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 20% to 30%. Trading revenue, 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-time increase in trading volume and, reflecting the distressed condition of AIG, larger than normal bid-offer spreads on these closeouts.
The banks also benefited from revaluing their own debt where credit spreads widened. The theory is that the bank could currently purchase the debt at a value lower than face values and retire it to recognize the gain. Unfortunately, banks are not in position to realize this "paper" gain and ultimately if the debt is repaid at maturity, then the "gain" disappears.
Earning also were helped by a series of one-time factors. Bank of America realized 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 Goldmans Sachs profit benefited from the change in the reporting dates.
Barclays Bank recently sold its iShares unit (a profitable unit which contributed around 50% of the earnings of Barclays Global Investors) to a private equity firm for $4.2 billion, allowing the bank to book a gain of $2.2 billion that boosted capital ratios. CVC Capital only paid $1.05 billion with the rest ($3.1 billion) being borrowed from Barclays itself. The loan was for five years and Barclays is required to keep the majority of the debt on balance sheet for at least five years. In effect, the gain and capital increase is lower than the cash received (in effect, Barclays is treating part of its loan as profit and capital!). In addition, senior executives of Barclays received substantial gains from the sale under a compensation scheme where Barclays Global employees received shares and options up to 10.3 % of the division's equity.
Effects of changes in mark-to-market accounting standards, which arguably reflected political and industry pressure, 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, more than 70% of all rated debt was 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 about half 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, 2008. 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. Eurozone banks had reported $154 billion in write-downs and 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 loan 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.
Banks may also face write-downs in intangible assets (goodwill or surplus on acquisition) and future income tax benefits. The values of businesses purchased in a more favorable environment will need to be progressively reassessed. The tax benefits of losses can only be carried as an asset where there is a reasonable prospect of utilization in the near future.
In one of his raves on TV, James Cramer, the notorious American commentator, referred to bank accounts as "fiction." He referred to them as the work of Somerset Maugham, William Faulkner or Joseph Conrad. In reality, they are the works of lesser writers – "pulp fiction" or "romantic potboilers.''
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. The Federal Reserve hinted that banks – even banks that passed the "stress test" – would be required to hold extra capital. This is puzzling as surely a bank is appropriately capitalized or it is not. Given that the test is the basis for setting solvency capital requirements, this is hardly reassuring or a guarantee that further taxpayer funded recapitalization 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 deleveraging 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% to 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 recapitalize and consolidate the banking system.
Analysis of recent financial performance does not also take into account the underlying favorable 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; favorable changes in the fair value accounting treatment of securities; and 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 banks remain in the ICU (intensive care unit). Even after around $900 billion in new capital, the global banking system remains short of capital by $1 trillion to $2 trillion. This translates into an effective reduction in available credit of around 20% to 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, even though the performance of governments trying to rehabilitate the financial system has been problematic. In April 2009, Elizabeth Warren, chairperson of the Troubled Asset Relief Program (TARP) Oversight Panel, 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 Public-Private Investment Program (PPIP) approach is its belief that the system-wide deleveraging resulting from the decline in asset values'' – thus leading to an accompanying drop in net wealth across the country – "is in large part the product of temporary liquidity constraints [that are a consequence of] 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.''
Two other panel members, New York State Superintendent of Banks Richard Neiman and former New Hampshire Sen. John Sununun, 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." Many would question the selection of the words "incorrectly imply."
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.
Evidence of political influence and a palpable lack of transparency in dealing with the problems are emerging. There are allegations that the Treasury may have "pushed" Bank of America to consummate its controversial acquisition of Merrill Lynch when it sought to withdraw after additional losses came to light. The Treasury secretary at the time, Henry Paulson, is alleged to have suggested that Bank of America's management and board could be removed if it did not proceed. There are also suggestions that both the Treasury and Bank of America decided to avoid public disclosure of these events.
In his books "The Logic of Collective Action" and "The Rise and Decline of Nations," American economist Mancur Olson speculated that small distributional coalitions tend to form over time in developed nations and influence policies in their favor 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 paralyzing the economic system, causing inevitable and irretrievable economic decline.
Government attempts to deal with the problems of the financial system, especially in the U.S., 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 recognize losses on assets, remove toxic assets from balance sheets, recapitalize 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. There seems to be a patent unwillingness to admit to and confront the problems facing the industry. Recognition of the problem is generally a prerequisite to working towards a solution.
Amusingly, Peter Hahn, a former managing director of CitiGroup and now a fellow at London's Cass Business School, was reported by Bloomberg as saying: "When you look at the income numbers that have been put out by banks recently, they contain so much fudge and financial manipulation. You could say that the automobile industry has a clearer future at the moment."
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.
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)
Views are as of May 15, 2009, and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security.
Federated Equity Management Company of Pennsylvania.
http://www.prudentbear.com/index.php/guestcommentaryview?art_id=10228
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