Why This Series?
This will be the beginning of a multi-article series that seeks to assess the Fed's monetary policy and its effect on markets, and thus how we should invest going forward. My objective in writing this series is to make the case for why the traditional models of asset allocation will not provide the same results going forward as they have in the past, and thus a new approach is necessary. I form this conclusion by analyzing the data, and exploring the economic environment that investors find themselves in, as well as the unprecedented level of global central bank action and how this will affect the process of portfolio construction to meet the goals of the future. The series will have a particular focus on engineering the best portfolio possible by incorporating cutting edge academic research into the portfolio construction process. The series will consist of five pieces which together represent an in-depth discussion about the Fed, the economy, and how to invest in the new normal.
The 2008 Financial Crisis and The Fed's Response
The 2008 financial crisis was the worst since the Great Depression of 1929, and by some measures, it was worse. In 2008, the S&P 500 fell by over 37.02% as the financial crisis took hold, figures four, five, and six below illustrate the take no prisoners effect of a violent market drop.
The crisis was caused by a combination of government induced lending to unqualified borrowers, brought on by the community reinvestment act (12 U.S.C. 2901), as well as Wall Street speculation on real estate prices. Wall Street banks packaged Mortgage Backed Securities (MBS) rated AAA with subprime debt in various groups called tranches. These tranches of debt, then went bad when the subprime loans were deemed worthless. Wall Street packaged Collateralized Debt Obligations (CDO), which are pools of securities packaged together for sale to investors. The senior tranches of this debt are generally safer and have higher credit quality, while junior tranches are generally made up of riskier securities with higher yields. The challenge during the crisis was that Wall Street was packaging these CDOs with more and more risky debt and less and less of the AAA debt. On top of this, they created securities known as Synthetic CDOs, which use derivatives and other securities to obtain their investment goals without owning the assets of a CDO. The following chart depicts the creation of a Synthetic CDO in detail.
Source: Financial Crisis Inquiry Commission
When these junior tranches went bad, the House of Cards came down and brought trillions in consumer real estate and equity market wealth with it. Banks were most seriously hit with billions in worthless securities on the books. In response, the government took action to combine failing banks to create even larger financial institutions, and initiated new regulations under Dodd-Frank. The reality, however, is that this bill does little to increase the safety of our financial institutions, and only provides the illusion of safety with increased capital requirements.
A Quantitative Analysis of Risk
In conducting a quantitative analysis of the risks within financial services firms, there are multiple avenues to be considered. In terms of fair value accounting, IFRS 13 and FASB 157 are the two methodological statements for application. As we are going to focus the analysis on U.S. banks, I will limit the scope of this writing to U.S. GAAP application, and leave concerns from IFRS out of the discussion. Currently, U.S. GAAP only requires netting of derivatives exposure, providing investors with only a part of the overall exposure of any financial institution. Two additional pieces are required to more accurately understand the risks from derivative securities. First is the PFE, the potential future exposure, largely calculated through counter party risk. The second piece is the CVA (Credit Value Adjustment), this adjusts for the deterioration in credit quality of counter parties. It is important to note, however, that the CVA has no standardized method of calculation, adding another layer of uncertainty in arriving at a dependable quantifiable value of the derivatives exposure. (For additional exploration-Ernst & Young laid out this point well in this piece.)
One additional layer of exposure is found in the Level 3 section of the valuation hierarchy. According to FASB 157, assets can be valued according to a hierarchy.
Level 1 represents securities where readily available markets are available, and thus observable pricing exists. Level 2 are securities where inputs are observable either directly or indirectly, such as in markets that are thinly traded or where observable inputs can be estimated based on the prices of similar assets. Level 3 assets are assets where no observable market prices are available. In such a scenario, banks are allowed to use various methodologies to determine the prices of these assets.
In my opinion, the challenge with these Level 3 values is that they are given a certain value simply because the banks say that is what they are worth. With no observable inputs, it is hard to put much confidence in the stated prices of these assets without a more dependable model for price discovery.
It is important to note that the challenges with Level 3 assets extend beyond the world of bank balance sheets. The May 4, 2015 issue of Barron's includes a very interesting exploration of the subject on page 31, as it relates to bond mutual fund financial statements. The article discusses a specific fund currently under investigation, but also deals with the issues of Level 3 securities on the books of many mutual funds. The story quotes the independent auditor of the specific fund in question in its most recent annual report as stating the following in relation to Level 3 assets:
"These estimated values may differ significantly from the values that would have been used had a ready market for the investments existed, and the differences could be material." The article also warns investors that during a crisis many assets classified as Level 2 can quickly become Level 3. I would echo this view in relation to bank balance sheets, as we learned during 2008 many of these arcane securities buried deep within bank balance sheets may carry a material variance between stated value and real market value."
Analyzing Level 3 in the Largest Banks
Bank of America (NYSE:BAC)
As you can see from this analysis from page 241 of Bank of America's annual report (2014), Level 3 assets represent 3.37% of the total assets after netting. The company is holding over 1,592,332M in total Level 1, 2, and 3 assets before netting with Level 2 making up 86.7%. I give BAC management a great deal of credit for maintaining a low value of Level 3 assets, but I believe the high value of Level 2 assets may expose investors to unquantifiable, and possibly material risks, in a financial crisis as there is no way of knowing how much of Level 2 would become Level 3 in such a scenario. Additionally, according to the OCC's Quarterly Report on Bank Trading and Derivatives Activities for the 4th quarter of 2014, BAC had total credit to capital exposure of 93%, and 85% as of the fourth quarter of 2015.
Wells Fargo (NYSE:WFC)
Note 17 and Table 65 of the 2014 Annual Report, illustrates an exposure of 2% for investors to Level 3 securities. WFC is holding the majority of its assets at level 2, representing 94% of assets after netting. Additionally, according to the 4th quarter OCC report on Bank Trading and Derivatives Activities, WFC has total credit to capital of 22%, and 31% for the fourth quarter of 2015.
JPMorgan Chase (NYSE:JPM)
Page 163 of the Annual Report indicates total Level 3 assets as a percentage of total assets measured at fair value of over 7.2%, which appears to be rather high when compared to peers. Additionally, according to the 4th quarter OCC report on Bank Trading and Derivatives Activities, JPM has total credit to capital of 177%, and 209% for the fourth quarter 2015. Note 3 of JPM's annual report lays out the detail for fair value accounting for the firm.
Page 262 of the 2014 Annual Report shows total Level 3 exposure of 2.42%. Additionally, Citi had a credit to capital ratio in 2014 of 172%, and 166% in the fourth quarter of 2015. Before netting exposure, Citi is holding close to a trillion dollars in derivatives at $892,760M. After netting of $824,803M occurs, this number is reduced to $67,957M, and this total includes Levels 1, 2, and 3 securities. The total Level 3 exposure after netting is $11,269M which is 16.58% of the net exposure of $67,957M, and 2.42% of total investments in Levels 1, 2, and 3 of $302,901M. What would be worrisome to me if I were a Citi shareholder is that the vast majority of the assets in the hierarchy are recorded in Level 2. The question is how much of Level 2 would become Level 3 in a crisis?
It is important to note that many of these risks are mainly material to the investment thesis if we were to have another financial crisis. Level 3 assets are not a day-to-day concern for investors, generally speaking. That being said, they would be material should another crisis befall us. As nothing has been done to address the root cause of too big to fail, we now have larger financial institutions with more complex securities on the books, and another financial crisis may be inevitable.
The Fed Response to the Crisis
The Federal Reserve acted quickly instituting, what could be best characterized as an unprecedented experiment in monetary policy. The Fed put these extraordinary monetary policy measures in place to unfreeze markets and induce risk taking in the economy. They did this by implementing a combination of Large Scale Asset Purchases (LSAP) as well as Zero Interest Rate Policy (ZIRP). The combination of these policies were introduced to drive down the risk premium for long-term bonds (BRP), and drive up the risk premium for equities (ERP).
While Ben Bernanke, the Fed Chair at the time defends his actions in monetary policy, the effects of these policies, which I will explore in the next article, are muddled at best and a down right failure at worst. The Fed's objective in instituting this monetary policy was to drive up the prices of equity securities with the hopes of creating a real wealth effect. At the same time, the Fed hoped to induce risk taking in the real economy by driving down interest rates. The idea was that the two-fold effect of driving down interest rates to the zero lower bound, and inducing a rising equity market would allow us to avoid the negative effects of the great depression. But many question whether this was simply a mechanism to delay rather than avoid the worst of the financial crisis.
In part II, we will discuss the implications of these policies on asset prices.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: This article is for informational purposes only and is not an offer to buy or sell any security. It is not intended to be financial advice, and it is not financial advice. Before acting on any information contained herein, be sure to consult your own financial advisor.