Author: cantercapcharlie

“Basel: Faulty” Questions

And Some Random Thoughts

Regarding “Basel: Faulty,” what further empirical evidence would cause you to question your conclusions?  What might make you more confident?

Answers and thoughts:  Most importantly, the balance sheet averages I employ for European banks are data I assembled myself from publicly available data. The original source was mostly Bloomberg.  I am confident that they mirror reality reasonably well, but it’s possible that they do not precisely reflect the actual aggregates.  The BIS has a database containing data that could corroborate my arguments.  Unfortunately, I found this database impenetrable.  Partly, this was an issue of terminology.  I would be most grateful to anyone who could help me access the BIS data or supply the relevant data.

As I point out in the post, much of the asset growth for European banks from 2000 to 2007 was attributable to derivatives. Unfortunately, derivatives accounting was, then at least, a fraught discipline.  For instance, when we see UBS’ derivatives book grow from E26 billion in 2000 to E450 billion in 2007, it is not necessarily the case that there has been a commensurate increase in risk to the UBS balance sheet.  But it is also possible that the underlying risk was greater, perhaps much greater, than the balance sheet reflects.  Valuations were hazy and largely a function of management discretion.  Given the euphoria that characterized the mid 2000’s and the license that Basel II provided in valuing derivatives, I think it is unlikely that the actual risk was less than that presented on the balance sheet.

One characteristic of most derivatives is that if one is short (as most banks tend to be) and unhedged, one’s exposure will snowball as the market moves against you.  This effect will be compounded if doubts arise about counter party solvency and even more so if potential buyers decide they don’t really understand the instruments.  Speculators may also “pile on” the trade if they believe an institution is in trouble.  So whatever the exposures might have been on paper at a given balance sheet date, those exposures were certainly far larger in the depths of the crisis.

Remember that by the time the crisis hit, quants and traders were — effectively — running the banks: the inmates were running the asylum.  Everyone deferred to them because anyone with the temerity to argue with their math got laughed out of the room.  There are innumerable examples of risk managers being fired for questioning the growing exposures.  Management, too, was intimidated and, in any case, the quants were making so much money for everyone that management could not afford to reign them in.   No one could afford to kill the golden goose.  That doesn’t absolve senior management — quite the contrary — but it does help explain how it all came about.

There is a fascinating post-mortem authored by the Swiss bank regulator concerning the losses at UBS.  It goes into some depth describing the groupthink that contributed to management’s capitulation to the traders.

Ironically, but not at all surprisingly, the elaborate mathematical models spewed out by the quants during the good times turned out to be as bogus as the BIS “risk ratings” that caused the whole mess.   I remember attending a bank analyst conference in, like, November, 2007 when one of the presenters tried to explain CDO’s and CDO squared. Everyone’s jaws just dropped.  No one in the audience had ever heard about them and no one could imagine anything so stupid.  Also, I remember being astounded to discover that the principal risk model employed by many banks was “Value at Risk.’  I had thought that VAR had been consigned to the dustbin of history after the collapse of Long Term Capital in 1998.

Partly, the ascendancy of quants and their models was due to the length of the “great moderation” that preceded the crash.  Everyone was lulled into a sense of false security by the stability of the markets, most notoriously Alan Greenspan (I believe that it was the continued leveraging dictated by Basel I that produced this stability.)  Of course, if everyone had read their Minsky, they would have known that an extended period of stability is just a rubber band waiting to snap. (See Bob Barbera’s excellent book “The Cost of Capitalism.”)

Things might not have gotten so out of hand absent the then prevailing devotion to free market Gospel.  In his superb book “How Markets Fail,” John Cassidy details how “efficient market theory” (CAPM) came to dominate finance.  CAPM reinforced the myth that no asset –derivatives included — could possibly be more risky than it was priced to be.  Anyone who disputed this orthodoxy was dismissed as a crank ( e.g. Hyman Minsky and Benoit Mandelbrot. )

Remember too, that this didn’t all happen suddenly.  It’s not as if one day all these managements decided to bet their banks on sub prime real estate derivatives.  It was an incremental process.  Quarter by quarter, management was under pressure to produce the revenue and profits to beat prior quarters.  They took on more leverage and increasingly esoteric derivatives to achieve this because they were just repeating what they had successfully done in the past.  The incremental risk was pretty much invisible to them, and, anyway, it had all been blessed by the regulators.

To convince me that my “Basel” hypothesis is false, someone needs to identify an alternative source of the cash that flooded into the mortgage market and other credit markets from 2000 to 2007. One possibility is foreign countries. Ben Bernanke once remarked that losses from the sub-prime “bubble” by themselves could not explain the severity of the 2008 crisis.  He invoked the “savings glut’ as an explanation.  Ben may have almost single-handedly saved western civilization, but I think that the “savings glut” thesis is unlikely.

“Savings glut” is simply another expression for the immense US balance of payments deficit that built up from in the early 2000’s.  By 2007, our cumulative trade-related debt totaled nearly $8 trillion.  This helps explain why most of the speculation took place in dollar based assets.  However, a payments imbalance such as this is essentially a zero sum proposition that creates no NET worldwide demand for credit.  Lenders of dollars are borrowing other currencies, usually their own.  I have seen no evidence that the largest debt holders – China, Japan, Canada – and their banks were significant buyers of subprime instruments.  Germany was to a small extent.

However, it just seems logical to me that the immense US trade deficit and commensurate payments imbalance must have played some role in the crisis. I believe that the connection is that surplus countries were a source of demand for the short term low rate dollar instruments (repo and ABCP) that provided the funding for European bank and shadow bank activity.

The advent of the Euro in 2000 also contributed to the credit bubble, especially within the Eurozone.  Prior to 2000, a German bank that wanted to lend to a Greek importer not only had to consider the credit of the borrower, but had to consider how easily that borrower could obtain Deutsche Marks in the future in exchange for his Drachma, a much less liquid currency.  The Euro eliminated this constraint, opening the floodgates to credit to the periphery.

It is not clear how significant an influence Basel II had on bank risk profiles and banker behavior, but it certainly heightened risk-taking.  Basel II was not officially promulgated until 2004 and was not adopted by many European banks until 2008.  It was never officially adopted by US banks.  However, the broad outlines of Basel II had been apparent since at least 1999.  So banks had been adjusting their business models in anticipation of Basel II for at least 5 years.  Driven by “efficient market” dogma, the centerpiece of this regulation was the A-IRB (Advanced Internal Ratings Based) approach, which relied on the banks themselves to provide risk models for their own portfolios.  As a quid pro quo for bringing banks on board, it was widely recognized that bank capital ratios would be allowed to drop (see Dan Tarullo’s 2008 book Banking on Basel.)

Trump’s Immigration Fatwa

I recently read an article by a conservative writer who I normally respect.  But this piece brought me up short. In it, he defends the recent immigration edicts of Donald Trump, our so-called president.  In doing so, he argues that: 1. We are, after all, at war with Muslims and 2. Illegal Mexican immigration “puts American culture at risk.” Plus, he asserts that there is no prejudice against Chinese and Indian immigrants.  I thought I’d share the letter I wrote in response.

To whom it may concern,

This was not, to my mind, an example of your best work.  On the positive side, I think that most immigrants from India and China will be pleasantly surprised, indeed shocked, to discover that they have never encountered prejudice here in the USA.

On the negative side, I didn’t realize we had declared war on Muslims.  If we are indeed at war, please don’t notify the millions of Muslims in the US and the hundreds of millions in Bangladesh, Malaysia and Indonesia.  They don’t seem to have gotten the memo either.   If they’d known they were at war, they probably would have harmed us by now.  I can only pray that Trump’s hateful actions don’t get them good and riled up, stoking a real war with actual adversaries.  That would be very bad for everybody.

Trump minions hate Muslims, but not because we are at war them, which we’re not. They hate Muslims for all the time honored reasons: because Muslims are in the wrong tribe, because they wear funny clothes and because a demagogue has whipped his stooges into a racist frenzy. The problem is, of course, that this frenzy is misdirected.  Yes, Islamic terrorism is a danger, but so is getting hit by lightning.  In the heartland, there are much worse dangers.  Thousands of young people die every year in the heartland from opiate overdoses, yet the minions insist that Muslim immigrants are a mortal threat? If they want to know the real problem (which they don’t), maybe they should take a look in the mirror.

I think it’s interesting that Saudi Arabia was not among the countries included in the immigrant interdict.  Of all Muslim countries, Saudi Arabia is the most oppressive and is probably the greatest threat to us.  They finance ISIS.  Many of the 9-11 perpetrators were Saudis. Osama bin Laden was from a very high ranking Saudi family and had much support among the elite. And yet the Saudis got off scot free.  You don’t suppose that Trump has business interests with Saudis?

The absence of Saudi Arabia from the ban underscores the craven political nature of Trump’s actions.  I don’t know if Trump himself hates Muslims or not.  What I do know is that there are no moral constraints on the depths to which Trump might descend to bolster his power and flatter his own vanity.  The ban was nothing but a sop to his teeming minions.

On the subject of Mexicans, I don’t know what numbers you are looking at.  It is my understanding that there has been no net Mexican illegal immigration in 8 years.  That means that most illegal immigrants have been here for at least a decade. If they did commit a crime in coming here, it was committed out of true need and aspiration for a better life. On the spectrum of heinous crimes, illegal immigration ranks right up there with Jean Valjean filching a baguette.   As far as I’m concerned, the statute of limitations has run out, and these immigrants are now Americans, and our neighbors.

Illegal or not, our recent immigrants are, for the most part, true heirs to the ethos exemplified by my Swedish, Irish, and Mayflower forebears. That ethos centers on hard work, thrift, and family.  Isn’t that the nature of immigrants? If they weren’t enterprising they wouldn’t come here at all.  In fact, they are a lot more representative of what I consider to be true “American Culture” than Trump’s whining minions, pining for defunct coal mines, addicted to disability payments and incapable of getting off their butts and acquiring new skills.  True Americans don’t blame scapegoats for their problems.  Whatever their country of origin, true Americans take responsibility for their own lives and forge ahead.

I have a modest proposal.  Let’s deport the Trump minions and replace them with a whole lot more Mexicans, Muslims, and Asians like the ones I have known.  People who work.   People who strive.  That would be a country that our founding fathers might recognize.

Capital Crimes

Dodd Frank, Basel and the Equity Fetish

In typically ad hoc fashion, Dodd Frank alludes only vaguely to the establishment of new capital standards for banks.  Predictably, however, the regulatory agencies have taken that allusion and run with it, implementing unnecessarily conservative standards for smaller banks and truly debilitating ones for large ones.

As if that weren’t enough, the Basil Committee in 2012 put the finishing touches on Basel III.  And if you enjoyed Basel 1 and thrilled to Basel II, just wait ’til you get a load of Basel III!  We have now entered a world in which Europe and the US scrapping like schoolboys to see who can raise capital standards higher, and no bank can ever have enough.  (Of course, the European banks aren’t really compelled to comply.)  Recently US regulators have pulled ahead of their European brethren in the capital scrap.  The Europeans are backing off as they realize just how far behind their banks are lagging and just how unworkable the current structure is.

I won’t even attempt to explain the Basel III rules or the US domestic rules in detail; it is truly mind-numbing stuff.  Still, it is important to get at least a sense of what banks (and investors) are dealing with.  I encourage readers to google “Davis Polk Revised Basel III Leverage Ratio”. Read it and then answer the following question: what kind of bureaucratic groupthink could possibly make this stuff up and actually think it could work in the real world?

The key point is that US regulators are intent on raising bank capital to levels unprecedented in recent years.  For the bigger banks, their goal is clearly to raise capital to levels that will impair their ability to function as going concerns and force them to break up.

It is not clear to me what is motivating regulators to adopt such a draconian approach.  Possibly, their motives are honorable; they believe that they are simply faithfully executing the amorphous directives of Dodd Frank.  Or perhaps they genuinely believe that the Financial Crisis arose because banks had too little capital.  If that’s the case, then the correct answer to the question, “How much capital is enough?” is always “more.”

On the other hand, it’s possible that their motives are less high minded.  That is, they may be more focused on building their own power bases and – above all – avoiding humiliation in front of a house banking committee panel.  This would explain why they are so single- mindedly intent on ensuring that no major bank fails on their watch.  To accomplish this goal, they are  making sure that banks abjure all risky pursuits. Pursuits such as lending money, for instance.  If the economy suffers as a result, that’s not their job, man.

There are two big problems with regularly and capriciously hiking the capital bar on the big banks. First, planning for banks becomes impossible.  More importantly, lending is discouraged. In case no one noticed, I’d like to point out that there are two ways to increase capital ratios.  One can increase equity, or one can reduce assets.  US SIFIs (ie the largest banks: “systemically important financial institutions”) are doing both. From 2010 to 2015, total assets of the 5 biggest US banks actually shrank. Applauded by regulators, a trend like that is hardly consistent with robust economic growth.

The regulatory thrust toward more onerous capital standards is abetted by a phalanx of academics keen on savaging an industry whose leaders make a whole lot more money than they do (Unfairly of course: bankers aren’t nearly as smart.)  In the vanguard is the duo Admati and Hedwig whose diatribe “The Banker’s New Clothes” advocates bank capital ratios as high as 30%.  Why such a high bar?  Well, don’t you see, because that’s how much capital banks carried prior to the turn of the century (no, not that century, they mean 1900.)   That’s ironic, since it was the 1907 panic, from which JP Morgan personally rescued the financial system, that was the genesis of the Federal Reserve in the first place.

Central to the more-capital-is-always-better thesis is that excess capital imposes no costs on bank investors or on society.   That is, the market doesn’t care if a bank with 5% capital and a 18% ROE becomes a bank with 30% capital and a 5% Return on Equity.  In other words, they assert that bank stock investors are indifferent between return and capital.  Not only does this suggest a charming allegiance to the thoroughly discredited Capital Asset Pricing Model, it also makes one suspect that they may never have owned a bank stock.

In fact, it’s just common sense that compelling banks to carry excessive capital must impose a cost on both shareholders and on society.  It is simply a question of opportunity costs. Such severe standards misallocate capital both for the firm and for the economy.  The banking industry today has $15 trillion in assets.  If banks are now being forced to hold 10% capital, when 6% is adequate, then $600 billion of society’s precious capital is being squandered.  Many enterprises could make more productive use of that $600 billion than just letting it molder in bank vaults.  I certainly could use some.  The annual cost of wasting $600 bill is uncertain, but at a cost of capital between 7% and 11% it’s somewhere between $42 and $66 billion annually.

Let’s get some historical perspective to help us estimate the economic cost of incenting banks not to lend.  Just prior to the previous financial crisis, in 1990, bank loans peaked at $2.9 trillion. In the depths of the recession, they bottomed out at $2.7 trillion.  As the economy recovered, loan portfolios grew commensurately.  By 1998, six years later, bank loans had increased to $3.9 trillion, a 6.5% compound growth rate from the bottom.

Now compare 2008 with 1992.  Commercial loans peaked in 2007 at $7.9 trillion, dropping during the crisis to $7.3 trillion in 2009.  Given the magnitude of the recession, one would have expected loans to rebound faster than in 1992.  Yet by the close of 2015, loans have grown from the bottom at a compound rate of just 3.3%. (Remember too that these numbers are overstated due to the forced mergers of troubled shadow banks.)  This points to a lending shortfall of about $300 billion annually, or $1.8 trillion in aggregate, give or take.

Of course, the important question is: “If loan growth has been unnecessarily constrained to 3% when it would otherwise have been 7% or more, what has been the impact on GDP?”  Now one would think that a quick call to any economist would get you a precise answer to this question.

Unfortunately, I have been unable to scrounge even a rough estimate.  So I’ll use my own heuristic. It looks to me that historically a $1 increase in real GDP has been associated with about $2 in real loan growth.  If that is so, a $1.7 trillion loan shortfall points to a GDP shortfall of close to $1 trillion over six years.  Maybe that’s too high, but even half of that means that GDP has been cut by nearly $100 billion annually. Not quite 1% of GDP per year, but close enough for government work.

Constraining big bank lending wouldn’t be such a bad thing if smaller banks were in a position to pick up the slack.  But that’s clearly not the case.   For one thing, small banks can’t accommodate the needs of many large bank customers.  Moreover, while regulators are not imposing the same onerous capital standards on small banks (yet), direct regulatory costs fall much more heavily on smaller banks. Thus, if regulators command JP Morgan to hire a risk manager at $400,000 that’s a drop in the bucket.  For a small bank that’s big bucks.  The regulator’s war on big banks wouldn’t weigh so heavily on the economy if they weren’t also intent on putting small banks out of business.

Now let’s look at the cost of excessive capital from the standpoint of the firm to illustrate just how debilitating 30% capital levels would be for the industry and the economy as a whole.  (I have not yet figured out how to insert a table into the post, so for now you’ll just have to trust my numbers.) Assume that Hypothetical Bankshares has more or less average statistics (at least by 2006 standards); 1% ROA, 7.5% leverage ratio, 13% ROE. Its anticipated growth rate is 9%. In today’s environment, such a bank would carry a P/E of about 15x and a price to book of 1.75x.  That points to a stock price of $15.

Now let’s say that HYPE1 is compelled by regulators to quadruple its equity base to 30%.  What will the company’s fundamental profile look like and what valuation might the market now assign it?

First, HYPE2’s ROA would probably improve a bit to about 1.25% due to the influx of free cash from its new equity.  The ROE, however, will drop to 4.5%.  Assuming that the bank continues to pay a 30% dividend (albeit sliced 70%), its growth rate will be cut to 3%.

So ask yourself what price you would pay for a company earning 30 cents per share, and growing at 3%.  If its P/E is the same as HYPE1, it will be worth $4.50, but that would be insanely expensive, even if we assume that its required return on capital drops from 9% to 6%.  A valuation of 10 times earnings would give it a price of $3.00.

Now is where things get interesting. Even at $4.50, the HYPE2 will sell at 45% of book value.  At $3, it’s 30% of book.  Admati and Hedwig take pains to assert that book value for a bank is meaningless.  But we know different.  Assuming that the assets are valued accurately, HYPE’s market value would be a pronounced discount to the liquidation value of its assets.

In the old days, the response to such pronounced undervaluation would have been obvious; buy back stock aggressively and take steps to increase profitability.  Today, however, those avenues are blocked. Today there is only one rational response; liquidate the company and realize the difference between the $3 market value and the $10 book value.  Why accept a 3% return from even a de-risked bank stock when I can get the same return in high grade corporate bonds?

In practice, this liquidation would most likely occur through consolidation.  Inexorably, under this regime, the banking industry will consolidate until it has the concentration to force interest rates higher and achieve a competitive return on equity.  That process will impose an immense cost on society, especially small businesses who don’t have access to the capital markets.

So, finally, how much capital does a bank need?

Unfortunately, most of the books I have read about the 2008 crisis (and I have read just about all of them), totally wimp out on the topic of capital adequacy.  Non-committal pabulum like this is typical, “Managing bank capital is more an art than a science.  In light of the crisis, it is advisable to err on the conservative side and increase capital because the optimal amount of capital cannot be known.”

Well, excuse me, but that’s just wrong. The 2008 crisis was nothing if not an unprecedented real world experiment that told us, with some precision, just how much capital banks require under rather extreme conditions. Thanks to bonehead Basel, we know that 2.0% tangible equity ratios are not adequate.  (Duh.)  Higher capital, say in the 4-5% range, is plenty for some well-managed, low risk companies but probably too low for a systemic standard.  But, given the regulatory regime of 2007, bank tangible capital in the 6% range gave US banks in aggregate far more than sufficient cushion to allow them to withstand the worst financial crisis in 80 years and emerge nearly as sound as when the crisis started.

So who cares if banks have too much capital?  As you can now see, the answer is, we should all care.  Compelling banks to hold excessive capital has imposed an immense burden on both individual banks and on our economy.

Regulators and their academic apologists would take issue with this statement.  As far as they are concerned, Dodd Frank has been a resounding success because the banking system is “safer” than it ever has been in the past.  Meaning that banks have lots more capital.  But that is far too simplistic.

Think of it this way.  Say there’s an airport with a runway two miles long, more than sufficient for any plane.  One day, little Jimmy loses control of his big drone and crashes it on the runway.   As planes land, they struggle to avoid the wreck.  Some swerve off the runway, some run off the end of the runway, but all land safely.  Concerned, the FAA decides that the airport can be made safer if it spends $500 million dollars to add another 2 miles to the runway. Later, seeking to eliminate even the remotest chance for a crash, the FAA says, “We’ve run a stress test and we’ve concluded that if four drones crash simultaneously, you would need six more runway miles.”  Done, at a cost of $1.5 billion. So yes, maybe the airport is marginally safer, but $2 billion has been wasted and the real problem was never addressed:  Jimmy’s got his pilot’s license.

Do you remember Steve Martin’s routine “Theodoric of York, Medieval Barber?”  Having just killed his patient, Larainne Newman, with a series of gruesome bloodlettings, he observes philosophically, “You know, medicine is not an exact science, but we are learning all the time.  Why, just fifty years ago, we thought a disease like your daughter’s was caused by demonic possession or witchcraft.  But now we know that Isabella is suffering from an imbalance of humors, perhaps caused by a toad or a small dwarf living in her stomach.”

This is today’s bank regulatory regime.  Not only is it fighting the last war, it is bleeding us dry in the process.

 

 

 

 

Break up the Bankees

When I was a kid I went to a Yankees game and I was hooked. I became a diehard fan. But my timing could not have been worse.  This was 1963, and the team was on the brink of stumbling into a long slide.  So instead of Moose Skowron, Mickey Mantle and Whitey Ford I found myself rooting for Mike Kekich, Andy Kosco and Dooley Womack.

Still, in their one or two successful years during which I was a fan, I became aware of a movement which I’m pretty sure emanated from Boston to “Break up the Yankees.”  They were just too powerful it was said.  They hired all the best players (and sometimes just sat them on the bench.) They always won. They needed to be brought down a peg.  It just wasn’t fair. It just wasn’t American.

 Similarly, these days populists of all stripes clamor to ”break up the banks.”  This is also known as the “too big to fail problem.”  It is claimed that the large banks are too big, too powerful, and pose a significant risk to the economy.  Regulatory actions indicate that the Obama administration buys into this idea, even if it never says so explicitly.

Full disclosure; as an investor, I have always been a small bank guy.  I figure that any company that can consistently earn decent returns in one time zone, in one currency, dealing with local businesses is an inherently better business than one that earns similar returns traipsing all over the world.  Plus, small banks have the added benefit of occasionally getting acquired at big premiums.

Having said that, I don’t share the regulatory fixation on size as such.  If the financial crisis proved anything, it is that the main risk to the financial system is heavily leveraged, short term funded entities that are either beyond the reach of regulators or unequivocally bigger than their economies can support. Our largest banks do not fit either of these criteria.

Just prior to the crisis, Iceland’s Kaupthing Bank’s assets measured five times Iceland’s GDP.   (In relative terms, 50 times the size of JP Morgan today.)  Now that’s what I call too big.  Nations that allow their financial systems to become that unbalanced clearly face danger.  But we are nowhere near that point.  Wake me up when Morgan’s assets hit $100 trillion, give or take.

I’ll admit to being puzzled by the too big to fail debate.  Of course, as a taxpayer, I don’t want my tax dollars going to pay off shareholders of some mismanaged bank.  But that’s a straw man; it’s never happened that I’m aware of.  There are good reasons why big banks exist and have become bigger over time.   Companies like Wells Fargo, JP Morgan, US Bank, and State Street have grown to be as big as they are mainly because they have been better at what they do than their competitors.  I reject the notion that these companies represent a threat to the economy or – more to the point – that the government has some superior insight into how they should be structured.  It is bewildering to me that our government seems intent on destroying some of our truly great companies when so much of our economy struggles.

Plus, there are clear advantages to having big banks.  For instance, it’s nice to be able to make a deposit in Sheboygan and get cash in Hohokus without having to open another bank account and waiting a week for the check to clear.  Also, geographic and product-line diversification reduces risk for the bank itself.

Most importantly, big banks render regional economies far less susceptible to economic downturns than they once were.  The Texas bank collapse inflicted untold, and largely unnecessary, hardship for the state as loans were called in, properties foreclosed, and credit flows stanched.  Today in Texas, low energy prices are likely to cause losses for banks, but unrelated businesses need not worry about obtaining credit.

If you’ve read my earlier posts, you know that I am the last person to advocate slavish imitation of European fashions or fashions of any stripe.  Still, it’s possible that a look at the banking systems of other countries might provide insight into the too-big-to-fail problem.  Interestingly, one finds that NO other developed country seems the least bit concerned with the issue.  I am not aware of any populist groundswell in Germany or France or Canada, for that matter, to break up their banks.  The talk in Europe is still about nurturing “national champions.”

Why the comfort among foreign nations with their big banks?  Perhaps it is because banking is already so centralized in foreign countries that any attempt to change is viewed as futile.  But more likely, this comfort reflects a more sophisticated grasp abroad of the realities of modern finance.  That is, the economy has grown more complex and global, bank customers have grown larger and more complex and the bank products they demand are correspondingly more complex and require larger bank balance sheets.  It stands to reason, then, that banks, too, need to be larger and more complex.

I find it strange that populists slaver over the prospect of big bank break ups when banking concentration is a hallmark of all so-called “Democratic Socialist” economies. Sweden, Denmark, and Norway all really only have two to three banks each.  Concentration makes all of these institutions more readily controlled by the government, which is the point.  If that is the objective, then breaking up the banks is the last thing a red blooded (or even a pink-blooded) democratic socialist should want.

Compared to Europe, the US banking system is far more fragmented.  It may come as a surprise, for instance, that our largest bank, JP Morgan, is just about the world’s smallest big bank.  All European countries, most Asian and South American countries, Australia, and Canada have banking systems dominated by between 2 and 6 super banks.  Nearly all of these banks are many times bigger in relation to GDP than any US banks.  The biggest US bank, Morgan, has total assets of 1.6 trillion, representing 11% of US GDP.  Compare this to Credit Suisse (120% of Switzerland’s GDP), Deutsche (46%) or Toronto Dominion (32%).  Yet even though these foreign banks are at least three times the size of the biggest US bank, I do not detect any urgency to break them up.

I may be alone in this, but I consider it a supreme irony (tragedy?) that regulators recently allowed Royal Bank of Canada to poach City National, one of the finest American regional banks and Hollywood’s “Bank to the Stars,” largely because our banks needed to focus on raising capital and not getting bigger. The too big to fail boogie man doesn’t seem to terrify Canadian authorities even though Royal bank is, in terms of GDP, three times as big as Morgan.

These mergers underscore the advantage that foreign banks now have over US rivals both domestically and abroad.  To be sure, Canadian banks must adhere to Basel III, but they are not burdened by regulatory animosity or the load of additional capital buffers that US banks must shoulder (standards which remain moving targets.) This gives foreign banks like the Canadians a huge advantage in making US acquisitions.  If nothing changes they, and eventually other foreign banks, will continue to expand their footprint in the US at the expense of domestic US competitors.

Don’t get me wrong.  I have no problem in principle with Canadian Banks running the US financial system.  In my experience Canadians tend to be be competent, sensible folks.  But it’s difficult to comprehend how such a tilted playing field might benefit  US citizens.

Why too big to fail should be such a peculiarly American obsession is hard to grasp.  Maybe there is simply a bias in the US against “Wall Street” and “big city” ways (Donald Trump’s popularity notwithstanding).  Sadly, there is more than a hint of anti-semitism in all of this, redolent of Father Coughlin’s “Jewish Wall Street conspiracy.”

Riddle me this: Why does everyone want to break up the big banks, but not the big auto companies?  After all, bank “bailouts” such as they were, cost taxpayers nothing.  In contrast, GM cost taxpayers $38 billion. We’ll never get all of that back.  General Motors failed after a generation of execrable management, coddled unions, and let’s not forget, its own huge role in the financial crisis (does Ally financial ring a bell?.)

Plus, GM engaged in behavior far more reprehensible than that of any bank; selling cars it knew to be deathtraps.  This, at a time when the current administration was in control of the company (Let he who is without sin…, well, you know.)  Yet the fines paid by GM ($320 mil.)  were a pittance next to those paid by banks like  JP Morgan ($13 bil. and counting, mostly for loans it didn’t even make.)  So far, I’ve heard no calls for GM’s breakup.  And that’s a shame, since we already have such great old American names for its constituent parts; DeSoto, Studebaker, and of course, your father’s Buick.

A Tale of Two SIFIs

The Best of Managements,

The Worst of Managements

My apologies; neither of the banks I am about to discuss was ever large enough to be considered a SIFI (Systemically Important Financial Institution.)   I simply could not resist that title.

Often you’ll hear some especially specious reasoning from uber regulation advocates that goes something like this; “Banks need much more capital because if they have only 5% capital and asset prices drop 6%, they’ll be out of business.”  Statements like that are evidence of a profound ignorance of how the industry works.  First of all, loans typically represent only 2/3 of a bank’s balance sheet.  Plus, banks seldom extend in credit more than 90% of the value of any collateral. and usually much less.  At 90%, collateral values need to drop 11% before a loan is impaired.  Plus, banks typically have secondary sources of payment, such as personal guarantees.  Plus, banks have a loan loss reserve to dampen the impact of any losses they do incur.  Plus, any bank losses are deductible, so only 2/3 of any loss hits the P&L.  Plus, banks have earnings, and bank earnings are always under appreciated as a loss absorbing mechanism.

But above and beyond everything else, banks have management.  A really skilled bank management team can negotiate its way past almost any barrier the economy throws in its path. At its core, banking is about good management. And good management means operating efficiency and disciplined credit underwriting.  It is really all that matters.

TriCo Bancshares is a small regional bank with headquarters in Chico, CA.  Its footprint just happens to include California’s Central Valley, one of the the epicenters of the sub prime housing collapse.  In most of Tricos markets, home prices fell by more than 30% from their peak.  Worse, most of the local economies were dominated by home construction, the cessation of which produced massive unemployment. As foreclosures swept through these communities, banks both large and small incurred big losses.  Some smaller banks failed.

Trico did not seem well positioned to survive this conflagration.  At the close of 2006, it had $1.9 billion in assets and $1.5 billion in loans.  Of these loans, $150 million were construction-related and $500 million were consumer — largely home equity lines of credit.  This, against $169 million in equity.  Over the ensuing five years, Trico wrote off $87 million (7% of 2006 loans), including 10% of the higher risk categories.  (Its $500 million first mortgage portfolio produced minimal charge-offs.) Yet the bank never suffered a loss, much less had its solvency tested.

What was Trico’s secret?  Not excess capital.  Trico had two secrets; disciplined underwriting and strong core profitability.  In other words, good management.  In the five years we are discussing, Trico generated earnings before taxes and provisions of $239 million.   In just about the country’s worst market, Trico could have written off nearly three times what it did and still not have compromised its equity.

With its monomaniacal focus on capital adequacy, the current regulatory regime studiously ignores both the importance of bank earnings as the first line of defense against loan losses and the importance of cultivating top-notch management to produce those earnings.  In fact, it sometimes seems that regulators are intentionally doing what they can to drive down bank profitability and discourage the most talented managements.

In case you think I’m exaggerating, consider the following quote from an economist representing the “Basel” viewpoint at a Nov. 17,2015 Brookings Institution conference.   “The whole point … is to drive ROE’s down into the realm where you have safer institutions.”  Jaw-dropping stuff.

Now let’s shift our gaze from the sacred to the profane.

Corus Bank was a mid sized regional bank based in Chicago.  In the 90’s it had changed its name from River Forest Bancorp.  Famously conservative, River Forest went many years without taking a loan loss provision.  When queried about this, the then CEO observed, “We’re not in the business of making bad loans.”

But in the late 90’s Corus hit some serious turbulence in an attempt to aggressively grow its student loan business.  Problems were not debilitating, but this was a bank that should have been very much on the regulator’s radar screens.

So one would have thought that the regulators might have paid attention when Corus’ management in the early 2000’s decided to pursue a brand new strategy; making huge construction loans — mostly condominium loans — in Los Angeles, Chicago, and Miami.

For bank analysts, there are three traditional indicators that portend future loan problems: 1) extending new credit so the borrower has the cash to stay current on interest payments (often referred to as “extend and pretend.”.  Construction loans do this almost by definition.) 2) lending into unfamiliar markets and 3) very rapid loan growth.

Corus’ condo construction portfolio tripled in 2003.  It nearly doubled in 2004. It more than doubled in 2005, and increased 36% in 2006.  All told, in those five years, these credits increased from $123 million in 2002 to $2.6 billion in 2006.   True to its strategy, half of these loans were domiciled either in Florida or LA.  Ninety-nine percent of the company’s $4 billion loan book was some kind of commercial real estate.  Corus failed in 2010.

One can’t fairly blame Corus’ problems on regulators. Management concocted the strategy, management made the loans, and, for the year or two in which the strategy seemed to be working, management reaped the rewards. Yet still, in light of the bank’s prior record, one has to wonder, “Why didn’t the regulators stop them?’’

There’s a simple answer and the answer is. . . . .  Corus had too much capital.

In 2002 Corus was by far the best capitalized bank of its size in the country. We’ve talked a little bit about capital ratios.  Corus set a new standard.  In 2002, its tangible equity ratio was 17% — more than twice the bank average.  However, if one excludes from assets $725 million in “Fed Funds Sold” (i.e. cash),  the tangible ratio rises to 23%.  To many observers, this magnitude of squandered capital by itself raised questions about management competence.  But the regulators, awed by Corus’ capital base, pretty much allowed the bank to do whatever it chose.  Once they caught on, it was far too late.

To digress a bit, the Corus saga does not end here.  Corus was shut down in 2010 and its deposits assumed by the Bank of Montreal.  Most of its assets were bought at fire sale prices from the FDIC by a group led by Barry Sternlicht, CEO of Starwood.  Within three years, the value of these assets had rebounded to Corus’ carrying value and beyond. In other words, if regulators had waited just three years, Corus would not have been insolvent.  At the time of Corus’ failure, Miami had something like 23 years of condominium supply. But have you been there recently? Not only are all of those condos full, but there is much new construction.  I wouldn’t second guess the FDIC about shutting down Corus but it’s clear in retrospect that blowing out its assets at the bottom cost the agency dearly.

This happens every cycle. Bank losses in the ’80’s Texas collapse resulted predominately from real estate.  Once back then when I was in Dallas, I visited an expansive development outside the city that had been a total write-off for several banks.  It had a lavish office and retail center – empty – and hundreds of unoccupied new homes dotting hundreds of acres.  At the time, it seemed like a post-apocalyptic landscape; there were literally tumbleweeds blowing down the streets.

The name of that development was Las Colinas. If you visit Las Colinas today — or if you had visited even five years after I did — you would find one of the most vibrant micro economies in the country. Every office is full, every home is occupied, and the project has been greatly expanded.

Regulators must stop the practice of dumping the assets of troubled banks in a crisis. Doing this is totally counter productive. Not only does it transfer wealth from the FDIC (ultimately backed by taxpayers) to private investors, but it drives down the prices of these assets when things are worst, exacerbating the very problems the FDIC is trying to resolve.  This is especially the case now, under a mark to market accounting regime.  The FDIC should be given the capacity to manage a problem bank without dumping the assets into a weak market.  Or, at least, it should be allowed to hold on to the assets and hire private enterprises to manage them.  One thing’s for sure; if Barry Sternlicht is the bidder, that’s a bid I don’t want to hit.

To conclude.  I believe that there is no regulatory goal more important than to provide incentives that encourage the best people to enter the industry and employ the best practices once they get there.  Preventing banks from earning money, and regarding bank managements as incompetent at best and incipient criminals at worst is no way to accomplish this objective.

 

Born to Run

Bank Liquidity and the Solvency Illusion

Managing liquidity is an often underestimated imperative for any business (if you don’t believe me, keep your eye on the debt of energy companies as it comes due.)  Liquidity concerns are especially important for highly leveraged financial firms like banks.  But leverage is not a necessary condition for liquidity problems; Money Market Funds are not levered but still can suffer from runs due to their maturity mismatches.

So what is liquidity? For most businesses, liquidity is the ability to meet one’s obligations as they come due.  Currency in your fist, of course, is the best source of liquidity, followed by other assets such as accounts receivable and inventory that will soon become cash or can be readily sold.  Less liquid assets like plant and equipment are tertiary sources of liquidity.  They can be sold to get cash only with great difficulty, or they can serve as collateral for a bank loan.

For a bank, liquidity is more problematical.  Since bank assets almost always have longer maturities than bank liabilities, large banks need to replace maturing debt nearly every day.  In good times, this process is automatic, as depositors and short term lenders “roll” out of maturing obligations into new ones.  But if depositors suddenly sense a problem for any number of reasons real or imagined, they may decide not to roll their deposits.  Then, the bank must do one of three things to come up with cash; find another creditor, sell an asset, or borrow from the central bank.

When there’s even the slightest hint that a bank might be in trouble, bank creditors have every incentive to pull their deposits.  There is no upside to maintaining that deposit, only downside.  To bank creditors, the bank looks like a “black box.”  (This is a prime example of  what economists call “information asymmetry,” a concept made famous in an article on used cars by Nobel Prizewinner George Akerloff.  His spouse is also a pretty good economist.)  Shoot first, ask questions later is always the default strategy.  That’s why liquidity for all banks can evaporate so quickly when any individual bank is perceived to have a problem.  And that’s why it has always been crucial for the Fed to stand ready to backstop any bank with funding problems — to prevent a problem from escalating into a systemic panic.

In a panic, all banks must scramble to find funding. In extreme conditions, as in 2008, a bank can be reduced to selling assets to raise cash to pay its maturing debts.  The problem is that, like the plant and equipment of industrial companies, many of these assets are illiquid.  Asset markets that once appeared liquid can “freeze up” suddenly when doubt arises about asset valuations or counter party strength.  As a bank desperately tries to raise cash by selling assets, buyers step away, and asset prices plummet.  On such occasions, panic selling can drive prices to levels that, at least on paper, can wipe out a bank’s equity.  In the absence of good prices and good information, a bank’s solvency can be called into question.  (I define solvency to mean simply that the firm has more assets than liabilities.)  And so is the solvency of many other banks in the system.

Some folks like to pretend that there is a clear distinction between liquidity problems and solvency problems as if one could be addressed independently of the other. In the long term, there is certainly a big distinction.  But in the very short term (the time frame in which these judgments must be made) it is really a distinction without a difference.  There is neither adequate time nor information to conduct effective triage.

In an impressive recent analysis, Laurence Ball of the Center for Financial Economics argues that Lehman Brothers may not have been insolvent prior to its 2008 bankruptcy filing.  It was, it seems, a much closer call than the authorities or the financial press admitted at the time.  His paper underscores the difficulty of differentiating between a liquidity event and a solvency event.

Here’s a thought experiment that might help to illustrate the liquidity / solvency symbiosis.

Let’s say the year is 2006 and you want to buy a house down the shore.  The house costs $1,000,000.  (Seaside just ain’t what it used to be.)  So you take out one of those interest only mortgages for $1,000,000 and buy it.  You figure you’ll earn enough in summer rentals to cover the mortgage payments.

One day in 2012, Sandy comes storming through.  Your house survives, but is damaged.  You figure you need quarter million to pay for repairs and cover the mortgage until the tourist trade revives.  Your insurer is dragging its feet and you didn’t have flood insurance (everyone with shore properties run out right now and get it.  Make socialism work for you.)  Plus, your house is underwater (figuratively) because home prices are down 30%.  Temporarily, at least, nothing is selling.

Question.  Do you have a liquidity problem or a solvency problem?  Of course, the answer is it depends.   We now know that property values in most beach communities have bounced back nicely.  But that wouldn’t have helped in the short term. Temporarily, you are like Schrodinger’s cat; you are both solvent and insolvent. If FEMA comes through with a loan before you miss too many mortgage payments, then you discover you had a liquidity problem.  If not, your bank will foreclose and then you will discover that you actually had a solvency problem.  Of course, in New Jersey it will take decades for the bank to get title to your house, during which time you’ll be using it mortgage free.  That might be the best outcome of all.

Extra credit question: Is the FEMA loan a bailout?  If you pay it back?  If you don’t? (Be clever!)

There is no question that prior to the crisis, perverse regulatory incentives motivated most European Banks and many “shadow banks” to become inexcusably illiquid.  After the collapse of Northern Rock, Lehman and AIG, concerns naturally arose about the other large institutions.

Some large commercial banks encountered funding issues, and the Fed met their needs.  Recognizing the better part of valor, the surviving large investment banks scuttled into commercial bank charters so they would have unfettered access to Fed borrowing.  The Fed supplied generous funding through a variety of mechanisms and ultimately confidence was restored.  Some observers were miffed by the Fed’s support of financial companies, but that’s how the system was designed and thanks to Bernanke et al, it worked reasonably well.

As Barney Frank once observed, it is impossible to prove a counterfactual. Still, I believe that absent near-collapse in Europe and the failure or near failure of many shadow banks, no US commercial banks (OK, perhaps ex-Citi) would have encountered any liquidity problems at all. Lots of banks – domestic and foreign – borrowed from the Fed as they were encouraged to do, but in the end among the big banks only Citicorp and Wachovia needed to be recapitalized or absorbed by another bank.  (BankAmerica also received government equity, but only after being encouraged to buy Countrywide and strong armed into to absorbing  Merrill Lynch.) It’s doubtful that even these two outliers actually had been insolvent.

Section 165, Title 2 of Dodd Frank directs regulators to establish “liquidity requirements” and “short term debt limits” without defining “liquidity.”  In typical fashion, regulators have taken this directive and doubled down. To micromanage this effort, regulators have fashioned some of their patented sophisticated formulas – the “Liquidity Cover Ratio” (LCR) and the “Net Stable Funding Ratio” (NSFR).  They force large banks into contortions to increase liquidity as the regulators define it and redefine it on a regular basis.

Within limits, trying to improve bank liquidity can be a good thing.  Certainly, this should have been an imperative for regulators of European banks.  But in their ardor to purge liquidity risk from the financial system, US regulators are missing something absolutely fundamental: PROVIDING LIQUIDITY IS WHAT BANKS DO.   When a bank makes a loan, it creates a demand deposit that the borrower can draw on whenever he or she chooses even though the loan itself might not come due for years.  So a bank’s basic function creates liquidity risk by definition, and creates money in the bargain.   (The most cogent description I have found of this basic banking identity can be found, of all places, in the book Sapiens by Yuval Harari, pages 306 – 309.)

 So you can see that if banks are doing their job, the banking system is illiquid, and the rest of the economy —us— have lots of cash.  In Econ 101 this is known as “maturity transformation.” Liquidity-wise, the banking system is simply the mirror image of the economy.  Thus, compelling banks to become more liquid inevitably drains cash from all of us who are not banks. That is, we can’t get loans.  And credit restriction slows the economy.

I have a modest proposal that will be loved by  liquidity freaks and equity fetishists alike.  If we really hate leverage and fear illiquidity so much, we should simply require banks to hold 100% capital – no borrowing at all.  Failures and runs would become a thing of the past.  And so, of course, would loans.  No bank could ever again make a loan, because a new loan automatically creates a deposit (debt) — verboten under our new regime.  If a regulator’s prime objective is to avoid a Congressional Finance Committee grilling, this solution seems optimal.

Walter Bagehot

Walter Bagehot

The distinguished gentleman in the portrait is Walter Bagehot (pronounced “badget”), founder of the London Economist and author of “Lombard  Street,” which focused on the proper role of the central bank in the British banking system.  Published in 1873, his analysis of financial crises and the appropriate regulatory response has never been surpassed and ought to be gospel for modern regulators.  But clearly, they are all apostates.