Bordering on Insanity

Up until this past week, equity holders have been blessed with an unusually long period of time without a “correction” of 10% or more.  Of course, experts have been calling for such a correction for months.  If you enter a web search of “10% correction”, you will find articles from December, January, and February that predicted such a pullback – for reasons as varied as “the Fiscal Cliff”, Sequestration”, and simply “it’s time for a pullback”.  Accompanying that persistent skepticism (“wall of worry”) have been two other rather persistent themes:

1)     Unprecedented liquidity provided by the central banks of the United States and Europe (now joined by Japan); and

2)     Periodic commentary positing the premise that “if the bull market is going to be sustained, then the ‘financials’ need to ‘catch up’.”

The graph above dramatically illustrates the wide gulf in performance since 2007 between the S&P 500 and the KBE SPDR S&P Bank ETF. Source: YCharts.com)

The graph above illustrates an interesting dichotomy in valuation within the banking sector. Note that Wells Fargo (WFC) is valued a bit less highly than JP Morgan Chase (JPM) – despite the support of Warren Buffett and the growing consensus that it has a stronger capital base. Source Ycharts.com.

Building on my point above, the graph here shows an even more stark illustration of relative disregard for risk, as Goldman Sachs (GS) has a performance curve more similar to the S&P 500 than to JPM or WFB, despite GS’s greater reliance upon risky activities.  Source: Ycharts.com

I find such a premise puzzling for many reasons – just a few of which I offer you below.

First, take a look at the relative performance of the S&P 500 Index vis –a-vis an index of U.S. bank stocks (KBE). There has been a marked disjunction between those two indices. If one accepts the premise that the “market is efficient” (at least over longer periods of time) perhaps that under performance is well-deserved!  I periodically review details regarding the steady unfolding of financial history between 2006 and 2009 … if only to remind myself of the need for a healthy dose of skepticism when it comes to financial corporations.  It was the “unfolding” of that history of mismanagement, duplicity, and greed that simultaneously led to the eventual “undoing” of economic stability, resulting in the prolonged period of widespread economic hardship within which we still find ourselves.

Second, I have serious doubt that regulators are capable of managing the world’s financial system in ways that will steer us clear of one or more future financial whirlwinds.  I wish I could bring myself to feel differently, but I cannot.   The reasons for my skepticism are too numerous to recount in their entirety.  However, I can offer you a handful of compelling pieces of “evidence” that our national (and international) political and financial leaders have failed to learn from the 2007-08 crisis:

1)     Earlier this month, the Washington Post reported a story that, were it not such a serious matter, I might otherwise have considered an “April Fool’s” prank.  Word has gotten out that key advisers, experts, and policy makers within the Obama administration are convinced that the still fragile, but steadily growing, U.S. housing rebound has left far too many folks “behind” – including young people and those who suffer from battered credit scores. Accordingly, these leaders are actively working to get banks to adjust underwriting standards so as to broaden the pool of borrowers qualifying for a mortgage, making ample use of federally-insured mortgage programs to provide a backstop against possible default.

Adding an “Alice in Wonderland” quality to this effort is a simultaneous campaign to push the U.S. Justice Department into offering assurances to banks that cooperate with this plan that they will not face financial or judicial recriminations if some (or many) of said loans end up in default!

All I can say in response to that bit of news is to quote Albert Einstein, who is credited with this axiom of history and of life: “The definition of insanity is doing the same thing over and over again and expecting a different result.”

2)     Following the 2007-09 financial meltdown, politicians and regulators focused on creating standards through which to regulate financial institutions in order to curb the excesses of high financial leverage and loose (or non-existent) risk management. The international “Basel Committee on Banking Supervision” created a set of financial standards through which to keep financial institutions accountable moving forward – with focus upon capital adequacy, market liquidity, and “stress testing”. Originally, the standards were supposed to officially become effective between 2013 and 2015!

The work done through the Basel Accord was encouraging – successful consensus building regarding how (to turn a phrase) “keep the world safe from bad banks” (my words, not theirs).  Finally, we could breathe a sigh of relief and sleep more soundly at night… correct?

We might have, except for the fact that the political power and financial resources of big banks, combined with the incestuous relationship between the world of bank leaders and bank regulators (former U.S. Treasury Secretaries Henry Paulsen and Robert Rubin each served as CEO at Goldman Sachs; and Mark Carney, the current head of the Bank of Canada (destined by year end to move up to the Bank of England) and Mario Draghi, head of the European Central Bank, are also alums of Goldman Sachs) have dramatically “changed the game”.

Once the initial momentum and urgency of financial reform started to fade, economic and political “realities” started to kick in – or as my college history professor was wont to say, “Realpolitik” came to the fore! (If the term is unfamiliar, see http://en.wikipedia.org/wiki/Realpolitik ).  In 2011, the Basel committee discovered that over 200 banks fell short of their liquidity coverage ratio (LCR) standards – to the magnitude of 1.8 trillion Euros!  Oooops!

What was the reaction of the committee?  Hold firm to the standards and compel the banks to comply?  That might be what a really good college professor would do within a college classroom – push, prod, and motivate the students to the prescribed metric of performance!  (That is absolutely what Dr. Edwin Beisner did in my “Constitutional Law” class at Brown University – and I have been blessed by his standard-setting ever since!) However, the Basel regulators began a series of reformulations and adjustments to the bank risk capital standards that have had the effect of watering them down. Those steps have included lowering the capital and liquidity ratios, broadening the range of assets that quality as “liquid” (ironically, the revised standards now include mortgage-backed securities as qualifying in the “liquid” category, even though they were the central source of illiquidity in the most recent crisis), and lengthening the period over which the standards are “phased in” to 2019 (as opposed to the original 2015).

To draw upon the “classroom” analogy again, the decisions of the Basel committee have had the effect of letting the “students” grade their own tests.  Add to that the fact that bank accounting rules within the U.S. (looser standards than those in Europe) allow U.S. banks to record/report a lower portion of certain riskier assets (such as mortgage-linked bonds) on their books, and the result is that many U.S. banks end up writing the test upon which they are graded!

So, I ask you: within this topsy-turvy world of bank regulation, what will the likely result be?

3)    A news report out of Dublin, Ireland, on April 8 (it should have been announced on April 1) revealed that GDP Partnership has named the head of its Dublin office: Nick Leeson!   If any of you are too young to remember the banking/investment world in the mid-1990’s – Mr. Leeson managed to bring down the British bank that had served countless kings and queens, as well as financed England’s war against Napoleon Bonaparte – Barings Bank.  Leeson was Barings’ head trader in Singapore and in 1995 was caught red-handed (so to speak) sitting on over $1.4 billion in losses from unauthorized trades.  The result was Baring’s assets being sold to ING Groep NV (ING) for $1.53 – yes, $1.53!!

I am sure that Mr. Leeson learned a hard, but very helpful lesson during his years in jail. He later made a successful career as an international motivational speaker – reflecting upon his infamous career, his struggle with cancer, and the strength he has found to move ahead with life.  However, within the world of analogy (or “branding” or “imaging”, if you prefer) there is an unmistakable and compelling irony that GDP Partnership, in their effort to provide a stabilizing resource for those struggling with over-indebtedness, chose a figure so firmly associated with risk and excess.  (For an instant sense of Leeson’s past, check out http://www.nickleeson.com/rogue_trader_movie/index.html).

Leeson’s job title is “alternative insolvency practitioner” – for which he does (I must admit) qualify with flying colors, since he is one of history’s most successful “practitioners” of insolvency – managing to make an entire international bank insolvent.

In an interview with a Dublin newspaper, Leeson offered a trenchant (if ironic) observation: “Banks in Ireland were part of the problem by lending recklessly and now they have to be part of the solution.”

The question that I have, and perhaps you have, as well, is this:

Given the trends that I have pointed out above (Obama administration initiatives to recreate some of the conditions that led to the 2007-09 debacle; the seeming inability of bank regulators to truly “regulate”) can banks actually become a part of “the solution”?  Or is it too easy for the public, the regulators, the politicians, and the financial world to forget the mistakes, excesses, and financial chicanery of the past … and therefore too easily become blind to those “lessons” from history that can help us avoid (borrowing from Einstein once again) “insanity”.

Submitted by Thomas Petty

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