarios, however it failed to envision even the possibility of a Sovereign Default, that was deemed too stressful to be a reasonable assumption. This shows how fast things have deteriorated and how “Unstressful” Stress Tests are pointless. The other closely watched number is “Tier One Capital Ratio” – I barely understand what this even is despite my modicum of financial knowledge; what I DO know is that it doesn’t matter! Barclays, for example, are quite proud of their strong balance sheet and 11% Tier One Capital Ratio. Dexia had a Tier One Capital Ratio of 12% when it went bust last month. Go Figure! These figures mean nothing when nobody understands the assets on the balance sheet.
Banks have a nasty habit too – they are consistently profitable on the income statement, not that hard since all they have to do is borrow short from depositors and lend longer to businesses and mortgages. But unfortunately, these profits tend to lend to hubris at peaks in the business cycle which lead to an almost inevitable, although seldom as spectacular as 2008, blow up on the balance sheet. Some of their loan assets fail to be paid down and some of their bull market investments are shown to have been folly. There is a strong pattern of this repeating, profitable on the income statement and then a balance sheet blow up.
What Price Extreme Uncertainty?
In the current climate banks are a speculation on future economic, legal and political action or inaction. At the weekend, banks were forced to take a “voluntary” 50% haircut on their Greek Debt holdings (politely termed Private Sector Involvement!) so that it didn’t classify as a Credit Event to trigger CDS payouts. See video below for a reality check on the nonsense of this latest stop gap….
The problem with this latest sticking plaster for the EuroZone is that it will have multiple unintended consequences, which most likely won’t become apparent until they smack us in the face. If CDS payouts can now be adroitly circumvented at a political whim then what is the point of the market existing? We only buy insurance so that it pays out when the house burns down – what point if the contract is voided as you stand amongst the ashes?! There is a $62.2 TRILLION (read it twice to check!!) market in notional CDS globally. This is larger than the cumulative economic output of Planet Earth in any one year – there is now a huge question mark over the viability of this entire product.
1) Many CDS are used for legitimate hedging purposes rather than speculation. These legitimate corporate/pension/endowment hedgers will now be very fearful for their exposures – this will kill any animal spirits or willingness to take risk/proactive business decisions.
2) Remember all those banks and insurance companies who have been falling over themselves to tell investors and the press how they have “slashed European Sovereign Exposure”? Well….what’s the fastest way to do that? You certainly couldn’t liquidate all those bonds because there aren’t any buyers! You just bought CDS on the bonds and you’ll be fine in the “unlikely outcome that there is a credit event”. Uhoh, seems the Euro Leaders have decided that CDS “speculators” don’t deserve to be made whole despite them paying up front for a legally binding, arms length insurance contract between consenting parties. This means that all those banks who thought they had hedged their “Euro Problem” are infact just as naked and long as they were before.
As Ben Davies of Hinde Capital termed it, the EFSF has become the “European FUBAR Slush Fund”. (If you don’t know what FUBAR means then google it!)
Earnings Hocus Pocus
Banks have been reporting earnings this last week or so and there is a worrying trend. Circa 100% of earnings reported by Morgan Stanley and UBS and a further 60% of earnings reported by Barclays can be attributed to something which I would politely term an accounting “finesse”. Banks have embraced the option to use these so-called “Credit Valuation Adjustments” for the past 4 years, under the Financial Accounting Standards Board’s FAS 159 rule.
See below a few choice quotes from people far more insightful than I on the subject, plus my 2 cents where I feel it might add something….
“It’s worth observing that a number of banks reported positive “earnings surprises” last week. If you look at those results for any of the major banks, it is immediately clear that the bulk of the earnings were of two sources: further reductions in reserves against potential loan losses, and an accounting gain known as a “Credit Valuation Adjustment.” Those two items, for example, were responsible for nearly 90% of Citigroup’s reported “earnings.” The Credit Valuation Adjustment (CVA) works like this: as the bond market has become more concerned about new financial strains, the bonds of U.S. banks have sold off significantly in order to reflect higher default probabilities. Under U.S. accounting rules, bank assets are no longer marked to market, but happily for the banks, the decline in the market value of their bond liabilities means that the banks could technically “buy their bonds back cheaper.” So the decline in the bonds, despite being due to an increase in investor concerns about bank default, actually gets reported as an addition to earnings! Surprise, surprise.”
(John Hussman, 24 October, 2011)
This is scarily similar to the stories we heard in 2007/8 which were dismissed as fear-mongering. David Einhorn, manager of Greenlight Capital who was short Lehman Brothers all the way to zero and is recognized as an expert in sniffing out accounting shenanigans , pointed out……
“Lehman was taking advantage of a new accounting mechanism that allowed it to book revenue based on the declining value of its own debts. In other words, because of the increasingly risky state of Lehman, loans that other firms had made to Lehman had dropped in value, and under the new accounting, Lehman could count this as a gain. This is crazy accounting. I don’t know why they put it in. It means that the day before you go bankrupt is the most profitable day in the history of your company because you’ll say all the debt was worthless. You get to call it revenue. And literally they pay bonuses off this, which drives me nuts.”
So….the spike in CDS, the huge increase in the credit spread/risk premium demanded by investors to hold bank bonds is being used to prop up bank earnings! Bank Earnings will then go someway to deciding Bank Executive compensation! This is ludicrous.
I won’t claim that Richard Woolnough of M&G has been reading my recent emails, but he may as well have been…..
“In the more grown up world, this quarter’s banking results have been poor and are also dressed up. What’s lurking under the costume?
The oddest thing about this quarter’s bank results is how they turn bad into good by the method in which the banks account for bad news. The banks have for a number of quarters been applying the following make-up to their balance sheets. When their credit quality deteriorates, the value of their debt falls. This looks bad. It reflects their inability to finance and directly affects the future costs of the business when they come to refinance their debt. However, the banks are allowed to take this loss that has been suffered by their bond holders and book it as a profit. You therefore get the oddity that as the outlook for the bank deteriorates, its credit spreads widen, and it is able to book the spread widening on its own debt as a profit.
The banks and their auditors think this accounting use is sound. We, however, wonder how correct it is. Presumably, using their logic, the accountants and management of Lehman Brothers would argue that the quarter it went bust was its most profitable ever because its debt traded at and near to zero. In fact, that last quarter of trading could well have earned more for the company than its previous 100 plus years of existence. Trick or treat.”
What is going on!? Why are CVA’s still allowed? Will we never learn? What are shareholders going to do when more Rights Issues are required?
As I suggested at the start, I don’t think the Developed World Economies or their stock markets recover until we have resolved the many problems deep within our banking sector.
Ben Dover said:
On the point about bank CEOs knowing or not knowing what goes on in their firms, I couldn’t agree more. Even though anyone working in financial services, especially banks, will confirm that it’s simply impossible for an executive level manager to have a firm grasp on all the product lines of a given bank, this doesn’t vindicate anyone from the responsibility. I believe it was Michael Lewis in The Big Short who most eloquently eluded to the scary state of affairs in terms attitude and morale. Even as late into crisis times as early 2008, there have been accounts of Wall Street executives semi-publicly boasting about their inability to fully understand the CDO market. An indicative example comes to mind from a Morgan Stanley investor call back in December 2007, when MS took its first subprime-related hit due to a $ 9.2 bn trading loss coming from Howie Hubler’s notorious “in-house” CDO fund. When questioned at the end of the call by an analyst on the catastrophic result, John Mack was unable to properly answer questions on the logic of MS’s CDO trades, let alone of the adequacy of their risk controlling measures, chief amongst which historic VaR. When you’re responsible to shareholders for the trades of an institution whose profit and loss depends to 40% on the very trades you can’t properly explain, then we’ve got a problem. My question is, did anything material change since? Has anything been done toward reducing the complexity of these institutions to a point where CEOs, presumably the ultimate guards of shareholder capital, have the faintest chance understanding what they’re responsible for? I highly doubt it.
Avid Reader said:
Good note. Do you have any comments on anything good the banks currently do? It is within (almost) everyones interest that they survive and indeed prosper, and you will agree, given the recent press it is easy to bash them.
I think that banks are a crucial part of any functioning modern economy. They are vital intermediaries and facilitators, but that is all they are.
I guess I’m probably a fan of Glass-Steagall over the current Universal Banking model. It makes intuitive sense to me that if you are going to have a speculative element in your bank – be it a prop desk or internal hedge fund or whatever, that this division should not have the benefit of an implicit government guarantee. Ergo, IB and Trading divisions should be in separate entities which are partnerships or hedge funds where the principals will bear all the losses without jeopardizing depositors “under the mattress” money. This sharing in the losses would vastly increase the “Give a Shit Factor” amongst management – they would become risk paranoid rather than ambivalent. No more “Heads I Win, Tails You Lose”!
Other comments I would add would be that I dont think banks are doing very much for the economy currently – many claim to be “open for business” but the reality is that credit standards have rightly tightened (spreads over normalised interest rates would be punitive/drachonian) and most banks are shrinking their loan book at the margin and practicing forbearance on the existing NPLs.
Finally, I think that the 60 year bull market in “Financialization” is probably completed and will start to wane. As a percentage share of the economy, financial services is 400% larger now than it was just after WWII. Financial Services are simply massive and for decades now have sucked intellectual and financial capital from the real economy. Would we rather the next Steve Jobs created the next Structured Product or financial derivative or that he started the next Apple/General Electric/Exxon Mobil?
In a nutshell – bankers should take deposits and make prudent loans against that book. Investors/Traders should take proprietary risk with specific risk capital that is burdened with the fear of unlimited liability.
Ben Dover said:
Banks (and especially investment banks) should all get back into the partnership structure they once had and problems relating both to size and risk would be solved at the same time. Something materially changed when Gutfreund took Salomon Brothers public (the first investment bank to do so and against the dissent of older Salomon partners) in the early 80′s and then all other IBs followed. There is a reason why law firms and doctors’ practices stay in the partnership structure. It is because its a required control mechanism that drasticially reduces, if not eliminates, the principal-agent problem. Should there allowed to be a difference in the degree of prudence as to how your capital versus your health or legal affairs are managed?
Ben Dover said:
From Mr Chris Lucas.
Sir, The 2007-08 financial crisis prompted calls from the Group of 20 and many others for an overhaul of financial instrument accounting. The urgent need for improvement has been highlighted by the banking industry’s recent results, with many banks reporting large unrealised gains through marking down the value of their own debt as their credit spreads have widened.
This reporting of so-called “own credit” gains and losses is an accounting requirement which is widely viewed by the market as one that misrepresents actual business profitability, makes results difficult to explain to investors and is unhelpful for an industry that wants to rebuild confidence through transparency in financial reporting.
The International Accounting Standards Board has already carried out much valuable work devising a new set of rules and Barclays, along with its peers, has been working productively with the IASB to achieve this. However, there is increasing uncertainty about when the new rules will become available for use – with current proposals suggesting a time frame of 2015 or later before they come into play.
The IASB recognises that this accounting treatment needs to be improved, and the new rules it has been working on would address this issue. Nevertheless, four years after the financial crisis began, European companies still have to report large unrealised gains and losses through income as a result of revaluing own debt. Thus financial reporting is more opaque and complex than it need be.
We urge the European Commission, the IASB, regulators and other interested parties to consider taking the straightforward step of amending current requirements in IAS 39. Addressing this issue will improve investor confidence and increase transparency in financial reporting by banks. We look forward to being able to adopt the new rules as soon as possible.
Chris Lucas, Group Finance Director, Barclays
Wowza! Another One!!