A tale of two banking crises: Japan and Korea

Economics may be a “science” but it lacks controlled experiments.  Especially in macroeconomics you can’t repeat an experiment with one variable changed and see how the single variable changes the outcome.  Economists have lots of statistical tools to deal with this – but those make the discipline either incomprehensible or diabolically boring.  [Apologies to all those who taught me econometrics.]

But every now and again people throw up a controlled experiment – two situations that are very similar and differ markedly only in one major element.  Yet strangely these situations seem under-studied. 

What I want to do here is give a stylised version of Japanese and Korean economic history and how it pertains to the banking crisis both countries had.  My knowledge of this however comes the way much of my stuff comes – from the history of the banks backwards.  So I am sure to offend people with deep understandings of the political/economic history and I welcome someone telling me I am just wrong.

First however I need a stylised history of Japan starting with the arrival of Commodore Perry’s black ships in 1853.

Before Perry Japan was almost autarkic.  There was a relatively weak central government and about 300 “han” – being relatively strong feudally controlled districts.  The emperor did not effectively speak for Japan when Perry came in, guns blazing.

The Meiji Restoration changed this.  Japan was reformed as a centrally controlled empire – with a ruling oligarchy ruling through the Emperor who claimed dominion over all of Japan.  The “han” were combined to form (75?) prefectures with a governor appointed centrally.

The view of the new oligarchs was that Japan would get rich through (a) industrialisation and (b) unequal trade treaties to match the unequal treaties imposed on Japan by Perry et al.  To this end they invaded Korea and started the military industrialisation that ended eventually with World War 2.  There were major wars in Korea and against an expansionist Tsarist Russia (especially 1904-1905). 

Ok – that is your 143 word history of Japan from Perry to World War 2.  Like any 143 word history it will leave out important stuff.  I just want to focus on how this foreign policy adventurism was financed.

Financing Japanese expansionism - and that financial system until today 

Firstly it is simply not possible to expand heavy industrialisation of the type required by an early 20^th Century military-industrial state without massive internal savings.  Those steel mills had to be funded.  And so they set up the infrastructure to do it. 

Central to this was a pattern of “educating” (the cynical might say brainwashing) young girls into believing that their life would be happy if they had considerable savings in the form of cash balances at the bank (or post office).  Japanese wives often save very hard – and are often insistent on it.  The people I know who have married Japanese women confirm this expectation survives to this day. 

Having saved at a bank (and for that matter also purchased life insurance from an insurance company loosely associated with the bank) the financial institutions had plenty of lendable funds.

The financial institutions by-and-large did not lend these funds to the household sector.  Indeed lending to the household sector was mostly discouraged and was the business of very seedy loan sharks.  To this day Japan has a relatively undeveloped credit card infrastructure with very high fees.  These high fees are a throwback to the unwillingness of the institutions to lend to households. 

Japanese banks instead lent to tied industry – particularly heavy industry.  It was steel mills, the companies that built power plants, the big machine tool makers.  Many of the companies exist today and include Fuji Heavy Industries, Kawasaki Heavy Industries and other giants such as Toshiba.  Most of these super-heavy industrials were tied to the banks (and vertically integrated) called Zaibatsu. 

Now steel is a commodity which has wild swings in its price.  Maybe not as ordinarily wild as the last five years – but still very large swings.  And these steel mills were highly indebted to their tied banks.  Which meant that they could go bust.

And as expected the Japanese authorities had a solution – which is they deliberately cartelized the steel industry and used the cartel (and import restrictions) to raise prices to a level sufficient to ensure the heavy industry in question could service its debt. 

The formula was thus (a) encourage huge levels of saving hence (b) allow for large debt funded heavy industrial growth.  To ensure it works financially (c) allow enough government intervention to ensure everyone’s solvency.

When the Americans occupied Japan their first agenda was to dismantle the Zaibatsu.  They were (in the words of Douglas McArthur) “the moneybags of militarism”.  

Like many post WW2 agendas that agenda was dumped in the Cold War.  The owners of the Zaibatsu were separated from their assets and some cross shareholdings were unwound – but the institution survived – and the Zaibatsu (now renamed Keiretsu) remained the central organising structure of Japan.  Dismantling Japan’s industrial structure did not make sense in the face of the Korean War.  The pre-war Zaibatsu had more concentrated ownership than post-war Keiretsu.

The point is that it was the similar structure before and after the war – and it allowed massive industrialisation twice – admittedly the second time for peaceful purposes. 

Now the system began to break down.  Firstly by 1985 steel was not the important industry that it had been in 1950 or 1920.  Indeed almost everywhere you looked heavy industry became less important relative to other industrialisation.  By the 1980s pretty well everywhere in the world tended to look on such heavy industries as “dinosaurs”.  This was a problem for Japanese banks because they had lent huge sums to these industries guaranteed by the willingness of the State to allow cartelisation.  You can’t successfully cartelise a collapsed industry.

Still the state was resourceful.  Originally (believe it or not) they opposed the formation of Sony – because they did not know how to cartelize a transistor industry.  Fifteen years later the UK Prime Minister French Prime Minister  President would refer to his Japanese counterpart as “that transistor salesman” and he was not using hyperbole.  Still the companies coming out of new Japan – technology driven mostly – did not require the capital that Japan had in plentiful supply.  If you look at the companies coming out of Kyoto (Japan’s Silicon Valley) they include such wonders as Nintendo – companies which supply huge deposits to banks – not demand huge funds from them.  [Incidentally in typical Japanese fashion the biggest shareholder in Nintendo is Bank of Kyoto.  Old habits re-cross shareholdings die hard.]

The banks however still had plenty of Yen, and they lent it where they were next most willing – to landholders.  The lending was legion and legendary – with golf clubs being the most famous example of excess.  [At one stage the listed exchange for golf club memberships had twice the market capitalisation of the entire Australian stock exchange.]

Another place of excessive lending was to people consolidating (or leveraging up) the property portfolios of department stores.  Think what Bill Ackman plans to do to Target being done to the entire country – and at very high starting valuations. 

Meanwhile the industrial companies became zombies.  I have attached 20 year balance sheets for a few of them here and here.  These companies had huge debts backed by dinosaur industry structures.  They looked like they would never repay their debts – but because they were so intertwined with the banks the banks never shut them down.  As long as interest rates stayed near zero the banks did not need to collect their money back from them.  As long as they made token payments they could be deemed to be current.  There was not even a cash drain at the banks at low rates.  The rapid improvement in the zombie-industrial balance sheets in the past five years was the massive boom in heavy industrial commodities (eg steel, parts for power stations etc).  Even the zombies could come alive again…  only to return to living dead status again quite rapidly with this recession.

Anyway – an aside here.  Real Japan watchers don’t refer to the banks as zombies.  They refer to the industrial companies as zombies.  (Although most of the Western blogosphere does.)  

Most of the banks had plenty of lendable funds and a willingness to lend them.  They did not have the customers – and the biggest, oldest and most venerable of Japanese companies were zombies.  So were the golf courses, department stores and other levered land holders.  I get really rather annoyed when people talk of zombie banks in Japan – it shows a lack of basic background in Nihon. 

Note how this crisis ended.

1).  The bank made lots of bad loans – firstly to heavy industrial companies and secondly to real estate related companies (golf courses, department stores etc). 

2).  The loans could not be repaid.

3).  The system was never short of funding because the Japanese housewives (the legendary Mrs Watanabe) saved and saved and saved – and the banks were thus awash with deposit funding.

4).  The savings of Mrs Watanabe went on – indeed continued to grow – with zero rates.

5).  Zero rates and vast excess funding at the banks made it unnecessary for the banks to call the property holders and (especially) the industrial giants to account for their borrowings.  Everything was just rolled.

6).  Employment in the industrial giants of Japan thus never shrank (Toshiba alone employs a quarter of a million people).  The economy continued to sink its productive labour force into dinosaur industries and dinosaur department store chains.

7).  The economy stagnated – but without collapse of any of the major banks and without huge subsidies to the banking system.  [The number of banks – mostly regional banks – that failed during the crisis was not large given the depth of the crisis.]

Now lets look at Korea. 

Korea was occupied by Japan until the end of WW2.  They chose to industrialise in the pattern they understood – a Japanese pattern.  For Keiretsu substitute Chaebol and you have the idea.  The Chaebol were private heavy industrial conglomerates tied to financial institutions and with intense government support. 

And the Chaebol suffered the same fate (slow irrelevance of heavy industry) as the Japanese heavy companies except they were called to account and many of them failed.

The reason is the different banking structure.  Korea started its Chaebol industrialisation later than Japan – and the one multi-generational part of the formula (educating young women that they should save and save and save) was just not done as well.  This is a multi-generational process.  

The result is that the Korean banks – unlike their Japanese counterparts – were short funds.  Endless funding at zero interest rates was simply not possible.  Given that the banks eventually collapsed – with many becoming government property and with the government winding up as the largest shareholder in almost all banks.  This was a spectacular crash – as opposed to a slow-burn malaise.  Chaebol failed.  In some instances their founders were imprisoned.  The strongest Chaebol is the one most associated with new industries (Samsung).  It survived and prospered – but others did not.

Korea had a much worse recession than Japan.  Vastly worse.  Japan was just low growth for a very long time.  By contrast the Korean economy crashed and burned.  But it also recovered very fast and at one point (1999-2000) the Korean Stock market was 1932 Great Depression cheap.  It bounced. 

It is my contention that the main difference between the Korean and Japanese crashes (and Korea’s case recoveries) was the funding of the banks.  In this view Korea’s was so sharp because the banks simply ran out of money – and that caused massive liquidations across the economy – systemic failures. 

The recovery was also sharp because the systemic failure meant that businesses that shouldn’t have failed (because they were profitable worthwhile businesses) got into deep distress.  Real companies died not because they deserved to die but because the system in crisis killed them.  There was a case for bailing out those companies – and the rapid recovery told you this was something systematic – not business specific.  The massive upward movement in the stock market at the end of the crisis was the secondary proof that good businesses were killed.  It was also probably the best investment opportunity globally in the last twenty years.

The economic decline in Japan was so gradual and so sustained precisely because there was no systemic failure and no reason to reallocate resources from bad businesses to good businesses.  Zombie companies could exist for decades – and there was no renewal.  A little bit of failure would have been a good thing – creative destruction.  And the survival of bad businesses in Japan is part of the reason the stock market never bounced there.  No investment opportunities.

Policy question:  how do you ensure the creative destruction without putting the good bits of the real economy to the sword? 

Investment question: what bits of the USA (and the rest of the world) will wind up looking like Korea and providing the best investment opportunity in two decades?  And what bits will look depressed for two decades before going into a bit of a decline? 

For discussion.  And thanks for bearing with a long post.

John

When the stockmarket does the analysis

Today the news is all about green shoots becoming brown shoots.  A couple of (entirely predictable) bad bits of data and the stock market goes down telling everyone that all is ill.  But green shoots were always a metaphor.  Almost all data suggests and continues to suggest is that things are getting worse – but less fast.  We are past the “point of inflexion”.

Unemployment is still getting worse – just less fast.

Mortgage delinquencies are still getting worse – just less fast.

Indeed there are very few things that are not getting worse.  Rupert Murdoch said that US television advertising is not getting worse but that was one of the few unequivocal “point of recovery” statements I have heard from a credible source.  (Rupert was early calling how bad it was too.)

That said – when things inflected the stock market started going up hard.  And people reinterpreted “point of inflexion” to mean “point of recovery”.  

Now being past the point of inflexion is important.  It doesn’t signal the end of difficulties – but at least it enables you to do some modelling.  When things are getting worse at an increasing rate (say mortgage delinquencies) and they are outside historical bounds, then anyone who tells you they can model them is frankly “just making it up”.  Even the most sophisticated analyst out there (including Warren Buffett) is just a talking head.

When things have inflected the confidence in your model will increase.  If things are getting worse at a less rapid rate then it makes some sense to model a slowdown on historical norms.  Whilst your number remains an “estimate” (and liable to be wrong) it is more likely to be a good estimate.  You have at least some basis for your statements.  

Before the inflexion almost everyone who estimated end losses on a rigorous basis (including me) underestimated them.  The only people who were right were people who diagnosed that this was not like other recessions and managed to pull a reasonable number out of the air.  I did a bit of that too and my guesses were better than my models.  But they were non-rigorous guesses.

The recession could suddenly turn for the worse again and what looks to be a reasonable estimate will (again) be wrong.  I would never bet my life or entire fortune on such an estimate – but moderate guesses are sensible – indeed as sensible as they ever get in stock market land.

The point of inflexion is important because “it is moderately safe” to be a stock analyst again.  

Not that you would know from today’s market action.  Green shoots it seems have dried up.  But that is reading from the stock market to the economy.  Reading the other way there were never any really substantial green shoots and never to actually dry up.

But that doesn’t mean all is ill.  We are past the point of inflexion – and that is good news independent of where the market is.  It is not great news for the people who will lose their jobs next month (and there will be plenty of such people - just less than last month.

But then we live in the age of omniscient markets.  The markets do the analysis.  Why bother reading this blog?

The hookers no longer cost too much: geopolitics and the price of prostitutes in the Baltic States

There is a article about me and about the Bronte Capital blog in the Sydney Morning Herald today. It mentions that I diagnosed the economic problems in Eastern Europe by analysing the price of hookers. That is true as far as it goes – though the original post was more nuanced than that.

The blog however owes a thank you to the (now suffering) people of Latvia. Before I mentioned their forthcoming problems I had about 50 readers. A post about the price of prostitutes got me my first 1000 reader day and my first mention in the main stream media (the Estonian business press).

For those that are new the argument was as follows:

• Latvia and to a lesser extent Estonia and Lithuania had a massive and unsustainable current account deficit. That means they bought more from the rest of the world than they sold (just like America buys far more from China et al than they sell). The current account deficits (relative to GDP) was however much bigger in Latvia.

• In a floating exchange rate regime this would usually be remedied by the currency falling dramatically, increasing the competitiveness of exports (and increasing the price of imports). The market provides a solution. With America this can't happen because the Chinese fix their currency against the US dollar. In the Baltic States the currency is fixed against the Euro.

• Normally to fix the exchange rate a central banker needs to buy the currency that is tending weaker. They buy it and remove it from circulation. In so doing the reduce the money supply in the weaker currency causing interest rates to rise and a mild monetary deflation (increasing the competitiveness of local industry versus foreign competition) and hence over time remedying the current account deficit.

• Unfortunately this monetary deflation causes a recession in the country with the naturally weaker currency. Ultimately that makes fixed rates unpopular in countries with chronic relative economic under-performance – because the populace doesn't like more or less continuous mild recessions. Some countries dealt with this through periodic competitive devaluations (Spain, Italy). Other just gave up on fixed exchange rates (UK). Generally the world has tended towards permanently fixed exchanges (Europe inside the Eurozone) or floating exchange rates (eg Australia).

• Now there is one exception to the idea that the country with a fixed exchange rate and a lack of competitiveness has a sort-of-perpetual monetary squeeze and low-level recession. And that is if somebody cheaply finances your current account deficit ad-infinitum. Then you can have the nice strong currency and spend it and not have any domestic price pressure. Unfortunately you also wind up owing your foreign benefactors just way too much money.
  

• The party has to end. And it can end quite sharply when the foreign benefactor becomes less willing to lend to you.

When that happens you are going to get a really big recession. If this sounds like the once seemingly endless willingness for foreigners to fund American spendthrift consumers you are right.

But in Latvia the situation was (at least) three times as unsustainable as the US. And ultmately Latvia has less credibility in repaying those loans than say the US.

When it ended in America we got a big recession.

In Latvia it ended when the Swedish banks providing the funding (Swedbank and SEB) themselves got into trouble. Latvia is experiencing something more akin to a depression. Latvian GDP has now dropped almost 20% - about the same proportionate drop as America in the Great Depression. And it is going to get worse still. This is really truly ugly – and the street riots I predicted in the original post have unfortunately happened in all the Baltic States. The governments (and the people can feed themselves) because of foreign aid – mostly through IMF packages funded by the Scandinavian governments.

Well what has all this got to do with the price of hookers?

At least partly for effect I noted that one of the most important (perhaps the most important) export industries in Latvia has been tourism. And it is not any type of tourism – it has traditionally been sex tourism. Latvians are beautiful Scandinavian people (if you like that Northern European look). They also have a more Scandinavian sexual morality and they were relatively poor. This meant that Ryanair put on discount flights and filled them with salivating Irish and English lads. Swill beer on the Friday flight over. Party all weekend, soil the plane on the way home. You could not walk around Riga as a single English guy and not be thought of as a Ryanair sex tourist.

The only problem is that the ridiculous exchange rate made the hookers very expensive.

Ryanair canceled the Shannon/Riga flight (and the Irish lads now go to Prague). The London Riga flights are less full. There are plenty of complaints on the web about over-priced bars and rip-offs in Riga. The oldest and one of the most dependable of professions was – due the ridiculous exchange rate situation – just priced out of existence.

Still markets are correcting in the end. Now that there is a Great Depression in Latvia there is price deflation. Lots of it.

The faster the deflation happens the faster Latvia will again become competitive. [Hint to the IMF – just float the currency and deal with the consequences of the new exchange rate rather than try to defend the old rate.]

Anyway the problem is that most industries have contractual arrangements which fix prices. Wages are very hard to flex downwards. Rents are fixed over sustained periods and the like. All of this means that people go bust rather than reduce prices – simply because prices are sticky.

Well – most prices. The contractual terms of prostitution are short (an hour, a night) and entry to the industry is unconstrained. That means that the prices are very flexible. Extraordinarily flexible.

The price – looking at websites I will not link for decency's sake – has fallen by at least two thirds in the past year – and the advertised price (for a non-English speaking young woman) is LVL30 – or less than 60 US dollars. I am sure the rip-offs are still there – but anecdotal evidence suggests the hookers no longer cost too much.

The first question is how far do other prices have to fall – and how bad will it get in Latvia before it improves.

I did say this was ultimately about geopolitics. The Baltic States all have sizable Russian Minorities. Russia under Putin is very concerned about the state in which those minorities live – and has been prepared to take military action to protect what it perceives as the interest of the Russian people. [Read Georgia/South Ossetia.]

Now I am not going to opine on the validity of the Russian claims. Tensions run very high on all sides.

I will note the Russian-Estonian relation riots in Estonia in particular have been lethal in the past (see the story of the Bronze Soldier).

And I will leave you with a somber note. In Latvia the hookers did cost too much. They don't any more – but most things still do – and there is no easy fix. However what is a classic text-book macroeconomic problem fast risks becoming a geopolitical one. And whilst there are big difficulties bailing out the Baltic economies one of them is not the size of the check you will need to write. These places are small and the checks disappear in a US or even European Budget.

And there are big difficulties allowing the Baltics to drown in their economic problems. Geopolitically a bailout looks like the cheap option.




John

For the benefit of Gaius Marius

 Gaius Marius of the (usually lower case) “decline and fall” blog left the following comment on my 77 Bank note.  

But American banks are not awash in funding – and given the profligacy (especially historic) of the American consumer – not to mention tax cut funded Iraq wars and the like – the US financial system is almost always going to be an importer of spondulicks. That might change in twenty five years – but it is not changing now.i think this is really the big question, isn't it? were not japanese banks in more or less exactly this position in 1991-2, but with corporate rather than consumer credits sucking up all available lending capacity? 

western banks are collecting fat spreads right now, but the true long-term test for the system won't be in loan supply -- it's in loan demand. if banks can't make sufficient new loans to replace the fat ones rolling off their books, earning power will diminish over time even as asset prices continue to deteriorate.

as i understand it, japan ended up with massive excess funds in banks because (beginning in 1996) the private sector started to repay loans (ie, aggregate loan demand went negative), to the tune during the early 2000s of 5% GDP. but in 1989, the japanese nonfinancial corporate sector was increasing its bank debt at a rate of in excess 12% of GDP (and issuing debt on the order of 5% GDP in capital markets to boot). that massive 17%-of-GDP swing in private credit took ten years to effect. aggregate private sector loan repayment seemed to have ended in 2005, but has probably resumed in this crisis.

to prevent a crash in monetary aggregates, the government borrowed out these excess deposits, which at 77 bank shows up as a massive investment portfolio in JGBs. 

for what it's worth, i think a more appropriate comparison would be to the 77 bank of 1991. i have a sneaking suspicion that 77 bank was then also a mirror image of the current 77 bank, but i'd love to be disabused of that notion.

 

The comment is reflected in several emails I have received.  It seems several people had the same idea - though maybe less well articulated than Gaius.

Well Gaius – you can be disproved of the notion.  I have uploaded a 20 year balance sheet for 77 Bank here.  It is here.  The loan to deposit ratio started at 74 percent and wound up at 64 percent – with the mix of the loans moving towards lower margin government loans over time. 

Japan was long funding when it went into its crisis.  The crisis was long, slow and with thin bank margins but very little “crisis” but a lot of sustained malaise.  The banks got longer funding as the malaise/liquidity trap went on.

Korea and Thailand were short funding when they went into the crisis – and the crisis was severe and relatively quick.  Banks failed rapidly (and were bailed out in both countries either through subsidy or nationalisation).

Note that relatively quick in this context is a depression level recession lasting a few years - rather than a sustained malaise lasting decades.

Still this difference has profound investing implications - and also some policy implications - and that makes it worth thinking about. 

JP Morgan lied to regulators

I purchased preferred shares in Washington Mutual when it was in distress and lost money when it was confiscated by Sheila Bair.  I have argued that it was the most extraordinary action made by government during this crisis and that an essentially solvent bank was confiscated.  

In anger I posted my response to the WaMu takeover the day after it happened.  I also purchased adwords on Google so that when you google Sheila Bair’s name you will get an advert linking to my blog and explaining why she should resign.  It is no secret I dislike Sheila Bair.

Moreover there are law suits (whose basic premise I agree with) that JP Morgan whilst doing due diligence on Washington Mutual was also badmouthing them in the press and encouraging the regulator to take them over.  [It is easier to sue JPM than the Federal Government.]

That said – we have a fairly comprehensive proof that JP Morgan did lie to regulators.  The only issue is did they lie to regulators when encouraging them to confiscate Washington Mutual or did they lie when they were conducting the stress test?  If they lied to Sheila Bair to get them to confiscate WaMu and she believed them then she must resign.  But the alternatives I see are worse.

Detailing the JP Morgan lies

First you need to look at the document that JPM released when it took over WaMu.

Here is – with what they think the losses will be in the various stress scenarios.

 

JP Morgan is predicting $36 billion in losses in WaMu's book in their base case and $54 billion in the "severe recession" case.

These losses are measured since December 31 2007.  The losses as estimated in the stress test are from the end of 2008 – and to get the numbers consistent you need to take about 8 billion dollars off these numbers as about 8 billion in losses were realised during 2007.

It already looks like we are in the severe recession.  Unemployment is well over 8 percent.  On these numbers – numbers that were presented by JP Morgan to the market and to regulators – JPM has to take a further $46 billion in losses on the Washington Mutual book alone.  (46=54-8).  

Almost all of these losses come from mortgages.  Indeed in the presentation JP Morgan made when it merged with Washington Mutual all the losses except about a billion dollars came from the mortgage book.  

The only problem is that the losses estimated on mortgages by the regulators (including Sheila Bair) in the stress test include only $39 billion in losses – being 12 percent of the entire mortgage book.  Here are the results of the stress test on JPMorgan.

The implication is that there are negative losses in the rest of JP Morgans very large book.  This is unlikely.  

So we are left with two possibilities both of which involve JP Morgan telling porkys:

1. The losses as estimated by the JP Morgan and told to regulators when they were manipulating Sheila Bair into confiscating Washington Mutual were lies – indeed were so grotesquely over-estimated as to be absurd criminal lies or 
   
2. The losses as estimated by JP Morgan and the regulators in the stress test are grotesque under-estimates – which – in order to be that grotesquely wrong had to involve major misrepresentations of their book by JP Morgan.
   

It is possible that both sets of losses were grotesquely mis-estimated - though the differences here are so stark that a simple and honest "bit of both" is not possible.

I prefer the first choice.  The losses at WaMu as suggested by JPM never made any sense – and I prefer the idea that – encouraged by JPM’s lying – Sheila Bair confiscated a solvent bank.

The second choice suggests the stress tests were totally phoney and allowed JP Morgan to lie at will.  If that is correct the regulators have a duty to confiscate JPMorgan as its embedded losses (using similar ratios as they used in arguing for the Washington Mutual takeover) leave it desperately and diabolically insolvent.

The idea that Sheila Bair confiscated a solvent bank encouraged by lying bankers should not surprise anyone familiar with big-bank lobbying prowess.  Most the bears in the blogosphere would prefer believe the stress test was phoney without any real assessemnt of likely losses.

John

Technical accounting note the losses in the stress test page were before 20 billion in purchasing adjustments.  Those purchasing adjustments were JPMorgan over-estimating the losses at WaMu so - as the loans come in a little better than expected JPM shows better-than-real earnings.

POST SCRIPTS:  The first response I got to this suggests a third possibility - that JP Morgan (and presumably all the other banks) were ASKED to give the regulators the information that they wanted to hear for the stress test - that they were asked to lie.  That I suspect stretches reality.  It is hard to keep things like that quiet - and also some banks (notably Wells Fargo) are very unhappy.

Christopher Flower’s short memory

I play in bank stocks.  Christopher Flowers is a name I see again and again.

He is a private equity guy - and he buys banks.  Big banks.  Lots of money.  And superficially that is appealing from a policy perspective.  After all private equity (Carlyle, Flowers, Cerberus et al) have capital and the government is usually pleased when new private capital comes into banks in the height of a banking crisis.  The issue was played in the New York Times (hat tip to and some decent analysis from Felix Salmon).  

Its just that private equity make very unsuitable owners for a bank.  Frightfully unsuitable.

The problem is that banks take guaranteed deposits (or at least deposits that need to be bailed out if the bank is insolvent) and private equity owns a whole lot of levered buy-outs and the like.  And if a small private equity firm owns a bank it could become a large private equity firm by lending to related parties.  There are very few entities as complicated and with as many conflicts as a large PE firm borrowing money from banks they control.

Mr Flowers puts his case in the New York Times article:

“I don’t think the Republic is going to be brought to its knees if private equity owns banks, personally,” Mr. Flowers said from his Midtown Manhattan office with its expansive views of Central Park. “We invest around the world — Japan, Germany, England, no problem.” 

Effectively he says the conflicts can be managed.

Well – if you really want to be sure of that just go have a look at the results of Shinsei and Aozora.  These were Japanese banks with controlling stakes from Flowers and Cerberus respectively.  When Aozora floated it had made very good profits by investing in other American private equity ventures.  

Flowers also invested in relatively risky structures in the US and Europe through his effective control over Shinsei.  Indeed the memory is very short – this Bloomberg article talks about Shinsei’s and Aozora’s recent results in the light of this conflict of interest.  It seems the bailout of Japan’s banks last time caused a sowed the seeds for another round of problems in Japan’s banks.  The New York Times alludes to this conflict of interest – but the conflict of interest has been around a long time – in good times and bad.  Aozora’s float – laden with what were then private equity profits – was years ago.  These guys are hardened professionals at conflict of interest in banking.

Or as the Bloomberg article puts it:

Shinsei racked up profits in its first six years under foreign ownership. The bank gave funds to J.C. Flowers to invest and had no discretion where Flowers placed the money, Flowers said. Neither Shinsei nor Flowers would give the amount.

The New York Times notes that the Federal Reserve strictly controls who can own a bank – and for good reason.  They also note that Mr Flowers has hired top tier Washington Lobbyists to try to get regulatory changes that suit him.  

If he manages to get Washington to listen to him then I fear for your republic.  This might not – as Mr Flowers notes – bring the Republic to its knees – but it is another step on the way to lemon socialism owned and controlled by the plutocracy.

J

Muddling through – why the American banking system will not turn Japanese – Part II

Welcome again to TPM readers.  My first post on TPM got more comments than the average post on my own blog.  And because the goals of the readership (policy/politics versus investing) are different I get a different perspective in the comments – which I find valuable.  

In the last post I described an absolutely typical Japanese regional bank (77 Bank).  The bank had massive excess deposits.  The marginal cost of funds to the bank was about 10-15bs and almost all of that was deposit insurance fees.

The place was awash in cheap funding (deposits).

Well somewhere in my economics undergraduate degree (like the first week) I learnt that marginal costs tend to determine the price of things – and yet I see lots of fairly big name macroeconomists forgetting this.

In banking the biggest single determinant of the price of a loan is the marginal cost of funds.  Its not the average costs of funds that matters – it is the marginal cost.

Loans are usually quoted in spreads – which is spreads over some index (swaps, treasuries).  But in almost all times the spreads are a (under) a few hundred basis points and the biggest determinant of the rate is the risk free rate not the spread.  

Now in a land where the banks are awash in funding the marginal cost of funds is pretty close to zero.  Welcome to Japan.  

But American banks are not awash in funding – and given the profligacy (especially historic) of the American consumer – not to mention tax cut funded Iraq wars and the like – the US financial system is almost always going to be an importer of spondulicks.  That might change in twenty five years – but it is not changing now.  

Because American banks – at the margin – are simply not awash in funding the marginal funding will be expensive – whereas in Japan the marginal funding is cheap.

And because of that loans will be expensive.  They will always cost at least a few percent (whereas in Japan you can often get mortgage funding for less than one percent).  

Now the average cost of bank deposit funding will not necessarily be high.  Banks with large deposit franchises (such as Bank of America) have a lot of very cheap deposits.  At Bank of America the interest free deposits are almost 250 billion dollar.  The marginal funds are expensive – the average funds may not be.  Loan spreads at the margin may be low one day (not yet) but loan spreads on average will remain healthy.

Banks in America have – at least by Japanese standards – very fat margins.  Wells Fargo has the fattest margins of pretty well any major bank in the world (which is why Warren Buffett likes it so much).  I have previously written about the large and increasing revenue of Bank of America here (and other places).  

The high levels of revenue are what is recapitalising the American banking system.  It is why the American system will muddle through and be right again within a couple of years.* Whereas the low revenue in Japan (resulting in 3% returns on equity in fully capitalised banks without credit losses) means that recapitalisation takes decades.

Now the banks can’t muddle through in America without government support – and they could not muddle through in Sweden or Korea or any other funding short country with collapsed banks without government support either.  The reason is that the government support is necessary to raise the funds that the banks are (at the margin) short of.  The crisis is precisely when the market no longer trusts the banks with funds without a government guarantee.  But provided they get that government support they recapitalise nicely.  Even in extreme cases like Norway where the banks were largely nationalised the government wound up making a profit on the bailout.  [The nationalised banks were guaranteed.]

In Japan by contrast the banks were desperately insolvent – but for the large part they did not need government support.  Why?  Because they had excess deposit funds and it is very hard to go bust when you are awash with cash.  You can however stay a zombie for decades because you do not have enough profit to recapitalise yourself (of to deal with small losses which are inevitable in banking).  

It’s a paradox… the banking systems that are short of funding (such as America, Scandinavia, Korea and Thailand) have the highest need for government support in the crisis and the greatest prospects to muddle through without being zombies five years hence.  

The policy question is how much government support the banks should get and for what fee to the government.  One view (sometimes expressed on this blog) is that real capitalists nationalise.  The returns should – in a capitalist system – go to the party that takes the risk.  With government support that party is the taxpayer – and the returns should thus go to them.  That is what the real capitalists in Norway did.

But in Sweden some banks were supported without being nationalised – and private shareholders did very nicely.  Most countries wind up with a combination of public support for private shareholders and nationalisation.  (In Korea for example Woori is a combination of banks that were fully nationalised whereas Kookmin is by and large a combination of banks that were only partly nationalised.)  

That said – the US government policy is to support the banks largely without taking ownership (Citigroup excepted).  If they keep this policy (and there seems little doubt that they will) then the banks will recapitalise over time through their very high revenue bases.  Bank shares will – in most cases – recover.

Sure the taxpayer takes the risk without getting (much) upside.  Its lemon socialism – take the risks and the losses at the taxpayer level – and given the full benefit of the bank revenue expansion to shareholders.  It is not a great policy.  I do not approve – but I approve more than I might otherwise because I am an Australian (and hence not an American taxpayer) and I managed to buy some Bank of America shares real cheap.

And for that, this non-American taxpayer thanks you.

Disclosure: still long BofA.  It goes back to its all time high market capitalisation – and if they manage to avoid too much dilution (ie new share issuance at low prices) then it will go back somewhere near its all time high stock price.

John

*Muddling through within a couple of years may not be a desirable macroeconomic outcome (though it may be a good political for Democrats because the system will come good for the next Presidential cycle).  In Korea the recession was great-depression deep.  But the system came through.  Countries that dealt with problems quickly (by a combination of nationalisation and full bank guarantee) tend to deal with the macroeconomic crisis better (though sometimes at the expense of bank shareholders).  

PS.  The really observant will notice that both Kookmin and Woori have English language websites whereas 77 Bank does not.  The reason is that the Korean banks need to raise money - and they thust must talk the language of capital markets (English) whereas 77 Bank is awash in funds and can afford to speak Japanese only.

Why American banks will not wind up looking like Japanese banks - Part 1

I have to welcome a few readers from Talking Points Memo.  They are reproducing my posts at least to the extent that they go to explaining banks and the financial crisis to a policy/politics driven audience.  Given the purpose of the Bronte Capital blog is primarily to explore investment ideas the policy/politics wonks at TPM might find my posts a little odd.  [My purpose is largely to make lots of money.]  

Nonetheless I do have things to say which I think are important from both an investment and a policy/politics perspective.

To this end I want to explain why I do not think the American banking system will wind up looking like the Japanese banking system at the end of this crisis – and what the implications of that are both in a policy and an investment sense.  

To start with thoguh most American readers have no idea what Japanese banks look like.  So I will repeat the second substantive post on this blog – a post which looked at 77 Bank – a regional bank in Japan.  

Next week I will do a post which explains why American regional banks will not look like 77 Bank at any time in the next twenty five years.  So enjoy a post that is almost a year old.  I have annotated it where appropriate.

Old post - originally titled "Japanese regional banks - a mirror on America"

77 Bank is a regional bank in Sendai (the capital of Miyagi prefecture). The Japanese guys I know think of Sendai as a backwater – a place where the “cool guys” hang out on motorcycles wearing purple clothes. Economically it is just another rapidly aging backwater where the young (other than those that hang out on motor cycles wearing purple clothes) are moving to Tokyo.

The name 77 Bank harks to tradition. During the Meiji restoration the Emperor gave out numbered bank charters. Traditional regional banks still label themselves by the number. www.77.co.jp and many other numbered sites belong to banks.

77 Bank has a very large market share (near 50%) in Sendai. The market is more concentrated that the great oligopoly banking markets of Canada, Australia, Sweden etc. It should be profitable – but isn’t.

Here is its balance sheet:

(click for a more detailed view).

Note that it has USD42.6 billion in deposits. This compares to $35.8 billion for Zions Bancorp – as close to an American equivalent as I can find.  [Disclosure - I had been short Zions Bank at various times - but not for the great collapse in its local commercial property market.  I lost money.  I thought Zions modestly risky - but it wound up very risky.]

77 only has USD26.4 billion in loans though. If you take out the low margin quasi-government loans it probably has only USD20 billion in loans.

This bank seems to be very good at taking deposits – but can’t seem to lend money.

This is typical in regional Japan. It is also a problem – because when interest rates are (effectively) zero the value of a deposit franchise is also effectively zero.

So – guess what. It sits there – just sits – with huge yen securities (yields of about 50bps) doing nothing much.

It’s a big bank. It has next to no loan losses because it has no lending.

Here is an income statement:

(click for a more detailed view)

Profits were USD87 million on shareholder equity of 3251 million. You don’t need a calculator – that is a lousy return on equity for a bank without credit losses.

You might think that given that they have no profitability and no lending potential they might be returning cash to shareholders. Obviously you are new to Japan. Profits are 27 yen per share and the dividend is 7 (which they thoughtfully increased from 6).

In a world where banks everywhere are short of capital 77 bank is swimming in it. Here is the graph of capital ratios over time:

This bank has an embarrassment of riches – and nothing to do with them.

Welcome to regional Japan.

An American Mirror

The title of this post was “An American Mirror”. And so far I have not mentioned America.

America is a land with little in deposits and considerable lending. There are similar lands – such as Spain, the UK, Australia, New Zealand and Iceland.

There are also mirror image lands – 77 is our mirror image.

Macroeconomic investing calls

We live in a world with considerable excess (mostly Asian) savings. Banks with access to borrowers made good margins because the borrowers were in short supply. Savers (or banks with access to savers) were willing to fund aggressive Western lenders on low spreads.

77 Bank has been the recipient of those low spreads. It has not been a fun place for shareholders as the sub 3% return on equity attests.

The economics of 77 Bank (and many like it) will change if the world becomes short on savings. There is NO evidence that that is happening now – and so 77 Bank will probably remain a lousy place for shareholders.  

The market produces what the market wants

This is an aside really. We live in a world with an excess of savings. This is equivalent to saying that we live in a world with a shortage of (credit) worthy borrowers. So we started lending to unworthy borrowers – what Charlie Munger described as the “unworthy poor [whoever they might be] and the overstretched rich”. We know how that ended.

Unfortunately the financial system cannot make worthy borrowers. It can only lend to them when it can identify them.

This Subprime meltdown heralds the death (for now) of lending to the unworthy. The shortage of the worthy however is as acute as ever – and money for the worthy is still very cheap.  [Money for the worthy is now difficult to obtain (at least outside Fannie/Freddie space), but still relatively cheap once obtained.]

The subprime meltdown does not solve 77’s problems.

John

One year later postscript:

The basic call that the global savings glut was not going away was right.  The global glut of savings - which found its way into endless dodgy subprime mortgages and other problem loans - still exists.  Chinese people still save to excess.  Americans are saving more.  The fundamental imbalance that drove the world financial crisis is still there.  It is not obvious how that is fixed.  

Japanese banks however have found that low margins are particularly dangerous - as there is little profitability to offset losses (even small losses).  And Japanese banks are now having losses.

How might the BofA stress test work

THERE ARE ALL SORTS OF THINGS WRONG WITH THIS POST.  BEST IGNORED.  LEFT FOR POSTERITY...

There is a joint press release from the Tim Geithner, Ben Bernanke, Sheila Bair (who I think really deserves to be in this company) and John Dugan (who is always wondering what he is doing in this company).  It outlines the stress test.  You can read it (word for word like me) if you are into self flagellation.

But here is the guts of it:

The bank must be able to have 4% tangible common equity and a 6% tier one ratio by year end 2010 in the adverse macro (that is stress) circumstance.  At bank of America there is plenty of preferred shares (both government and privately issued).  So the only constraint that matters is the 4% tangible common equity ratio.

The 19 Bank Holding Companies (including BofA) don’t need to meet the 4% test now – they only need to have enough capital now that they will in an adverse circumstance meet the 4 percent test later.  In other words when counting the losses that they might have in an adverse circumstance they are also allowed to count the earnings they will receive in the adverse circumstance.

That is good for a few banks.  Bank of America doesn’t meet a 4% tangible capital ratio now.  Not even close.  But its revenue is rising fast and it will be allowed to count three more quarters of revenue in its calculation. 

Unfortunately they are not allowed to count anticipated near term increases in revenue (they are having them and in adverse circumstances bank revenue typically goes up).  Presumably they are allowed to count revenue (net of “abnormal” trading gains and losses) at the run rate that they generated it in the first quarter – which is – as noted elsewhere on this blog – is a record.. 

There does not seem to be a provision against counting near term changes in pre-tax pre-provision earnings derived from cost changes.  That means that Bank of America should be able to count the cost synergies but not the revenue synergies from the Merrill Lynch merger.  That is about 6 billion per year – but probably only next year.
If a bank does not pass a stress test there are a few capital management options that are not open.  The most important is to shrink the lending book.  The stress test must be able to met whilst maintaining lending at prudent levels to keep the economy ticking along.  I guess the government doesn’t want to discourage a crash by forcing lending down.  They can however meet the tests by selling assets or raising third party capital or even (as is the shareholder’s greatest fear) by turning the preference shares that the government owns into new mandatory convertible preference shares as per the last Citigroup bailout.

Well everyone “knows” that the BofA shortfall is 33.9 billion.   That number has been leaked widely – and is so precise that it would be embarrassing for the journalist to get it wrong.

Anyway I want to have a little think about what that number means…

Here is the balance sheet of BofA

 

The company has a total balance sheet of 2,322.0 billion – but only 977.0 billion of loans (less after provisions).  By the time you add in an investment bank you get an awfully big number of assets (trading and other).  But 86.9 billion in goodwill and 13.7 billion is other intangibles.  The tangible assets are thus 2221.4 billion.  4% of this is 88.9 billion. 

The shareholder equity is 239.5 billion but you need to subtract off the same intangibles.  You then wind up with 138.9 billion in tangible equity.  There is a whack of preferreds (including TARP) and you have 65.6 billion of tangible common equity.  Prima facie the company has 65.6 billion in tangible common equity.  The bank is prima facie short 23.3 billion of capital.  I have put this in the following spreadsheet. 

 Summary

Balance sheet data in billions Total assets 2322.0 Goodwill 86.9 Other intangibles 13.7 Tangible total assets 2221.4 4% of this is  88.9 BofA shareholder equity 239.5 Goodwill 86.9 Other intangibles 13.7 Tangible equity 138.9 Preferred stock (including TARP) 73.3 Tangible common equity 65.6 Current tangible common equity ratio 3.0% Prima facie current shortfall 23.3

This number differs a little from the numbers in the last quarterly report.  Here they are.

This suggests that we have a 3.13 percent tangible common ratio – and the difference is tax assets and liabilities associated with the intangibles – see the footnote.  I am just going to accept the number.  Addition - main difference is the risk weighting of some of the off balancec sheet stuff...

Using that number we have 3.13 percent tangible capital, somewhat better than the 3.0 percent calculated above – and the shortfall is “only” 19.3 billion rather than 23.3 billion.  The widely mooted current shortfall is about 20 billion.

But it is not the current shortfall that matters.  It is the projected adverse circumstances shortfall at the end of next year that matters.

Now suppose that BofA has zero growth between now and the end of next year.  Then the required capital will not have changed – and the bank will have had some pre-tax, pre-provision earnings. 

It will in fact have had a lot of them.  Pre-tax, pre-provision earnings are running about 13 billion per quarter at the moment ($39 billion for the rest of this year plus another 52 billion next year for a total of 91 billion).  It will also have a further 6 billion in “earnings” from the Merrill Lynch synergies.* So they will have 97 billion in earnings before losses.

But lots of losses – an amount that none of us really know.  If they have 77 billion in losses they will still recover the 20 billion current shortfall and they will thus pass the stress test. 

Now is 77 billion possible?  Yes – but it is pretty bad if you think it has to come from the loan book.  The loan book is 977 billion and already has 29 billion of provisions against them.  The loan book might be that bad in an adverse circumstance – but frankly I doubt it.  The actual losses last quarter were way less than that rate – though the company provisioned considerably more than they charged off and they projected the losses would get worse.   Expost addition - the loss here is more or less what they think will happen in the stress test.  I happen to think the stress test loss estimate is just too high - but that is one of those things that people will differ about.

The non-loan book (and the off-balance sheet credit card book) could cause distress in the stress scenario.  The particular issue is the credit card book – and I would expect profits to go away – but this is MBNA not Metris – and my guess is that the book will hurt but not kill.  A credit card stress test here is solvable with 5mg of valium (a very small dose – read a mg for a billion dollars and you get it about right).

Far more problematic is the possibly they could blow up the (Merrill Lynch) trading book again.  Merrills – rather than anything else is the black box at BofA.  I suspect/hope that Bank of America has been steadfastly trying to de-risk the Merrill Lynch book.  Sure they shouldn’t have purchased it – but they have taken a whack of charges against it and the trading book is likely – at least in the next thirty days – to show some reverses.  After all –what were those year end charges about.  And they can sell good slabs of this book reducing total assets and hence required tangible common equity.  Still it is the trading book that is the black-box here and I have no idea how much valium is required to remove stress. 

The best thing though about the non-loan book is that it is easy to liquidate.  They can shrink it.

Indeed the easiest thing to shrink is the cash balance.  I have pointed out that the cash balance of BofA is enormous – and in the stupid rule of the week the 4% TCE ratio includes 4% of cash.  The rule is pretty clear – 4 percent on total assets including the huge excess cash balances BofA is holding.  Just by increasing risk (through shrinking cash balances) BofA can solve $6 billion of its shortfall.

But in the end it comes down to the trading book which should, after some run-off, be shrinkable.  The only question being how much do they lose by shrinking it?  And that depends where it is marked.  And to that – well I think you need to be an insider to know.

 

 

Disclosure: still long BAC.

 

 

John

 

*I think those earnings are as dodgy as they sound – but I think they can count them in working out stress test capital. 

 

 

All lies and jest

Please note - I am aware this note provides a selective interpretation of a New York Times article - and being selective is likely to be wrong.  

In The Boxer (from Bridge over Troubled Waters) Art Garfunkel sings that a man hears what he wants to hear and disregards the rest.  Like many a good song lyric it holds an underlying truth.

And I risk hearing what I want to hear about Bank of America.  I could be wrong.  I am long the stock for a few dollars so far – and being long probably have selective hearing.  But there are plenty of people intellectually (and financially) committed to the idea that BofA is insolvent – and they are also hearing what they want to hear.  

There is a lot of talk about Bank of America failing the stress test.  The number that they need to raise varies from more than $10 billion to $45 billion with $34 billion being the consensus number of today.  [I round $33.9 to $34 billion - what is a hundred million dollars between friends?]

The New York Times seems to quote original sources … and manages to pin down a senior BofA executive (Alphin) by name.  That is better than most papers have done.  The usual source is “people familiar with the matter”.

Now here is a quote:

Mr. Alphin said since the government figure [$34 billion] is less than the $45 billion provided to Bank of America, the bank will now start looking at ways of repaying the $11 billion difference over time to the government.

So lets get this straight…

A while back Ken Lewis was talking about repaying the entire $45 billion in TARP money.

He backed off.  He said at the annual meeting that the required capital was not in BofA’s hands.

Now they are talking about repaying $11 billion.  That leaves $34 billion – capital which the government says that they need.

This hardly sounds like they need fresh tangible common equity.  Just that the TARP money is a decent buffer and will convert if the tangible common ratio falls below some threshold.  

This interpretation is consistent with the denials the other day by BofA that they were looking to raise $10 billion.

Incidentally this is way better than I originally thought.  The tangible common to tangible assets (not including excess cash balances) is well below 4% now.  Even as a long I think some dilution is warranted.

That said - the quality of leaks on the stress test to date has been awful. 

And maybe Mr Alphin’s comment is also misquoted.  And maybe I am way off base.  In my interpretation.  

Maybe Simon and Garfunkel were right – it is “all lies and jest”.  That is about par for bank accounting and behaviour.