The recent rally in equity markets—the largest for decades—was predicated, in part, on the improving fortune of banks.
Banks have reported better-than-expected profits. US banks seem likely to pass the “stress” test. Repayment of taxpayer funds by some institutions, at least, seems imminent. Scrutiny suggests that the episode reflected the late US politician 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 sheets. The issuance of government-guaranteed bank debt provided underwriters with a “double subsidy”—the government guaranteed the debt but then allowed banks to earn generous fees from underwriting government-guaranteed debt.
High volatility generated strong trading revenues. The 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. Conspiracy theories notwithstanding, it seems likely that these were collateral amounts due to the counterparty or the 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.
Banks also benefited from revaluing their own debt where credit spread widened. The theory is that banks could currently purchase the debt at a value lower than face values and retire them to recognize the gain. Unfortunately, banks are not in the position to realize this “paper” gain, and ultimately, if the debt is repaid at maturity then the “gain” disappears. If you are confused then consider Morgan Stanley where the revaluation of issued debt worked in the opposite way. 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.
Earnings were also helped by a series of one-off 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 its 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.
Barclays Bank recently sold its iShares unit, a profitable unit which contributed around 50% of the earnings of Barclays Global Investors (BGI) 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 its 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 BGI employees received shares and options exceeding (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 the changes could increase earnings by up to 10-15% 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, at least 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 Boston-based 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 2008. Around $2.7 trillion of the losses are expected to be borne by banks. IMF estimated that in the US, 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 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. Under changed accounting standards, banks can no longer make substantial doubtful debt provisions in good years when losses are low to provide for an expected increase in bad debts when the economical cycle deteriorates—a practise that came to be known as dynamic provisioning. Criticisms regarding income smoothing led to this practice being discontinued. Increasing bad debt will flow directly into bank earnings as credit losses increase and 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 favourable 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.
The stress tests do not provide comfort regarding the health of banks. As chairperson of RGE Monitor Nouriel Roubini has pointed out, the likely macroeconomic environment is likely to be significantly worse than the adverse scenarios used.
The US Federal Reserve hinted that banks— even those 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 recapitilization of the banking system is not going to be needed.
The proposal floated by some banks to return taxpayer capital misses an essential point. They did not offer to waive the government/Federal Deposit Insurance Corporation guarantees, which have allowed them to fund 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 a 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 recapitalize and consolidate the banking system.
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. Comments are welcome at firstname.lastname@example.org