1 July 2008

Voodoo Banking

June 30, 2008

Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall).

CitiGroup recently announced that it was seeking Board members who had “expertise in finance and investments”. What was the experience and expertise of the Citi Board and senior management that has registered over US$45 billion in losses? Shareholders, especially the ones that have provided over US$40 billion in new capital, will be hoping that the new recruits also possess “magic” to restore Citi’s fortunes. The same applies to the banking sector generally.

Banking, especially investment banking, has delivered strong returns to shareholders in recent years. The “high” returns of financial stocks and the future earning prospects need careful examination.

Until the late 1970s/ early 1980s, banking was highly regulated. It was the world of George Bailey (played by Jimmy Stewart) in It’s A Wonderful Life. Community banking was the rule. The banker could dip into his “honeymoon money” to stave of a potential bank run. It also fueled jokes - the “3-6-3” rule; borrow at 3%; lend at 6%; hit the golf course at 3 p.m.

Once de-regulated, banks evolved into complex organisations providing varied financial services. De-regulation brought benefits for the economy (better access to capital and more varied investment opportunities) and the banks (growth and higher profits).

Over the last 15 years, increased competition (within the industry and increasingly from non-banking institutions) and the reduction of earning from the commoditisation of products forced banks to rely on “voodoo banking” - performance enhancement to boost returns. Focus on risk adjusted returns (introduced in the early 1990s by JP Morgan and Bankers Trust) changed the “business model”.

Traditionally banks made loans that tied up their capital for long periods e.g. up to 25/30 years in a mortgage. In the new “originate to distribute” model, banks “underwrote” the loan, “warehoused” it on balance sheet for a short time and then parceled them up with other loans and created securities that could be sold to investors (“securitisation”). The bank tied up capital for a short time (until the loans were sold off) and then the same capital could be reused and the process repeated. Interest earnings over the life of the loan could be discounted back and recognised immediately. Banks increased the “velocity of capital” – effectively sweating the same capital harder to increase returns.

In the traditional model, banks earned the net interest rate margin over the life of the loan – “annuity” income. When loan assets are sold off and the earnings recognised up-front, banks need to make new loans to be sold off to maintain earnings. This created pressure on banks to find “new” borrowers. Initially, creditworthy borrowers without access to credit in the regulated banking environment entered the market. Over time, banks were forced to “innovate” to maintain lending volumes.

Banks created substantial new markets for borrowing:

· Retail clients – expanding traditional lending (housing and car finance) and developing new credit facilities (credit cards and home equity loans).

· Private equity – providing borrowings in leveraged buyouts and sundry other highly leveraged transactions.

· Hedge funds/ private investors – providing (often) high levels of debt against the value of assets.

Banks increasingly also out sourced the origination of the loans to brokers, incentivised by large “upfront” fees.

The expansion in debt provision relied increasingly on quantitative models for assessing risk. It also relied on collateral - the borrower put up a portion of the price of the asset and agreed to cover any fall in value with additional cash cover.

The model allowed banks to expand the quantum of loans and allowed extension of credit to lower rated borrowers. Banks did not plan to hold the loan long term and were only exposed to “underwriting” risk in the period before the loans were sold off. Where the loan was collateralised, the value of the asset and the agreement to “top up” the collateral where the asset value fell was considered to provide ample protection.

Favorable regulatory rules (the capital required was modest), optimistic views of market liquidity and faith in models underpinned this growth in lending.

Banks also increased their trading activities, especially in derivatives and other financial products. Initially, this was targeted at companies and investors seeking to manage financial risk. Over time it increasingly focused on creating risk allowing investors to increase returns and companies to lower borrowing costs or improve currency rates. As profits margins eroded, banks created ever more complex exotic products, usually incorporating derivatives. Derivatives also increasingly became a way to provide additional leverage to customers.

The development of hedge funds was especially important. They borrowed money (against securities offered as collateral) and were extensive users of derivatives. They also traded frequently and aggressively boosting volumes. Prime broking services (bundling settlement, clearing, financial and capital raising) emerged as a major source of earnings for some banks.

As wealth and sophistication grew, investors increasingly sought investments other than bank deposits or even equity, bonds or mutual funds investing in them. Banks created or purchased wealth management businesses (asset managers and private banks) to service this requirement. The clients of the wealth management units were also major purchasers of securities or financial products created by the banks.

Major banks expanded into emerging markets where similar products could be created and sold to a new client base. Global banks had significant advantages in terms of intellectual property and (sometimes) capital resources over local banks. Profit margins in emerging markets were also larger.

Banks also increased their own risk taking. Traditionally, banks took little or no risk other than credit risk. Over time, banks increasingly assumed market risk and investment risk. Originally, banks traded financial products primarily as “agents” standing between two closely matched counterparties. Over time banks became principals in order to provide clients with better, more immediate execution and also increase profit margins.

Increased risk taking was also dictated by business contingencies. Advisory mandates (mergers and acquisition; corporate finance work) were conditional on extension of credit. Banks increasingly “seeded” or invested in hedge funds to gain preferential access to business.

Clients often sought “alignment” of interests requiring banks to take risk positions in transactions. This evolved into the “principal” business as banks increasingly made high risk investment in transactions. In some banks, this evolved into a model where the bank acted purely as “principal” rolling back the clock to the days of J.P. Morgan. Banks convinced themselves of the strategy on the basis that the risks were acceptable (it was their deal after all!), the risk could be always sold off at a price (market were liquid) and (the real reason) high returns.

Enhanced revenues (growing volumes and increasing risk) were augmented by increased leverage and adroit capital management. “Regulatory arbitrage” evolved into a business model. Required risk capital was reduced by creating the “shadow” banking system – a complex network of off balance sheet vehicle and hedge funds. Risk was transferred into the “unregulated” shadow banking system. The strategies exploited bank capital rules. Some or all of the real risk remained indirectly with the originating bank.

Banks reduced “real” equity – common shares – by substituting creative hybrid capital instruments that reduced the cost of capital. The structures generally used high income to attract investors, especially retail investors, while disguising the (less obvious) equity price risk. In some cases, banks used these new forms of capital to repurchase shares to boost returns. For example, CitiGroup repurchased US$12.8 billion of its shares in 2005 and an additional US$7 billion in 2006.

Banks increasingly “hollowed out” capital and liquidity reserves – that is, they reduced these to minimum levels. Concepts of “purchased” capital and “purchased” liquidity gained in popularity. The theory was that banks did not need to hold equity and cash buffers as these items could always be purchased in the market at a price.

Bank profits in recent history were driven by rapid and large growth in lending, trading revenues and increased risk taking. Banking returns were underwritten by an extremely favourable economic environment (a long period of relatively uninterrupted expansion, low inflation, low interest rates and the “dividends” from the end of communism and growth in international trade)

Bankers would argue that the source of higher returns was “innovation”. John Kenneth Galbraith, in A Short History of Financial Euphoria, noted that: “ Financial operations do not lend themselves to innovation. What is recurrently so described and celebrated is, without exception, a small variation on an established design . . . The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version.”

Elite athletes often use performance enhancement drugs to boost performance. Voodoo banking operated similarly enabling banks to enhance short-term performance whilst risking longer-term damage.
Bank Earnings – The “V”, “U” or “L” Recovery

In 2007, equity markets fell out of love with financial institutions, especially those with large investment banking operations. 2008 saw something of reconciliation - the bigger the write-off, the bigger the dividend cut, the bigger the capital raising, perversely the greater the investor buying interest. There are reasons for caution.

The asset quality of major banks remains uncertain. Svein Andresen, secretary general of the Financial Stability Forum, which is made up of global regulators and central bankers, recently told a conference of bankers in Cannes: “We are now 10 months through this crisis and some of the major banks have yet to make disclosure in [crucial] areas.”

Despite significant writedowns, sub-prime assets remain vulnerable. There are substantial differences in valuations (see Exhibit 1). Lack of detailed disclosure about valuations compounds the uncertainty.

Exhibit 1
Values (%) of CDO Super Senior Tranches

Underlying Collateral
High grade
CDO squared



Source: Bank of England (April 2008) Financial Stability Report No.23 at page 9

Other assets - consumer credit, SME loans, corporate lending and high yield loans - all look vulnerable as the real economy slows. Banks have increased provisions but it is not clear whether they will be adequate.

Bank balance sheets have changed significantly. Traditional commercial bank assets consisted primarily of loans and high quality securities. Traditional investment bank assets consisted of government securities and the inventory of trading securities.

In recent years, asset credit quality has deteriorated. High quality borrowers have dis-intermediated the banks financing directly from investors. Banks also hold lower quality assets to boost returns.

Bank balance sheets also now hold investments – private equity stakes, principal investments, hedge fund equity, different slices of risk in structured finance transaction and derivatives (of varying degrees of complexity). Sometimes, the assets don’t appear on balance sheet being held in complex off-balance sheet structures with various components of risk being retained by the bank.

Under US accounting rules, asset must be classified into:

· Level 1 (Mark-To-Market) - liquid assets or instruments that are actively traded.

· Level 2 (Mark-To-Model) - instruments that cannot be priced based on trade prices but are valued using observable inputs.

· Level 3 (Mark-To-Make Believe or Mark-to-Myself) - the asset or liability cannot be priced using observable inputs and requires the use of modeling techniques and substantially subjective assumptions.

Asset quality uncertainty can be gauged by looking at bank’s Level 3 assets (Exhibit 2):

Exhibit 2
Analysis of Level 3 Assets

JP Morgan
Goldman Sachs
Merrill Lynch
Morgan Stanley
Lehman Brothers
Total Assets (US$ bn)

Level 2 Assets (US$ bn)

Level 3 Assets (US$ bn)

Total Capital (US$ bn)

Level 3/ Total Assets

Level 3/ Total Capital

% Change in Level 3 Assets Needed to Eliminate Capital

% Change in Level 2 & 3 Assets Needed to Eliminate Capital

Notes: All data is as at end 2007 and based on published financial statements.

In the first quarter of 2008, the position deteriorated. For example, Merrill Lynch’s Level 3 assets increased to US$69.86 billion as of March 28 from $41.45 billion on Dec. 28 (an increase of 69%) equivalent to over 225% of capital.

There are several areas of concern. Banks have benefited from hedging transactions (some of these are difficult to value Level 3 transactions). The exact nature of the hedges is not disclosed. The value of the hedge is based on models and estimates. The lack of disclosure around the value of the hedges, their nature and hedge counterparties make it difficult to gauge whether they will be effective in reducing losses.

A further area of concern is the practice of “circular asset sales”. Banks have sold risky assets where the seller has provided the buyer with favourable terms. Banks have sold leveraged loans on the basis that the bank lends the buyers 75-80% of the price at below market rates. Sellers have given undertakings that if future asset sales are at lower prices than that paid by the buyer then the seller will compensate the purchaser. These provisions have allowed banks to sell assets at prices that avoid the need to further mark down its positions.

This creates uncertainty about the value of bank assets. Further write-downs in asset values cannot be discounted.

Banks require re-capitalisation. The capital required is in excess of US$ 300-500 billion (15-25% of total global bank capital) to cover losses. Capital is also needed for assets returning onto their balance sheet (as the vehicles of the “shadow banking system” are unwound). This capital is required to restore bank balance sheets. Additional capital will be needed to support future growth.

Banks have raised a significant amount of capital but face increasing competition. Insurers, including the monolines, and the government sponsored enterprises (Fannie Mae and Freddie Mac) also need re-capitalisation. This may limit availability and increase the already high cost of capital for banks.

Availability of capital, high cost of new capital and dilution of earnings will impinge upon future performance.

Earning growth in recent years has been driven by a rapid expansion of lending – both traditional and disguised forms such as securitisation and derivatives activity. Bank balance sheets have expanded at rates well above GDP expansion. Lower volumes in the future will mean lower earnings.

Lack of lending capacity may also affect other activities. Corporate finance and advisory fees are driven by the capacity to finance transactions and also co-investing in risk positions. Lower origination of lending driven deals may reduce this income significantly. Investment banks generated around US$15 billion on fees in 2007 from “financial sponsors” - private equity firms involved in leveraged transactions. Banking fees for leveraged finance deals are expect to be down at least 50% in 2008. Some banks have reported declines in fees of around 90%.

Structured finance has contributed strongly to earnings in recent years. Securitisation, including CDO activity, has been a major growth area. Volumes have collapsed. As at end June 2008, US ABS issuance (US$106 billion) is 73% lower than that in 2007. Home Equity ABS issuance (US$303 million) is 99.8% lower than 2007 (US$198 billion). Year-to-date CDO issuance (US$14 billion) is down 93.8% from 2007 (US$225 billion).

In mid 2008, there were signs that the securitisation markets were showing tentative signs of life. Caution is needed in interpreting the activity.

Many “securitisation” transactions re-packaged existing assets into securitised format to allow banks to take advantage of cheap funding from central banks. This used the fact that central banks now allow AAA rated asset backed securities to be used as collateral for direct funding or can be exchanged for government bonds that can be financed by repurchase arrangements.

In the securitisation transactions completed only the highest rated (AAA) securities have been sold to investors. The riskier assets have stayed with the banks. The credit spread required by investors for these investments remains high. The economics of securitisation are unfavourable and will limit activity.

The slowdown in structured finance has complex effects. Banks generated large earnings from off balance sheet vehicles in the shadow banking system. The vehicles provided banks with the ability to “park” assets and reduce capital. They also provided significant revenue – management fees; debt issuance fees and trading revenues. Recovery in these earnings is unlikely any time soon.

Trading revenue has been a bright spot. Increased volatility and much wider bid-offer spread have generated increases in both client driven and proprietary trading earnings. Volatility and the need to adjust trading positions created strong trading flows and earnings. As the markets stabilise, trading flows and earnings decline.

Several factors may limit trading income. Derivatives and structured investments, especially complex products, generated significant earnings. Problems in structured finance highlighted concerns about complexity, transparency and valuation. Market volatility has resulted in significant losses in some structured investments. Revenues may diminish as investors and borrowers curtail their use of such instruments preferring simpler products that are less profitable to the bank.

Trading revenues relied heavily on hedge funds and financial sponsors. Hedge fund activity is likely to slow through consolidation and reduced leverage. Derivatives and hedging activity from private equity transactions and structured finance has been significant. Hedging revenues typically contribute 50% or more of bank earnings from a private equity transaction. Reduction in financial sponsor activity will limit revenue from this source.

Banks have increasingly relied on proprietary trading to supplement earnings. This increases risk and depends on the availability of capital. It relies on availability of counterparties and liquidity. Concern about counterparty risk and reduction in market liquidity in some products increases the risk of this activity and reduces its earning potential.

Banks will continue to earn revenues from traditional activities – normal corporate finance advisory work, traditional lending, hedging activity and arranging debt and equity issues for corporations. Weaker economic conditions may reduce revenue growth. The sharply positive shape of the US$ yield curve and the volatility of the US$ has created growth for fixed income structured products. New opportunities – distressed debt and corporate restructuring; emerging markets; commodities – may emerge.

Future earnings will be affected by the availability of risk capital. The banks may not be able to access capital to the extent needed. The demise of the shadow banking system will mean that purchased capital will not be available. Regulators may also increase capital levels for some transactions exacerbating the capital problem.

Risk models in banks are a function of market volatility. The low volatility regime of recent years reduced the amount of capital needed. Increased market volatility will increase the amount of capital needed. This may restrict the level of risk taking and therefore earnings potential.

Rating agencies have downgraded a number of investment banks and many are still on “negative watch” as a result of concerns about asset quality, capital requirements and earnings outlook. Lower credit ratings may limit the ability of banks to trade. Where accepted as counterparty, the banks may have to post increased collateral. There is anecdotal evidence that large hedge funds are now asking banks to post collateral as surety to mitigate credit risk in transactions. Merrill estimated that a downgrade of its credit rating by one category (notch) would require it to post an additional US$3.2 billion of collateral on over-the-counter derivative transactions. Similarly, Morgan Stanley and Lehman Brothers estimated that a single level ratings downgrade would require posting an additional US$973 million and US$200 million of additional collateral. Weaker credit ratings will affect the ongoing profitability of affected banks.

Higher costs will also increase limiting earning recovery. Bank funding costs have increased. Most firms have been forced to issue substantial amounts of term debt to fund assets returning to balance sheet and protect against liquidity risk. To the extent, that these costs cannot be passed through to borrowers, the higher funding costs will affect future funding.

Banks have issued high cost equity to re-capitalise their balance sheets. Hybrid capital issues paying between 7.00% and 11.00 % pa will be drag on future earnings. Highly dilutionary equity issues (often at a discount to a share price that had fallen significantly) will impede earnings per share growth and return on capital.

Banks also face additional short-term costs. Litigation against banks has increased. There may also be prosecutions of banks. The costs of these are unknown. In the longer term, banks face higher regulatory and compliance costs.

As banks begin to adjust their business models (selling assets and reducing staff), significant restructuring costs will affect earnings in the short run. The benefits of the restructuring will yield benefits but they will take time to emerge.

Accounting factors may also affect any earnings recovery. FAS157 allows the entity's own credit risk to be used in establishing the value of its liabilities. Changes in the entity's credit standing are therefore reflected as changes in fair value. This results in gains for credit downgrades and losses for credit upgrades.

As credit spreads increased, US banks have taken substantial profits to earnings from revaluing their own liabilities (Exhibit 3). European banks have also taken significant gains. If markets stabilise and the credit spreads for banks improves then banks will have to reverse these gains. There may be significant mark-to-market losses especially on new debt issues by banks at high credit spreads since mid-2007.

Exhibit 3
Effect of Incorporating Bank’s Own Credit Spread On Earnings

Bank Effect

Gain of US$ 453 million “due to changes in the Company’s own credit risk (or instrument specific credit risk”

JP Morgan Chase
Gain of US$ 771 million on long term debt “due to changes in instrument specific credit risk”

Goldman Sachs
Gain of US$216 million “attributable to the observable impact of the market’s widening of the firm’s own credit spread on liabilities for which the fair value option was elected”

Lehman Brothers
Gain of US$ 1.3 billion from “estimated changes in the fair value of these liabilities [… these instruments are primarily structured notes…] attributable to the widening of our [Lehman’s] credit spreads

Merrill Lynch
Gain of US$ 2 billion from “changes in the fair value of liabilities for which the fair value option was elected that are attributable to changes in Merrill Lynch credit spreads”

Morgan Stanley
Gain of US$840 million “from changes in the fair value of the Company’s short and long term borrowings, including structured notes, for which the fair value option was elected that were attributable to changes in instrument specific credit spreads”

Notes: All data is as at end 2007 and based on published financial statements.

Banks are high fixed cost businesses. Major elements of banking infrastructure are fixed and display economies of scale and scope making them sensitive to revenue slowdowns. Flexible remuneration (low fixed compensation and a high variable incentive component (bonus)) is often cited as evidence of a highly variable cost structure. Unfortunately, a shortage of and competition for talent means that even the level of labour cost flexibility is overstated.

The fallacies of banking conglomerates (“financial supermarkets” (CitiGroup); wealth management and investment banking (Merrill Lynch; UBS); Banc-assurance) also become exposed. Diversification of income sources and a balanced portfolio of counter cyclical businesses have been much extolled. In reality, the businesses are highly correlated.

Falls in AUM (assets under management) from falling asset prices reduce asset management income. Decline in performance fees from funds (for example, as experienced by Goldman Sachs) also affect performance. Wealth management and insurance business are buyers of products originated by the related bank (that is the rationale for the corporate grouping after all). In many cases, this results in investment losses in business downturns.

Many banks purchased wealth managers and private banks at aggressive valuations in their desire to build “distribution”. The “goodwill” component of such acquisition, if unamortised, may need adjustment.

Investors are looking for a rapid recovery in bank earnings. Earnings may recover but the “gilded age” of bank profits may be difficult to recapture.

Glamorous banks reliant on “voodoo banking” may find it difficult to achieve the high performance of the “go-go” years.

Banks with sound traditional franchises that have avoided the worst excesses of the last 10-15 years will do well in the changed market environment. Such old fashioned banking may ironically do well in the “new” environment. Interest rates that they charge customers have increased. Bank deposits have become far more attractive than other investments. Stronger banks have also benefited from a “flight to quality”.

Normally, a dysfunctional financial sector and weakened individual firms would result in significant consolidation through mergers and acquisitions and asset sales. Consolidation activity usually provides support to values. In this instance, many likely predators are themselves weakened. There is also a shortage of capital to undertake such transactions. Acquisitions, in the present environment, are complicated by uncertainty about assets values and a weakening economy. For example, the JP Morgan and Bear Stearns transaction was effectively a “distressed” sales at what everybody assumed was “bargain” prices. All this makes the inevitable “consolidation” difficult and reduces the support to bank valuations.

As this column has written previously, the share of global output absorbed by the financial services sector has increased inordinately in the great bull market of the last quarter-century, and is now due to fall back towards its previous level, around half its relative size currently.

Will the recovery in bank stocks take the form of “V” or “U”? It may be a “L”. With the Northern Rock and Bear Stearns bailouts, central banks and governments have signaled that major banks are “too big to fail”. This is a necessary but not sufficient condition for recovery of bank earnings and stock prices. The recovery might take the form of a “L” (Kirsten ITC font) – note the small upturn at the far right of the flat bottom.

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