Tuesday, March 10, 2009

Fools seldom differ

Warren Buffett was on CNBC last night.  Maybe he is getting old and vain and likes to be on TV.  Maybe he is falling for the (considerable) charms of Becky Quick – but he allowed himself to be interviewed for three hours starting at 5am Omaha time.

That made it good evening TV for me in Sydney Australia.

I was amused to hear my own views – parroted back to me in a more articulate and folksy manner than this blog.  

There is a saying – usually ironic – that “great minds think alike”.  I immediately think of the come-back that “fools seldom differ”. 

Whether Buffett and I are fools – well I will leave that for others to decide.  However Joe Kernan (and not the dulcet Becky) got out of Buffett what I believe to be the money quote of the whole interview:

BUFFETT: Yeah, the interesting thing is that the toxic assets [of American banks is] if they're priced at market, are probably the best assets the banks has, because those toxic assets presently are being priced based on unleveraged buyers buying a fairly speculative asset. So the returns from this market value are probably better than almost anything else, assuming they've got a market-to-market value, you know, they have the best prospects for return going forward of anything the banks own.  The problems of the banks are overwhelmingly not toxic assets, you know. They may have been one or two at the top banks, but they are not going to do in--if you take those 20 banks that are subject to the stresses, they're not going to do those banks in. Those banks have the earning power which has never been better on new business going out of this to build capital positions if they pay low dividends which they're starting to do now.

JOE: Hm.

BUFFETT: Toxic assets really are not the problem they were. Now, when I said it was contingent--I didn't remember being exactly contingent on TARP, but it was contingent on the government jumping in. 

JOE: Right.

BUFFETT: The government needed to act big time in September, I will tell you that.

JOE: So...

BUFFETT: And they did act big time.

JOE: So you are OK with the shift to providing the banks with capital as opposed to the original intention of the TARP for actually getting the toxic assets off the books?

BUFFETT: Yeah, and interestingly enough, they don't need to supply the banks, in my view, with lots of capital. They need to let almost all of--I mean, the right prescription with most of the banks is just let them pay very little in the way of dividends and build up capital for awhile, and they will build up a lot of capital. The government has needed to say--what the government needs to say is nobody's going to lose a dime by having their deposits in these banks. They're going to make lots of money with the deposits.

JOE: Hm.

BUFFETT: The spreads have never been wider. This is a great time to be in banking, you know, if you just get past the past and they are getting past the past. I mean, right now every time a loan is made to somebody to buy a house--and we're making, you know, making millions of loans--four and a half million houses will change hands this year out of a total stock of less than 80 million. So those people are making good mortgages. You want those assets on your books and you get a great spread in putting them on now. So it's a great time to be in banking, but you do have to get past this past. But the toxic assets, in my view, you know, if they've been written down to market, I'd rather buy those assets from the bank than any other assets they've got.

JOE: Hm. OK...

Lets pick this apart:  Warren Buffett has been saying that the toxic assets are the best assets of the bank (provided they are marked to market).  This is precisely what I have been saying.  Moreover he says it for precisely the same reasons that I do – which is that they are being priced based on “unleveraged buyers” buying a fairly speculative asset.  Compare this to my explanation in the “long post” – which was that they had large yields because you could not borrow to buy them.

Then Buffet says that the returns from the toxic assets are better than almost anything else.  Several people (including some high profile academic economists) disagreed with me about the spread on those assets.  That is fine – they are also disagreeing with Warren.  He is wrong fairly regularly too.

Then he says the problem of American banks are not overwhelmingly toxic assets.  This is a radical view – but it is in my view correct.  The problem with the banks is that nobody will trust them and they have not been able to raise funds.  The view that this is a liquidity crisis – and not a solvency crisis – has long been a staple of the Bronte Capital blog.  It is radical though.  Krugman, Naked Capitalism and Felix Salmon think alike – asserting – seemingly without proof – that the problem is solvency.  Buffett doesn’t even think the US banks (on average) require capital – a view that most people would find startling (though again I think is correct provided appropriate regulatory forbearance is given).  

Moreover Buffett thinks it is not solvency for the same reason as me.  To quote: “those banks [including presumably most of the big 20 banks in the US] have earning power which has never been better on new business going out of this to build capital positions even if they pay low dividends which they're starting to do now.”  I have been criticised endlessly for pointing out that on pre-tax, pre-provision earnings American banks can quickly regain solvency provided they can maintain funding.  This was the point of my Voodoo Maths post – and also the point of much of the long post.  

Moreover he goes on to repeat that the opportunities in banking are simply wonderful now – so long as you can get past the past.  This was the point in my series of posts on Bank of America’s quarterly numbers.  To anyone that looks at the American numbers it is self-evident that the margins in banking are going up sharply and that the opportunities are large right now.  However this simple observation set my inbox on fire – to the point that I felt I needed four posts (links 123, and 4) to defend the obvious.  

(Incidentally the margin expansion is not evident in the UK – where the banks are properly insolvent – and it is not evident in France where the banks are almost certainly highly solvent.  I can’t work out why it is not in evidence in France but if someone wants to explain it send me an email. I would be pleased.) 

There were other parts of the interview where Buffett simply agreed with me.  For instance he thinks that bank liabilities should simply be guaranteed at this point (at least for the large banks) and that guarantee should carry the personal weight of the President.  The alternative is either endless government injections costing as much as the guarantees or uncontrolled liquidation –a dozen Lehmans - as the banks run out of funding.  They did issue guarantees in Sweden – and I was hoping and praying that the US would become Swedish.  

Krugman is finally coming to the view that the important technical question is whether to issue that guarantee.  He is right.  Provided the guarantees can be issued at reasonable cost they should be issued.  Both Warren and I think the cost would be reasonable in the USA.  By contrast I am not sure the UK has the blanket guarantee option because the UK banks are very large relative to the UK economy and they started highly capital inadequate.  US banks by contrast started with a lot of capital.

Buffett did not approach the issue of how you treat banks after you have issued that guarantee.  I think you should have a process for assessing their capital and require that they have sufficient.  Those that do not have sufficient and can't raise it you should nationalise (by diluting the shareholders and preference shares out of existence).  That was the point of my “nationalisation after due process” post.  Though the nationalisation question is entirely secondary to the question of whether you treat this like a liquidity crunch (by guaranteeing liquidity) or whether you treat it like a solvency crunch (by forcing insolvent banks to liquidation).  I know which side I am on – and it is the same side as Warren.

Now it is all very nice to be demonstrably thinking the same way as Warren Buffett.  I should have an operating funds management business after I get through complexities of Australian licensing and similar hurdles.  If people widely believed that I thought like Warren I would be inundated with money – and that would be a good thing – at least for me.  

But I have to note that Warren was not entirely straight forward in the interview.  Warren did not think he could get the preference share deals he got from GE or Goldman Sachs now.  That might be true with Goldies – but it was unequivocally false with GE.  With GE you could construct a better deal on market.

This blog (painfully) admits its mistakes and tries to analyse them.  A money manager should be brutally honest with himself.  Warren however is an old man and his credibility is harder to question that mine.  But Warren was wrong with his GE preferred (if only because he could get a better deal later).  He should have admitted that (at a minimum) his timing on that one was awry.  

It would be inordinate vanity to hope that I will be better than Warren.  But I hope at least to think clearly and rationally like him.  Oh, and to hold myself to a decent standard of self-analysis and criticism when I stuff up.  



John 

15 comments:

Christian said...

It seems to me that your disagreement with the likes of Yves Smith is not so much a disagreement on principle but stems from a difference in (temporal) perspective.

If I may be so bold to summarize your general position in a few words, it is that the "good bank" parts are so profitable right now that they earn enough to bailout the "bad bank" parts eventually ... if they are given time.

On that note I agree. As you say the problem lies with: "... so long as you can get past the past."



In a certain way, the difference between providing the banks with capital directly from the government now, or issuing guarantees and have the private sector funding them is not that large at all.
Those private investors can either buy US public debt which then gets transformed by the government into capital for the banks, or they can provide capital to the banks directly albeit with a government guarantee.

I suppose the only real difference lies in what "the market" considers to be better, implicit or explicit guarantees of the banks liabilities.

Overall, I think a guarantee is more likely to be successful, simply because it's a more explicit method and by that ensures a more equal treatment of banks.
In a sense this is only because politically, a statement of guaranteeing bank liabilities is more believable than the promise to provide capital to them as needed, when they need it.

I try not to ramble too much in comments, so I suppose I'll stop here and let you tell me (if you want) whether that makes sense, you'd need some clarification of my thoughts, or if I'm simply wrong.

Anonymous said...

In the early UK examples, Northern Rock and HBOS, it was clear that the main problem was funding (largely the over-reliance on wholesale deposits and securitisation), and an ever-increasing danger that liquidity would dry, leading to a bank-run and insolvency. The primary missing ingredient was not capital. It would have been possible to provide liquidity by way of toxic asset purchases, normal asset purchases or a guarantee. Once the UK government decided that insolvency was the problem, rather than the likely result of the problem, capital became essential and state ownership virtually inevitable.

One can distinguish other cases, however, to which capital was relevant. RBS became inadequately capitalised through hubristic acquisitions, and Lloyds became inadequately capitalised through acquiring HBOS with the encouragement of the Prime Minister. Barclays is probably inadequately capitalised, because its low level of writedowns is statistically an outlier.

But the original Paulson-style approach via the purchase of toxic assets, combined with deposit guarantees, should have been correct. The TARP would have made a profit, liquidity would have returned to the system, and the banks would have remained solvent. The deteriorating level of delinquencies in asset backed securities - where there is a feedback loop from bank illiquidity - could have been mitigated.

By addressing the wrong variable, Governments have made matters infinitely worse than they need have been.

Hubert said...

John,

disagree with your GE comment. WB certainly knows that he was wrong or early with GE. But to admit that would bring even more trouble to GE. So if he can get away with not explicitely talking about it - the better for both Buffett and GE. It would have been the commentators job to get at this, not Buffetts.

OTOH I think he is playing a game in his banking recommendations to the presiden: I think Buffett is sweating that current Wells Fargo will own the bank in its great future. The margins on toxic assets and new business are great but if the rules stay the rules until the end of 2009 the small equity cushion of WFC should force the regulators hands. In effect Buffett tries to lobby his position there. He wants to make the big money (back). How about giving the taxpayer a good deal for a change ? On what moral principle should Wells Fargo and its owners be treated differently than smaller banks ?

John Hempton said...

On GE - he could have just admitted his timing was awry - and suggested that he thought the preferreds would pay (which they will). That would have been sufficient.

There is NO moral principal on which the shareholders of large banks - the too-big-to-fail variety - should be treated differently to small banks.

There is ONLY a practical principal. We know what happens when there is an uncontrolled failure of a big financial institution (Lehman). We know it is bad.

So you are left with a choice - treat shareholders of large banks nicer by only diluting them a lot (my view) or blow up the whole economy by having strings of Lehman.

Morality comes not at all into it. Just be practical.

J

Fergus O'Rourke said...

John, I would be interested in your view of where the Irish banks are situated in the liquidity/solvency spectrum. My own inclination is to regard them as having liquidity rather than solvency issues, although they do have a significant toxic asset problem in the area of property development.

Hubert said...

Okay, I get your point.
But would it not be practial to get the same type of funding that Buffett got with Goldman Sachs ? What Buffett did to Goldie shareholders should be done by the taxpayer unto Buffett.


Also, what many have overlooked, Buffett hinted in the Citi context that Obama should guarantee ALL bank liabilities.

But then it should at least charge a few hundred basis points accordingly for moral and practical reasons and change rent-seeking moral hazard bank debt investing by PIM & Co at least from now on.

John Hempton said...

Hubert - you are right. The government extracted very generous terms in almost all bail outs.

Buffett got better terms from the best run investment bank (goldies) than the US Government got from really crappy banks. Whole heartedly agree here.

The terms however are secondary to whether a guarantee is given. I figure you should give it - and then have a fair system to impose brutal terms.

--

As for the Irish banks - I have an opinion only of Anglo Irish. (Insolvent.)

I do not have an opinion of the others.

J

John Hempton said...

To clarify - the banks were very generous to the shareholders - not the government.

As for Anglo Irish - an undiversified portfolio will kill. And did. Corus bank on a grand scale.

John Hempton said...

I meant the bailouts were generous to shareholders. Typing slydexia - I mean dyslexia..

slydexia lures ko.

Anonymous said...

The banks' quarterly financial reports show that as of Dec. 31:

_ J.P. Morgan had potential current derivatives losses of $241.2 billion, outstripping its $144 billion in reserves, and future exposure of $299 billion.

_ Citibank had potential current losses of $140.3 billion, exceeding its $108 billion in reserves, and future losses of $161.2 billion.

_ Bank of America reported $80.4 billion in current exposure, below its $122.4 billion reserve, but $218 billion in total exposure.

_ HSBC Bank USA had current potential losses of $62 billion, more than triple its reserves, and potential total exposure of $95 billion.

_ San Francisco-based Wells Fargo, which agreed to take over Charlotte-based Wachovia in October, reported current potential losses totaling nearly $64 billion, below the banks' combined reserves of $104 billion, but total future risks of about $109 billion.

Anonymous said...

John,
hate to rain on your parade...

but if unemployment hits 9.4% this year(http://www.bloomberg.com/apps/news?pid=20601087&sid=aWHdSE69tNtk&refer=home),
the banks are toast.

I believe the banks are using 9% unemployment rate in 2010 for scenario planning purposes.

Hitting 9.4% in 2009 is like cliff jumping.

God help us all.

Brian said...

While it might seem folly to argue with Buffett, I'll point out the following:

-Buffet is to a considerable degree talking his book here, Wells Fargo, Amex, US Bancorp, Swiss Re

-He asserts, without any further proof or evidence as to the quality of the assets, that toxic assets will not sink the banks. Time will tell, but the banks' consistent claims that all the marks were only temporary have been shown to be bunk so far through the cycle. How big was the hole on Lehman's balance sheet? These assets sank Wamu, Wachovia, National City, Countrywide, and a baker's dozen of smaller banks since Jan 1. LM sold their remaining SIVs for 25 cents on the dollar - what are Citi's worth? I won't belabor the point, but assertions that the assets aren't toxic is, in my view, speculation so far unsupported by facts.

-CDS on Berkshire suggest some see considerable risk in his asset base, it would be good for his assets to be revalued upward, hence an incentive to talk up the market

-Buffett is not infallible as shown in his purchase of Conoco in the summer, his market call in September, his purchase of two Irish banks, and his GE and Dow Chemical trades of last year

-If the assets are so good, why isn't the disclosure better? If that is the constraint that keeps you from getting additional capital, put your loan book and the marks on the web and let the market see that it is wrong. I don't see anyone stepping up to do that. Watch what they do, not what they say.

gaius marius said...

mr hempton -- i don't wish to stir any pots -- but reading the analysis of chris whalen over at institutional risk analyst leaves one with a very different view.

i understand well enough the muddle-through mechanics with the aid of low-cost gov't financing you are highlighting here. whalen, however, is talking about the losses that he thinks will be reported for q1 as a catharsis event which will make evident the need to resolve not only C and BAC, but (at a distance of a few quarters perhaps) JPM and WFC.

have you followed whalen's arguments? and would you care to address the difference between these two views?

Blank Xavier said...

JH wrote:
> I have been criticised endlessly
> for pointing out that on pre-tax,
> pre-provision earnings American
> banks can quickly regain solvency
> provided they can maintain funding.

Why?

Henry Bee said...

John, I've long shared your views (and what is now also Buffett's) on the health of banks. You have long argued that we're nothing like Japan. But have you looked at Richard Koo's presentation? It is perhaps the most lucid analysis I've seen since the crisis began. I'd love to see you blog about it because of its inherent differences with your views.

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The content contained in this blog represents the opinions of Mr. Hempton. Mr. Hempton may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Hempton's recommendations. The commentary in this blog in no way constitutes a solicitation of business or investment advice. In fact, it should not be relied upon in making investment decisions, ever. It is intended solely for the entertainment of the reader, and the author.  In particular this blog is not directed for investment purposes at US Persons.