For me, one of the largest red flags in the market has been the continued poor health of 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 (and if you can prove it wrong please let me know): "There has never been a bull market in history that hasn’t been led 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 3 p.m.), 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 analyze. Royal Bank of Scotland (NYSE: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.
There is such an obsession with complicated ratios and stress tests! The most recent set of European stress tests modeled 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 un-stressful stress tests are pointless.
The other closely watched number is the Tier 1 capital ratio. I barely even understand what this is despite my modicum of financial knowledge; what I do know is that it doesn’t matter! Barclays (BCS), for example, is quite proud of their strong balance sheet and 11% Tier 1 capital ratio. Dexia had a Tier 1 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, which is 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 one of the many "Emergency Summits" in October 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 is the 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.” Uh-oh, 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 in fact 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, 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 (NYSE:MS) and UBS (NYSE: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 four 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, as well as my two 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 some way to deciding bank executives' 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.
Tier One Capital Fun & Games?
This post from FT Alphaville was incredibly illuminating.
Another examples of opaque accounting shenanigans far beyond the understanding of your average investor/regulator and likely one that will be made to look equally foolish in the future.
I really do not think that Tier 1 capital ratio — the same one the banks use to lure depositors as a sign of their "strong balance sheet" — should be allowed to constitute an asset, which only exists because of scandalous mismanagement/losses in your own recent history.
What is going on? Why are CVAs 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 will recover until we have resolved the many problems deep within our banking sector.
The rules of the game need to be simplified and the interests of depositors, shareholders and employees scrutinized and better aligned.