Archive for the ‘Banking and Finance’ Category.

When Regulation Makes Things Worse -- Banking Edition

One of the factors in the financial crisis of 2007-2009 that is mentioned too infrequently is the role of banking capital sufficiency standards and exactly how they were written.   Folks have said that capital requirements were somehow deregulated or reduced.  But in fact the intention had been to tighten them with the Basil II standards and US equivalents.  The problem was not some notional deregulation, but in exactly how the regulation was written.

In effect, capital sufficiency standards declared that mortgage-backed securities and government bonds were "risk-free" in the sense that they were counted 100% of their book value in assessing capital sufficiency.  Most other sorts of financial instruments and assets had to be discounted in making these calculations.  This created a land rush by banks for mortgage-backed securities, since they tended to have better returns than government bonds and still counted as 100% safe.

Without the regulation, one might imagine  banks to have a risk-reward tradeoff in a portfolio of more and less risky assets.  But the capital standards created a new decision rule:  find the highest returning assets that could still count for 100%.  They also helped create what in biology we might call a mono-culture.  One might expect banks to have varied investment choices and favorites, such that a problem in one class of asset would affect some but not all banks.  Regulations helped create a mono-culture where all banks had essentially the same portfolio stuffed with the same one or two types of assets.  When just one class of asset sank, the whole industry went into the tank,

Well, we found out that mortgage-backed securities were not in fact risk-free, and many banks and other financial institutions found they had a huge hole blown in their capital.  So, not surprisingly, banks then rushed into government bonds as the last "risk-free" investment that counted 100% towards their capital sufficiency.  But again the standard was flawed, since every government bond, whether from Crete or the US, were considered risk-free.  So banks rushed into bonds of some of the more marginal countries, again since these paid a higher return than the bigger country bonds.  And yet again we got a disaster, as Greek bonds imploded and the value of many other countries' bonds (Spain, Portugal, Italy) were questioned.

So now banking regulators may finally be coming to the conclusion that a) there is no such thing as a risk free asset and b) it is impossible to give a blanket risk grade to an entire class of assets.  Regulators are pushing to discount at least some government securities in capital calculations.

This will be a most interesting discussion, and I doubt that these rules will ever pass.  Why?  Because the governments involved have a conflict of interest here.  No government is going to quietly accept a designation that its bonds are risky while its neighbor's are healthy.  In addition, many governments (Spain is a good example) absolutely rely on their country's banks as the main buyer of their bonds.  Without Spanish bank buying, the Spanish government would be in a world of hurt placing its debt.  There is no way it can countenance rules that might in any way shift bank asset purchases away from its government bonds.

Another Reason for Declining Business Formation

I often criticize others for attributing 100% of any bad trend to their personal pet peeve.  To some extent I am guilty of that in my last post, where I blamed declining business formation on increasingly complex regulation and licensing.  I think there are good reasons for doing so -- I have spent the last 6 months passing up on business growth opportunities because I was too consumed with catching up on regulatory compliance minutia, particularly in California.  And I have watched as many of my smaller competitors who have fewer resources to dedicate to such compliance issues have left the business, telling me they could no longer keep up with all the requirements.

But there is seldom just one single cause for any trend in a complex, chaotic system (e.g. climate, but economics as well).  One other reason business formation may have dropped is the crash of the housing market and specifically in the equity many have in their homes.

Home equity has historically been an important source of capital for small business formation.  My first large investment in my company was funded with a loan that was secured by the equity in my home.  What outsiders may not realize about small business banking nowadays is that it is nothing like how banking is taught in high school civics.  In that model, the small business person goes to her local banker and presents a business plan, which the banker may fund if they think it is a good risk.

In the real world, trying to get such an unsecured loan from a bank as a small business will at best result in laughter.  My company is no longer what many would call "small" -- we will do millions in revenue this year.  But there is no way in the world that my banker of over 10 years will lend to my business unsecured -- they will demand some asset they can put a lien on.  So we can get financing of equipment purchases (as a capital lease on the equipment) and on factored receivables and inventory.  But without any of that stuff, a new business that just needs cash for startup cash flow is out of luck -- unless the owner has a personal asset, typically a house, on which the banker can place a lien.

So, without home equity, one of the two top sources of capital for small business formation disappears (the other top source is loans from friends and family, which one might also expect to dry up in a tough economy).

Postscript:  Banks will make cash flow loans if guaranteed by the SBA.  This is another whole can of worms, which I will not discuss today.  SBA loans are expensive and difficult to get, and the SBA has a tendency to turn the money spigot on and off at random times.  I have often wondered if the SBA helped to kill cash flow lending by banks.  First, why make risky small unsecured loans when you can get a government guarantee?  And second, with more formulaic lending criteria, SBA lending eliminated the need for loan officers who were good at evaluating business risks.  I can say from personal experience that the folks who can intelligently discuss a business plan and its risks are all gone from banks now (at least in the small business market).

Apparently, Rental Homes Are Not Like Bonds

It is always hard to tell if the media is really offering a balanced sample of customer experiences when they pile on some company, but the Huffpo makes a pretty good case that large Wall Street home rental companies are doing a terrible job at customer service.

If so, I am unsurprised for three reasons:

  • I run what is essentially a property management company.  One thing I have learned is that everyone outside of the business systematically underestimates basic maintenance and operating costs, and few if any ever factor in the costs of longer-term capital maintenance.  Further, and perhaps more critically, outsiders frequently underestimate the detailed, even minute focus on process and organization that is necessary to make sure everything is getting maintained satisfactorily  particularly when the portfolio gets larger than the executive group can personally oversee.
  • I have rented out a second home for a few years.  It is difficult and expensive to stay on top of basic maintenance, and this is with one property that one is intimately familiar with.  I challenge you to find many people who will say they made money renting their second homes, particularly given the high cost of property management.  They may have made money on the appreciation of the real estate value, or reduced the net costs of owning a vacation home, but I seldom run into anyone making money on a annual basis (as long as the real cost of capital is being considered in the equation).
  • Wall Street has a long history of treating operational assets as financial assets.  There is a huge mindset difference between the two.  The book Barbarians at the Gate included some early history of LBO firms like KKR, and it is interesting the culture clashes they faced as they tried to explain the need to be operationally involved in their investments to the financial guys who wanted to treat them as Deals.

Single-Minded Obsession on Home Ownership

This article from the LA Times confused me greatly:

Advocates for borrowers took such comments to mean that the banks would prioritize debt write-downs on first mortgages, which banks resisted before the [$25 billion] settlement. Now, with nearly all the promised relief handed out, it is clear that the banks had other ideas.

The vast majority of the aid to borrowers, it turns out, came in the form of short sales and forgiveness of second mortgages. Just 20% of the aid doled out under the national settlement went to forgiveness of first-mortgage principal, the kind of help most likely to keep troubled borrowers in their homes. In terms of borrowers helped, just 15% of the total received first-mortgage forgiveness.

The five banks collectively delivered twice as much aid using short sales, in which owners sell their homes for less than the amount owed and move out, with the shortfall forgiven.

In all, the lenders sought credit for nearly $21 billion related to short sales and $15 billion related to second mortgages. That compares with $10.4 billion in write-downs on first mortgages.

Critics on the Left (example) are calling this a failure of the program, that most of the relief went to short-sales and 2nd mortgage forgiveness rather than first mortgage forgiveness.  The original article has this quote:

"It just shows you that the banks are running the government," Marks said. "There's virtually no benefit to borrowers, and yet you give the banks credit for short sales and getting second liens wiped out — something they were going to have to do anyway."

Hmm, well I am not the biggest fan of bankers in the world, but short sales and second lien forgiveness are principle forgiveness as well, just of a different form.  If they wanted a settlement that was first-lien forgiveness only, they should have specified that.

In fact, both short sales and second lien forgiveness have tremendous value to individuals if one considers individual well-being one's goal rather than just this obsessive fixation on home ownership.  

For many people, the worst part of their negative equity is that it created a barrier to their moving.  Perhaps they could find a job in another part of the state or country, or they wanted to move into a home or apartment with less expensive payments but were stuck in their current home because they could not afford to bring tens of thousands of dollars to closing.  In such cases, a short sale is exactly what the homeowner needs and facilitating and expediting this likely helped a ton of people  (It is also an example of just how unique our mortgage rules are in the US -- in almost any other country in the world, the amount of the negative equity in a short sale would get hung on the seller as a lien that must be paid off over time.  Only in the US do buyers routinely walk away clean from such situations).  Given that first mortgage loan forgiveness more often than not does not save the loan (ie it eventually ends in foreclosure anyway), short sales are the one approach that lets lenders get away clean for a fresh start.

As for second mortgages, I can tell you from personal experience that it is virtually impossible in the current environment to restructure or refinance a first mortgage with a second lien on the house -- even in my case where everything is performing and the underlying home value is well above the total of the two liens.  Seriously, what is the point in reducing principle in the first mortgage if there is a second mortgage there, particularly when the second mortgage is likely far more expensive?  For people with a second mortgage, forgiveness of that is probably the first and best gift they could get.  They may end up still losing their home, but they can't even begin to discuss a restructure or refinance without that other mortgage going away.

Irony and the New Fed Chairman -- Progressives Support Continued Excess Financial Profits for the 1%

I have a column up at Forbes on Monday discussing the irony of how progressives, in opposing Larry Summers as Fed Chairman, have essentially made common cause with the 1%, who opposed Summers because they feared that he might end the quantitative easing gravy train for the financial markets.

Nervous in the Market

No particular point to this post - just thinking out loud.  As a warning, the best way to make a million dollars with my investment advice is to start with 2 million.  I know others are in the same boat so perhaps this is just commiseration

This is an odd stock market.  To me, and to many others, stock price increases have outpaced the economic recovery, and are being driven now in large part by huge injections of printed money by the Fed via ongoing quantitative easing.

First and foremost, quantitative easing has been a savior for bank income statements.  Much of the new money ends up in banks, which shows up as increasing excess deposits.  Even at fractional interest rates, a trillion dollars of new deposits does wonders for bank profitability.  It's an odd sort of bank bailout, cheap if someday the Fed can unwind its balance sheet gracefully, very expensive if not.

Second, though, this money has also found its way into the securities markets, inflating what many people fear may be a bubble in equity and bond prices  (and perhaps even into a newly-reignited bubble in real estate, as house flippers again make their presence felt in California and Arizona home markets).  I have a friend at a party the other night who shook his head in remorse that he had missed the recent run-up in equity prices.  But, unlike many personal investors, he is too smart to jump in now.

I have stayed in the market, though at a reduced mix of my assets, having been convinced by others that you don't fight the Fed and as long as the Fed was injecting money into the financial markets, that security prices would rise almost irregardless of the fundamentals.

Which raises this problem:  I am as certain as one can be in such things that in the next 6-12 months the stock market will be lower, at least 10-20% lower, than it is today.   I am also fairly certain there is some positive run left before the bubble deflates  (you can see that today -- the market is up about a percent as I write this).  So I stay in, ready to skedaddle at a moments notice.

My fear is that almost everyone in the market has the same plan, so that the skedaddling will happen so quickly and so in mass that it will be hard for me as a casual investor to stay ahead of it.  As a result I am slowly liquidating, willing at some point to just miss out on the last stages of the bubble.

The real question is liquidate into what?  Bonds are perhaps more overvalued than stocks, so I certainly tend to stay away from long-duration bonds and bonds that have enjoyed a big run up, such as high-yields, which are trading at some ridiculously small premium to government bonds.  I would not invest in Europe right now at the point of a gun, and I have been anticipating a bursting of the China bubble for a couple of years now.  Commodities are always a crap shoot -- gold is falling and if OPEC does not act soon oil will be falling soon too.  Right now I have decided to sit for a while in short duration bonds, checking my greed at the door and accepting a low return.

Sleep With The Dogs, Wake Up With Fleas

JP Morgan finds itself under the government microscope for having heartlessly... cooperated with the government four years ago

The U.S. Department of Justice and New York Attorney General Eric Schneiderman teamed up last week to sue J.P. Morgan in a headline-grabbing case alleging the fraudulent sale of mortgage-backed securities.

One notable detail: J.P. Morgan didn't sell the securities. The seller was Bear Stearns—yes, the same Bear Stearns that the government persuaded Morgan to buy in 2008. And, yes, the same government that is now participating in the lawsuit against Morgan to answer for stuff Bear did before the government got Morgan to buy it....

As for the federal government's role, it's helpful to recall some recent history: In the mid-2000s, Bear Stearns became—outside of Fannie Mae and Freddie Mac—perhaps the most reckless financial firm in the housing market. Bear was the smallest of the major Wall Street investment banks. But instead of allowing market punishment for Bear and its creditors when it was headed to bankruptcy, the feds decided the country could not survive a Bear failure. So they orchestrated a sale to J.P. Morgan and provided $29 billion in taxpayer financing to make it happen.

The principal author of the Bear deal was Timothy Geithner, who was then the president of the Federal Reserve Bank of New York and is now the Secretary of the Treasury. Until this week, we didn't think the Bear intervention could look any worse.

Somewhere there was a legal department fail here - I can't ever, ever imagine buying a company with Bear's reputation that was sinking into bankruptcy without doing either via an asset sale or letting the mess wash through Chapter 7 so there could be an old bank / new bank split.  But Bank of America made exactly the same mistake at roughly the same time with Countrywide, so it must have appeared at the time that the government largess here (or the government pressure) was too much to ignore.

Why Is No One From MF Global in Jail?

Whether crimes were involved in the failures of Enron, Lehman, & Bear Stearns is still being debated.  All three essentially died in the same way (borrowing short and investing long, with a liquidity crisis emerging when questions about the quality of their long-term investments caused them not to be able to roll over their short term debt).  Just making bad business decisions isn't illegal (or shouldn't be), but there are questions at all three whether management lied to (essentially defrauded) investors by hiding emerging problems and risks.

All that being said, MF Global strikes me as an order of magnitude worse.  They had roughly the same problem - they were unable to make what can be thought of as margin calls on leveraged investments that were going bad.  However, before they went bankrupt, it is pretty clear that they stole over a billion dollars of their customers' money.  Now, in criticizing Wall Street, people are pretty sloppy in over-using the word "stole."  But in this case it applies.  Everyone agrees that customer brokerage accounts are sacrosanct.  No matter what other fraud was or was not committed in these other cases, nothing remotely similar occurred in these other bankruptcies.

A few folks are talking civil actions against MF Global, but why isn't anyone up for criminal charges?  Someone, probably Corzine, committed a crime far worse than anything Jeff Skilling or Ken Lay were even accused of, much less convicted.   This happens time and again in the financial system.  People whine that we don't have enough regulations, but the most fundamental laws we have in place already are not enforced.