24 April 2009

“Catastrophic to Awful!” - The Banking Spin CycleBy: Satyajit Das

The recent rally in equity markets - the largest for decades - was predicated, in part, on the improving fortune of banks.

Banks reported better than expected profits. U.S. banks seem likely to pass the “stress” test. Repayment of taxpayers’ funds by some institutions, at least, seemed imminent. Scrutiny suggests that the episode reflected Adlai Stevenson’s logic: “These are conclusions on which I base my facts.”

Banks beat “well managed” low-ball expectations. In the last quarter of 2008, publicly traded banks lost $52 billion. Despite a return to profitability for some institutions, in the first quarter of 2009, banks are still expected to lose around $34 billion. For example, UBS and Morgan Stanley recorded losses.

The quality of earnings was questionable. Core businesses declined by 20-30%. Trading revenues, especially fixed income, rose sharply at most big banks reflecting high volumes of bond issuance, especially investment grade corporate issues and government guaranteed bank debt.

Corporate issuance was the result of the continued tightening in credit availability as banks reduced balance sheet. The issuance of government guaranteed bank debt provided underwriters with a “double subsidy” - the government guaranteed the debt but then allowed the banks to earn generous fees from underwriting government guaranteed debt.

High volatility generated strong trading revenues. Key factors were increased client flows and increases in bid-offer spreads (by up to 300% in some products). High trading revenues also reflect principal position taking and trading. It will be interesting to see if trading revenues are sustainable.

Questions remain about the impact of payments by AIG to major banks including Goldman Sachs ($12.9 billion), Merrill Lynch ($6.8 billion), Bank of America ($5.2 billion), Citigroup ($2.3 billion) and Wachovia ($1.5 billion). Non U.S. banks also received substantial payments including Société Générale ($12 billion), Deutsche Bank ($12 billion), Barclays ($8.5 billion) and UBS ($5 billion). Conspiracy theories notwithstanding, it seems likely that these were collateral amounts due to the counterparty or settlement of positions that were terminated. At a minimum, the banks benefited from a one-off increase in trading volume and also larger than normal bid-offer spreads on these closeouts reflecting the distressed condition of AIG.

The banks also benefited from revaluing their own debt where credit spread widened. The theory is that the bank could currently purchase the debt at a value lower than face values and retire them to recognise the gain. Unfortunately, banks are not in position to realise this “paper” gain and ultimately if the debt is repaid at maturity then the “gain” disappears. If you are confused, then revaluation of issued debt worked differently at Morgan Stanley. The bank would have been profitable without a $1.5 billion accounting charge caused by an increase in the price of its debt from lower credit spreads.

Earning were also helped by a series of one-off factors. Bank of America realised a large gain on the sale of its stake in China Construction Bank and also revalued some acquired assets as part of the closing of its Merrill Lynch acquisition. Goldman Sachs changed it balance date reporting results to the end of March rather than February. Given that its last financials were for the year to the end of November 2008, Goldman separately reported a loss for December 2008. It is not clear how much Goldman Sachs profit benefited from the change in the reporting dates.

Effects of the change in mark-to-market accounting standards are also not clear. New guidance permits banks to exclude losses deemed “temporary” and also allows significant subjectivity in valuing positions. This may improve the financial position and overstate both earnings and capital. Some commentators believe that the changes could increase earnings by up to 10 to 15% and capital by up to 20%.

The market ignored continuing increases in bad debts and provisions. After all “that’s so yesterday!” Further losses are likely in consumer lending (e.g. mortgages, credit cards and auto loans), corporate and commercial lending.

In recent years, it has become an article of accepted faith that corporate debt levels have fallen. In aggregate, that is perfectly true. However, the debt has become concentrated in a number of sectors - commercial property, merger financing, private equity/ leveraged finance and infrastructure and resource financing.

The overall quality of debt has deteriorated significantly. In 2008, over 70% of all rated debt were non-investment grade (“junk”). This is an increase from less than 30% in 1980 and around 50% in 1990. The debt is also heavily reliant on collateral; the loans are secured against financial assets (shares and property). Reduced ability to service the debt and falling collateral values may prove problematic. For example, the recent distressed sale of the John Hancock Tower produced around 50% of the value paid a few years earlier.

In April 2009, the International Monetary Fund (“IMF”) estimated that banks and other financial institutions face aggregate losses of $4.1 trillion, an increase from $2.2 trillion in January 2009 and $1.4 trillion in October 2009. Around $2.7 trillion of the losses are expected to be borne by banks. The IMF estimated that in the United States banks had reported $510 billion in write-downs to date and face additional write downs of $550 billion. Euro zone banks had reported $154 billion in write-downs face a further $750 billion in losses. British banks had written down $110 billion and face an additional $200 billion in write offs.

Banks may not be properly provisioned for these further write-downs. Recent accounting standards made it difficult for banks to dynamically provision whereby banks provided in low loss years for any eventual increase in loans losses when the economic cycle turns. Criticisms regarding income smoothing led to this practice being discontinued. Increasing bad debt will flow directly into bank earnings as credit losses increase as the real economy slows.

The stress tests do not provide comfort regarding the health of the banks. As Nouriel Roubini, Chairperson of RGE Monitor, has pointed out the likely macro-economic environment is likely to be significantly worse than the adverse scenarios used. Given that the test is to be the basis for setting solvency capital requirements, this is hardly reassuring or a guarantee that further taxpayer funded recapitilisation of the banking system is not going to be needed.

The proposal floated by some banks to return taxpayer capital misses an essential point. The banks did not offer to waive the government/ FDIC guarantees, which have allowed them to fund in the capital markets. The suspicion is that the proposal had more to do with avoiding close public scrutiny of compensation and hiring practices. Goldman’s compensation costs increased 18% in the first Quarter while employee numbers were down around 7% translating into a 27% increase in employee costs.

The reality is that the global economic system is de-leveraging and levels of debt must be reduced. As result, asset values are declining and sustainable growth levels have fallen significantly. In this environment, banks are likely to continue to suffer losses on assets (bad debts and further write offs) and earnings will remain sluggish (lower loan demand and lower levels of financial transactions). Higher funding costs and the need to raise capital compound the difficulties. For the banks currently: “On the liability side, some things aren’t right and on the asset side, nothing’s left.”

Many major global bank shares are still, on average, trading at levels 70%-90% below their highs. Following the collapse of the “bubble” economy, Japanese banks staged a number of significant recoveries in share price before falling sharply necessitating government intervention to recapitalise and consolidate the banking system.

Analysis of recent financial performance does not also take into account the underlying favourable current dynamics of the banking industry. Banks are currently beneficiaries of very low and, in some cases, zero cost of deposits. Banks also benefit from a sharply upward sloping yield curve that allows them to generate significant earnings from borrowing short and lending long. Banks have also benefited from subsidies and support from governments. They have also benefited from favourable changes in the fair value accounting treatment of securities. Banks have also benefited from sharply lower competition in most market segments. Adjusting for these factors, it is surprising that banks haven’t actually performed better.

The truth is that bank remain in the ICU (intensive care unit). Even after around $900 billion in new capital, the global banking system remains short of capital by around $1-2 trillion. This translates into an effective reduction in available credit of around 20-30% from previous levels. Bank earnings and balance sheets remain under pressure.

The financial system will need continued government support for some time to come. The performance of governments trying to rehabilitate the financial system has been problematic.

In April 2009, Elizabeth Warren, Chairperson of the TARP Oversight Panel Report questioned the very approach to resolving the problems of the financial system: “Six months into the existence of TARP, evidence of success or failure is mixed. One key assumption that underlies Treasury’s [PPIP] approach is its belief that the system-wide deleveraging resulting from the decline in asset values, leading to an accompanying drop in net wealth across the country, is in large part the product of temporary liquidity constraints resulting from non-functioning markets for troubled assets. On the other hand, it is possible that Treasury’s approach fails to acknowledge the depth of the current downturn and the degree to which the low valuation of troubled assets accurately reflects their worth.”

Richard Neiman (New York State Superintendent of Banks) and John Sununu (former New Hampshire Senator), two other panel members, issued dissenting findings noting: “We are concerned that the prominence of alternate approaches presented in the report, particularly reorganization through nationalization, could incorrectly imply both that the banking system is insolvent and that the new administration does not have a workable plan.”

Constant changes in tack in the dealing with financial system problems do not suggest a consistent and well thought out strategy in dealing with the problem. Less than rigorous stress tests, using the PPIP to leverage FDIC funding into a lopsided subsidy for private investors or converting the preferred stock into shares to avoid having to seek additional congressional mandates also suggest political constraints in resolving the issues.

Mancur Olson, the political economist, in his books (The Logic of Collective Action and The Rise and Decline of Nations), speculated that small distributional coalitions tend to form over time in developed nations and influence policies in their favour through intensive, well-funded lobbying. The policies result in benefits for the coalitions and its members but large costs borne by the rest of population. Over time, the incentive structure means that more distributional coalitions accumulate burdening and ultimately paralysing the economic system causing inevitable and irretrievable economic decline.

Government attempts to deal with the problems of the financial system, especially in the US, Great Britain and other countries, illustrates Olson’s thesis. Active well funded lobbying efforts and “regulatory capture” is impeding necessary actions to make needed changes in the financial system. Urgent steps are necessary to accurately recognise losses on assets, remove toxic assets from balance sheets, recapitalise the banks and allow normal financial transactions to resume. If such actions are not taken then the broader economy and sustainable growth levels will be adversely affected.

The solvency risk of major banks is now primarily a question of whether the sovereign can afford to and will support the institution. However, the health of the global financial system remains fragile. Banks have gone from catastrophic to just awful. By most standards, that condition does not constitute a necessary and sufficient condition for a recovery in the global economy.

© 2009 Satyajit Das All Rights reserved.

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).


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