Debtor's Prison

"BANKING is the industry that failed. Banks are meant to allocate capital to businesses and consumers efficiently; instead, they ladled credit to anyone who wanted it. Banks are supposed to make money by skilfully managing the risk of transforming short-term debt into long-term loans; instead, they were undone by it. They are supposed to expedite the flow of credit through economies; instead, they ended up blocking it.”    - The Economist, 05.15.09

Once again we find ourselves suggesting this week’s print edition of The Economist, which includes a special report on the international banking system. In spite of referencing the British newspaper often, we’ve told you in the past our opinion concerning its frequent unsubstantiated claims and ill-defined terms. For that reason, we intend to do a thorough clean-up this time and present to you only the facts that can be extracted from the series of articles. When we say facts we mean purely that, and we will present them in the order in which they appear in the report. The report is somewhat lengthy, so we will simply list all the facts and comment in italics. Mind you, we will only state facts that are claimed as such by The Economist, we will not have verified these facts. We will however select only those that seem more robust and interesting to rational observers. The aim is to save you time reading the report, and maybe even providing a refreshing paraphrasing of the sir’s staid old Brittania-on-Thames.

• The IMF estimates that average government debt for G20 countries will exceed 100% of GDP in 2014, up from 70% in 2000 and just over 40% in 1980.

Notice that it took 20 years for the debt ratio to increase from 40% to 70%, yet it will take (according to the IMF) only 14 years to increase another 30%.   This is really very significant level, since it essentially means that the ENTIRE global GDP is all owed by governments.   Moreover, we think the IMF is very conservative at times and is likely not fully projecting what will likely be a continuing massive surge in gov debt issuance as countries all over strive to pay for deficits and lever up their currencies before the fiat currency event horizon.

• Total market capitalization of banks worldwide halved in 2008, going from $8tr to $4tr.

This is roughly the same proportionally to the total loss on world equity markets, which lost nearly half their value.  Given the trouble at the banks, we are surprised it wasn't more.  

• In its latest Global Financial Stability Report, the IMF estimates that the total bill for financial institutions will come to $4.1 trillion.

This is an awesome amount.  We do bid you remember how often the IMF has revised its estimations of global losses from the GCC, they started back at $1tr.  We doubt the revisions are over and believe that the total amount of losses stemming from credit markets will exceed this number.

• The commitment of governments to the banking system transfers the existential threat from the banks to sovereign borrowers.

This is a sage statement, and somewhat self-explanatory.

• Banks are reducing the amount of risk they take, which means reducing their proprietary trading and concentrating more on clients and activities that consume less capital.

We have underlined this statement because we have serious doubts about its veracity.  As we saw in yesterday's post on CDS market liquidity, banks have been profusely increasing their derivative trading.  Perhaps the wily ol' sir was referring to a particular type of prop trading, but it's certainly misleading when a $200tr market in which they trade grew by 14% in Q4 08 alone.

• Mike Poulos of Oliver Wyman, a consultancy, expects the number of banks in the US, currently some 8,000 or so, to drop by 2,000 or more as a result of the crisis.

Though this "fact" is only someone's opinion, we include it since it reinforces one of our discussion themes of the coming wave of bank failures and consolidation.  We have even speculated that part of the reason some banks are hoarding cash is to prepare for the buying frenzy.

• The taxpayer is already the majority owner of Royal Bank of Scotland (RBS) and Lloyds Banking Group in Britain. American taxpayers are set to own the largest single stake in Citigroup.

Nationalization is covertly making its inroads and seems to go on unfettered despite the "vigorous" debate around it.    The problem of course, as mentioned below, is that the taxpayer has fronted all the costs and in exchange will receive bank shells that will have an extremely hard time getting back to profitability.

• Moody’s was lambasted in early 2007 for awarding gold-plated AAA ratings to the big Icelandic banks on the false premise that the authorities in Reykjavik could afford to rescue them.

Few institutions cause us so much ire as credit rating agencies.  They should be disbanded for their absolutely ludicrous models and prescriptions that played a major role in this whole mess.   The Islandic example is just one of the myriad of idiocies on the part of the rating agencies.  Moreover, their absolute lack of accountability worries us tremendously.   What's worst is that Uncle Benny continues to prop them up by requiring their seal of approval for asset purchase programs, shutting out competition for alternative rating methods.

• During Sweden’s bank bail-out in the 1990’s, it took 4 years for the liability guarantees to be lifted. The state remains the largest shareholder in Nordbanken, a previously fully nationalized bank.

Sweden's bank bailout plan is often lauded for its efficacy in resolving the crisis.   Therefore, it would seem that this is kind of like a best-case scenario of what we can expect for the government guarantees currently in place.  So much for hopes of a quick exit.

• Britain’s Financial Services Authority (FSA) has already issued proposed guidelines on liquidity which will require banks to hold a greater cushion of liquid assets, mainly in the form of government bonds.

We found this interesting though somewhat vague.  For starters we would like to know how liquidity will be measured.  For example, CDSs have seen a surge in liquidity, does this mean that banks will be able to hold CDS as "liquid assets".   Will this be a constantly re-adjusted portfolio based on liquidity measures.  It will certainly be interesting if they are required to hold more government bonds. At first this would seem to indicate a decreased need for quant easing, but instead we think the FSA's motivation might belie the declining demand for gilts, and the need for a market to absorb the supply.

• Deals such as the takeovers of Bear Stearns by JPMorgan Chase, and of Merrill Lynch by Bank of America, have further blurred the boundaries between retail and investment banks.

This is moderately interesting, but certainly true.   Though Citibank's demise has shredded the old lore about the "universal bank", we are certainly experiencing an aggregation of functions at the higher echelons of the banking industry.  We expect this will continue as consolidation and reduction of competition takes firmer hold.  

• “We will buy credit protection but not sell it, buy catastrophe risk [protection] but not sell it,” says the boss of a bank that has negotiated the crisis successfully.

We wonder who this bank boss is, but he certainly seems to have it right!   If this bold claim is correct, then we bet it's not one of the "Big 5" bosses because they buy and sell profusely, left and right, up and down, on everything that you can slap a contract on.

• All of Canada’s main banks were profitable in the quarter ending January 31st, when market conditions were at their worst.

Kudos to the "younger brother" for teaching the "older brother" a little bit about risk management.  Of course, structural differences also contribute to this huge contrast, as do the next couple of facts.

• In Canada, independent brokers originate less than one-third of the mortgages in Canada, compared with up to 70% in the US during the bubble.

This is all due to the prevalance of the securitization markets in the US.   This allowed all sorts of lenders to quickly underwrite a gargantuan volume of loans that were quickly packaged and sold off as securities to suckers all over the world.

• Interest paid on home loans is tax-deductible in the US, encouraging people to borrow more; not so in Canada.

This is a well-known fact that is surprisingly rarely mentioned as contributing to the crisis.  Sure, a tax-deductible home payment might sound nice as it promotes ownership.  But, we must be honest, it also encourages over-leverage.

• The theory that risk had been dispersed because of securitization added to the false sense of security.

This was the quintessential naivete that dominated market pre-GCC.   Of course, hindsight is 20/20, but the sheer degree of its folly is such that we must really ask ourselves how, as a civilization, we can fool ourselves to such a deep and pervasive illusion.   We also admit to have been caught up initially in this idea in the wee years of happy cowboydom, but surely people in charge of all the models and metrics should have known that in distributions of systemic risk there actually lay a huge, fat DARK WING.  Right?

• Thanks to Iceland’s crisis, the creditworthiness of banks will also be far more closely tied to the creditworthiness of the countries in which they are headquartered.

Surely, an inevitable development.  As more private sector debt gets absorbed onto sovereign balance sheets, nations themselves will come under scrutiny for their ability to actually hold up a dying banking sector.   Nations are the new banks, and banks are becoming shell subsidiaries.    Nationalization is not necessary for this transfer of risk assessment to take place.

• Institutions that keenly exploited the pricing differences between long-term assets and short-term liabilities paid heavily when liquidity dried up and they were unable to refinance fast-maturing debts or sell the assets that they held.

Many many times we have stated that the game of musical chairs that is funding long-term assets with short-term liabilities is a dangerous game.  It has brought down the banking system and now threatens to bring down certain central banks that have been taking up the music where it left off.

• Many subprime mortgage-backed securities were held in off-balance-sheet vehicles that funded themselves by issuing short-dated, asset-backed commercial paper to money-market funds and other investors.

This is another very interesting feature.  Given what we have seen in The Commercial Paper Market, the ABCP is a market that served to fund a big part of all the off-balance sheet structured-investment vehicles (SIVs).  What we would like to know is what percentage of the $650bln or so left of ABCP is related to SIVs and also what proportion of SIV funding came from ABCP.

The shadow banking system is to blame for the drop in Net US banking lending since many lenders underwrote debt that was then repackaged and sold.    Britain and France have a very high loan-to-deposit ratio as do the EU and Spain.

• An estimated $8.7 trillion of assets worldwide are funded by securitization. More than half of the credit cards and student loans originated in the US in 2007 were securitized.

Again, this just illustrates the penurious state of the securitization markets and the huge risk they have represented from the onset of the GCC to this day.

• “The problem comes when you start securitizing things for which you cannot compute the odds of default,” says Stephen Cecchetti, chief economist at the Bank for International Settlements.

               Right on Mr. Cecchetti, right on!

• The chance of losses on securitized products increases as the economy worsens.

This is one of the main problems in the price models of securitized assets and the naivete and short-sightedness leading up to the GCC.  Everyone believe the "diversification" stupidity and failed to realize that in fact risk had been dispersed for the center of the distribution, but that systemic risk had actually increased greatly in the FAT, DARK WINGS.

• The likes of Deutsche Bank, UBS and Credit Suisse have all unveiled strategies to cut their proprietary activities in illiquid markets and focus on high-volume “flow” businesses: for example, helping clients to manage exchange-rate and interest-rate risk.

Aha!   This is correspondent to the great increase in interest rate derivative notional that we saw in A detailed look at derivative markets.  

We find the CoVAR statistic very interesting.   Notice that the bank names have been withheld, even though the source of the graph is the BoE and Bloomberg.   Is this public information or not?   Regardless, we will take a guess and say that 1,2,4,7,8 are the big 5 banks since they are at most risk from each other's weakness.

• Goldman Sachs’ most demanding pre-GCC stress test, known as the “worst of the worst”, which took the most negative events since 1998, increased them by 30% and assumed they all happened at the same time, was still not pessimistic enough for what was to come.

               Not that this was necessary, but it does speak for itself. 

• A corporate bond and a cash-collateralized credit-default swap written on the same company ought to offset each other—if the company looks likely to default, the bond will fall and the swap rise. In late 2008 the system-wide evaporation of liquidity meant that banks could lose money on both.

We include this statement in spite of the last dubious sentence.   The first part is certainly correct, and banks have in fact lost money on both the credits and CDS.  What we disagree with is that in the CDS market it was necessarily from a lack of liquidity.  In fact, we are seeing the opposite, as CDS liquidity reflects higher systemic risk.

• An analysis by Citigroup that looked at the Great Depression, Japan’s “lost decade” and the Swedish banking crisis, showed that loan books collapsed in all cases; by 50% peak to trough in the US, 30% in Japan and 25% in Sweden. This depressed earning even before taking into account credit losses.

Starting to get the picture?   Many more bank losses are to come, and the profitability of them in the future is under severe doubt.  

• A recent report on the future of wholesale banking from Morgan Stanley and Oliver Wyman reckons that bid-ask spreads have increased by anything from 50% to 300%.

Remember that banks make most of their money from the bid-ask spreads, so the actually stand to benefit from this increase. 

• Survivors of the crisis will also be protected by higher barriers to competition.

We believe this is true and aligns well with our belief that there will be a lot of consolidation in the banking sector and an even greater market share taken up by the largest banks.  

This stunning chart tells the tale of household credit freeze.   Call it what you want.  A higher savings ratio, lack of credit demand, lack of supply, bank hoarding, whatever.  The point is very clear, household new net borrowing has absolutely plummeted.   Who's going to be around to spend the US economy out of a recession?

• According to McKinsey, American consumers have accounted for more than three-quarters of the country’s GDP growth since 2000 and for more than one-third of worldwide growth in private consumption since 1990.

               NO ONE.

Thanks sir for your report, cheers!

*my apologies to those that saw this post in a half-completed stage, it was a technical glitch.

May your capital be safe and your investments prosperous,

MAAA