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BaU vs. NN I: Finance Fumes, Realities and Pecora II (Refresh)

Well we've refreshed ourselves on the economic (here) and market situations (here) with the primary conclusions being we've stopped the cliff-diving but are bumping along at the bottom of the cliff in a very rocky landscape. One that feels better only because it's not so much worse. As for the Markets we referred to them as "euphorilusion" since they ran up with a V-shaped recovery, earnings expectations beats that were really cost cutting with meat-axes and valuations run wild. No matter what happened this last week with the daily runups we still think that's true and without going into a repeat discussion if you want to check out the updated multi-period SP500 chart here it is.

That naturally leads us to the next stage in reality checking - what's the real reality behind earnings. Or, put another way, how are businesses performing and how are they likely to be performing in the future ? Which reminds us to explain that BaU is "Business as Usual" and NN is "New Normal". In other words, on the whole, we find way too many executives just waiting to be saved by the magical miracle recovery so they can revert to BaU (is there a sad parody of Value at Risk here ?) instead of making the reset adjustments required to cope with a NN. Nowhere is this problem more acute than in the Finance Industry, whose surprise earnings drove the market rally but are actually more vaporware and fumes than anything else. Based on various combinations of government money, guarantees, proprietary trading, reduced competition and so on and so forth. And which do not address the continuing threats of over-valued assets, rising bad loans, and long-term shifts in the industry.

More to Come: Bad Loans, Bad Earnings ?

We've organized the readings around several key themes and article collections, starting with the fact that banks are still sick and facing more problems. To quote the first excerpt, "...numerous large banks around the country are still struggling with deteriorating finances. Two dozen banks with at least $5 billion in assets get the lowest one-star rating on Bankrate.com's safety and soundness test...".

On top of which you should recall that all the bad securities are still on the books with grossly unrealistic market values, the CRE market looks to be starting the next wave of boulders rolling into the pond, foreclosures are continuing to grow, including in the prime mortgages and their traditional lines of business aren't doing very well at all. Even if nothing else changes, that is if the sand they're standing on doesn't turn out to be quicksand, they're still very weak and facing years of on-going operating and profit problems. Which explains why the drumbeat of bank failures continues and will keep growing, and the banks biting the dust are big ones. Which is changing the structure of the industry. To quote from another excerpt, "Scores of additional failures are expected in coming years, as the industry works through trillions of dollars worth of residential and commercial real estate problems.". BtW - we traced thru all these cyclical and structural problems in a prior post you might want to look at: Beyond the CRE "Bombshell": Real Stress Testing for Finance. In other words there are no major surprises here other than everybody seems to be surprised at problems that have been visible for a long...long time. That probably illustrates another major problem - one of the biggest - the tendency to subsitute ideology, delusions and wilfull ignorance for analysis and real data. Need to understand how the buzz saw works if you're going to be in a sawmill.

Goldman, Front-running and Bank Performance

In our last post on the Finance Industry (More Darkside Earnings Tales: Banks,Goldman und Unsinn) we covered some of the longer-term ground and asked where all these earnings were coming from so we won't repeat it. If you'll recall we use a "model" of the industry that looks at several key lines of business. In fact that model has three views we re-use: LOB vs Function, LOB vs Drucker Principles, and LOB vs Timeframe. Those Lines of Business are Wealth Management, Consumer Banking, Credit Cards, Business Banking and Securities Management. We include Transaction Services, M&A, Investment Banking, Proprietary Trading and Alternative Investments as sub-sets of the latter, where Alternative Investments include Venture Capital, Hedge Funds and Private Equity. Each and every one of those LOBs is facing major challenges currently, cyclically and structurally. And the Industry is failing, as best we can judge, to do anything about any of them. In an earlier post we even offered up a set of suggestions for strategic initiatives and innovations that would lead to some improvements in industry potential performance. (Firestorms, Finance, Futures: From Sociopathic Dysfunction to Value Creation). The result - da nada !

In the Darkside post what we found was that the only source of profits was proprietary trading, where GS was the exemplar. Or should we say bete noir ? Their, to say the least, highly unusual and unexpected profits all came from proprietary trading and, after the surprise, shock and outrage, a lot more people did a lot more investigating. The bottom line here is that their performance is so aberrational as to be completely incredible - hence the conclusion that seems defensible based on many folks work: GS is a hedge fund in disguise which makes it's money by making markets for clients and front-running them. In other circles that's called a violation of fiduciary trust.

We think the accompanying composite chart tells a terrible and scary story: re-regulation created aberrational finance industry profits which led to two stock bubbles that are still uncorrected and were built on the backs of loading up the rest of the economy with debt. And the primary beneficiaries, speaking of fiduciary problems, were the key players in the industry. How long is that going to continue ?

Alternative Investments: Venture Capital, Hedge Funds, Private Equity

David Swensen of Yale changed the world of institutional and endowment fund management by putting an emphasis on alternative investments. He shifted the portfolios from the traditional and conservation Stocks, Bonds and Funds to a much heavier emphasis on alternative strategies and was very successful for a long time. But the thing to bear in mind is that when he started in the early 1980s those alternatives were under-utilized and under-valued. Investment managers talk about the alpha and beta of investment returns. Beta is the amount of return that's based on market correlations. In other words the proportion of return being driven by the normal up and downs of the market and the economy. Alpha is the return resulting from finding hidden value. Put another way Swensen went after alternative investments when they had a high Alpha, a low Beta and one that was uncorrelated with the rest of the market.

Now as money from institutions, wealthy investors and asset managers flooded into the market you get what you always get - a huge surge in suppliers to meet that demand. In other words thousands more Hedge Funds, PE firms, etc. etc. The last time we saw a flood of hot money was the late '90s boom in Venture Capital chasing dreams of Tech Bubble pots of gold. In the last ten years the VC industry has barely performed as well as the Rusell2000, if that. 

Many firms have gone out of business but what we're looking at now is a huge shakeout, the return of funds and major industry consolidation. We suspect that the same thing for all the other alternative investments. You see Alpha = Anomaly. That is exceptional returns result from finding pockets of value that are under-appreciated and under-priced. Now all the alternatives are just so much BaU, or Beta. Worse yet, implicit in the prior chart, they are just leveraged Beta and the piper wants to be paid for his music.

Dick Bove, Fume Trading and the Last Word

We'll give Dick Bove, the well-known bank industry analysts the last work here because he brings it all home. This is a fairly recent interview on Canada's BNN where he discusses bank earnings, valuations and outlooks. When someone as respected as Bove speaks it'd pay you to listen. When someone that respected has been so right for so long and so contrarian you should really think about it. And when you put what Dick has to say together with our survey on the big picture and structural outlook you should start changing you atttitudes, actions and activities. The Finance Industry of the future will not look anything like the Industry that's evolved in the last thirty years.

But there are three other conclusions that are even more important:

1. On the whole nobody is paying any attention.

2. As a result nobody is doing anything.

3. Society cannnot afford to let the industry keep running around without adult supervision.

Updates, Adds, Refreshes

This morning's headlines are about the re-appointment of Bernanke, a great thing IOHO, and banks starting to raise more capital (Deutsche Bank plans Tier 1 issue, reopens market), on which topic you'll see more as the tide rolls on we suspect. But if our whole theme now is BAU and Denial our theme last year was broken business models, bad practices and malfeasant management. We collected all of last year's major posts on that topic and posted an "essay" on Scribd. Having just read-read it we strongly urge you to download it and at least review. With the caveat that no on is paying attention to:Credit, Leverage, Malfeasance and Broken Business Models.

Finally Simon Johnson and Michael Perino had this interview on Bill Moyer's Journal discussing the Pecoro Hearings in the 1930s which uncovered all the shennanigans that brought about the crash and led to the regulatory infrastructure created under the New Deal. At the time they didn't anticipate new Pecoro II but Congress has since chartered a blue-ribbon panel and, trust us, you need to hear the people singing. As Drucker said, "change the people or change the people". Well, the Industry is refusing to change...what do you think is going to happen ?

Sick Banks

Banks still sick The economy may have pulled out of its plunge, but you'd never know by a look at many big banks. Even after a rousing market rally that spurred new capital into giant institutions such as Wells Fargo (WFC, Fortune 500) and Bank of America (BAC, Fortune 500), numerous large banks around the country are still struggling with deteriorating finances. Two dozen banks with at least $5 billion in assets get the lowest one-star rating on Bankrate.com's safety and soundness test, which is based on an assessment of regulatory filings for the quarter ended March 31. More than half of those banks are ranked "troubled" or worse by research firm Bauer Financial, using the same data. Three of these banks, with a total of $45 billion in assets, have made public statements indicating they could soon collapse. "There are some big ones in fairly dire straits," said Karen Dorway, director of research at Coral Gables, Fla.-based Bauer. "If you see some of these fail, it could add to the stress on local economies." Many banks have had their capital eroded by losses, while their balance sheets remain bloated with billions of dollars in depreciating real estate investments and construction loans. These banks have been setting aside more money for future losses, but in many cases the increases in loan loss reserves haven't kept up with the surge in nonperforming assets. That means profits could be pressured even at stronger institutions. The problems at troubled banks could slow the recovery for their healthier counterparts. So far this year, 69 banks have failed -- the most since 1992. The Federal Deposit Insurance Corp. has already imposed a one-time fee on member banks to shore up its deposit insurance fund and has said it may impose another later this year. The FDIC's so-called problem bank list had 305 institutions -- with $220 billion in assets -- on it at the end of the first quarter. The agency has set aside $22 billion to cover failure-related costs this year. A law enacted this spring gives the FDIC access to up to $500 billion in Treasury credit though 2010. Even so, the scale of the banking problem will surely test the agency's mettle. Veribanc, another bank rating agency, suggested as much this spring when it reported a raft of first-quarter rating downgrades and forecast 97 bank failures for the year. "If the past quarter's trend continues, more than half of all banks could be downgraded during the remainder of 2009," Veribanc said.

Failures and Consequences

Who wins when banks fail Shares of BB&T Corp. shot higher Friday after reports that it might be scooping up the remains of Colonial BancGroup. It's no wonder: Such purchases give healthier banks a chance to grow on the cheap. That's valuable at a time when many institutions have been shrinking in response to the recession. More than 70 banks have failed this year. Scores of additional failures are expected in coming years, as the industry works through trillions of dollars worth of residential and commercial real estate problems. While most of the biggest recent bank failures have been resolved via sales to major institutions or investor groups, regional banks have been bulking up as well. Since the banking crisis started last year, six regional banks have bought at least two failed banks from the FDIC. The leader has been Zions Bancorp (ZION), a Salt Lake City-based institution that has acquired four banks from the FDIC. Other buyers of multiple troubled banks include U.S. Bancorp (USB, Fortune 500), the Minneapolis-based bank that last year bought the remains of troubled thrifts Downey Savings and PFF, which failed on the same day. The joint purchase of Downey and PFF wound up being the third largest deal by assets for failed banks last year, after the WaMu and IndyMac sales. In addition to BB&T (BBT, Fortune 500), analysts have pointed to Cincinnati's Fifth Third (FITB, Fortune 500) and Atlanta's SunTrust (STI, Fortune 500) as regional banks that might be chosen to participate in future deals. Some bankers have downplayed questions about buying failed institutions. Such deals "really are off our radar," Fifth Third chief executive officer Kevin Kabat told investors last month, noting that there have been relatively few bank failures in the Midwest. But given the advantageous terms, no one is ruling FDIC-assisted deals out, either. U.S. Bancorp chief executive officer Richard Davis said in a conference call with analysts and investors last months that the bank "will always be available" for any "opportunities that come along" on the FDIC failed bank list, though it is keeping an eye out for bigger ones.

Re-visiting Goldman

Goldman facing compensation, derivative inquiries Goldman Sachs Group Inc., one of the banking industry's top performers, said Wednesday that government agencies have asked about its compensation practices and use of credit derivatives. been among the most hot-button topics in the financial services industry since the credit crisis peaked last fall. In a filing with the Securities and Exchange Commission, Goldman said it is cooperating with the requests from undisclosed regulators. A spokesman from Goldman declined to provide further details about the inquiries. Politicians have recently questioned the methods big banks use to determine compensation packages, especially in the wake the government's bailout last fall of the banking sector, known as the Troubled Asset Relief Program. Banks have also faced criticism for use of risky derivatives contracts, which have been partly blamed for the collapse of Goldman's competitor Lehman Brothers Holdings Inc. and the near-collapse of insurer American International Group Inc. Fearing more fallout after Lehman and AIG's problems, the government launched the bank bailout program. Goldman, however, has been quickly able to rebound from last fall's sector-wide troubles to return to its perch as a highly profitable Wall Street trading giant. During the second quarter, Goldman ramped back up its aggressive trading practices as markets began to stabilize and posted a profit of more than $2.7 billion. Profits were strengthened by fixed income, currency and commodities trading.

Alternative Investments: Venture Capital, Hedge Funds, Private Equity

Coming venture capital shakeout a good thing Before the dot-com boom and bust, the world of venture capital was much different.Venture firms invested in technology companies for the long haul. They didn't look at the initial public offering as their "exit.""A public offering early in my career wasn't an exit," said Andy Rappaport, a partner at August Capital, a 25-year-old VC firm near Silicon Valley. "Most of the money that we created for our limited partners was created after they went public. That was because most of the companies you would take public had their growth ahead of them." But the dot-com bubble changed everything. In 1999-2000, in came the fast money, with some firms hiring freshly minted MBAs -- the young, get-rich-quick kids who could make sense of the Internet boom and whose buddies from business school were fledgling entrepreneurs. The venture capital lemming thrived, with investors throwing money at copycat ideas, and hoping their investment went public first. Now, 10 years since the formation of many of those fat funds during the boom, a reckoning is coming. And it won't be pretty. But it will be good for the bloated industry, which still has too much money sloshing around and not enough big hits. Many VCs still invest in companies that don't have enough growth yet to go public, and shouldn't try. The recent slower pace of the first and second quarters of 2009, where $3.2 billion and $3.7 billion were invested, respectively, indicates VC is getting back to 1997-98 levels. Now, it looks like $15 billion to $20 billion will become the new investment norm for the entire venture-capital industry. "Some of you have seen the VC numbers for the first and second quarter," said Fred Wang, general partner at Trinity Ventures, at the AlwaysOn Summit at Stanford University last week. "People are waiting for venture to come back." But he added that is unlikely to happen. "These numbers are the new norm. Venture capital is going to see a big shift," he said. How will that play out for investors, start-up companies and technology innovation? Returns have not been as stunning as you might expect. The big payoffs come from only a few winners a year, if that, such as Internet giants Amazon.com Inc. in 1997 and Google Inc. in 2004. Those major triumphs have to compensate for otherwise mediocre performance across a portfolio."The venture industry's current returns are unsatisfactory," according to a recent report called "Right-Sizing the U.S. Venture Capital Industry." The report was written by Paul Kedrosky, a senior fellow at the Kauffman Foundation in Kansas City, Mo., which focuses on entrepreneurship. The study says that the venture industry leads the Russell 2000 small-cap index on a five-year and 10-year investing horizon in annualized returns, while lagging slightly on 10-year total returns. The Russell had a total 10-year return of 18%, while venture capital had a total 10-year return of 16%, according to data in the Kauffman study.

Credit Markets, Credit and Policy

Commercial Credit Crunch Means We May Not Be Out of This Yet Commercial property values have fallen an average of 35 percent, with further declines expected as the recession drives more tenants out of business or puts them behind in their rent payments. The process of securitizing new loans has ground to a complete halt, and the limited financing that's available now comes from banks and insurance companies on much tougher terms. Loans now are typically for no more than 60 percent of a property's current value, with an interest rate four percentage points above the Treasury rate. Borrowers must also repay principal, which is like adding another two percentage points to an interest-only loan. All of this has been wrenching for the industry -- particularly for some of the biggest names, such as General Growth Properties, Maguire Properties and Tishman Speyer, which bought at the top of the market. Not only has their equity been pretty much wiped out, but those who financed their bubble purchases have lost anywhere from 35 cents to 100 cents on every dollar lent. Unfortunately, this isn't just a tragedy for rich developers, bankers and investors. It's also a problem for the rest of us. For starters, local and regional banks have so many souring commercial real estate loans that they have begun to fail at a rate not seen since . . . well, you know. The latest was Colonial Bank of Alabama, which was rescued last week at a cost to the Federal Deposit Insurance Corp. of about $2.8 billion, the sixth-largest bank failure in history. And over the coming year, it will be a rare Friday afternoon that the FDIC doesn't announce the takeover of some bank that lent too much to local builders and commercial real estate developers despite abundant evidence that a bubble had developed. It's a good bet the agency will have to replenish its coffers by drawing on its line of credit from the U.S. Treasury. Then there's the matter of half a trillion dollars in securitized loans that were made during the bubble and will be coming due over the next few years. These will need to be refinanced. Unless the securitization machine can be cranked up again, there's simply not enough lending capacity at the banks and insurance companies to fill the gap. Moreover, there can be no refinancing until the current owners of the buildings come up with billions of dollars in fresh equity to make up for what has already been lost.

Falling short That leaves the government pondering just what the link is these days between banks and the real economy. The Bank of England has spent £125 billion since March on quantitative easing (pumping money into the system by buying gilts and a few other securities) but has seen little change in either the yield on government debt or bank loans to non-financial firms.

Posted by dblwyo on August 23, 2009 02:38 AM |

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