Vox Rationalis

Analyzing the U.S.'s Four Largest Banks

"Secondly I have grouped the 4 together for a number of reasons. Many investors like to invest in ETF's like the XLF and KBE and the 4 holdings are 37% of the XLF and 33% of the KBE."

If this was the reason you grouped these, why did you instead mention only the S&P 500 in your article? No mention whatsoever of why these should be grouped. But let's break this down a little further - current holdings of XLF:

1 JPMorgan Chase & Co. 12.61%
2 Bank of America Corp. 9.57%
3 Wells Fargo & Co. 9.32%
4 Goldman Sachs Group Inc. 6.48%
5 Citigroup Inc. 3.87%
6 U.S. Bancorp 3.35%

So why no GS, which makes up a much higher portion of the XLF? Or more importantly, why C at all, since its losses dramatically pull down all of your numbers while accounting for over 10% of the group's market cap?

"Now if you go to Value Lines 2010 estimates for the four banks and take out Citigroup from the picture you get a ROIC for the remaining 3 of 2.4% compared to 2.1% for the four, so the other three still do not inspire."

Wow. I hadn't even read to the end of your article: "I want to see at least 20% ROIC (return on invested capital) before I even think about investing a dime in any enterprise." You really have a complete lack of understanding about how banks work, and should have known better than to provide any advice without more study.

A banker is an intermediary who directs capital to where it can be put to good use. Take this function away, as you suggest by limiting banks to their deposits only (which, by the way, are borrowed funds with a different name), and capital no longer moves as efficiently, the cost of doing business increases, and economic activity and growth decline.

And so, since banks operate on the margin, that their returns are lower than other businesses is not just intuitively obvious to the casual observer, but NECESSARILY so. Dramatically simplifying, banks MUST be low-return businesses or other businesses couldn't afford to borrow money.

As an example, consider Hudson City Bankcorp, which Forbes named the Best-Managed Bank of the Year for both 2007 and 2008. Here are the ROIC figures, according to their annual report:

2007: 1.03%
2008: 1.27%

The big three banks have ROIC of 2.4%, much higher than the Best-Managed Bank in America, and you think they're dramatically too low? If your 20% were really a good yardstick for banks, do you think HCBK would be thought of so highly? I ran a screen just for giggles. Of the 38 large-cap banks (<$8B), only one -- Banco Bradesco -- had a ROIC higher than 10%, coming in at 11.4%. Most of the Canadian banks - which have been sailing through the trouble unscathed - run between 5% and 10% ROIC.

Banking is all about leverage and risk; if there were no risk, there would be no reason to limit the amount of money a bank borrows and then lends -- no need to limit leverage. Of course, risk is inherent in any borrowing, and the recent industry failure to manage risk is a big part of what we're all dealing with now. Do I want a banker who takes no risk? Of course not, because my returns as an investor or depositor would be surely reflect this risk intolerance. I want a banker who properly assesses risk. We pay for the banker's ability to assess and manage risk in a leveraged environment - not ROIC.

"So it seems from [2010 loan loss reserve estimates] that JPM might have a lot more bad loans on the books then the others and that C's situation may not be as bad as people think."

Man, this is just ignorance - you should follow the banks for a while before spouting advice on them. WFC has taken HUGE amounts of heat among analysts for not increasing its loan reserves more (WFC insists it is generating sufficient cash to cover its losses without adding to reserves). Citi really hasn't had to increase reserves as much as it should, because it's mostly government-owned anyway and needs every productive dollar it can get. Taking JPM's higher number as an indicator that it has more losses is just plain stupid - it could just as easily, and in fact far more likely, indicate that JPM is a more conservative operator.

Apologize to the nice people for wasting their time. DISCLOSURE: long WFC, BAC.

Analyzing the U.S.'s Four Largest Banks

Sorry, but there are big problems here. First off, source your data.

The clearest logical problem is the impact on the "analysis" of grouping these companies together. This only makes sense if one is considering buying the group as a basket. Strikes me that very few would consider this, and so it makes no sense to group them for any analysis; comparing them would be more useful.
JPM and WFC, by most accounts, are very well-run, and have done a much better job managing risk than most banks. BAC's purchases put very much it in a category of its own.

And as for C - does it make any sense whatsoever to group C with ANY other company? What happens to your numbers if you pull C from the discussion?

Today May Be Markets' Turning Point

I think the turning point is now. I mean now. Right... now. How about...now? Now? Maybe now. Now! NOW! Now now now now now...

Five Reasons the Market Could Crash This Fall

On Aug 04 09:59 AM The Goy wrote:

> I think you left out the fact that the US government is going to
> seriously raise taxes next year, so selling is going to happen this
> year.

This would make sense, except that there is likely a significant amount of capital losses carried forward from last year which will offset realized gains.

Paulson Owes Bank of America's Shareholders a Better Explanation

I think this is far off-base. The problems here are Ken Lewis', not Bernanke's or Paulson's. The fact is, BAC abjectly failed to perform adequate due diligence prior to the shareholder vote on 12/5, and then told Paulson on 12/17 that BAC was considering evoking the MAC clause to cancel the deal. Here's what would have happened had Lewis followed through on this course:

Merrill would have gone bankrupt. Merrill's creditors and shareholders would have sued BAC, and would have won. BAC would likely not have been unable to survive the judgment. Meanwhile, who knows what effects would have occurred across the financial markets.

If Paulson threatened Lewis by reminding him that the Fed has the authority to remove him and the BAC board, GOD BLESS HIM. If the threat worked, seriously, think about what this says about Ken Lewis. How do you get to be Ken Lewis without having the intestinal fortitude to do what you think is right in the face of such a threat, damn the personal consequences?

Bank of America entered the deal on September 15, and the shareholder vote was on December 5. In that 81 day period, BAC was supposed to be sifting through Merrill's books so that it understood EVERYTHING that Merrill was doing. But apparently, that wasn't enough, because 12 days later BAC had suddenly become aware of a material change sufficient to kill the deal. Does anybody believe this? I think a judge would be hard-pressed to blame anybody but the BAC accountants.

The world changed dramatically before December 5, not after it. The bottom line is that BAC had 11 weeks to perform due diligence and back out of this deal, during a time when the financial world was dramatically and permanently changing. That BAC didn't understand what was on Merrill's books was BAC's fault.

And then there's Ken Lewis. Did he fail to perform his fiduciary responsibility? If he truly thought that invoking the MAC clause would have served his shareholders' best interest, why didn't he? If that's what he thought, he failed in his fiduciary duties and should resign or be removed. If that's not what he thought, then he should own up to it.

Like Paulson or not, on this one, the blame lies elsewhere.

Weekly Unemployment: Lying with Numbers

On Jul 09 03:54 PM Mad Hedge Fund Trader wrote:

> ...we have fallen back to 2000 levels of total employment.

Complete and total nonsense. Look at ANY data on the subject.

> Only one out of 2.4 Americans now has a job.

Hogwash. With 300M people in America, this would mean 125M employed; the latest number is 140M. Which, by the way, means that a higher percentage of the population is now employed than at almost any time between 1970 and 1983. [ftp://ftp.bls.gov/pub...

> Stocks, real estate, and many other asset classes have also given
> up the decade’s gains.

Yes, the S&P 500's return in the last 10 years is -20%. Of course, this arbitrary sample starts pretty close to the peak of the dot-com bubble, doesn't it? Consider the returns for the four years prior to that ending 6/99: 30.2%, 34.7% 26%, 26.1%.

As for real estate, no way real estate's back at 2000 levels. The Case Shiller 20-city composite was 40% higher in April than January 2000.

Weekly Unemployment: Lying with Numbers

"Lying With Numbers" - Was this talking about the headlines, or this article?

"The critical fact is that that the number of non-adjusted new claims for unemployment insurance benefits rose by 175,834 claims year over year."

This is THE critical fact? Really? You think that the important analysis of unemployment claims is year-to-year? Why? Isn't a year an arbitrary number? Why not two years? Why not three? Your analysis is stunning - you're able to glean from your calculations that the economy is worse now than it was a year ago. Quick - somebody call the Nobel committee!

Let's just be clear about this - when December comes, and the unemployment rate is still rising, but year-to-year first time claims are lower, you'll be saying that things are getting better?

"...we have a catastrophic rise in the number of new claims for unemployment on our hands."

"Catastrophic"? Hyperbole much?

Bail Out for Dummies - Part I

growser7 wrote:

> You can tut-tut all you like...

Being critical of somebody pushing the notion that the ENTIRE banking system may be twice as damaged as the 1,000 or so S&Ls that failed is "tut tut"-ing? I guess I wasn't clear enough - I don't know how bad it is, but Durden's suggestion of magnitude is ludicrous. I don't know how big the largest gorilla in history was, but I'm pretty sure King Kong was fiction.

> You can conjecture all you like about toxic assets and the FDIC...

I'm not the one guessing about toxic assets, and my discussion of the FDIC (which, again, has nothing to do with bank assets) was purely fact-based.

> what I am seeing is the federal debt ballooning at a rate which will swamp us all.

Perhaps, but perhaps not. Remember that the debt burden at the end of WWII was more than 120% of GDP, well above where we will be in a few years, and Japan's is much higher still. That said, I'm right there with you when it comes to persistent, non-crisis mode deficit spending. One of the very important lessons I hope we the people are learning is that deficit spending during expansions is like a noose tightening around the nation's neck; it causes nervousness and it's a little uncomfortable -- until the bottom falls out.

Will we remember the lesson when the situation isn't so dire? I'm afraid we may be repeating ourselves; during the Carter administration, the national debt was perceived to be a real problem. But then, once the economy turned around during Reagan's term, we forgot all about it, and grew the structural, persistent deficit in unprecedented fashion. Let's hope that cycle doesn't continue.

> The real monster in the closet is a lot bigger than you think.

You don't have enough information to know what I think. All I've written is that Durden's guess about the government's assessment is implausible, and that Roubini's assessment is very unlikely to be greatly exceeded.

Bail Out for Dummies - Part I

This article’s like a child looking into a dark closet at night. We're pretty sure there's something in there, and it’s really scary. But some of the details our imagination is trying to explain here aren’t nearly as bad as we think.

There are three problems with this piece: omissions, logic, and math. Other than that, it’s just fine.

First, Durden doesn’t adequately describe the FDIC's role, and doesn’t differentiate between it and the many programs created to deal with this crisis. Deposit insurance has been around for 75 years, and the only recent change is the insured deposits limit increasing from $100,000 to $250,000. Big deal? Not really, since CPI has increased 150% since the $100,000 limit was instituted in 1980. Really, the new limit just catches up to the 1980 level. If it were not changed, large depositors needing insurance would simply have been forced to open accounts at multiple banks.

Worse, Durden’s statement that “the various Bail Out programs now support OVER 72% OF THE TOTAL LIABILITIES ON THE BALANCE SHEET” (my caps for his boldface)” doesn’t mention that 58% of the dollars in Durden's “support programs” are in the FDIC insurance, not in a “bail out” program.

“The implications… $3.6 trillion, or another $2.4 trillion to go... $3.1 trillion in total US losses, or another roughly $2 trillion to go. These provisions are optimistic. Why? BECAUSE THROUGH ITS VARIOUS IMPLICIT AND EXPLICIT GUARANTEES THE ADMINISTRATION IS SAYING THE TOTAL PAIN COULD POTENTIALLY REACH $8.8 TRILLION.”

Nonsense. These programs do not serve the same ends, some overlap, and the size of the largest is unrelated to the banks’ assets. The FDIC’s insurance provides no direct support of the banks, except that it boosts depositor confidence. But the size of this backstop is tied to deposits, not loans. By Durden’s reasoning, if insured deposits increased by $100 billion tomorrow, the government would believe losses could potentially be $100 billion more. Or, taken to extreme, if insured deposits increased by $10 trillion tomorrow, potential losses could be $10 trillion higher. This is, of course, nonsense, since massive increases in deposits would DECREASE the chances of any loss, including a major one.

Add to the logical problems a mathematical one. Durden writes that the government thinks the banks could lose $8.8 trillion for the simple reason that the maximum value of the various government programs he mentions is $8.8 trillion. But look at the assets: the banks and S&Ls held $8.07 trillion of loans, according to the Fed data Durden cites. Add in $1.3 trillion in munies, corporates, and foreign bonds, $83 billion of equities and mutual funds, and $2.44 trillion of unknown miscellaneous assets, and the TOTAL possible losses are $11.9 trillion -- IF THE VALUE OF EVERY ONE OF THESE ASSETS AT EVERY BANK FELL TO ZERO. Durden thinks “the administration is saying” this portfolio could lose 74% of its value? Really?

Durden then bemoans the fact that the least desirable assets are increasingly being used as collateral for Fed loans, but this couldn’t make more sense. If, in the future, the banks need to sell assets, clearly they should sell those that are the least distressed (those that are closest to their expected long-term value). By allowing lower-quality assets as collateral, the Fed increases the chances that banks survive. And since this is the Fed’s goal, it would make no sense to tie up the banks’ best assets as collateral.

“…as we head to the full funding capacity on all the Bail Out programs ($8.8 trillion), Zero Hedge expects to see as much (not necessarily the full amount) as $7 trillion more of new Treasury issuance as the true "worth" of the assets is realized.”

So you actually think the banks’ portfolio as described above is worth as little as 42% of face value? Really? It's worth noting that the cost to the government of liquidating failed S&Ls averaged about 30% of assets. And that's the assets of just the failed firms.

“The scale of the problem is simply insurmountable using current mechanisms in place.”

You just got through explaining that you didn’t expect the government to fully use the $8.8 billion of funding programs, but now you’re saying it isn’t enough? So where is the scheme lacking?

“The bottom line is that every dollar printed by the Treasury directly goes to fund a dollar in deposits, bypassing M1-M3.”

I guess you didn’t know that most of these deposits are included in M2, and all are included in M3.

“If the $8 trillion pool in total deposits realizes that it is supported by assets which even the government is saying are worth fractions on the dollar…”

Psst… FDIC. Some 65% of all deposits have no need to be concerned with bank assets – that’s the whole point. As for the other $2.8 trillion, suppose it’s all withdrawn from suspect banks. Where do you think it’s going? Unless it’s going into millions of mattresses, those dollars will make their way back onto banks’ balance sheets. The funds won’t disappear – they’ll find their way to productive use. Such is the magic of the market.

“...the risk of a wholesale systemic bank run becomes unstoppable even with all the government backstops in place, as the latter will be contingent on continued willing recipients of those rapidly devaluing pieces of paper known as U.S. Treasuries and once that assumption is questioned or outright proven false, all bets are off.”

Wow. Congratulations, you win the “most absurd alarmist claptrap of the day” award. Financial markets are forward-looking, right? Then why, oh why, is the “rapidly devaluing” 10-year Treasury yielding just 2.86%? What was it before this rapid devaluation? Let’s see, in the last couple of months it’s... pretty much moved sideways.

I mean, it’s not like you’re the only one who has access to this information. The market’s pretty good at discounting known information – why aren’t your prognostications of doom reflected in Treasury prices?

The thing in the closet is real, and it is indeed scary. But Durden’s description doesn’t make sense. I don't know how big it is, but the odds that it's much worse than Roubini says are smaller than tiny. We may not figure out exactly what’s in there until the light of a new day.

Warren's (Ridiculous) Prescription for Banks: Wipe Out Shareholders, Fire CEOs

"It would be easy to dismiss the woman as irrational..."

Would it have been as easy to write "it would be easy to dismiss the man as irrational"? It's kind of a strange sentence structure; usually (but not always) "woman" would be "her" or "Warren" if a writer was not making a point of highlighting the subject's sex.

Bank Liabilities: Why the Discussion Isn't Explicit

User 366653 wrote:
> First, I think "the market" is missing something: Trust preferreds
> have seniority over straight preferreds. Therefore, it would be hard
> to imagine that C or anyone else would orphan the trust preferreds
> by eliminating the dividend without offering the option of conversion
> to common as a way out.

Of course, Ford did just this last week - at the same time it offered a conversion of debt to common, it deferred payments to the trust preferreds. Different situation, of course, since I don't believe Ford has any straight preferreds, but relevant.

Bank Liabilities: Why the Discussion Isn't Explicit

On Mar 06 10:47 PM Nick Waddell wrote:
> Does anyone know if Canadian banks mark to market?

Sure they do. What they didn't do was lever up with absurd amounts of correlated risk, in no small part because the Canadian regulatory regime remained intact during the last ten years while ours turned into swiss cheese.

An Obama Speech to Light Wall Street on Fire

Burke and Herbert is a local bank near Washington DC. It had record profits last year.

Record profits. In 2008. Not all banks have these problems.

Certainly there are thousands -- literally thousands -- of banks out there that did NOT overload on bad mortgages, that did NOT write CDS, that did not over-leverage themselves. Read your local papers, listen to your radio stations. You'll hear about them. They're the small banks that chose to really know their customers. They didn't fudge documents. They didn't sell and resell and resell option ARMs. They didn't try to make millions of dollars for their officers. They are responsible and their banks are in doing just fine.

By the way, there are some larger banks that are doing just fine as well. Their stock prices may not show it, but their financials do.

Don't you dare say that the big banks shouldn't bear the majority of the blame.

Turning Japanese: The Audacity of Reality (Part 3 of 3)

"How could the entire US banking system be effectively insolvent??? Stop listening to fools like Myrtle."

There was a bit out yesterday estimating that Americans lost $10.2 trillion of wealth last year. It's not hard to me to see why the banking system could be insolvent.

But, RBS was out with an analysis a few weeks ago indicating that many British banks are technically insolvent. Lost to most who quote this analysis was the bit where RBS said this is not an unusual circumstance at this point in an economic cycle. This is because the values of all assets, even performing assets that are not for sale, drop enough to push the balance sheet negative.

By the way, just because institutions are technically insolvent, we may not want to let them fail. Consider this scenario extended from the one above. The government takes over the bank, pays off the depositors, and sells the loan book to Bank2 at the market price of $720. The government (taxpayers) loses $16 in the deal. Bank 2 then holds those loans to maturity, profiting not only from the interest but also from the repayment of the capital that it bought at a discount. If the first bank had been allowed to continue and no more defaults occurred, it would have become technically solvent in two years, and would have continued to be profitable, eventually recovering $80 of “lost” capital as the loans matured.

"Listen to Nouriel Roubini..."

Ask Roubini about your money creation theory.

"The inflation he [Jefferson] was talking about was credit inflation."

Can you produce the context of the quote to support this assertion? I didn’t find the full text of the speech.

"Yes, the fed increases the monetary base as well, but it is credit inflation that is so dangerous because individual banks control it, not the gov't."

Even your wrong-headed video states that the government controls the overall money supply, including the "debt money" supply. It just gets the mechanism completely wrong and the multiplier wrong by a factor of 10.

"When banks stop lending the money supply crashes and you get a deflationary crash."

Right! That's why the Fed's pulling out all of the stops to expand the monetary base, and why its actions are not (yet) inflationary.

"The fact that it was too much trouble to read for comprehension means you watch too much TV, sheeple."

Your the one who's primary source is a youtube video. I think you're going to feel pretty dumb when you finally figure this out.

Turning Japanese: The Audacity of Reality (Part 3 of 3)

“How could we have a global banking system meltdown if banks don't lend more than they really have on deposit?"

Fair question. Read carefully.

Let's say a new banker puts $100 of capital into a new bank, and takes 20 deposits of $50 and pays 2% interest. Now say the bank makes 9 loans of $100 each and charges 4% interest, keeping $100 (1/10) on reserve in case depositors demand some of their money (hence the term "fractional reserve"). As long as the loans perform and the group of depositors don't remove too much of their money, everybody's happy. If you look at the balance sheet of the bank, there will be assets of $900 in loans and $200 in cash, and liabilities of $1000 of deposits. The bank has $100 of owner's equity (assets less liabilities), and so a simple measure of leverage (assets divided by equity) is 11x. This is close enough to where U.S. banks operate.

At the end of one year, the banker collects $36 in interest on the loans, and pays $20 in interest to depositors. To keep it simple, assume the depositors withdraw all interest payments so that deposits (liabilities) remain $1000 throughout this example, and that there are no taxes and no cost associated with running the bank. The bank's profit is $16 (which is a 16% return on equity invested). Now the balance sheet has the same $900 in loans and $1000 in deposits, but cash has increased to $216. At this point owner's equity has increased to $116. Let's suppose a dividend of $6 is paid, reducing cash to $210 and equity to $110. Leverage now stands at 10.1x.

Now, suppose one of the borrowers doesn’t pay the next year. The bank collects $32, pays interest of $20 and has $12 of profit. This is okay, right? Still profitable. But now the bank has to write down the value of that loan, as it's certainly not worth as much as it was when payments were current. Let's say they drop that loan's value to $75, reflecting increased risk. The balance sheet now shows $875 of loans, $222 of cash. Equity has fallen to $97. The bank suspends the dividend. Leverage is 11.3x.

Now suppose the defaulting lender goes bankrupt the next year and the bank is able to collect only 30% of the debt - perhaps because this was a home equity loan and the first position lender took almost the entire proceeds from a foreclosure sale. The loan comes off the books, and $30 cash is added. The bank again collects $32 and pays $20 to depositors, adding $12 more to cash. Now the balance sheet shows $800 in loans, $264 in cash, and $1000 in deposits. The bank's equity has fallen to $50, and leverage has increased to 21x.

But the bank’s not done with this year, because here's where mark-to-market accounting comes into play. Suppose the value of the assets underlying all of these loans has fallen, as has happened with housing. The loans can no longer be sold to other banks for full value, because if the borrowers default the holder of the note will lose money. According to mark-to-market rules, the bank must reduce the value of these assets on their books to the going market price, EVEN THOUGH the bank intends to hold them to maturity and EVEN THOUGH all remaining borrowers are up-to-date in their payments.

Let’s say the remaining 8 loans have lost 10% of their value on the open market. The balance sheet now shows $720 (8x$90) in loans, $264 in cash, and the same $1000 in deposits. Equity is now -$16. The bank is insolvent, even though it still operates profitably.

It’s quite easy to see how fear in the marketplace could have quickly driven down the book value of anybody holding mortgages. It’s also clear (to me at least) that this impact means mark-to-market needs to be reviewed.