John Mauldin
Today’s Outside the Box is a little bit different – which, considering that most Outside the Box pieces can be classified as a little bit different, is not that unusual; but this one needs to come with a warning label that you may find it a tad wonkish.
It’s from my friend Chris Whalen of the Kroll Bond Rating Agency. When I want to understand something about banks, Chris is one of my go-to guys.
It’s from my friend Chris Whalen of the Kroll Bond Rating Agency. When I want to understand something about banks, Chris is one of my go-to guys.
In Chris’s latest memo he talks about the push to increase the capital levels of the eight largest US banks. He is critical of that effort in that it doesn’t address the real issues. He highlights the fact that even if we do increase the capital requirements of the largest banks, that doesn’t mean we won’t have problems with them in the next crisis.
It wasn’t insufficient capital that got the banks into trouble the last time around. If we don’t sufficiently address the issues that hurt the banks and the economy then, there can be no assurance that there won’t be problems of a similar nature next time, even with increased capital. This is worth thinking about as you ponder the risks to your portfolio that will come with the next downturn. You can’t assume there will not be problems with US banks. Maybe there won’t be, but I wouldn’t ignore the risk. Good management is more important than capital.
I write this introduction from 32,000 feet, flying back to Dallas. I had several great meetings while in New York; but the highlight was dinner last night with Art Cashin; Jack Rivkin, a longtime PaineWebber partner and now the brains at Altegris; Peter Boockvar of the Lindsey Group; Rich Yamarone, chief economist at Bloomberg; Lakshman Achuthan, the guiding light at ECRI; and Vikram Mansharamani, a Yale professor and author of Boombustology. These are the proverbial smartest guys in the room, and I posed a series of questions to them about the timing of the next recession, their thoughts on the upcoming election, and the economy in general.
I’ll take up their range of predictions and consensus regarding the recession call in this weekend’s letter, and go into some of the risks these gentlemen see, as well as dive into more of my notes from the conference.
My decision to not go to a game three or four of the NBA finals and hope for a game six –knowing that it could be a possible closer and hoping that it would be a win for the Cavaliers while I was down front in a box seat – now looks to be a bit suspect. I may not be making that trip unless Lebron and the Cavs get their act together and sweep the Warriors at home. After those first two games, I think I’ll hold off booking the tickets.
You have a great week. I think I’ll call a few more friends and get some additional takes on a recession. Just for giggles and grins.
Your thinking about portfolio risk analyst,
John Mauldin, Editor
Outside the Box
Large Bank Risk:
Liquidity Not Capital Is the Issue
“Credit means that a certain
confidence is given, and a certain trust reposed. Is that trust justified? And
is that confidence wise? These are the cardinal questions.”
– Walter Bagehot, Lombard
Street (1873)
Summary
·
Kroll
Bond Rating Agency (KBRA) notes that since the 2008 financial crisis and the
passage of the Dodd-Frank legislation two years later, global financial
regulators have been pushing a deliberate agenda to increase the capitalization
of large banks. Despite the fact that the 2008 financial crisis was not caused
by a lack of capital inside major financial institutions, raising capital
levels has become the primary policy response among many of the G-20 nations.
·
KBRA
believes that using higher capital to change bank profitability and,
indirectly, corporate behavior is a rather blunt tool for the task of ensuring
the stability of financial markets. Part of the problem with using capital as a
broad prescription for avoiding rescues for large financial institutions, aka
“too big to fail” or TBTF, is that this approach explicitly avoids addressing
the actual cause of the problem, namely errors and omissions by major banks
that undermined investor confidence.
·
One
of the key fallacies embraced by regulators and policy makers is the notion
that higher capital levels will help TBTF banks avoid failure and, even in the
event, the failure of a large bank will not require public support. KBRA
believes that there is no evidence that higher levels of capital would have
prevented the “run on liquidity” which caused a number of depositories and
non-banks to fail starting in 2007.
Discussion
Since the 2008 financial crisis and the passage of
the Dodd-Frank legislation two years later, global financial regulators have
been pushing a deliberate agenda to increase the capitalization of large banks.
The objective of this increase in capital, we are told, is to make public
rescues of the largest banks less likely and to change their corporate
behavior. Despite the fact that the 2008 financial crisis was not caused by a
lack of capital inside major financial institutions, raising capital levels has
become the primary policy response among many of the G-20 nations and the
prudential regulators who oversee global banks.
Most recently, Federal Reserve Board Governor
Daniel Tarullo revealed on Bloomberg TV (June 2, 2016) that he is
“quite confident” that the eight largest U.S. banks will get hit with an
additional capital surcharge that will translate into a “significant increase”
in capital. However, he noted that there will be “some offsets in other parts
of the stress tests so that it won’t be just a straight addition of the
surcharge.” Tarullo opined that he doesn’t think the charge will go into effect
for the next round of tests, and instead there might be a “phase in.”
Lawmakers and federal regulators have made a number
of other changes in the regulation of US banks that impact asset allocation and
risk taking, including greater emphasis on liquidity and an end to principal
trading. Policy makers have explicitly ruled out direct punishment for
individual or institutional instances of fraud, thus we are left with an
indirect approach that punishes the creditors, shareholders and customers of
the largest banks. President Obama formed a “Financial Fraud Enforcement Task
Force” in November 2009 to “hold accountable those who helped bring about the
last financial crisis,” but the Obama administration has generally chosen to
pursue institutions over individuals when it comes to fraud prosecutions.
“More
equity may get [bank] boards to care more,” argues Dr. Anat Admati of Stanford
University, but KBRA believes that using higher capital to change bank
profitability and, indirectly, corporate behavior is a rather blunt tool for the
task of ensuring financial stability.
Part of the problem with using capital as a broad
prescription for avoiding rescues for large financial institutions, aka “too
big to fail”, is that this approach explicitly avoids addressing the actual
cause of the problem, namely errors and omissions by the officers and directors
of major banks that undermined investor confidence. A combination of poor loan
underwriting, excess risk taking in the trading and investment portfolios,
deliberate acts of deceit, a systemic failure to disclose the true extent of
bank liabilities, and/or acts of securities fraud actually caused the failure
of or need to rescue institutions such as Wachovia Bank, Washington Mutual,
Lehman Brothers, Bear, Stearns & Co American International Group (NYSE:AIG)
and Citigroup (NYSE:C), to name but a few. These rescues or events of default
were driven by a sharp decline in liquidity available to these obligors and led
to the wider financial crisis in 2008 and beyond.
Thus when regulators and policy makers sign on to
the idea of higher capital levels as a solution for TBTF, are we not all
effectively burying our collective heads in the sand? In mid-2008, when
Wachovia was receiving inquiries from bond investors about early redemption of
long-term debt, the bank’s stated level of balance sheet capital was not at
issue. Instead, investors, counterparties, and corporate/institutional
depositors were concerned that they no longer understood or trusted the bank’s
asset quality and financial statements, and therefore backed away from any risk
exposures with the bank. This is also why the Federal Reserve Board and
Treasury chose to conceal the true condition of Wachovia from the FDIC, as
former FDIC Chairman Sheila Bair documents in her 2013 book.
Fed Chairman Ben Bernanke noted in the dark days of 2008:
Meeting creditors’ demands for
payment requires holding liquidity--cash, essentially, or close equivalents.
But neither individual institutions, nor the private sector as a whole, can
maintain enough cash on hand to meet a demand for liquidation of all, or even a
substantial fraction of, short-term liabilities... [H]olding liquid assets that
are only a fraction of short-term liabilities presents an obvious risk. If most
or all creditors, for lack of confidence or some other reason, demand cash at
the same time, a borrower that finances longer-term assets with liquid
liabilities will not be able to meet the demand.
There are two basic reasons why the current
fixation with higher capital levels should be a cause for concern among policy
makers. First, there is no evidence that higher levels of capital would have
prevented the “run on liquidity” which caused a number of large depositories
and non-banks to fail starting in 2007. Reckless and questionable financial
decisions characterized, for example, by a failure to properly evaluate the
creditworthiness of borrowers were the proximate causes of an erosion in
investor confidence which ultimately caused these firms to collapse. (See
Whalen, Richard Christopher, The Subprime Crisis: Cause, Effect and
Consequences (2008). Networks Financial Institute Policy Brief No. 2008-PB-04. http://ssrn.com/abstract=1113888)
Careful observers of the banking scene in the 2000s
noted that names such as Washington Mutual and Countrywide Financial were
starting to contract in terms of sales volumes and access to liquidity as early
as 2005. The originate-to-sell mortgage production models used by these and
other banks depended crucially on access to stable market funding and a steady
supply of new paper. In mid-2007 when Bank of America (NYSE:BAC) announced a
partial rescue for its largest warehouse customer, Countrywide, the mortgage
bank led by Angelo Mozilo was already doomed because of ebbing loan volumes and
liquidity. More non-bank than commercial bank, half of Countrywide’s balance
sheet was funded by non-deposit, market sources.
Second, significantly higher capital levels and
other regulatory constraints reduce the profitability of banks and limit credit
expansion. The fact that the U.S. banking industry was able to fund the
post-crisis cleanup internally by diverting income is a remarkable achievement,
yet the response from policy makers has been to take deliberate action that
make banks less profitable and less able to fund future losses.
More, higher capital levels have negative effects
on capital formation and credit creation that may work against the broader
goals of financial stability and economic growth. Witness the declining bank
lending volumes in the US residential mortgage market. Banks which cannot
achieve sufficient equity returns to retain investors will, over time, either
shrink or discontinue businesses altogether to survive. Under the current
regulatory regime, banks in the G-20 nations are effectively being turned into
utilities which take little or no credit risk and thus do not support economic
activity.
Not only do higher capital levels and other forms
of punitive regulation reduce the availability of credit from depositories, but
these strictures will tend to force consumers and businesses to seek out credit
from unconventional sources that may actually increase systemic risk to the
financial system. The proliferation of various types of non-bank lenders
purporting to offer “new” business models are a familiar response to increased
regulation and tougher prudential standards. Many of these models have
originate-to-sell business models similar to that used in originating subprime
mortgages in the 2000s. For example, JPMorgan Chase & Co. Chief Executive
Officer Jamie Dimon, says marketplace lenders might find that sources of
funding evaporate during a downturn. (Hugh Son et al, “Dimon Says Online
Lenders’ Funding Not Secure in Tough Times,” Bloomberg News, May 11,
2016.)
Capital
vs. Confidence
One of the key fallacies embraced by bank
regulators is the notion that higher capital levels will help TBTF banks avoid
failure and, even in the event, the failure of a large bank will not require
public support. First and foremost, banks fail not because they run out of
capital, but because a lack of confidence results in a diminution of liquidity
available to the enterprise.
Indeed, during and after the 2008 financial crisis,
with the notable exception of Citigroup and AIG, U.S. banks as a group did not
require government support and consumed little capital in resolving failed
institutions. Instead, banks diverted current income to fund loan loss
provisions and FDIC insurance premiums. Using data from the FDIC, Chart 1 shows
provisions, net charge-offs, and pretax income for all U.S. banks since 1990.
Note that the sharp drop in industry operating
income in 2008-2009 included the cost of pre-paying several years of FDIC
insurance premiums. Not only did the U.S. banking industry fund the clean-up of
most failed banks privately and without taxpayer support, but the financial
crisis turned out to be an issue of reduced income rather than capital
impairment. Though hundreds of banks did fail because of loan losses, the
balance sheets of these institutions were marked to market and absorbed by the
surviving banks, which largely used income rather than capital to manage the
resolution process. Indeed, at no point did any major bank “run out of capital”
because the institutions which did fail stumbled long before due to a lack of
cash liquidity and were sold by the FDIC.
Ultimately, market liquidity is a function of
investor confidence, and not capital. Cash flowed into the largest banks in the
weeks after the failure of Lehman Brothers because the banks were big and
investors believed these banks would receive government support. Liquidity is
the key determinant of whether a bank or nonbank fails. Indeed, for most credit
professionals surveyed by KBRA, credit spreads and ratings, and other dynamic
market indicators, are far more important measures of particular counterparty
risk than static, backward-looking measures of balance sheet capital.
In Chart 2, we show total capital vs. loss reserves
since 1990. Again, aside from accounting adjustments and some large bank
resolutions in the 2008-2009 period (see circle in Chart 2), the U.S. banking
industry has continued to build capital steadily. When Wachovia Corp was acquired
by Wells Fargo at the end of 2008, the target charged off its entire loss
reserve and equity capital in Q3 2008, resulting in a substantial write-down of
doubtful assets and the creation of a loss reserve for the acquirer. As the
FDIC noted at the time, this transaction involving the fourth largest U.S. bank
holding company skewed the aggregate industry data during that reporting
period.
Conclusion
In his famous exchange with attorney Samuel
Untermyer over a century ago, John Pierpont (“JP”) Morgan stated the problem of
bank solvency correctly and for all time. In those days, bear in mind, the Fed
did not exist and JPMorgan & Co was the de facto central bank.
Because Morgan was not a member of the New York Clearinghouse, other banks had
to stand in line inside the bank’s lobby to transact business:
Untermyer “Is not commercial
credit based primarily upon money or property?”
Morgan: “No sir. The first thing
is character.”
Untermyer: “Before money or
property?”
Morgan: “Before money or
property or anything else. Money cannot buy it ... because a man I do not trust
could not get money from me on all the bonds in Christendom.”
The chief flaw with the current regulatory focus on
capital, KBRA believes, is that it ignores important qualitative factors
involved with the ownership and management of banks that ultimately determine
corporate behavior. When banks and non-banks decided to underwrite and sell bonds
based upon subprime mortgages in the 2000s, the level of balance sheet capital
was not at issue. Merely raising the level of capital required for banks may
provide the illusion of progress in the minds of many policy makers, but for
investors the most basic issue involved in any counterparty risk assessment
comes down to trust.
Managing the liquidity of a bank or non-bank
involves not just cash and collateral, but also reputation and transparency.
Measuring the static level of capital on a bank’s balance sheet may provide
some comfort as to enhanced financial stability. Managing liquidity, however,
is a dynamic task that defies easy quantification but is, at day’s end, crucial
to maintaining financial and economic strength. By focusing much of the
attention of regulators and policy makers on the static issue of capital, KBRA
believes, we are not addressing the true qualitative, behavioral issues that
undermined investor confidence in all types of financial institutions and led
to the 2008 financial crisis.
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