Hemingway once wrote that a man goes broke “slowly, then all at once.” Before 2008, many market participants may not have fully appreciated this insight, but we are hopeful that Wall Street’s Celebrity CEOs (and retired all-stars like Jimmy Cayne and Dick Fuld) now have a better understanding. Unfortunately, it is becoming more apparent daily, that our politicians and central bankers do not. Regulation is needed. We have previously discussed our support for the reinstatement of Glass-Steagall and separation of savings banks and riskier financial institutions. Government support and insurance is necessary for savings banks to provide their traditional services to the real economy as we first learned in the 30s. This support, and accompanying tax payer dollars, should not facilitate reckless speculation and propriety trading behind the closed doors of any other financial institutions.
While we have seen increasing support for this school of thought, most proposals have yet to address an equally important risk plaguing our complex financial system – leverage, as they say, can make a man go broke all at once. Until leverage ratios are addressed, and banks are required to maintain greater capital levels, we will continue to face the risk of additional financial accidents. We recently came across an eye-opening piece from Sprott Asset Management, a Toronto based firm that we respect tremendously, that highlights the excessive leverage in the banking system. A few excerpts are below:
When the crisis was in full bloom last year, there was much talk of banks “de-leveraging” their balance sheets back down to more appropriate levels. Traditionally, banks would “de-lever” by selling portions of their loan portfolios to other banks, but in 2008 there were no buyers for financial assets at any price. Over the course of the last twelve months, however, many people have assumed that the banks were steadily improving their leverage levels from those of 2008. After all – the bank stocks have all rallied dramatically since March. They must be in better shape, right? Closer inspection reveals that they’ve achieved very little in the way of de-leveraging thus far, and have merely been propped up by various forms of government liquidity injections, guarantees, out-right share purchases and support from existing shareholders.
In order to better explain the leverage issue, we must first clarify how we calculate it as a metric. Leverage can be measured in many ways, but our preferred choice as equity investors is to look at how much ‘tangible common equity’ supports a bank’s ‘tangible assets’. It serves to remember that the concept of ‘equity’ simply represents what you’re left with when you subtract your liabilities from your assets. We remove ‘intangibles’, such as goodwill, from this calculation because they have no real value. You cannot buy goodwill and then sell it at a profit – and under a bank bankruptcy scenario, which we have seen so often over the past year, goodwill is worth nothing. What we are interested in calculating, therefore, is how many tangible assets are supported by one dollar of tangible common equity. This number gives us an indication of how levered a common equity investor in a bank stock is to changes in asset prices. The higher the leverage, the more exposure each dollar of common equity has to a change in asset prices, and the more risk you face as an investor.
Applying our definition of leverage to the current system reveals the inherent weaknesses that still exist within it, and confirms why we question the value in bank stocks. In Chart A, we apply our leverage ratio to the top five Canadian banks, top ten US banks and select European and US banks that have been bailed out by their respective governments. We have used their ‘tangible assets’ as reported in their respective filings, with no interpretation for asset quality – an element worth noting for our more critical readers.
The examples above show that our leverage measurement is a good variable to review before making a common equity investment in a bank. The higher the leverage ratio, the greater the risk of losing your common equity. While we haven’t delved into the asset “quality” of any of these banks, we have been watching US bank failures for a market-based indication of the quality of their assets in a liquidation scenario. High profile examples include Colonial Bank, the largest US bank failure thus far in 2009, which had total assets of $25 billion and cost the FDIC $2.8 billion in losses – representing an 11% write-down on their assets. Also notable was Chicago’s Corus Bank, which cost the FDIC $1.7 billion on total assets of $7 billion – representing a 24% write-down. For Colonial, 10:1 leverage was too high, and in the case of Corus, a mere 4:1. Citing the most recent bank failures in the US, it would appear that most financial assets are still being written down by at least 10%. Although each bank is different and has its own specific asset allocation, this raises major cautionary flags for us, given that the banks listed above still utilize leverage ratios well above 20:1. For such a seemingly complicated industry, it surprises us that such a simple red flag continues to stump the regulators who oversee it.
Disclosure: Short KRE