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.

Regulation Never Works As Planned

One constant seems to run through my whole professional career.  The regulators impose some new rules…and within a reasonable period of time, the private sector finds ways to get around the new rules.  Then the regulators impose further new rules…and within a reasonable period of time, the private sector finds ways to get around them.

Back in the 1960-1971 period, I was in the Federal Reserve System and one of the main new financial innovations that the Fed was dealing with at the time was the Eurodollar deposit.  The “time lag” then was about six months. 

That is, the Fed would see some activity it wanted to get greater control of and it would impose new rules or restrictions on the activity.  The banks would then respond to the new rules or regulations.  About six months later the Fed would discover what the banks were doing to get around these new rules or regulations.  Then, the Fed would move into action once again.

At that time, however, we did not refer to the commercial bankers as “greedy bastards.”

In fact, any void seemed to call forth the ingenuity of the financial community.

The credit inflation, begun in the early 1960s, provided the incentive for the financial community to engage in more financial innovation over the next fifty years than ever before in human history. 

Restrictions on the interest rates that financial institutions could pay on deposit—Regulation Q—could not stand up to the inflationary expectations that got built into interest rates.

The consequent volatility in interest rates made it worthwhile to develop interest rate futures and interest rate options.

The desire to drive more and more credit into the housing market resulted in the government creation of the mortgage-backed security and the validation of “slicing and dicing” of the cash flows generated by financial instruments.

This slicing and dicing spread to government issues and we got the Treasury “Strip” securities...and more.

And, the continued credit inflation resulted in greater and greater amounts of risk taking and things like credit default swaps to hedge against risk taking.  We got more and more financial leverage and this required new ways to “cut things up” or hide things “off-balance sheet” or make things “synthetic” or deal only in “nominal” values. 

And, the beat goes on.

To me, this comes out in the rant of JPMorgan’s Jamie Dimon the other day against Ben Bernanke.   His blast, I believe, was one of pure frustration.  We want to be bankers, Dimon said, but the Fed…and Congress…and the Administration…force us to be financial innovators, constantly creating ways to get around the ill-considered new rules and regulations that continuously flow out of the government. 

He could have said, “If you want us to stop the financial innovating do two things.  First, stop inflating credit as you have done for the last fifty years and are continuing to do at this very minute!  Second, let things settle down and stop trying to regulate the very things you are causing us to do because of your inflation of credit!”

Will the government do this?  Not likely, and that is why Dimon is so frustrated.

My prediction: the financial system, over the next five to ten years, will be different in major ways from what we now see in front of us. 

The reason is that bankers…and the public…will create a new and different financial system. 

For, example, what about the “shadow-banking system” that was created in the past twenty years or so?  Maybe this “system” will become the preferred lender to business.

It is still there, thank you, and it is “filling in the current void.”  See the front page New York Times article this morning: “Bank Said No? Hedge Funds Fill Loan Void.” (http://dealbook.nytimes.com/2011/06/08/bank-said-no-hedge-funds-fill-a-void-in-lending/?ref=business)  “With traditional lenders still avoiding risky borrowers in the wake of the financial crisis, hedge funds and other opportunistic investors are stepping into the void.  They are going after mid-size businesses that cannot easily raise money in the bond markets like their bigger brethren.”   No telling where hedge funds…and others…will be found these days.  

And, this doesn’t even include what might be done electronically.

What is money?  What is finance?

As I have argued many times in previous blog posts, money…finance…is just information…just 0’s and 1’s!

“Concerns about the integrity of money have also seen a fundamental shift…While fraud is still a concern, the financial collapse of 2008 has called into question the competence of the central banks that are supposed to manage national currencies.  In this week’s technology special we examine how the internet is allowing groups of people to set up means of exchange that are independent of both the banks and the state.”

Hold on there…

What about gold or silver?

“Private currencies are nothing new, but novel possibilities such as bitcoin now beckon.  Though bitcoins are magicked out of nothing, money is what money does, and many people are happy to accept bitcoins as payment for real goods and services.  The bitcoins in circulation are now worth around $50 million in conventional currency.”

“Governments may want to clamp down on what they see as a way to evade taxes…”

“But the future of money, as so much else, may be shaped by the internet’s ability to bring interested parties together outside the ambit of governments or big companies. “

“Under a scheme operating in the city of Macon, Georgia, special bonds are issued to residents—but each person receives only half a bond, and can only redeem it by locating the person with the matching half.  Participants must seek each other out through online social networks such as Twitter, then decide together how to spend the cash.  Attempts to set up such ‘local currencies’ have been tried many times before, but have usually proven too difficult to co-ordinate and organize.  Social media offer such schemes a new lease of life.” (New Scientist, June 4, 2011)

The point is that regulation never works as planned because humans are just too ingenious and improved information technology and the spread of information eventually winout over time.  As a consequence, regulators…and politicians…are always fighting the last war.  Another way to phrase this is that regulators…and politicians…are always out-of-date!

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.

The Shadow of Lula

It is remarkable to see the accolades being heaped on retiring Brazilian President Luiz Inácio Lula da Silva. Who would have believed this would be the case eight years ago.

Even the Financial Times has as its lead editorial “Brazil Dazzles Global Finance” (See http://www.ft.com/cms/s/0/9de004be-ca68-11df-a860-00144feab49a.html). “Brazilian finance will be felt increasingly in international centers.” Brazil’s development bank, with a balance sheet larger than the World Bank, has chosen London as its main foreign office.

Brazil is a player. Statements like this cannot be put in a future tense any more like “Brazil wants to be a player in the world.”

And, the Brazilian Finance Minister Guido Mantega gained global headlines this morning with his comments about “a trade war and an exchange rate war.” Brazil has one of the stronger currencies in the world right now. The value of the dollar has fallen by about 25% relative to the
Brazilian real since the beginning of last year.

Brazil is now listened to around the world.

This is just one more indication of how the world has changed.

Every day, we, particularly in the United States, must remember that things are different now. Although the United States is still a very powerful nation, quite a few other countries have increased significantly in power so that the relative position of the United States is not the same as it once was.

And, there are other hints. JPMorgan Chase has reorganized so that it can become more of an international force. Economically, it cannot just rely on its position in the slow growing United States economy anymore.

We also see the changes in leadership in the United States. For example, the bank that formerly was the largest bank in the United States has someone born in India as its CEO, Vikram Pandit, who was brought into this position to save Citigroup and turn it around.

And what about the biggest, most aggressive investment bank (now a bank holding company) in the United States, Goldman Sachs. There are rumors that a Canadian by birth, someone who has been Goldman’s Asian chief, Michael Evans, is playing a larger part in the management of the company and might even be a successor to Lloyd Blankfein, the current chief executive. Also, Mr. Evans does not have a back ground in Goldman’s trading unit, a place many other Goldman Sachs’ leaders have come from.

The world is open. People and products and services are flowing more easily from country to country.

We still see individuals that resist this fact.

It is hard to believe that this growing global integration can be ignored by investors, governments, and financial institutions, manufacturing concerns, and others who want to perform well in these times.

Well done Mr. Lula!

Ho-hum, the Financial Reform Bill is Going to be Passed

Perhaps the most benign statement about the passage of the United States financial reform bill passed by the House of Representatives last week and whose passage is pending in the Senate comes from Richard Bove, banking analyst at Rochdale Securities: The bill, he states, “doesn’t seem to be terribly onerous.” (See “JPMorgan Brushes Aside Bill Concerns,” http://www.ft.com/cms/s/0/24bcbc8c-8858-11df-aade-00144feabdc0.html.)

In terms of the regulation of swaps, especially credit default swaps, “The once-feared swap provision has become toothless.”

The recent debate in Congress over the financial reform bill: A lot of “sound and fury signifying nothing.”

This legislation, the most comprehensive reform of the financial system since the 1930s, seems be passing into the history books with very little fanfare.

Sure, the financial institutions “huffed and puffed” and spent tons of money to fight Congress “every inch of the way.” But, what else did you expect. Perhaps you need to read a good economics book on “Game Theory”.

And, now?

Can’t you hear the executives at the big banks say, under their breath, “Well, the bill is passed, now we need to get back to business. Sure we spent a lot of money that could have gone elsewhere, but that is now history. In terms of where we are going to focus in the future, we just continue doing what we have been doing, finding the best way to do business and to make money. The bill, itself, will cause some inconvenience in some areas, hurt the smaller institutions more than the larger ones, but will not basically change what we are going to be doing.”

The article cited above states it all. JPMorgan acquired a large energy and metals trader last week. How will the financial reform bill impact this deal? After all, “Commodities are among a handful of derivatives still targeted…” by the bill.

The author of the article writes: “Blythe Masters, head of commodities at JPMorgan, said the bank already traded most energy through an affiliate and the law would ‘not substantially’ affect business.”

I have been arguing for months that the large banks had already moved beyond the reach of the regulations being discussed in Congress and that anything enacted by the legislators would be DOA, “dead on arrival.” The large banks started to reform and restructure themselves soon after the fall of 2008 when the financial crisis was at its peak! By the spring of 2009 these banks were well on the way to the future.

Congress, on the other hand, was mired in the past.

JPMorgan, to my mind, is one of the organizations leading us into the future. See, for example, my blog post “Follow the Dimon,” (http://seekingalpha.com/article/212236-follow-the-dimon). But, there are many others that are also out there pushing finance into the future.

Similar discussion are taking place in all areas of the finance field. Just this morning, the Wall Street Journal contained the article “What’s a ‘Prop’ Trader Now?” relating to the proprietary trading that many of the largest financial institutions engage in. (See, http://online.wsj.com/article/SB10001424052748703620604575349161970563670.html?mod=ITP_moneyandinvesting_0&mg=com-wsj.) The article addresses issues like, “What are ‘Prop’ traders?” and “How are banks redefining ‘Prop’ traders?” and “Where are ‘Prop’ traders located within the organization?”

The answers to these questions will help the larger financial institutions “churn out” billions of dollars in profits. Thus, the banks are willing to spend millions of dollars in hiring “the best and the brightest” lawyers and financial experts to come up with the answers. Congress is just not capable of matching the resources available to these publically-traded firms and so will lag behind what is going on in the private sector. To me, the information “gap” between the public sector and the private sector has never been larger.

The problem is that Congress is attempting to achieve “outcomes”. They want to keep banks from becoming “too big to fail” and to keep banks from taking on too much risk. Historically, we see that laws and regulations that seek “outcomes” are bound to fail because, specifying “outcomes” tells those being regulated what they have to “get around”, what they have to “evade.”

In this Age of Information, it has become exceedingly easy to “get around” laws and regulations and “evade” the restrictions imposed by the legislators and regulators. (See the series of posts I began on January 25, 2010, “Financial Regulation in the Information Age”: http://seekingalpha.com/article/184153-financial-regulation-in-the-information-age-part-a.)

Laws and regulations work better when they are aimed at processes, the way that the regulated firms do business. These kinds of rules and regulations have to do with information flow (corporate disclosure and transparency), how trades are made, how trades are constructed, margin requirements, and so forth. One can see successful examples of “process” oversight in the creation of the Financial Futures Market and the Options Market in the latter part of the 20th century.

A proposal for overseeing the assumption of risk by financial institutions has been put forward by Oliver Hart, an economics professor at Harvard, and Luigi Zingales, an economics professor at the University of Chicago, in the Spring 2010 copy of National Affairs, titled “Curbing Risk on Wall Street,” (http://www.nationalaffairs.com/publications/detail/curbing-risk-on-wall-street). I have threatened several times to present a critique of this proposal in one of my posts. Hopefully, I will accomplish this soon for the Hart/Zingales proposal, I believe, offers a lot for people to consider.

So, the world goes on. The financial reform package will be passed. Banking and finance will continue to thrive. Big banks will get bigger and there will be fewer and fewer small banks. Hedge funds and venture capital funds will, in general, continue to do what they do well. And, sometime in the future there will be another financial crisis.

Things are not different.

End note: for a “good read” check the lead article in the business section of the New York Times on Sunday about Ken Rogoff and Carman Reinhart and their book “This Time Is Different”: http://www.nytimes.com/2010/07/04/business/economy/04econ.html?_r=1&scp=1&sq=ken%20rogoff%20and%20carmen%20reinhart&st=cse.

Follow the Dimon!

For months I have been arguing in my blog posts that the larger banks have already moved beyond the regulators although they have always been far in advance of the politicians. These latter two groups of people are attempting to create a regulatory system that will prevent the events of 2007 through 2009 from happening again.

Would somebody tell them that the big banks are somewhere else.

JPMorgan Chase announced some major changes in their top management structure yesterday. These changes, to me, are just the most visible sign that the banking of the future is going to be significantly different from the banking of the past. But, we’ll come back to this later on.

The management changes also confirm, to me, that Jamie Dimon is the pre-eminent banker in today’s world.

Why?

A long time ago I stopped looking at the “glow” of the person running things, the Chairman, President, or CEO, and I started concentrating on the people around the glorious leader. I found that the fact that the leader of an organization had very, very capable and experienced people around them was a better indicator of the quality of the person in charge than was his or her own sparkling image.

Top people have top people around them. In addition, winners help to make everyone around them perform better.

Jamie Dimon has these qualities.

I believe that Jack Welch also had them.

One person I had contacts with at one time who, I felt, didn’t have these qualities and was a disaster waiting to happen, was Donald Rumsfeld.

Jamie Dimon has a top notch team around him and is positioning them to take on the world. In my estimate, more than one of the individuals that are on this team will be a Chief Executive Officer of a major bank in the United States…or, the world.

Many people that Jack Welch had around him went on to lead major companies around the world.

But, back to the banking changes: JPMorgan is going off-shore!

The New York Times has it right, “JPMorgan Sets Sights Overseas,” (http://www.nytimes.com/2010/06/23/business/23bank.html?ref=business). Dimon has given out the mandate to his closest lieutenants “to start a global corporate banking business and scout out opportunities in Europe, Latin America and Asia.” Mr. Dimon, himself, has recently been in China, India, and Russia and wants to especially focus on these three BRIC countries as well as Brazil and also Vietnam, Indonesia, Malaysia, the Philippines and parts of Africa.

My suggestion: Watch what Mr. Dimon and JPMorgan do. My guess is that they will point the way to the future and will do a good job along the way!

But, what about American and Europe?

In terms of banking and finance, I am not sure the political and governmental leaders in these areas of the world know what they are doing. For one, as I have said over and over again, in terms of financial regulation…they are fighting the last war!

Politically, both areas are split and looking for direction. No one can tell at this time where “direction” will come from.

So, what better time than this to move to where the action is going to be!

If anything, the fiasco going on in Washington, D. C. is going to drive business and finance further off shore. The BRIC nations are becoming wealthier and more savvy in the world. They are also accumulating more power as will be in evidence in the upcoming G-20 meetings. But, as Mr. Dimon indicates, there is a lot more going on if one looks to the other countries he has highlighted in his recent statements.

Moving in this direction will involve acquisitions, something that JPMorgan has already started doing. To build itself into a larger presence in these markets in a timely fashion, the company will have to acquire significant other properties. JPMorgan Chase is going to get bigger.

And, Washington was concerned with the size of the banks in the United States that were “too big to fail” in 2008?

Furthermore, this doesn’t even get into one of my favorite subjects, the “quantification” of finance. What is going on with respect to the “quants” in JPMorgan? My guess is that there has been significant movement in this area as well over the past two years.

The future of banking?

Keep your eyes on the Dimon. I think you will find that it will be time well spent!

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!

Why Should We Trust the Financial System?

Every day, it seems as if people are given more reasons to distrust financial institutions and the leaders of those financial institutions.

Lloyd Blankfein has become a joke!

Banks are not to be believed!

And, governments and members of governments have even lower ratings!

Finance is supposed to operate on trust and financial markets are said to function because people have confidence in them.

Well, if this is the case anywhere at the present time it must be in a parallel universe.

And, the stories continue. “It’s an open secret on Wall Street that many big banks routinely—and legally—fudge their quarterly books.”

“Window dressing is so pervasive on Wall Street…”

“The big question is the extent to which other banks (other than Lehman Brothers and Bear Stearns) used, and still use, creative financing, and whether they, like Lehman, broke any rules.”

These quotes are from the New York Times article “Crisis Panel to Probe Window-Dressing at Banks”: http://www.nytimes.com/2010/05/05/business/05repo.html?ref=business.

It is not just the big banks. It is on the public record that the Greek government lied to the world about its fiscal position. What other governments might be falsifying their records?

State and local governments in the United States are not forthcoming about their financial commitments and liabilities such as those connected with the funding of pensions and other contracts. And, many of these entities are facing the bankruptcy court these days.

Ponzi schemes come in many different flavors.

But, those that work in financial markets claim, at least in theory, that the markets are efficient, that the prices that exist in financial markets reflect all relevant information. They assume that participants in financial transactions are “sophisticated” meaning that the participants are canny professionals who have all the information they need.

That is why the executives at Goldman Sachs can, in good conscience, argue that their customers are “sophisticated” and are “big boys, fully capable of looking after themselves.” (See “Goldman and the ‘Sophisticated Investor” in the Wall Street Journal this morning, http://online.wsj.com/article/SB20001424052748703866704575224511672855990.html#mod=todays_us_opinion.)

What! The financial wizards claim that investors have all the information they need, yet they hide information from the public on a regular basis!

And, why does Lloyd Blankfein look silly testifying before Congress or on the Charlie Rose program?

Government officials hide information from the public on a regular basis!

And, then these same officials cry foul when financial markets sell off once the information on their lies becomes known.

Hello, Bernie Madoff…

We now know that Lehman Brothers and Bear Sterns used “shadow financial vehicles” and produced results that mislead investors and regulators. This seems to be the case most of the time in terms of companies that fail.

I know from the bank turnarounds that I was involved in, one of the first requirements of the new management was to open up the books and let the world know what actually was going on in the “troubled” institution. When this was done, the basic response I got from the investment community was one of “incredulity” and “disbelief.” The investment community could not believe that I was willing to make the books as open to them as I did. But, once they got used to this “openness” they began to trust me and what was being done at the troubled institution.

Secrecy, to me, is the worst thing the leadership of an organization can pursue. But, then, people tend to run to secrecy when things go wrong because they either were not capable of running the organization or because they made bad decisions.

As a consequence, my experience has made me a firm believer that openness and transparency, in all financial institutions…and governments…are a requirement for sound finance. Openness and transparency are a requirement for the building of trust in organizations and the system so that investors will have confidence in markets.

Openness and transparency should be one of the building blocks for any new financial reform and re-regulation that takes place.

Yet, the Obama Administration and the Congress seem to be focused on the past; they are fighting the last war. And, this means that any reform package they get will be out-of-date and irrelevant when it is passed. As the New York Times article reports “JP Morgan Chase and Goldman Sachs are examining how to use shadow vehicles to help them borrow money in the future.” The article points to such major players as BSN Capital Partners in London as one firm that has created such vehicles for banks in the past. Even the best seem to need secrecy!

International financial markets still don’t know all they need to know about the Greek situation…and the Spanish situation, and the Portuguese situation, and the Irish situation, and the Italian situation, and the English situation, and so on and so on. International financial markets still don’t know all they need to know about who holds the debt of these countries and how much of an impact would take place if the debt where to be substantially written down.

So we see that another financial crisis has taken place because the expectations of investors were surprised. (See my post http://seekingalpha.com/article/201382-greece-the-surprise-that-breaks-the-camel-s-back.) Maybe we are asking the wrong question, that question being “Why have investors lost confidence in these euro-zone securities?” May the question should be “Why did investors have confidence in them in the first place?”

The Changing Banking System

I remember when there were more than 14,000 banks in the United States. I also remember when there were 12,000 banks in the banking system. Even in those days, the financial industry only accounted for no more than about one-sixth of total domestic profits in America.

Now there are about 8,000 banks in the United States and about one in eight of these banks is either on the problem bank list of the FDIC or in rather serious trouble. The FDIC is closing three to four banks a week and it is expected to continue on this pace for another twelve to eighteen months.

The biggest banks in the banking system are doing well, profit wise. The reported earnings this week of JPMorgan Chase, Goldman Sachs, Morgan Stanley, Bank of America, Citigroup, and so on just re-confirmed the recovery of these giant institutions. Of course it is not the banking side of the business that is producing these results, although their loan problems seem to be diminishing. It is the trading side of the business that is creating such significant gains subsidized by the Federal Reserve zero interest rate policy. This is the “quiet” bailout of these banks because it does not require Treasury funds to support the effort and it helps bank assets improve so that insolvency becomes less and less of a problem.

Furthermore, regional banks appear to be recovering. PNC and BB&T have been doing well, but those lagging behind, Fifth Third Bancorp, KeyCorp, SunTrust Banks, and Huntington Bancshares all seem to be showing improvements which respect to their problem loans. PNC and BB&T actually reported profits for the first quarter, $671 million for PNC and $194 million for BB&T. So, the improvements continue down the supply chain (http://online.wsj.com/article/SB20001424052748703876404575200240959419542.html#mod=todays_us_money_and_investing.)
We are still waiting for the small- to medium-sized banks to start perking up. But, this is where more of the problem or troubled banks lie and where most of the bank closures or acquisitions are going to be.

This fact points to one of the major changes taking place in the banking system. We are going through another period where the number of banks in the banking system is declining. I would not be surprised at all if the number of banks dropped to the 5,000 to 6,000 range over the next few years.

This movement will continue the consolidation of the banking industry in the United States. Right now, $2 out of every $3 in domestic banking assets resides in the largest 25 banks in the country. These are the huge banks mentioned above and the large regional banks mentioned above.

How high might this concentration go? I believe that regardless of what Congress does with respect to financial reform and trying to limit the size of banks that the total amount of domestic assets residing in the largest 25 banks in the country will go to about $4 out of every $5 in the relatively near future. This means that there will be at least 5,000 banks competing for that other $1!

Another change that is taking place in the United States banking system is the presence of more and more foreign banks. This seems to be a perfect time for foreign owned banks to pick up acquisitions in the United States and not only gain size but also gain presence in different regional markets. In this respect, note the article “Foreign Firms Scoop Up Failed U. S. Banks” in the Wall Street Journal, http://online.wsj.com/article/SB10001424052748704830404575200134085458128.html#mod=todays_us_money_and_investing. Canadian banks are especially taking advantage of the banking situation in the United States, but banks in Japan and other countries are seizing the opportunity as well.

In March, foreign-related institutions controlled over 11% of the assets in the United States banking system. This is up substantially from thirty years ago and is expected to climb further in the near future. My guess is that this number will be in the 15% to 20% range over the next five years or so. And, these assets will not be owned by small- or medium-sized financial organizations.

This is the problem now faced by President Obama and the Congress in terms of financial reform. I just don’t see these trends reversing themselves. And, as banks get bigger they will also be controlling more and more of the banking assets in the United States. And, as the banks get bigger they will continue to move into more and more areas of the financial market and they will continue to create more and more financial innovations.

And, if they are not done in the United States they will be done somewhere else in the world for commercial banking is, in fact, worldwide and not just the playing field of Americans. Big foreign banks are becoming a bigger part of the United States banking scene just as big United States banks are becoming a bigger part of the banking scene in other countries.

The difficulty in writing regulations that try to control what these banks can do is, in the words of economists Oliver Hart of Harvard and Luigi Zingales of the University of Chicago, “doomed to fail because such regulations are extremely easy to bypass. It takes no time for a clever financier to design a contract that gets around most restrictions.” Finance is just information and information can be restructured in almost any way that someone wants it to be structured.

The evolution of the financial system is going to continue to be fought by those constrained to the old Keynesian fundamentalism. The current financial environment has been created by fifty years of government policy conforming to a dogma that considers an inflationary bias to the economy an necessary pre-requisite for sustaining high levels of economic growth and low levels of unemployment.

Well, this inflationary environment has fostered the undisciplined expansion of credit, the excessive leveraging of financial capital, and the creation of more and more financial innovation to underwrite both the expansion of the debt and the aggressive financial leveraging. It has also resulted in the relative growth of the financial industry.

Many of these same commentators have remarked about how the financial sector has grown relative to the rest of the economy. For example, Paul Krugman in “Don’t Cry for Wall Street”, has written: “In the years leading up to the 2008 crisis, the financial industry accounted for a third of total domestic profits — about twice its share two decades earlier.” He then makes the value judgment that “the fact is that we’ve been devoting far too large a share of our wealth, far too much of the nation’s talent, to the business of devising and peddling complex financial schemes — schemes that have a tendency to blow up the economy. Ending this state of affairs will hurt the financial industry. So?” (See http://www.nytimes.com/2010/04/23/opinion/23krugman.html?hp.)

Well, this is the financial industry that a government following the Keynesian economic philosophy has created. Two final comments: first, care needs to be taken in creating economic policies because the long run effect of the policies may not be what you want even though the short run effects are what you want; and second, once the size and structure of an industry has been created, it does not go away until the industry becomes technologically obsolete. The financial industry is thriving using information technology, a field that is just in its infancy. Finance and information technology have a long way to go.

A Quick Look at Profits

So far, two facts stand out to me in many of the current earnings releases. First, for many large financial firms, trading profits have provided almost all of the positive results that we have seen. Second, for many large non-financial firms, cost cutting has resulted in better-than-expected earnings.

Both of these lead me to the conclusion that the basic or fundamental businesses of the companies reporting are showing little or no life. In other words, the demand for the basic products or services they provide is listless, at best. And, results like these are not sustainable.

Yes, the results are encouraging. Profits are always better than losses. But, these profits are not connected with the core business of these companies and hence give no indication that either the financial firms or the non-financial firms have established some kind of competitive advantage that will last into an economic recovery.

In terms of the large financial firms, like Goldman Sachs and JPMorgan Chase, the trading profits have allowed them to post substantial earnings and get the government off their backs. Getting the government off their backs is important and will become more so in the future because these companies can pay to keep their top-flite executives or pay to attract other major talent to their organizations. They can buy time as their core businesses improve. However, trading profits are not sustainable and should not be counted over an extended period of time.

The large financial firms that have not produced, like Citigroup and Bank of America, will find themselves at a considerable competitive disadvantage, both in the United States and worldwide, as their competition can apply their strengths to continue to grow and increase market share. Plus, these non-producers are having to sell off assets like BOA’s sale of First Republic and Citigroup’s sale of Phibro even though both were profitable operations.

The last thing these organizations need is to have their pay the top officers receive drastically cut. Not only do troubled firms have problems hiring top talent, but to have the onus of the government hanging over the companies and controlling what top executives get paid is doubly bad. These financial institutions were too big to fail—immediately. But, they are not too big to fail a slow death. Certainly the government’s effort to impact the remuneration of the top executives at firms still receiving government help will skew the playing field to the Goldman’s and the JPMorgan’s.

One can understand in today’s environment that a lot of people are angry about big salaries and bonuses, especially to those that have been bailed out by the government. Certainly, the forthcoming big bonuses to be received by the executives at Goldman and JPMorgan do not help stem these populist attitudes about the pay at financial institutions. But, in this case, the response of the public is just helping the competitive position of Goldman and JPMorgan and hurting that of these other large banks because the actions on pay just makes Citi and BOA less competitive! Goldman and JPMorgan are smiling all the way to the bank!

The other banks, the regionals and the locals? They need time to continue to work out their loan and security portfolios. They need to regroup, get back to their core business and they will be fine. But, this is going to take time. Nothing substantial in profits here for a long time.

As far as the non-financial firms are concerned, their cost-cutting efforts are paying off. Their efforts to return to their core businesses are paying off. But, cost cutting alone does not produce sustainable exceptional returns. Cost cutting can be duplicated. And, as long as consumers stay on the sidelines and restructure their balance sheets and keep reducing their debt not increasing it, the final demand for goods and services will not show much bounce.

There is continued hope in one sector after another that sales will pick up. In computers. In retail sales. In food services. There is continued hope that sales will pick up during Thanksgiving, or Christmas, or at some other relevant time. But, these blips of hope seem to pass on as sales continue to disappoint. The hope is transferred to the next holiday.

Companies, for the past four or five months, have posted not-so-good earnings, but they raise their forecasts for the upcoming year.

There is nothing these companies are doing right now that produce sustainable results. Demand for their products and services must be forthcoming and, right now, there is little encouragement that this will happen any time soon.

All of these factors raise two concerns in my mind. First, what is the basis for the continued rise in stock prices. The profit results that have been achieved so far are not sustainable and point to no growth in earnings or cash flows for the time being. Furthermore, the cost cuts are great, they help companies get their focus back onto the right things. But, cost cutting does not result in a continued increase in earnings or cash flows. In addition, trading profits do not contribute to extended growth in earnings or cash flows. This is why I am concerned about the possibility that the rise in stock prices since March might just be a bubble. (See http://seekingalpha.com/article/167561-are-we-in-an-asset-bubble-or-not.)

Second, managements are refocusing their efforts and reducing inventories, labor, and other resources that they had accumulated during the go-go years. This restructuring, given past experience, will continue, even when the economy begins to recover again. These managements are not going to return to the same business practices as before. This will change the supply side of the economy and, as a consequence, full employment of resources will not be the same as it was earlier in this decade.

If this does occur, and I believe that it will, it will just be one more part of the trend that began in the 1970s. Through all the cyclical swings in the economy during the last forty years or so, the economy has never regained the height it had achieved in the previous upswing. That is, the next peak of employment, of capacity utilization, of industrial production, has never as high as it was at the previous peak.

This means that the economic policies of the last forty years or so have left more manufacturing capacity idle, more workers discouraged, and more resources wasted each cycle of the economy. The American economy is changing along with competition in the world. Artificial stimulus on the part of the United States government just tries to put people and other resources back into the jobs that they once held, like in autos and steel for example. And, such an economic policy only exacerbates the longer term trend. Furthermore, this is not helpful to the stock market.

It is easy to build a case that the rise in the stock market in the 1990s and the 2000s were asset bubbles created by easy credit. Given the performance of financial and non-financial firms at the present time could the Federal Reserve just be producing another one?

The State of the Banking System

There are three preliminary indicators that the banking system is coming along on its way to recovery. First, there is the “letting go” of CIT Group, Inc. The government must feel that it does not need to extend itself to help out this institution given its present troubles. (See my recent post on the CIT situation: http://seekingalpha.com/article/148730-cit-s-debt-issues-show-why-the-economy-won-t-be-picking-up-any-time-soon.) We’ll see if they continue this approach with other troubled institutions as additional situations arise.

Second, there is evidence that the regulators are taking a harder line at Bank of America and Citigroup. Each has its own problems, but the Feds seem to believe that they can step up their demands on these two financial institutions concerning boards, managements, business affairs, and so forth. They would not do this if they believed the system to be too fragile.

Third, I sense the Federal Reserve backing off from the more aggressive stance it took with respect to the bond markets one to two months ago. This is just a feeling that I will be following up on in the near future.

These actions provide some preliminary evidence that we are in the “working out” stage of the credit cycle where time is the biggest factor to contend with. Bailouts are needed to prevent “liquidity” problems when markets might crumble under cumulative selling pressures. But, this is a short run problem.

The “work out” phase of a financial crisis is the period when institutions still have severe credit problems but are not under short term pressures to relieve their balance sheets of “toxic” or “underwater” assets.

This does not mean that there will not be more failures of financial institutions and some of them may be relatively large ones. What it does mean is that the problems that still exist within the financial sector can be handled in a relatively orderly fashion. So, the banks and the regulators can operate within an environment that does not seem “desperate.” Severely troubled still, but not in a state of panic.

Within this scenario, the questions that remain about the banking system relate to earnings. We have seen Goldman Sachs and JPMorgan Chase & Co. post strong gains for the second quarter. However, most of the gains were attributed to trading activities, with secondary help from their underwriting business. These are not good, solid “banking” results. And, these organizations are highly diversified and can post returns from these areas, something that most other banks in the United States cannot do.

Still, the banking system seems to be in the stage of recovery where current cash flows can allow the individual banks to write off more and more of their loans and other assets over time and thereby restore the integrity of their balance sheets. With the results it achieved in trading and underwriting, JPMorgan Chase was able to take large write downs of home equity loans, mortgage defaults, and credit card charge offs while also increasing the amount of funds it set aside to increase its loan loss reserve. This is what other banks will be doing to reduce the burden of bad assets they are now carrying.

Overall, Total Assets in the commercial banking system grew by 8.9% from June 2008 to June 2009. The capital residual (Assets less Liabilities) in the system grew by 7.6% so that the capital asset ratio of the banking system dropped from 10.2% to 10.1%.

In terms of how the banks are attempting to protect themselves, the Cash assets of Commercial Banks in the United States were up 186%, year-over-year, in June 2009, although this rate of increase is down from a year-over-year rate of increase of 236% increase in May 2009.

Total Loans and Leases in the banking system rose just about 1.4%, year-over-year, in June while Commercial and Industrial Loans actually decreased by 3.1%. Commercial banks are just not lending to businesses which continues the trend which began last year. Banks are lending to consumers, up 5.5% year-over-year (primarily on credit cards and other revolving credit plans), and on real estate, up 6.4% year-over-year (the largest jump coming in revolving home equity loans).

The cash assets held in the commercial banking system declined regularly throughout June as the peak in cash assets held was reached in May. Thus, it appears that banks are backing off from taking everything the Federal Reserve has put into the banking system and stashing it away in “cash accounts”. This is confirmed by the aggregate banking data put out by the Federal Reserve which indicates that total reserves in the banking system dropped throughout June 2009 and the excess reserves also fell from peak levels reached in late May.

Thus, it appears that things are working out pretty much as the Fed hoped they would. (See my explanation of what the Fed has been trying to do, http://seekingalpha.com/article/145913-is-treasury-s-tarp-debt-already-monetized-part-ii.) Of course, the game is not over yet!

Bottom line: the banking system is working through its problems. The Federal Reserve and the regulators seem to be backing off a little, allowing the system to adjust over time to its dislocations. There is still room for a surprise, but, the more time passes, the less likely a surprise is likely to occur. In other words, the unknown unknowns have been substantially reduced and the known unknowns are what we are working on.

The banks are not lending except on established credit lines (credit cards and home equity loans) and there appears to be plenty of liquidity in the system as a whole. Whereas the lack of lending slows up the possibility for an economic recovery, it is an essential component of getting the banking system healthy again which is needed if there is to be any chance of a robust economic recovery in our future.