Sunday, August 22, 2010

Dynamic Portfolio Management and the Buildup of Cash

I am responding to a comment I received about one of my recent posts. The post related to the buildup of cash on the balance sheets of large commercial banks, large non-financial companies, and investment funds. The comment was:

“This giant 'pile of cash' is a myth. Check the other side of the balance sheet and you will see even more debt.”

In this post I will present the situation as I see it. I will use some of the concepts and arguments presented in the book “Financial Darwinism” by Leo Tilman which I just reviewed for Seeking Alpha. (

To begin with I argue that the managements of the large organizations mentioned in the first paragraph have adapted to the new world in which finance is looked on as a dynamic exercise rather than the static one that existed in the “Golden Age” of banking. In the dynamic world of finance, senior managements are constantly assessing and re-assessing the economic environment and adjusting their tactics and risk-taking strategies to match the financial environment as it changes due to variations in economic policy on the part of governments or economic shocks that can alter the trajectory of the business cycle.

About twenty months ago, the Federal Reserve decided that it needed to establish its target rate of interest in a range between zero and twenty-five basis points. And, the Fed decided that it needed to re-enforce this strategy by adding that it would continue to maintain this target range for “an extended time.” That was twenty months ago.

At the time, the yield on the ten-year Treasury bond was around 3.5%

Looking at this situation, senior managements could see that the financial terrain had changed. There was a real opportunity in the “carry trade” where they could borrow in the commercial paper market or in some other short term market for around 50 basis points and then buy Treasury securities that would yield them 350 basis points.

This meant that senior management could change its incremental business strategy, given the new circumstances, and earn a net spread of 300 basis points, RISK FREE. There was no credit risk because they would be investing in Treasury securities. And, there would be no interest rate risk because the Federal Reserve had promised that their interest rate policy would stay in effect for an “extended time.”

Tilman, in his book, refers to this kind of activity as “Balance Sheet Arbitrage” which is defined as “the ability of an institution to borrow at submarket levels.” This used to be the primary business of banks in the static world of banking, but had become less important in recent years as financial markets have changed and financial institutions have become more “intertwined.”

Certainly, however, there was an opportunity for senior managements to benefit from “Balance Sheet Arbitrage” within this new dynamic environment created by the monetary policy of the Federal Reserve. This was not a permanent change because the policy would only stay in effect for an “extended time”. Once the Fed allowed short term interest rates to rise again, interest rate risk would become a problem once again and the senior managements would have to re-assess and re-adjust their tactics in response to this changing environment.

While this Federal Reserve policy remained in place, commercial banks could do the following. On the liability side of its balance sheet, a bank could issue $1.0 billion in short term debt. The bank would then take the $1.0 billion and invest in 10-year Treasury securities. This investment, if my calculations are correct, would provide the bank with $30.0 million in profits, given the 300 basis point spread they could earn. The marginal costs of such a transaction would be miniscule so that we can basically ignore these expenses. But, now the bank has $30.0 million in “cash” which is covered on the other side of the balance sheet by an increase in net worth.

Instead of doing this the bank could write off $20.0 million in bad loans which would be taken against net worth, but the $30.0 in cash would still remain on the balance sheet. The $20.0 million write-off would not only improve the balance sheet of the bank but it would also reduce the taxes the bank would have to pay. This whole transaction would result in the bank earning a one percent return on its assets after taxes, something that most banks would not object to.

The ”giant pile of cash”, however, is not a myth. You can look on the other side of the balance sheet and “you will see even more debt.” However, in the “carry trade” you have investments that match up with this debt. This is how the “carry trade” works. The cash is “real”!

The important thing here, as Tilman argues, is that senior managements must change their strategies once the environment changes. The investments that resulted from the activity describe above were not obtained to “buy and hold” as banks did in the static world of banking. Once the environment changes, senior management must change as well.

What are we looking for here? We are looking for any indication that the Fed is going to change its monetary stance and allow short term interest rates to rise. Rising short term interest rates will also result in rising long term interest rates but the long term rates will generally not rise as rapidly as will the short term interest rates. The spread on the “carry” will lessen and could even turn negative. Senior managements will not want to continue this investment activity given a shift in the monetary policy of the Federal Reserve.

One other point that Tilman makes that I should mention. In such an environment where senior managements continually re-assess and re-position their organizations, “mark-to-market” or fair market accounting is a must. In the static world of finance where institutions bought and held investments, mark-to-market accounting was not as much of an issue as it is in the modern, dynamic world of finance.

In using the “carry trade” within the current policy regime of the Federal Reserve, these large organizations are taking advantage of the opportunities that exist within the “real time” financial markets. When the policy situation changes, they, too, must change their efforts: and this will mean selling off the assets.

If these organizations insist in accounting for these assets at purchase price they are deceiving themselves and deceiving their stakeholders. The risk that the Federal Reserve will change its policy stance exists. The senior managements of these organizations must accept the reality of this risk and reflect this in the changing market value of its assets. There is no way they can justify maintaining the accounting value of the assets as if they were in a “buy and hold” mode.

Furthermore, in a dynamic environment where the senior managements of banks are constantly re-assessing and re-adjusting their portfolios it is very difficult to justify some portion as assets that have been obtained to hold to maturity. This is another fall-out of moving to the dynamic world of finance. The lines between categories blur and it becomes harder and harder to make distinctions between what is something and what is something else. Since environments change, assets that were “honestly” purchased to hold to maturity may have to be sold. The risk of selling assets at a loss must be recognized by banks and presented to stakeholders in mark-to-market accounting.

Conclusion: large quantities of cash have been amassed on the balance sheets of big banks, big non-financial organizations, and big investment funds. This build up is not a “myth”. The buildup of cash has been subsidized by Mr. Bernanke and the Federal Reserve System. If would seem as if these large organizations owe Mr. Bernanke a big “thank you” for all he has done for them.