Restructuring Big Banks

The “new” trend amongst the big banks is to cut jobs.

The “big” HSBC has announced that it will be cutting 10,000 jobs in the near future, part of what many analysts expect to be part of a 30,000 reduction in jobs that will occur over time. 

This joins the efforts of other major banking organizations to scale down such at the Swiss banks Credit Suisse which announced earlier that it was eliminating 2,000 positions and UBS which said it was eliminating at lest 5,000 jobs.

In the UK, Lloyds Banking Group stated in June that it was cutting about 15,000 jobs which follows the news that the Royal Bank of Scotland has already dropped 28,000 positions with more to come in the near future.  Goldman Sachs is also cutting staff, as is Barclays Bank. 

Then, of course, there are the European banks in Ireland, Spain, Greece, and elsewhere that are facing massive amounts of restructuring. 

The big banks have had a fifty-year ride becoming over time huge global empires.  They have gone into this business and they have gone into that business without taking a breath in the process.  As “Chuck” Prince, former Chairman of Citigroup said…the music kept playing, so that the dancers had to keep dancing.

Which led to the situation that I discussed in my last post,  “Can Anyone Manage the ‘Too Big To Fail’ Banks?” (http://maseportfolio.blogspot.com/). 

A problem associated with this situation is whether of not these “Too Big To Fail” banks can be regulated.  There is, of course, some belief that these banks cannot really be controlled, especially with the advances that are taking place in the world of information technology. (See my “The Future of Banking: Dodd-Frank at One Year”, http://seekingalpha.com/article/281090-the-future-of-banking-dodd-frank-at-one-year.)

The question I asked in the first post mentioned was whether or not their shareholders could significantly influence these large commercial banks so that some control could be established over bank managements to reign in “undisciplined” growth and risk taking.  That is, could market performance become a sufficient reason for shareholder governance in the case of these financial institutions that were deemed “Too Big To Fail”? 

The basic reason given for the reduction in jobs given by the banks mentioned above was that revenue growth had deteriorated and cost cutting was needed to bring return the banks to greater profitability.  

Banks profits rebounded after the financial crisis, first, because of trading profits earned in volatile financial markets, and, second, due to reductions in provisions for loan losses. 

However, the banks have not been able to continue producing higher profits due to these factors and with lending, even at the larger banks, so anemic, managements have had to look elsewhere to beef up margins. 

In my mind, this effort at cost cutting does not answer the fundamental question about the future of the large commercial banks. 

Cost cutting is one, immediate management response that can improve profit margins.  The fundamental question to me is whether or not this cost-cutting is connected in any way with a management effort to restructure an organization so as to make sense establish the economic rationale of the bank and to be able to better manage the risk profile of the bank. 

The concern here is that the cost cutting is tactical and not strategic. 

These large financial institutions have grown almost without limit for fifty years and have added businesses more often than not just to increase the size of the organization and have added risk to their business structure without sufficient knowledge or control of what was being assumed.  Furthermore, many organizations used accounting “gimmicks”, financial leverage, and inadequate risk-taking oversight to achieve reported performance goals, which hid basic structural weaknesses.

The fundamental question has to do with whether or not bank managements are to be held accountable for their poor performances.  Will the focus of bank management’s change? 

Many times a change in the focus of bank management will only occur if there is new leadership of the management team.  In the case of HSBC, Lloyds, and Barclays, there has been a change in the past year.  These “new” leaders are expected to shift the direction of their organizations.  Citigroup and Bank of America have had new leaders in the past two years or so.  Citi has seemingly undergone a significant change in direction although better performance is still in the future.  Bank of America seems to be going nowhere, fast.

HSBC also announced another move that seems more “strategic” in nature.  It has agreed to sell 195 branches in upstate New York to First Niagara bank.  This effort, along with the closing of branches in Connecticut and New Jersey, is part of an attempt to rationalize its branch network, worldwide.  HSBC is also seeking to sell its credit card business.    Other areas of the bank are under scrutiny.

Of course, these moves are only “strategic” if they are more than just the “fad” of the moment.  And, this is the ultimate question.  Cost cutting can be a fad.  Other organizations are doing it so I cannot be criticized for cost cutting since others are doing it. 

This “strategy” can be extended to other efforts that only last until “things start to pick up again.”  That is, this “strategy” will only continue until the music starts to play again and everyone must get out, once again, on the dance floor.

Thus, one can still ask, “Can anyone manage the ‘Too Big To Fail’ banks?”

My view is that it is too early to tell. 

Right now the incentive is to re-trench and re-structure.  However, in man circles, especially in the United States, there is still a lot of pressure for governments to inflate credit.  (Need one mention Paul Krugman of the New York Times, “The President Surrenders”, http://www.nytimes.com/2011/08/01/opinion/the-president-surrenders-on-debt-ceiling.html?_r=1&hp.) 

If credit inflation remains the policy of choice of the United States…and others…and continues to dominate the economic scene then I believe that the “fad” will end and the financial institutions will start to dance again.            

If debt deflation dominates, then I truly believe that we will see better management in the financial sector and financial conglomerates will become more rational and risk-taking will be better controlled.  As I have written elsewhere, this is the other side of the process where government provides too much stimulus for an extended period of time, people and businesses respond accordingly, and then, since this situation becomes unsustainable, people and businesses must adjust back to a position that is more sound, economically, and therefore more sustainable. 

Can Anyone Manage the "Too Big To Fail" Banks

An interesting article: “Once Unthinkable, Breakup of Big Banks Now Seems Feasible,” (http://dealbook.nytimes.com/2011/07/27/once-unthinkable-breakup-of-big-banks-now-seems-feasible/?pagemode=print) appeared in the New York Times on Thursday.

The basic question posed in the article: “Lawmakers and regulators have failed to remake our system with smaller, safer institutions.  What about investors?”

Our largest banks are not performing that well.  Shouldn’t stockholders demand better performances?

In terms of Return on Shareholder’s Equity (ROE), Wells Fargo has been at the top of the list of the Big Four.  With the exception of 2008, Wells has earned an ROE of around 10 percent, give or take a little. 

JPMorganChase has not done as well since it was attempting to play “catch up” with the others in the Big Four in the middle 2000s.  Other than in 2008, it has consistently improved its performance with some analysts arguing that it will earn around an 11 percent ROE in 2011.

Citigroup and Bank of America are lagging substantially behind these two.  Citi seems to be recovering from the disasters of 2007, 2008, and 2009, but its performance is still far from stellar.  Bank of America is…terrible.  Both companies will probably not see a 10 percent ROE for many years. 

The point the author of the above article, Jesse Eisinger, is trying to make is that such terrible performances should be met with shareholder demands to restructure in order to improve performance.  Of the four, Citigroup has made the greatest effort to do this but it is an indication of how badly the bank was managed that even this effort has left a lot of work still to be done. 

Bank of America seems to be in a daze.  I don’t think anyone there knows what they are doing.

JPMorganChase, having survived the financial collapse as well as anyone, is trying to expand into areas round the world in which it has not previously been competitive. 

The question proposed by Eisinger is a good one.  Given the performances of these organizations, shouldn’t the shareholders demand some leadership that would rationalize these organizations and get them back on the track to earning competitive returns, which in my mind is an ROE, after taxes, that exceeds 15 percent?

How has the market reacted?  Well, the only bank whose stock price trades above book value has been Wells Fargo trading at about 1 ¼ times book.  JPMorganChase trades at book; Citigroup trades at about ¾ book; and Bank of America trades at around ½ book.

The banking industry, led by these four banks, spent the latter part of the twentieth century building up financial conglomerates through mergers and acquisitions.  The push was to build, build, build.  Financial performance came from financial engineering and financial innovation.  Increased risk taking and greater and greater financial leverage were the games to be played.  Off-balance sheet accounting became a way to hide risk and to “jack up” returns.

As former Citigroup chairman and CEO “Chuck” Prince is famous for saying, “If the music is still playing, you must keep on dancing.”

The problems that accumulated due to the merger and acquisition binge that took place before the financial crisis hit was exacerbated from actions taken after the financial crisis hit by the acquisitions these organizations made in cooperation with the federal government.  Need one mention the acquisitions of Merrill Lynch, Washington Mutual, and Bear Stearns, among others?

Conglomerates, generally, have never had a history of being great financial performance.  Just putting together different kinds of businesses without any reason, without the possibility of achieving any synergies, has not produced exceptional results.  In most cases the resulting performance of such combination is abysmal.

Given this belief, one really needs to ask a question about the “quality” of the performances recorded before 2007.  The amount of accounting tricks, off-balance sheet “slight of hand”, failure to mark-to-market underwater or bad assets and so on sure made some of these banks look like they were really something.

Yet, when things got tough all this “magic” went away.  Banks even stated that some of the calls for accounting “sanity” caused them all the troubles they ran into.

Again, “If you say the problem is out there, that is the problem.”

In my view, the regulators are never really going to get these organizations under control, make them economically sound.  The pressure to do this must come from the owners, the shareholders.

Eisinger presents three reasons why this is unlikely.  First, a large number of bank owners (institutions) tend to be “passive and conflicted.”  Second, top managers get paid for running larger institutions.  If the banks became smaller, top executive salaries would decline.  Third, the growth in world trade requires large banks to support the large, multinational corporations. 

To me, the only true test is performance.  Can large, multinational banks earn a return that justifies people and institutions investing in them?  Can they earn a 15 percent ROE after taxes through achieving sustainable competitive advantage?  Or, do they need to take on excessive business and financial risk accompanied by accounting “gimmicks” to earn such a return?

I have three immediate responses to this.  First, financial regulators and legislators can never do the job we would like to think they might do.  For one, they are always fighting the last war.  They are still trying to prevent a 2008-2009 crisis from happening again.  In addition, given the changes taking place in information technology, it will be extremely difficult to keep up with everything that is going on in the banking system thereby making these institutions even harder to regulate.

Second, the number of “banks” in the banking system is going to continue to decline.  Small- and medium-sized banks are going to find it harder and harder to find niches that are not being eroded by the Internet, mobile devices, and non-banking organizations.  My prediction has been that America will have less than 4,000 banks in five years and this trend will continue. 

Finally, the best thing that Congress and the regulators can do is to require more openness and transparency in the banking system.  We have seen what accounting tricks, lack of disclosure, and failure to record realistic asset values can do to “pumping” up the banking system.  Required greater disclosure can go a long way toward investor understanding what a bank and its management are doing. 

Also, other tools can be used to bring market instruments into the picture as an early-warning system like the one recently proposed by Oliver Hart and Luigi Zingales in the journal National Affairs, and “To Regulate Finance, Try the Market” in Foreign Policy.

The regulators are not going to correct the “Too Big To Fail” problem.  Maybe the owners of the “Big” Banks should correct the problem.

Where the Action Is

Commercial banks aren’t lending. That we know.

But, there is action elsewhere and, I believe, that this behavior tells us a lot about how the recovery is working itself out…although it is not a recovery like the ones of the recent past.

There is a lot of money in the financial markets…in the shadow banking system…and worldwide.

Where is the action taking place?

Well, for one, in the bond market. We have major companies issuing bonds at ridiculously low interest rates. For example, Microsoft just completed a new bond deal. On September 23, 2010, Microsoft Corp., the world’s biggest software maker, sold $4.75 billion of bonds, “at some of the lowest rates in history for corporate debt.” The offering information stated that “Proceeds may be used to fund working capital, capital expenditures, stock buybacks and acquisitions.”

This follows Microsoft’s “first ever” debt issue which came in May 2009. An analyst noted at the time, “Redmond, Wash.-based Microsoft is sitting on $25 billion in cash, so the company doesn’t need the bond proceeds ‘unless they have something big in mind.’”

And, Microsoft is not the only major company taking advantage of the AAA bond market.

Then there is the “Junk Bond” market. The New York Times trumpets “Junk Bonds Are Back on Top.” (http://www.nytimes.com/2010/10/08/business/08bond.html?scp=1&sq=junk%20bonds%20are%20back%20on%20top&st=cse)

Jim Casey, “one of today’s junk-bond kings” and who runs the junk-bond business at JPMorgan Chase claims that “even those heady days of the 1980s” when Michael Milken ruled Wall Street and who Mr. Casey worked for at Drexel Burnham Lambert, “seem a little tame.”

So far this year, it is reported, that in the first nine months of this year corporations have raised $275 billion in this market worldwide, up from $163 billion in 2009.

“In high-yield, it’s undeniable that these are the best years that anyone has seen in their career.”

Whew!

It is estimated that “about 75 percent of the deals are aimed at refinancing, rather than taking on additional debt.” The risk profile of the companies has gone up!

And, who are big players helping to underwrite these deals? Let’s see, JPMorgan, Bank of American and Merrill Lynch and Citigroup…the top four!

Further action?

Well check out the private equity interests. They are raising capital in the billions. To do what? “Many banks are looking to sell large portfolios of commitments to private equity funds that they made during the credit bubble.” Banks are doing this because these “assets” are underwater and also because new higher capital requirements will make their “ownership” very expensive.

This just points to a whole host of private equity interests moving into the area of distressed assets. And, they are moving in aggressively. We read the article in the New York Times this morning about short-seller David Einhorn, the founder of Greenlight Capital. (See “A Bear Roars”, http://www.nytimes.com/2010/10/14/business/14views.html?ref=todayspaper.) One of the interesting insights relating to the work of Mr. Einhorn is the detail that Greenlight Capital put into its “due diligence” of the target.

The attention being focused on “distressed assets” today is not just a casual thing. Fund managers are aware of the risks they are under taking, just as they are aware of the potential returns that are available. As some have said, they are “taking care.”

One analyst remarked on the condition of the market: “We are seeing a steady river of deals” and “we expect this stream to carry on for some time.”

This is all part of the movement I reported on in “Corporations are Hoarding Cash and Keeping Their Powder Dry,” (http://seekingalpha.com/article/228507-corporations-are-hoarding-cash-and-keeping-their-powder-dry).

There seems to be a tremendous re-structuring of the economy taking place. I now believe that the re-structuring that is going on is beyond the power of the government to reverse. I believe that a similar re-structuring took place in the 1930s and 1940s, a re-structuring that the government, at that time, could not reverse. The 1950s represented the start of a “new era”.

The structure of the industrial base of the United States is dis-located with American industry using only 20% to 25% of its capacity. The structure of the work force is dis-located as 20% to 25% of the age-eligible workers in the United States are under-employed. And, the income/wealth distribution in the United States has become more and more skewed over the past fifty years.

These “dis-locations” will not be resolved by what corporate America seems to be doing now. Large companies, large banks, private equity funds, hedge funds, and other money sources are building up their cash reserves. They are looking, I believe, to buy assets, to buy “distressed companies” and so forth.

Imagine that Microsoft, a company that had never issued any debt in its history, has raised over $8.5 billion in new cash over the past 18 months or so while it is sitting on $25 billion in cash. Can you picture this money going to fund working capital and capital expenditures? I can’t but I can certainly see it going to fund stock “buybacks” (which raises its ability to purchase other companies) and to fund acquisitions.

Actions like this, however, will not result in higher levels of employment or greater investment in capital that would spur the economy along. If anything, a re-structuring, like the one I am writing about will have exactly the opposite effect.

Yet, this may be how the economy goes about recovering!

As I said above, I now believe that the re-structuring that is going on is beyond the power of the government to reverse. If this is true, neither a further quantitative easing on the part of the Federal Reserve System nor additional fiscal stimulus on the part of the federal government will do much in the way of achieving a more rapid economic recovery. If I am correct, the economic re-structuring will take place at its own speed. But, this will require a different response on the part of the government.

Three Perfect Quarters: Goldman, JPMorgan, and BofA

The news is out! Three perfect quarters!

JPMorgan Chase and Bank of America join Goldman Sachs in turning in a perfect quarter. See “3 Big Banks Score Perfect 61-Day Run” at http://www.nytimes.com/2010/05/12/business/12bank.html?hp.

Before, we only knew that one of these three had achieved this performance. See my post “Goldman’s Perfect Quarter”: http://seekingalpha.com/article/204473-goldman-s-perfect-quarter.

According to the New York Times: “Despite the running unease in world markets, three giants of American finance managed to make money from trading every single day during the first three months of the year.
Their remarkable 61-day streak is one for the record books. Perfect trading quarters on Wall Street are about as rare as perfect games in Major League Baseball.”

It was something to have just one bank achieve this perfect record. But, THREE!!!

As I said in the previous post: THANK YOU MR. BERNANKE!!!

Who loves the big banks? Why the Federal Reserve does! Keep the subsidy flowing, baby!!!

And, now Congress is going to audit the Fed.

The Fed seems to be at an all-time low in the eyes of Congress and the public. The Fed, by some, is given credit for “saving the world”. Yet, they don’t appear to be getting much credit for it these days. Ah, the problems with being a savior!

Central banks used to be well-respected institutions and their heads used to be the solid leaders of finance and banking.

Not anymore.

I don’t remember a period in which the Fed has lost more prestige or more good-will than it has in the past seven or eight years. Not even Bill Miller achieved this kind of record!

Bank of America and the Appointment of Sallie Krawcheck

This continues to be a trying time for the finance industry. Articles like the one that appeared this morning in the Wall Street Journal just do no good for the stature of those who admit to working in finance in one way or another. The article I am referring to is “Behind BofA’s Silence on Merrill,” http://online.wsj.com/article/SB124952686109510009.html.

The problem is one similar to that described by John Plender, the Chairman of Quintain PLC, in the Financial Times yesterday, “Ditch Theory and Take Away the Punchbowl,” http://www.ft.com/cms/s/0/e8b88624-8107-11de-92e7-00144feabdc0.html. Plender presents the folksy strategy for central banking ascribed to William McChesney Martin, former Chairman of the Board of Governors of the Federal Reserve System. Martin is reported to have said that the task of a central banker was to take away the punchbowl before the party got out of hand.

To me, the role a financial officer, especially a Chief Financial Officer, is similar. A financial officer ultimately must be the naysayer in an organization. If the financial officer does not act out this role in an organization then the Chief Executive Officer is not going to be well served by the finance function and the organization is going to be exposed as it grows and considers alternative business options!

No one else in the organization performs this function. A “good” Chief Executive Officer wants a strong person in this position because without someone there to say “no” from time-to-time, the CEO will be like the emperor that is wearing no clothes. A “good” CEO knows this. One thing I look for in evaluating a management team is the strength of the people a CEO surrounds him- or herself with, especially the strength of the CFO.

A strong Chief Financial Officer knows that there is no such thing as a free lunch. That is, when it comes to finance, you never get something for nothing. If you want a greater return on your assets, you can take on riskier assets, or you can increase you financial leverage which, of course, increases risk, or you can mismatch the maturities of your assets and liabilities which, of course, increases risk. Of course, we can extend the idea of “no free lunch” to proposals coming from marketing, or information processing, or purchasing as well, but I am sticking with financial issues because that is where the concern is today.

In the euphoria of the credit bubbles that took place in the 1990s and the 2000s, CFOs and other finance people that believed that there was “no fee lunch” and acted upon this belief seem to have fallen out of favor with CEOs seeking to make bundles of money in the bubbles. Of course, not everyone acted in this way but a significant number did and we are all paying the price for this today.

When one sees articles like the one in the Wall Street Journal mentioned above, you can understand why people on Main Street and why Senators and Representatives in Congress can pick on bankers and others who are in the finance profession. It certainly seems as if a trust was broken and greed ruled the kingdom.

The hiring of Sallie Krawcheck by BofA is, therefore, a hint that maybe BofA understands that it needs to build up its credibility. Krawcheck has a reputation for openness and integrity that has stayed with her throughout her career. The argument is that this trait got her in trouble with the CEO of Citigroup, Vikram Pandit, and cost her the position of CFO which she held at Citi. Taking over responsibility for BofAs global wealth and investment management business in not the same as becoming CFO of the institution, but it indicates that BofA is pulling in someone that is not only talented and capable in finance, but also will add some credibility to the organization in terms of honesty and transparency.

One can learn a lot about leaders and the organizations they lead by observing how they respond to people that possess these qualities, especially in times of trouble. Citigroup seems to have a history of releasing top people that question how financial affairs are being handled. Richard Bookstaber comments on how Citi operated in the area of risk management in his book “A Demon of Our Own Design”. We also see that Jamie Dimon was asked to leave Citi when he began to clash with the leadership of that organization on issues of risk and management. (See my review of a book about Dimon: http://seekingalpha.com/article/148179-book-review-the-house-of-dimon-by-patricia-crisafulli.) It seems as if Citigroup worked hard and long to get itself into the position it is now in.

Of course, BOA and Citi are not isolated cases. One can name any number of organizations from Bear Sterns to Lehman Brothers to AIG to Wachovia to Countrywide to so and so and on and on. The depth and breadth of the problem just indicates how far the finance profession has lost credibility.

That is why I would advise at this time that investors look even more closely at the people, especially the finance people, that the leadership of an organization brings on board. Strong financial leadership is needed within an organization, leadership that stresses telling the truth, reporting asset values at realistic levels, and leadership that rejects accounting rules that only muddle if not mislead investors and regulators.

In this regard I would argue that we have to get back to mark-to-market accounting. To me, people only kid themselves when they finance long term assets with short term liabilities in order to capture additional return and cry and whine when they have to mark down the values of their longer term assets if the market goes against them. They are brave enough to gamble on this mismatch of maturities. They also need to be brave enough to accept the consequences of their actions. There is no free lunch!

In my experience there is one thing that financial integrity does: it causes people to act earlier than they would otherwise. The situation I saw over and over again in doing bank turnarounds was that people postponed doing anything about a bad position because they were not forced to recognize a problem early on. As a consequence they put off doing something about the bad situation and put it off until the problem grew into a much larger problem where they could not postpone action any longer. Good management recognizes problems and deals with them early on.

Hopefully, the hiring of Sallie Krawcheck is a sign that organizations are recognizing the need for strong financial leadership. Then, in hiring more people like her, maybe emperors won’t have to go out into crowds to discover that they don’t have any clothes on. The absence of clothes will have been discovered long before then and the situation will have been corrected.

Bank of America dot Gov

It is becoming clearer and clearer what it means to have government involved in the affairs of banks and businesses. Where all the initial talk was about the “moral hazard” presented by government bailing out the private sector and how this just means that in the future banks, and other organizations, will just take on more and more risk because they know that if things go bad, the government will be there with a rescue net to save the institution.

Now, we are seeing the other side of the bailout business. In the AIG case executives and others were angry because the government interfered with bonuses and other executive decisions. And, we have the government putting lids on executive pay. And, we have government wanting to rewrite mortgages, and cap interest rates on credit card debt, and so on and so on.

This is the other side of the coin.

And, now we learn from testimony given by Ken Lewis, the CEO of Bank of America, that Hank Paulson and Ben Bernanke put a “sock” in his mouth and strongly advised him that he say nothing to the shareholders or anybody else about the implications of the merger between Bank of America and Merrill Lynch.

Furthermore, we hear from New York’s Attorney General Cuomo that Paulson threatened to fire Lewis and remove the entire Board of Directors it Bank of America did not go through with the merger with Merrill Lynch! The reward—money from the Government to help BOA through the process.

The shareholders? Well, they lost on the value of their stock. And, they also will have higher taxes or an inflation tax that they will have to pay in the future.

In addition, why should any company, financial or non-financial even think of an acquisition in the future because the government may force the management to swallow hard, take on something that is not necessarily desirable for the company, and, of course, not inform investors as to the implications of the merger transaction?

And, why should the stockholders of any company approve any acquisition that is at all questionable? The precedent has been set that they might be approving something that will cost them considerable wealth as the stock of their company tanks, and they are given no information to give them any confidence that the transaction might be a worthy one.

What if the shareholders balk? What if they fail to approve such a merger? Will the government step in and force through the merger anyway?

Talk about a mess!

Two thoughts come to mind that I must express.

First, the combination of Paulson and Bernanke was a disaster as far as I can see. I have written about how Bernanke seemed to panic last fall and the result was the TARP. (See my post “The Bailout Plan: Did Bernanke Panic”, http://seekingalpha.com/article/106186-the-bailout-plan-did-bernanke-panic.)

Paulson didn’t do much better in his handling of the crisis and the creation and oversight of the TARP. I always thought that Paulson found the whole bailout idea not to his taste and had hoped that he would be able to get out of Washington before the collapse. Unfortunately for him—and for us—he didn’t make it. As a consequence here was a man doing something that he despised, and his heart, and mind, was really not in the effort. He has left us a very unhappy legacy!

When I reflect on the events of the last fall I keep coming up with the feeling that we would be hard pressed to have found two people less capable of handling the situation than the two that were then in charge. And, then there was the “Decider”, but he was AWOL!

The second thing has to do with the fact that the bankers, and other business leaders, are getting pelted with all the blame for the financial collapse and crisis that we have experienced. Thus we have the “bad guys” in our sights. Thus, they should pay.

But, what if the conditions that existed were created by the government and these bankers and other business leaders were just responding to the incentives initiated by the government? We had a credit bubble connected with the stock market in the 1990s. The credit bubble resulted in negative real rates of interest and consumers stopped saving. The saving rate fell from 7.7% of disposable income in 1992 to about 2.0% by the end of the decade. Then there was the huge deficits that resulted from the 2001 tax cuts and the “war on terror”. This was accompanied by negative real interest rates gain which resulted in the credit bubble in the 2000s and the housing boom. The consumer savings rate remained around two or below, even becoming negative for a short period of time.

The foreign exchange market in the 2000s indicated a fear of a renewal of inflation as the value of the dollar fell by more than 40% against major currencies. What were financial managers to do in such an environment? Generally, because spreads narrow in such times and arbitrage opportunities are based on smaller differences, you tend to leverage up and mismatch maturities. This response is a normal one to gain the needed returns on equity to keep money from leaving your fund or institution.

Is this greed? Yes, but it is also just the natural response of competitive people to the incentives that are created, in this case, by the government. The Bush 43 administration may have been composed of “Free Market Capitalists” but this “gang that couldn’t shoot straight” did more to harm capitalism than most other administrations in the history of the United States.

So, government gets it both ways. It can create the crisis. And, then it can impose itself on the economy to right the system after the crisis occurs. And, best of all, the blame can all be put on “greedy” bankers and the lack of regulation.

I am sure that before this is over we will hear many more horror stories.

Households and the Debt Problem

The Federal Reserve released new data on the financial condition of the household sector of the United States. Like other sectors of the economy, the financial condition of this sector has deteriorated over the past year.

The value of household assets dropped about 15% falling from $77.3 trillion to around $65.7 trillion. Most of the decline came from the fall in housing values and in their stock market portfolios.

In terms of household holdings of stocks, the value of the stocks households owned, mutual funds that were held and funds in retirement plans, the loss was $8.5 trillion. That is, the value of stock holdings fell from $20.6 trillion to $12.1 trillion.

Although mortgage credit fell during the year, total household liabilities stayed roughly the same at about $14.2 trillion. This means that debt as a percentage of assets rose from around 18% to 22% during the year (or net worth as a percentage of assets dropped from 82% to 78%).

Mortgage credit at the end of 2008 was $10.5 trillion so that other household liabilities totaled around $3.7 trillion, with consumer credit making up $2.6 trillion of this latter number. Mortgage credit fell during the year, but not because the household sector was trying to get out of mortgage debt. The primary reason for the decline was foreclosures and the reduction in the willingness of financial institutions to lend.

What this means is that households took on increased leverage during the year, not because they wanted to in order to grow their balance sheets, but because of the decrease in the value of their assets and because of the need to borrow due to lower incomes. The increased leverage was a result of the collapse of the mortgage market, in particular, and the economy, in general. The increased leverage just happened—it was not planned.

In order to protect themselves in the face of these changes, households moved assets into cash and cash equivalent accounts. Banks deposits held by households were at about $7.7 trillion at year end.

This is important information for understanding the state of the economy and the contribution the household sector might make toward turning the economy around. The household sector was in free fall in 2008 and was reacting to events, not leading them.

Households took three major shocks last year: first was the decline in housing prices; the second was the rise in unemployment; and the third was the fall in the stock market. Not only was their cash flow significantly hurt, but the value of their assets fell precipitously. They borrowed in an effort to hold on and they became more liquid so as to be prepared for that “rainy day.”

The year 2009 does not look any better than 2008. Housing prices continue to plummet. The stock market has dropped since the first of the year. And, unemployment has ratcheted up. That is, one can assume that the direction observed in the balance sheets of American household in 2008 will continue to be followed this year. Even if the stock market were to stabilize or rise through the rest of the year consumer spending, I believe, will continue to be weak. Even if housing prices stabilize. Even with the implementation of the Obama stimulus plan.

According to the best information we have there are three further shocks looming on the horizon. The first two have to do with the mortgage market: over the next 18 a large amount of Alt-A and Options mortgages are supposed to re-price. Given the weakness in employment that is expected to continue and the lower household incomes, this event could be devastating. And, on top of that credit card delinquencies are rising and these are expected to grow given the financial condition of the household sector.

Consumers will continue to withdraw from the marketplace as they add debt where they can in order to maintain at least a part of their former living standards. Also, consumers will continue to try and become more liquid so that they can be prepared should they need to need cash to tide them over a rough time. Any improvement in the stock market will be met with households selling more stock so as to move the funds into more liquid assets, the rise in the market making it easier for them to get rid of stocks—even at a loss.

And where are the funds going to go that come to households from the Obama recovery plan? My guess is that a good portion of them will go into liquid assets, or into paying down debt. Households are scared right now. They are going to use whatever they have as conservatively as possible. This even goes for those that have some security in their employment condition.

The data that are coming out confirm the strength of the problem that the policy makers face. The United States has a tremendous debt overhang. This debt problem is going to have to be worked off. Economists talk about “the paradox of thrift”, the problem that consumers are not spending at this time and probably will not spend much in the near future, even though if everyone opened up their pocketbooks and spent, everyone would be better off.

This situation is like a “Prisoner’s Dilemma” game. If everyone else increases their spending reducing their savings and, willingly, increasing their debt and I don’t follow their lead, then I will be a lot better off that all these other people. But, if everyone else believes as I do and doesn’t reduce their savings and doesn’t increase their debt, then I end up losing big to everyone else. So, as in the “Prisoner’s Dilemma” everyone defaults to the decision to save more where they can and to pay off their debt. The consequence of this will be that consumer spending will remain weak and much effort will be extended, where possible, to work themselves out of debt.

The overall problem is that there is too much debt outstanding. The policy makers are focusing upon stimulating the economy by increasing spending. If the debt overhang is truly too great, then the stimulus package will only have a small multiplier effect on the economy as households try and get their balance sheets back in some kind of order.

Such behavior will not have much affect on the economy, and it will also not have much affect on the stock market. Government policy makers must direct more attention to resolving this debt problem. It seems to me that this is what the financial markets are trying to tell them. As Citigroup and Bank of America claim they are showing some signs of profitability. As General Electric survives a reduction in its credit rating, meaning that GE Capital has more of a chance to re-structure itself. As General Motors indicates that it has reduced costs sufficiently to rescind the request for another $2 billion from the government in March. And, as other financial institutions seek to repay to TARP money they had received last fall, the stock market rebounds.

It is the debt problem that is the big concern of the financial markets. In my opinion, as long as the government policy makers put their primary focus on stimulating spending, the financial markets—and the economy—will continue to flounder. When they refocus on the more crucial problem they will find that the financial markets will be more supportive of what they are doing.

The Citigroup "Rally"

The performance of the stock market today, March 10, 2009, I believe, provides us with a clear indication of what is predominantly on the minds of investors. The major concern of investors is the value of the assets that are carried by companies on their books, and especially on the asset values on the balance sheets of financial institutions.

I say this because Citigroup has been the “poster child” of what most investors feel is wrong with the financial markets and the economy. The perception is that Citigroup is so weighed down by assets that are not performing and that must be written down that there is little or no hope for its survival outside of a full takeover by the United States government.

Focus has been so strongly focused on the “asset problem” that other institutions, like Bank of America and JP Morgan Chase & Co., have also been affected with concerns about the value of their assets. As a consequence, the stock price of these and other financial institutions have declined drastically due to the uncertainty as to whether or not they are solvent.

The stock market took off right from the opening bell this morning. The cause—a memo written by Vikram Pandit, the chief executive officer of Citigroup, to employees of his organization indicating that Citigroup had been profitable for the first two months of 2009 and was likely to turn a profit for the first quarter of the year. If this happens it will be a sharp turnaround in performance for the company, a move to the black after five consecutive quarterly losses.

There was no indication about any special write-offs or credit losses, but the memo gave hope to the idea that Citigroup, even after such write-downs, would post a profit for the first quarter.

The hope that was forthcoming, I believe, is the hope that Citigroup will now be operationally in the black going forward and that this kind of performance would give them the time and cushion to continue to work off bad assets and take more modest charge-offs against profits in the future.

The hope is certainly not that Citigroup is “out-of-the-woods.” That would be too much to hope for. To me, what is captured in the market response is that Citi may still have time and not be forced into some precipitous governmental takeover action.

Now, let me say that this was just one day and just one piece of action released by someone that needs, in the worst way, to give some sort of encouragement to his troops. Tomorrow is another day and there will be more information and more market maneuvering in the future. But, it was a day in which there was a possibility for hope—no matter have small that hope might be.

The problem had been that investors had perceived asset values declining with no bottom to be seen. And, there was no one or no event in sight that might put a stop to this decline.

This is why I believe that the financial markets have not been giving President Obama and his team “good grades” on their efforts to craft an economic policy and a bank rescue bill. The economic recovery plan was proposed and passed by Congress, yet there was no “bounce” in the market due to this program. So far, any bank rescue bill talked about or outlined has been deemed a dud.

It is this latter failure that the financial markets have been reacting to. To the financial markets the concern over asset values has dominated everything else. The recovery plan does not address this issue and so does not provide any confidence to investors over possible bankruptcies and takeovers related to institutions that are insolvent due to the bad assets on their books. Expenditures on infrastructure and education and health care and so on are one thing, but a stimulus package like the one that passed Congress cannot prevent a collapse of the financial system as the value of assets plummet and are recognized.

And, so the memo relating to the two-month performance of Citigroup hit the market and gave investors some encouragement that there might be some possibility that the problem related to asset values maybe…just maybe…could be worked out. And this attitude spread to other companies and other areas in the stock market.

We see that the stock of Bank of America Corp. rose 28 percent, the stock of JPMorgan Chase & Co. rose 23 percent, and the stocks of PNC Financial Services and Morgan Stanley increased by double digit numbers. Of especial interest is that the stock of GE rose by 20 percent reflecting the spillover of the positive attitude given to the banks was also given to GE and the concern over the fate of GE Capital.

Again, all of these companies have seen the price of their stocks decline in the past six months or so because of the concern over the value of their assets.

As mentioned, stocks rose from the opening bell, seemingly responding to the contents of the Pandit memo. But, the market responded to other news that they interpreted in a positive manner.

Fed Chairman Ben Bernanke gave a speech that reinforced the “good news” coming out of Citigroup. In this speech, Bernanke discussed the need for moving onto a new regulatory system. The part of his statement that market participants focused upon was Bernanke’s claim that the accounting rules that govern how companies value their assets needed to be changed. The Fed Chairman was careful to say that he did not believe that the mark-to-market accounting rules should be changed. Still he did talk about how asset values should be treated and investors reacted to this in a positive way. Again, the focus of the market was on asset values and little else.

There was one other bit of news that the financial markets reacted to in a positive way and that was the comment of Barney Frank about the “up-tick” rule. This statement, although important in itself, was only a side-show in the movement of the stock market today. Its just that when the good news is poring in, look out!

The important take away about the performance of the stock market today is that the major focus of the investment community is on the value of the assets on the balance sheets of banks and other organizations in this country. This message should be read loud and clear by the Obama administration. Spending plans are fine, but the recovery of the country depends very heavily on what is done about the value of the assets on the books of banks and other organizations and how losses in value are going to be worked off.

This is important too because of what is on coming in the future. It seems as if the credit problem is going to accelerate as the defaults rise on credit card debt, as interest rates need to be reset on Alt-A and option payment mortgages over the next 18 months or so, and the looming bust in the commercial real estate market. The asset value issue is not going to go away soon.

So, we got a rise in the stock market. We may get several more in the next week or so. I don’t believe anyone can predict the movement in the stock market over the coming six months. There are still too many uncertainties. And, even if the stock market were to rise over the next six months, my bet is that the asset valuation problem is still going to be with us. And, in all likelihood it will still be with us next year at this time.

A Case Study in Unknown Asset Values: A. I. G.

My blog of March 1, 2009, “Uncertain Asset Values and the Stock Market” (http://maseportfolio.blogspot.com/), was written before the most recent news surfaced about the continuing bailout of A. I. G. I believe that the example of A. I. G. represents a perfect ‘test case’ for what was presented in that post.

The March 1 blog contended that the major uncertainty facing the investment community…and the Federal Government…is the value of assets on the books of many of the nations businesses…especially many large and important firms that are “too big to fail.” The argument is that this uncertainty has to be cleared up as much as possible before the economy is really going to have a chance to regain its health.

The problem now is that not only are companies withholding information from the investing public…but the government is also withholding information from the investing public. Specifically, companies…and the government…are afraid to release information on who they are dealing with…the “web of counterparties”…because of their concern that the release of these names would cause a panic leading to deposit withdrawals or the cashing in of insurance policies and so forth.

This is the old “after-the-fact” problem. I used to be a part of “information sessions” for journalists to help them understand banking and the issues that surrounded the banking industry. One of the concerns that always came up at these sessions was about what responsibilities “the press” had in reporting on troubled banks. That is, if a journalist “knew” that a bank was in trouble…what responsibility did that person have to report that the bank was having problems…and thus, perhaps, cause a “run” on the bank.

This is an “after-the-fact” problem. The bank is already a troubled bank…now what do I do?

One of the arguments I made was that journalists should keep up closely enough with banks to report when banks were starting to experience difficulties. By making this information public, the press could help prevent the bank getting too far into a mess because it would want to avoid the bad publicity and work to rectify the difficulties before they got “out-of-hand.”

This, of course, was very difficult because of the insufficient reporting requirements applied to banks and the secrecy surrounding the regulatory examinations. And, if banks knew that they were being scrutinized that closely by “the press” they would certainty make it just that much more difficult for the “outsiders” to obtain information.

So, investors and communities had little information on financial institutions that were important to them and had to “trust” the regulatory agencies to apply the appropriate oversight to the banking system. Of course, the regulatory agencies did not always have “full information”, especially as the financial conglomerates began transacting in very sophisticated derivative securities and taking many assets “off balance sheet.”

I believe that the company A. I. G. is a striking picture of how this scenario played out. A. I. G. is a holding company that began as an insurance company and then diversified itself into a financial conglomerate that included a hedge fund and other “black box” investment vehicles. Their primary regulators were the state insurance regulators (and some international regulatory requirements) and the state laws caused the subsidiaries to be highly segregated so as to ensure the safety of those the insurance subsidiary had insured.

The rest of the company was not regulated to any degree. As a consequence, A. I. G. was able to build up a huge financial conglomerate that could engage in untold transactions that were both un-regulated…and un-disclosed! The accounting and reporting rules were such that investors…and the public…and the government…and even other areas within the company did not have any idea about the risk exposure of the holding company or the “spider-web” of relationships that made it a potential “carrier of contagion.”

And, we…and the government…still don’t know what the potential damage could be from this dismal situation!

As a consequence, the probability of a fifth (this last bailout was the fourth return to A. I. G.) is a lot higher than we would like it to be. And a sixth? And a seventh?

With the government owning almost 80% of the company it would seem like any additional funds would be relatively small.

But, that is the problem…we don’t know! No one seems to have a handle on the value of the A. I. G. assets!

And, as I argued in “Uncertain Asset Values and the Stock Market”, this problem exists throughout the economy. What about the assets of Citigroup? What about the assets of Bank of America? Again, to quote the earlier blog, “It is not altogether clear that even the people running a large part of this economy have any idea about the value of their own assets.” Again, I take A. I. G. as the example.

And, then we have General Electric…and the problems of GE Capital. Again…we have another conglomerate with few pieces that go together. For years, GE Capital carried the rest of General Electric. And, what happens if you have one subsidiary making up for the “not-so-good” performance of other subsidiaries? You put more and more pressure on the performing subsidiary to produce exceptional results. And, how do you do that? You take riskier assets into your portfolio and you increase leverage. Simple!

Now, GE Capital is suffering along with other financial companies that attempted to extend “exceptional” returns. And, with GE Capital failing to perform…the spotlight is being focused on all the other subsidiaries that were only mediocre performers. Consequently, General Electric must face the value of ALL of its companies and determine what are the asset values under its umbrella.

This, to me, is the picture that is unfolding…and the problems we face are not going to be resolved until we get a better grasp on asset values. But, we need to do this quickly because…and this is the problem of bad assets…the value keeps dropping if the difficulties are not resolved. This is true of bad assets in an individual institution…I saw this over and over again in the banks I helped turnaround…and it is true with the financial and economic system. In fact, that is the problem with a contagion…bad assets tend to play off of bad assets…and the difficulties cumulate. This is all the more reason for attempting to get a handle on asset values as soon as possible.

A $787 billion economic recovery plan is insufficient to overcome the possibilities of a multi-trillion dollar write-down of assets!