Long-Term Treasury Yields and Inflationary Expectations

The yield on the 10-year Treasury bond closed at 3.48 percent yesterday. Just a little over five months ago the yield on the 10-year Treasury bond was at 2.48 percent, a full 100 basis points lower than the current yield. What’s happening and where are we going?


Two extraordinary factors are impacting Treasury yields at the present time and have been there for quite some time now. The first of these is the effect that the quantitative easing of the Federal Reserve is having on market rates. The second is the “flight to quality” that has kept the yields on Treasury securities below what they otherwise might be. How do I account for these two factors?

Well, first I start out with a “rough” estimate of the real rate of interest. The base figure that I have used for years has been 3.0 percent.

(I just found out this morning that this is similar to what my former colleague Jeremy Siegel,
Professor of Finance at the Wharton School, UPENN, uses: http://www.ft.com/cms/s/0/00d6f8d0-2ec7-11e0-9877-00144feabdc0.html#axzz1Chh2pOYC.)

This figure, the 3 percent estimate is a “before-the-fact” estimate and therefore is a long term expectation. An “after-the-fact” estimate is often made by taking the nominal rate of interest, say the roughly 3.5 percent mentioned above and then subtracting actual inflation from this figure. This is “after-the-fact” because the numbers used to calculate the real rate have already occurred.

The 3 percent estimate is important because it can be compared to another, so-called, real rate of interest, the yield on inflation-protected securities, called TIPS. Yesterday, the yield on 10-year inflation-protected securities was 1.04 percent at the closing, substantially below the 3 percent estimate.

Siegel, I believe rightly, calls our attention to this discrepancy because he believes that the current yield on inflation-protected securities must rise toward the higher number and this will mean that the holders of these securities may suffer substantial capital losses on the securities because the price of the securities must decline to allow the yield to rise.



Investors are not fully aware that this decline might happen in this area of the bond market.

The difference between the current market yield on these securities and the “before-the-fact” estimate of the real rate of interest represents the impact that the Fed’s quantitative easing along with investor’s “flight-to-quality” is having on the current market yields. If this is true then the nominal bond yields in the market are roughly 200 basis points below where they would be without the Fed’s actions as well as including the international flight to safe United States Treasury issues.



If this is the case then we could argue that the yield on the 10-year Treasury security should be around 5.50 percent rather than 3.50 percent.

If this is the case then the longer-term “inflationary expectations” that investors have built into market yields would be around 2.5 percent.



The question then becomes, is this estimate of inflationary expectations “in the ball park”?
I like to look at the year-over-year rate of change of the GDP price deflator as my estimate of the rate of inflation because I have less concern that this figure is being “messed” with than the more popular Consumer Price Index. Looking at this measure of actual inflation we see that inflation does seem to be picking up.



In this chart we see that the rate of inflation is picking up and is now just below 1.5 percent. We can note that once inflation starts to pick up, it does not reverse itself in the near term. Furthermore, looking at the performance of inflation over the past ten years, an inflation rate of 2.5 percent is not unreasonable for a moderately growing United States economy. And, remember, this 2.5 percent can be interpreted as the compound rate of inflation over the next 10 years, a period far beyond the inflation that might be experienced over the next year or so.

Added to this is the fact that inflation is picking up, not only in the developed countries in the world, but also in the emerging countries. Inflation in the Eurozone is running a little above 2.0 percent, in the UK, a little under 4.0 percent, and in China and India, the rate of inflation is now in excess of 5.0 percent. Thus the trend in the world is for increasing rates of inflation.



My rough estimate that the yield on the 10-year Treasury bond should be around 5.50 percent in 2011 is slightly above the forecast I presented earlier. (See “Long-Term Treasury Yields in 2011: http://seekingalpha.com/article/243018-long-term-treasury-yields-in-2011.) The reason for this change, I believe, is that investors, world wide, are believeing that inflation is becoming a bigger problem than earlier expected. The European Central Bank has ceased its special purchase program of securities because of the rising concern over price increses. The Bank of England has experience similar concerns. The only central bank that does not seem concerned yet is the Federal Reserve.



And, of course, my forecast assumes that the Federal Reserve will, at some point this year, back off from quantitative easing.



But, why should we expect the Federal Reserve to back off from QE2 any time soon? Chairman Bernanke has been late on every shift in monetary policy since he has been a member of the Board of Governors. Why should we expect anything different this time?

How the Crisis Catapulted Us Into the Future

“How the Crisis Catapulted Us Into the Future,” is the title of Martin Wolf’s opinion piece in the Financial Times this morning. Wolf, in the article, ruminates on what he experienced last week at the World Economic Forum held at Davos and how this all fits into the world we are now living in.

Wolf concludes: “The crisis has not proved a great turning point, so far. But we cannot conclude that it is of small significance. It has brought some transformation, much acceleration of previous trends and, above all, great uncertainty. That uncertainty was present all along. But now we know.” (http://www.ft.com/cms/s/0/5fc7e840-2e45-11e0-8733-00144feabdc0.html#axzz1Chh2pOYC)

The usual items are mentioned. First, the “turnarounds” such as the tightening of financial regulation, the de-leveraging that still continues, the lessening of “global’ imbalances”, and the vulnerability of the Eurozone’s “excessive accumulations of private and public sector leverage.” Then there are the “accelerations” such as the new focus on sovereign fiscal affairs, the “accelerated shift in the global balance of economic power,” the changes in relative attitudes in the west and in the east, and the uncertainties related to how the future is going to work out.

There is another change that has taken place over the past three and one-half years that Wolf doesn’t allude to but is one that has also accelerated during the crisis and will play an even more important role in the future. A consequence of the financial crisis has been the rapid advancement in the use of information technology in the world and the effect this advancement has had in changing the way we all do business and how we govern and how we all live.

First, the headlines in newspapers all over the world tell us of the events taking place in Tunisia and Egypt, and in Jordan and Syria, and elsewhere. Could these events, would these events have taken place if information had not spread about conditions in different parts of the world and if communications had not been as complete as they are. In Egypt the Internet was closed down, but that didn’t stop information from traveling.

Analysts have argued that two factors seemed to be catalysts for the uprisings that have taken place: food prices and unemployment. In terms of the former, information spread that food prices were an international concern and impacting countries with autocratic governments the worst. Unrest was experienced in other countries as more and more people reacted to governments that were a part of the problem and not a part of the solution.

In addition, people had more and more information that countries other than the developed countries were experiencing economic expansion. China and India and Brazil, among others were creating a future and putting people, educated people, to work. This was not happening in Tunisia or Egypt, Jordan or Syria or in some of the other countries experiencing unrest.

Information and the spread of information is something governments are going to have to take more and more into consideration in the future. But, this does not just extend to social issues.

Governments are finding it harder and harder to hide things. One of the fallouts of the crisis in the Eurozone is that governments like Greece were hiding things so that its financial condition was not really apparent to its people and to people in the investment community. Spain is now experiencing some of this within its regional governments. This is causing Spain real headaches in attempting to stem the impending financial crisis it faces.

But, people in the United States cannot be too smug in this area. More and more we are finding out how state and local governments “hide things” in managing their finances especially in the accounting for pension fund liabilities.

On top of these revelations, there was the release of large amounts of inside information connected with the organization called WikiLeaks. This, apparently, has had some impact on middle eastern events as well as disclosures relating to military and diplomatic relationships. We were reminded once again of this release of this “secret” information in the article in the New York Times Magazine, “The Boy Who Kicked The Hornet’s Nest” which appeared over the weekend. (http://www.nytimes.com/2011/01/30/magazine/30Wikileaks-t.html?adxnnl=1&ref=magazine&adxnnlx=1296651604-/6As33QJtY/sr5n+tM0J5w)

Information spreads and, although it may be contained in the short run, over the longer run its spread cannot be stopped. This is a major problem for governments.

The WikiLeaks adventure also spilled over into the business sector as several firms or banks were threatened with disclosures. But, the information “leakage” problem extends far beyond just WikiLeaks. Today, in Mr. Wolf’s paper, the Financial Times, there was a detailed piece on “industrial espionage” titled “Data Out of the Door.”( http://www.ft.com/cms/s/0/ba6c82c0-2e44-11e0-8733-00144feabdc0.html#axzz1Chh2pOYC)

“Cyber-spying has fast become a specific threat for many companies. ‘Industrial cyber-espionage is one of the biggest problems that all nations are facing,’ says Melissa Hathaway, a former US intelligence official and the leader of a digital security review set up by President Barack Obama.

The scale of hacking to gain corporate information has gone so far, she says, that the Securities and Exchange Commission…might soon need to require companies to assess routinely for the benefit of shareholders how well they are protecting themselves from electronic attacks.”

On the other side of the ledger, this fact also says a lot about what companies can and should
reveal to the investment community. People can get more and more company information these days and it is very important for a business to accept this fact and address the issue of how open and transparent it must be to earn the trust and confidence of the investing community.

Nothing can be worse for a company to be ‘”caught out” and have to admit it was hiding information from the public that should have been released.

Modern information technology is impacting business in another way raising all sorts of different questions. How closely can finance be regulated when finance, which is nothing more than information, can be transmitted around the world in seconds…or less? How can financial transactions be understood when financial information can be “sliced and diced” in any way it can conceivably be re-constructed? How fast can transactions take place? How fast should transactions be able to take place? How secure are all these transactions? How have “the Quants” changed their business practices since the melt down of August 2007? What other ways can the “physical” be transformed into just information?

Rahm Emanuel, formerly President Obama’s Chief of Staff, once stated that one should “never waste a crisis.” I believe that many people and organizations, especially people and organizations within the financial industry, acted this way during the crisis. As a consequence, the world is a very different place now than it was three and a half years ago.

The problem going forward is that many people and businesses are looking forward to what they can do in the future while many governments and other institutions, like religious groups, are only looking to regain the past. This divergence only adds to the uncertainty that Mr. Wolf observes in the world today.

Federal Reserve Continues to Underwrite Big Companies and Big Banks

Economic spokesperson for the Obama administration, Ben Bernanke, and the Federal Reserve System continue to underwrite “big”…Big Companies and Big Banks.

The Federal Reserve has just released its survey of senior credit officers. The headlines, “Large United States Banks are Starting to Ease Credit Terms.”

Terrific!

“Large companies may also be finding an appetite to borrow, especially for mergers and acquisitions…The start of January was marked by a record level of M&A and 77 per cent of banks that reported an increase in loan demand said deal financing was a somewhat to very important reason for it.” (See http://www.ft.com/cms/s/0/6dbf2546-2d71-11e0-8f53-00144feab49a.html#axzz1Chh2pOYC.)

But wait…”A flood of cash by investors seeking to profit from rising interest rates is having an unintended effect in the deal world, where this money is being recycled into corporate buyouts.

Investors have been selling bonds which typically lose money when interest rates rise and putting their cash in funds that invest in bank loans that finance corporate buyouts. The loans have floating rates, so the interest they pay investors rises as rates go up.” (http://professional.wsj.com/article/SB10001424052748704254304576116542382205656.html?mod=ITP_moneyandinvesting_0&mg=reno-wsj)

Wow! Have I got a deal here!

And, what about big banks? Well, Bloomberg has an answer for that: “Fed’s Easy Money Helps European Banks Refinance.” (See http://www.bloomberg.com/news/2011-02-01/fed-s-easy-money-helps-european-banks-refinance.html.)

Seems as if European banks are selling record amounts of dollar-denominated bonds to refinance almost $1 trillion of their debt maturing this year. “As a result of the extra dollars created (by the Fed’s quantitative easing), cross-currency basis swaps show that it’s cheaper for European banks to sell bonds in dollars and swap the proceeds back to euros than it was at the same time last year.”

European lenders “sold $43.8 billion in investment-grade bonds in the U. S. (this January), beating the previous record of $42.4 billion last January.”

So the Federal Reserve’s quantitative easing is doing good!

Yes, but what about economic recovery and the smaller banks and smaller businesses?

The Financial Times article continues: “If most of the increased loan demand is for M&A, it may be slow to feed through into higher investment in the economy.

The scope of easier credit also remains limited: Large banks say they are lending more to large companies, but life has become no easier for small companies and small banks.

There was also little sign of any improvement in lending for either commercial or residential real estate.”

It is in the smaller banks and the smaller businesses that solvency concerns still reign. It is in
commercial and residential real estate that economic conditions remain depressed and credit woes abound.

Big banks and big corporations have lots and lots of cash. The reason for this build up in my mind has been for the “Great Acquisition Binge” of the 2010s. (See my post “Where the Real Deals will be in 2011: http://seekingalpha.com/article/244709-where-the-real-deals-will-be-in-2011.) And the bank lending reported above is just adding to the acquisition cycle. The big banks are now increasing lending and, it looks as if the increased lending is going for more and more buyouts. The hedge funds and private equity funds are now stepping up their involvement in this exercise as is evidenced by the interest in floating rate loans.

And, how is this banking activity helping to get the economy growing more rapidly and reduce unemployment?

If anything, the increased merger and acquisition activity will result in a “rationalization” of business which will mean that the acquiring firms will engage in more downsizing of the acquired firms and this will mean that more workers will be laid off.

Companies will become bigger…there will just be fewer companies around.

If this is the case, why does the Federal Reserve continue to underwrite the big banks and the big corporations?

I continue to argue that the Federal Reserve is pursuing quantitative easing as aggressively as it is doing in order to keep the smaller banks going as long as possible so that the FDIC can close as many as they need to in an orderly fashion. Eleven banks have already been closed this year.

Last year the FDIC formally closed a little more than 3 banks per week throughout the year. However, the number of banks in the banking system dropped by two to three hundred (we don’t have the final numbers on this yet) when you count the mergers and acquisitions that took place in the banking industry.

My guess is that we will experience the same amount of contraction of the banking system in 2011. The monetary stance of the Federal Reserve is crucial for the banking system to continue to contract in an orderly fashion. But, this is not necessarily spurring on economic growth.

Until this contraction is over, the feast will continue for the biggest banks and the biggest corporations.

Banking Keeps Changing: BankUnited and China's ICBC

There were two pieces of banking news last week that seemed to fall below the radar screen due to the visit of China’s President Hu Jintao and the events in Tunisia and Egypt. These two pieces of news had to do with BankUnited, a Florida bank that was “saved” by a group of buyout firms, and with ICBC, the world’s biggest bank by value which happens to be a Chinese bank, who announced that it was buying an American bank.

Bank United sold 29 million shares of stock at an initial public offering on Thursday evening for $27 per share. This put the value of the bank around $2.6 billion.

To me the important thing about BankUnited is the owners of the bank which include Wilbur L. Ross, Jr., the Blackstone Group, the Carlyle Group and Centerbridge Partners. BankUnited was Florida’s biggest bank when it failed in May 2009. The unique ownership of the bank came about when the FDIC sold the bank to this group of “private” investors.

The FDIC was “desperate” to attract capital and private-equity firms were where the money was. So the FDIC cut a deal with this group to “unload” BankUnited. This was a first because private-equity had never shown much interest in owning commercial banks…the returns were just not that great given the risks. And, the regulators never cared much for this kind of money…private-equity firms were only interested in a “quick” buck.

The deal for BankUnited was “rich” because the FDIC needed to unload the property. But, once one deal was cut, more followed, but they were not necessarily as “rich” as the first one. Now private-equity firms have acquired more than 50 banks.

The IPO on Thursday produced a lot of money for the owners. The owners are expected to take away more than $500 million from the offering and they still will maintain an ownership in the company of about 70%, more than $1.8 billion. The buyers put up $945 million to complete the deal with the FDIC.

The stock price rose almost 5% on Friday.

BankUnited is now highly capitalized, very profitable, is growing deposits, and also is making loans. And, management is now looking to buy other banks.

Commercial banking meets “Shadow” banking. But, this wasn’t the way it was supposed to be. Banks were supposed to get smaller because there was too much systemic risk when banks were too big to fail. Also, we had to go back to the “good ole days when banks were banks and other financial institutions were “other” financial institutions. But now we have private-equity firms owning more than 50 banks!

It seems like everything that the Obama administration and the regulators wanted has just been the opposite of what they have actually done.

In the decline in the number of banks which now exist, about 7,700, to less than 4,000 over the next several years, banks are going to continue to get bigger and the boundary between financial institutions and money sources are going to get more and more blurred.

Why? Well, for one, it pays, and it pays well. Second, there are just too many banks that need financial help and the Federal Reserve and the FDIC are going to do everything in their power (and maybe more) to make sure the weaker institutions are absorbed or consolidated into other organizations in as orderly a fashion as possible.

The second piece of news has to do with another foreign bank acquiring an American bank. This time, however, the foreign acquirer is Chinese: ICBC will acquire 80% of the Bank of East Asia’s retail branch system in New York and California. This acquisition must still be approved by United States regulators. If this deal is approved it will be the first time that a mainland bank in China would be operating under the regulatory framework of the United States. Up-to-now, American regulators have not approved the soundness of the Chinese banking system because it is government controlled and politically directed.

Although some wholesale business has been allowed in the past for Chinese banks, approval of this transaction would be entirely different because it would mean that the deposits of this bank would now be insured by the FDIC. Thus, the Chinese banks will not only have to open their books to the regulators, but it would also expose the Chinese regulators to scrutiny.

This acquisition will not alter the American banking landscape much in the near future. The bank was already foreign owned, it was Hong-Kong based, and it already had strong ties to China. The bank is only about $700 million in asset size and most of the bank’s business is with Chinese businesses.

However, the crucial thing will be that the Chinese will own a bank in the United States. How big it is at first and how much business it does with Americans at first is not the important thing. I go back to the advice given me some years ago: the Chinese think in terms of decades while people in the United States think in terms of years. The Chinese will own a bank in the United States!

Thus, the ground continues to change. The American banking system is going to become more and more global with the presence of foreign banks taking on a bigger and bigger role within the country. And China, and Russia, and Brazil, and India, and Canada, and others will be included. As I have stated before, I believe that the branches of foreign banks and the largest twenty five domestically chartered banks in the United States will hold more than 80% of the banking assets in the United States. There is just going to less and less need and less and less room for smaller domestically chartered banks to exist.

It is just not realistic to believe that the banking system of the next five years is going to look anything like the banking system that existed before the recent financial collapse. The owners of banks will also be different and will include governments and private-equity firms and individuals and others. We are only kidding ourselves if we think that we are going to return to anything like that. Cries of support for Main Street are just the wishful thinking of those that would like to return to the past. The world moves on.

Rather than trying to retain the past we need to ask what will be needed in the future. Parts of the American landscape are fading. One part of that landscape is the small, locally owned bank that serves just the community it resides in. My grandfather ran a small bank in a small town in the Midwest. He hated the large banks in the nearby big city and wanted to keep them out of his territory. He argued that large banks just “sucked deposits” out of a local community and only made loans to large businesses within the big city. As a consequence, the local community suffered. The small, vibrant, self-sufficient and morally-driven local community has always been a part of the American dream.

This, for better or worse, is not the future. In fact, to some, it was not the past, but that’s
another story.

The Great Recession has changed things. Let’s prepare for the future, not hope for the past.

The U. S. Budget Deficit: It's Time to Get Serious!

The United States budget deficit will reach $1.48 billion in the 2011 fiscal year, according to the Congressional Budget Office.

The response: everyone seems to be pointing fingers at everyone else.

The President, on Wednesday evening in his State of the Union address, indicated that something needed to be done about the budget deficit.

Yesterday the CBO released its figures.

The evening news reported that the White House had some general things to say about the projection but would not come out with more specifics because they were waiting for the Republican response that they knew was coming.

There’s leadership for you.

No one in the top leadership positions in the country seem to be staking out a firm position on this. Like Health Care 1, the President is asking Congress to do something, but is not willing to step down from his intellectual tower to set out a path. As a consequence, like HC1, no one in the country really knows where he stands on containing and controlling the deficit.

As a consequence, no one really seems to be serious about the deficit.

The current estimate was constructed assuming that all current law will be used as the basis for the projection. If, for example, all the Bush tax cuts are allowed to expire, as is now the law, this will result in the budget deficit climbing to about 76% of GDP in 2020.

However, if Congress does not allow these tax cuts to expire and if Medicare programs are held constant, along with other spending and taxing programs, the budget deficit will rise to about 97% of GDP in 2020. This would place the cumulative total of deficits at around $12 trillion over the next ten years.

For the last 12-18 months, I have been arguing that the cumulative budget deficit for the next ten years will come in at least around $15 trillion, given the current attitudes about the budget deficit in Washington, D. C.. In my mind, Congress, given current attitudes, will not rescind the programs that are now in place, and, like always, will add more that will only cause the cumulative deficit to rise from current projections.

It seems as if the Congressional Budget Office is coming toward my forecast as time goes forward.

And the Gross Federal Debt continues to climb: the year-over-year rate of increase is now close to 20%. The compound rate of increase in the Gross Federal Debt between 1960 and 2007 was in slightly above 7% which some of us felt was excessive.

Since it took until fiscal year 2009 for the debt of the United States to approach $12 trillion, the idea that this figure would be doubled in the next ten years seems “unreal”. Yet, that is the way things look.

And, there are three major “holders” of this debt…Japan, China, and the Federal Reserve. Going forward it seems almost surreal the proportion of the new debt the Federal Reserve may have to acquire. There is, of course, the $900 billion that the Fed is intending to acquire as a part of QE2. But, what will the Fed have to do after that? With so much government debt coming on board it is frightening to speculate.

Why am I so pessimistic? Well, we really don’t know how much the health care program is going to cost us. We don’t know what military challenges we are going to be facing. The world is very unsettled now and I don’t see how commitments are really going to be lessened over the next ten years given all the turmoil taking place around the globe. We don’t know how the budget crisis affecting state and local governments is going to work out. Many are saying that the federal government will not play any role in state or municipal bailouts, yet, can you imagine the federal government not playing a role? And, what about the housing market and the government agencies called Fannie Mae and Freddie Mac? How much is this area going to impact the federal budget? One last unknown here is the cost of getting the commercial banking system back to full solvency. No one knows what these costs might be.

The problem with debt is that the more you have the fewer choices you have. Debt reduces your room to maneuver. And, as with Europe, it seems to me that the options are running out.

The other thing about creating more and more debt is that the options become less and less desirable.

That is why you don’t want to get yourselves “head-over-heels” in debt…you want to be able to make your own choices and you want the alternatives available to you to be desirable ones.

Right now, the choices are not good! And, we don’t seem to have any real leaders around in positions of authority that will step up to the table to take charge.

Funny, but the two Presidents that did take a leadership role in budget containment were George H. W. Bush (Bush 41) and Bill Clinton. Bush 41 made some decisions with respect to taxes that arguably cost him a second presidential term. But, Bush’s efforts set the stage for the Clinton era of strong economic growth and shrinking federal deficits.

There just is no leadership on this issue coming from the places that should be exercising leadership. To be more specific, in my experience, the top person, the CEO, the person where “the buck stops”, must take a leading role in getting something done or it just does not “get done” right. Secretary of the Treasury Robert Rubin was a major force behind the Clinton move on the budget, but the effort would have gone nowhere without Clinton getting on board and taking the lead.

As with the health care bill, people are not seeing Obama carrying the flag. Oh, he talks and talks, but where does he really stand? Tim Geithner has all but disappeared. The only real spokesperson for the administration on economics and finance seems to be Ben Bernanke and his “talk” has been getting lost in all the attention being given to other members of the Board of Governors of the Federal Reserve System.

The deficit problem is not going to be brought under control immediately. But, the lesson we can learn from the situation going on over in Europe is that someone eventually must take the lead. If no leader steps out in front of the crowd, the misery just drags on and drags on. The debtors just keep banging on the door. And, what happens during periods like this? Well, you lose focus.
I have seen this doing business “turnarounds”. When things start going downhill in a business and the debtors, or regulators, keep banging on the door, you stop doing what you should be doing in order to run a good business. You just have to “put out fires.” Thus, your organization continues to go downhill.

Likewise with a government: if the focus of the government is diverted from doing what it should be doing in order to resolve budget and debt issues, the government continues to experience problems in areas it should be focusing on.

It is past time to “get serious” on the federal government’s deficit problem. Are there any leaders in the room?

For the Banks, Mark-to-Market Accounting Dies Again!

“Strategic vision of financial executives on how to generate economic performance while controlling risk is likely to become a differentiating factor, a determinant of not only success but of the very economic viability of financial institutions in the changed world. Have leading financial firms and institutional investors come to the same conclusion?”

This is from the book “Financial Darwinism” by Leo Tilman.( http://seekingalpha.com/article/221607-making-money-in-the-21st-century-financial-darwinism-create-value-or-self-destruct-in-a-world-of-risk-by-leo-tilman)

The banking industry has provided an answer and the answer is “No!”

The banks have beaten down the accounting industry: “Banks Force Retreat on Fair-Value Plan” is the title in the print edition of the January 26, 2011 Wall Street Journal; “Retreat on ‘Marking to Market’” is the title in the electronic edition. (http://professional.wsj.com/article/SB10001424052748704013604576104012708309774.html?mod=ITP_moneyandinvesting_1&mg=reno-wsj)

“Accounting rule makers, bowing to an intense lobbying campaign, took a key step Tuesday to reverse a controversial proposal that would have required banks to use market prices rather than cost in order to value the loans they hold on their balance sheets.

The debate over the proposal is the latest chapter in a battle pitting investors who wanted better disclosure of the value of bank’s assets against the banks themselves. Banks have argued against so-called fair-value accounting, saying market prices would have left them at the mercy of volatile markets and could have caused additional strain during the financial crisis.”

The banking industry is still back in the middle ages. And, this is just what Tilman is arguing about.

To Tilman, the “golden age” of banking was when commercial banks worked with a “Static Model” of banking. Banks lived off the “carry trade”: because of highly restricted and regulated banking markets, banks operated in quasi-monopoly positions where they could earn relatively high returns on the loans they made and pay zero or close to zero on the deposits they attracted, providing them with a “lusty” net interest margin (NIM). Their model was static because they could originate loans or buy securities and hold them until they matured. Marking to market was not an issue. Credit risk was the only real risk bank lenders had to be worried about.

Today a “Dynamic Model” of banking exists and the transition to this dynamic model was horrendous. The “buy and hold” strategy could no longer work. In the late 1960s, interest rates began to rise. In the 1970s, declining NIMs became a major problem and the banks countered the declining margins by moving into fee income. In the 1980s all hell broke loose as NIMs practically vanished and banks began diversifying into other assets in order to generate returns that justified their existence.

Banks did not adjust their thinking in terms of risk management during this time period. As Tilman describes in his book, as commercial banks moved into Principal Investments (α-type investments) and investments exhibiting Systematic Risks (β-type investments) their risk management knowledge and skills lagged far behind the dynamic changes that were taking place in financial markets.

On top of this commercial banks continued to add leverage to their balance sheets as a means of generating another 5 or 10 basis points or more to their return on equity.

When the cookie began to crumble, it became obvious that financial institutions had mis-managed their risk exposure and had leveraged-up to such a degree that there was little or no way to keep the cookie together. The industry had to be bailed out.

In the modern world where the “Dynamic Model” of financial management rules, the “buy-and-hold” philosophy that applied to the “Static Model” of banking is legacy.

By getting rid of “Mark-to-Market” the banking industry is kidding itself and just setting itself
up for future trauma. It is hiding its head in the sand and pretending that the world has not changed.

The world has changed. Net interest margins are not what they once were. Buy-and-hold policies are not realistic. And financial leverage is going to be more severely regulated. So who is going to manage risk if it is hidden on the balance sheet?

My advice to bank managements: mark your portfolios to market. You don’t have to, but, for once, “get real.” If you are going to buy risky long term investments…accept the fact that they are subject to interest rate risk…and credit risk. You don’t get the return unless you assume something to justify the extra return. Who are you fooling by not marking-them-to-market? You are only kidding yourselves.

Tilman argues that generating “economic performance while controlling risk” is going to be “a differentiating factor”, a determinant of success but also of the economic viability” of a financial institution.

In the 1950s and 1960s banking was a very quiet and stable environment. The industry did not attract the “best and the brightest.” There was the joke around Philadelphia that in wealthy families that had three sons, the smartest became a doctor, the next smartest became a lawyer: the dumbest became a banker.

The thrift industry was even worse. Tilman titles his book “Financial Darwinism.” In the case of survival, most thrift managements were awful, much worse than bank managements, and, the thrift industry is dead,! Are the smaller commercial banks the next in line for extinction?

When I joined the Finance Department at the Wharton School, UPENN, (in 1972) "Finance" did not have a course on the financial management of commercial banks. (I did create that course while I was there.) The reason why no bank management course existed was that the big banks, City, Morgan, Chase, and so on, did not recruit students at Wharton. They recruited from the history department, the literature department, and so forth…well, they really recruited from the social clubs, the tennis team, and the golf team. They wanted people who could socialize with customers and get along with them at the highest social levels. They didn’t want some sharp intellect that was quantitatively orientated to work in “their shop.”

Bankers have never liked uncomfortable situations. They have been notorious for keeping bad loans on their books until they absolutely have to charge them off. They are also notorious for refusing to acknowledge that some of their assets might be “under-water”. Bankers are notorious as risk managers.

Risk management is going to be a major differentiator of bank performance in the future. We have seen how inadequate risk management can help the industry self-destruct. Anyone investing in banks…or regulating banks…should pay special attention to how a management recognizes risk; the policies and procedures it puts in place to manage risk; and the efforts it makes to disclose to people the value of the assets the bank has on its balance sheet.

The banking industry is changing. I have just written up my view of some of the changes that are coming (See http://seekingalpha.com/article/247809-banking-is-changing-look-out-for-opportunities) Good risk management is going to be a “decider” of who survives

China Leads the World...In Clean-Energy Power?

These are the lead paragraphs in an article on China… the “Green” nation:

“For years, China was seen as a major obstacle to global efforts to combat climate change because of its refusal to reduce emissions under the Kyoto Protocol.

Now, for some, the concern is not that China is moving too slowly but that it is rushing ahead so fast that clean-energy companies in the West will be left in the dust.” (http://dealbook.nytimes.com/2011/01/25/efforts-to-halt-climate-change-provoke-new-optimism/?ref=todayspaper)

This article brings to mind two pieces of advice I received several years ago that I have found to be relevant over and over again.

The first is that China thinks in terms of decades, whereas the West thinks in terms of years.

This puts the West at a substantial disadvantage. We deride the Chinese because they are not moving as fast as we, who focus on what is happening “right now”, think they should be moving.

Then, when the actions of the Chinese fall into place, people in the West respond as if the success of China took them by surprise.

While the leaders in the West have focused on “legacy” issues like putting people back to work in the old jobs they got laid off from or in supporting declining industries, issues like science education (http://professional.wsj.com/article/SB10001424052748704698004576103940087329966.html?mod=ITP_pageone_1&mg=reno-wsj), all types of education (http://www.nytimes.com/2011/01/16/opinion/16kristof.html?partner=rssnyt&emc=rss), and innovation take a back seat because they only have a “longer term” payback.

The second piece of advice has to do with how programs, governmental programs, should be designed. The emphasis of governmental programs should be on policies and not outcomes.

The article mentioned above contains a quote by Vincent Mages, a director for climate change initiatives at Lafarge, the giant cement company based in France, “China talks about programs and policies rather than focusing on targets.” Mages adds, “We focus on targets too much.”

When you focus too much on outcomes, desperation sets in when the outcomes are not being met. And, outcomes are generally tied to short-term time horizons. Some outcomes emphasized by the United States government have been on a 4.0% or a 6.0% unemployment rate or a housing starts goal or the real growth rate of the economy. And, these goals are usually connected with the year after they are set. Frustration in meeting these goals often lead to even more efforts to achieve them which often results in distortions of resource allocation and, even more important, they serve as a distraction from working on longer term objectives.

People in the United States do respond to needs and do respond to opportunities. Did the capital shortage expected in the 1980s ever arise? Were there any disruptions arising from Y-2000? Has America not led the world in innovation in the area of information technology? And so on.
People respond to incentives. Just check out the research presented in the two books “Freakonomics” and “Super Feakonomics.” People will cheat if the incentives are aligned in certain ways…even teachers. They will act in destructive ways if information is not open and available. They will focus on short-term outcomes if that is where the incentives are. People respond to the incentives that are embedded in the culture of a nation.

If we are not comfortable with the results we are getting, maybe we need to look at the incentives we are setting up for our children and grand-children. Maybe we, as members of this society, are, ourselves, emphasizing outcomes for people rather than programs or lifestyles.

So, maybe, just maybe, we should begin to think in terms of decades and not just in terms of the short-term results connected with next year’s or next quarter’s profits. Maybe we should take into consideration all the costs of the decisions we make and not just the immediate ones that affect us. Maybe we should become more interested in the kind of culture we are supporting and create more positively directed programs and policies and de-emphasize our efforts to achieve specific outcomes.

There are initiatives that are popping up. “Impact” investors, like those connected with Investors Circle in the United States, are growing in importance. Investors’ Circle aims to “catalyze the flow of capital to early stage companies that address major social and environmental problems as well as grow and support the network of values driven capital investors.” Return is important, but real return is based on “smart” decision making not just expedient decision making.

There is also a new breed of commercial banks being formed like New Resource Bank in California, Green Choice Bank in Chicago, and e3bank in near Philadelphia Pennsylvania. (Note of disclosure: I am on the board of e3bank and an investor in that organization.) These banks emphasize “smart” decision making with respect to clean-energy and the inclusion of the longer term costs of not taking into consideration environmental impacts. These efforts focus on decisions that have consequences over decades and not just on next year’s profits.

These efforts, however, are just small ones. They have not achieved the scale that the Chinese effort has achieved. And, until greater “scale” is achieved, “the West will be left in the dust.”

Maybe, just maybe, this competition from China is just what we need. We, in the West…and in the United States…have been very smug about our leadership in the world. Here is a “space” in which this leadership may cease to exist in the very near future.

Could this be the “jump start” we need to get the ball rolling? Nothing drives us harder than competition. We’ll see.