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  • Undercapitalized European Banks And Basel III

    I want to bring out a contrast between the capital structure and valuation of some selected major banks in Europe with similar large banks in the US. I bring this up because I believe most investors do not understand the root causes of slow broad credit growth at the present time, and because of this, miss the ongoing power of deflationary forces in the world economic system. They then see official policy both monetary and fiscal in loose positions, and expect rapid inflation to result, and are surprised when this does not materialize. To understand what is actually happening investors need to understand the private financial sector and its role in all this.

    My underlying thesis is simple. Financial capital is the scarce item in the present system. Losses stemming from the financial crisis of 2008 and sustained bad debt performance since have reduced the aggregate financial capital of the developed world's financial system. Regulators have responded to the risks that appeared in that crisis by moving to increase capital requirements for banks. Bank substitutes that boomed before the crisis but failed during it have also been collapsing. The net effect of all these forces has prevented any appreciable growth in broad credit. And macroeconomic weakness then follows from lack of credit growth, because that is equivalent to a static rather than a growing broad money supply.

    With that as some basic context, I present a few balance sheet and market cap items about 5 major European banks. I picked these as strong institutions in their respective countries, banks that are worth owning in good times. And all of them are from countries with basically sound finances and financial traditions - I will not be talking about Greece or Spain or Ireland.

    The five are Deutschbank in Germany, Barclays in Britain, BNP in France, ING in the Netherlands, and UBS in Switzerland. Yes ING also has insurance operations, etc. It is still to me a major bank as a bank. These 5 banks control between them total assets of over $10 trillion - DB being the largest at $2.55 trillion and UBS the smallest at $1.41 trillion. They are also major players in bond issuance, investment markets, etc. I am not picking out weaklings here, this is the cream of the crop.

    The first thing I want to point out about them is that you could buy all of them today, lock stock and barrel, for $223 billion. You get $45.44 in assets for every dollar of equity capital you put up, at market. Combined they are trading for about 86% of their tangible book, with only UBS trading above tangible book value. This means their assets to tangible book aka their equity leverage level is 39.25 times. Otherwise put, their equity capital is only 2.55% of assets.

    Now, under Basel I, the current international capital standard, the bare minimum level of tangible equity is 2%. Fall below that and regulators are supposed to seize the bank. That level is pretty ridiculously low. Understand, overall capital requirements under Basel I are higher, 8% of risk adjusted assets - but two major factors allow banks operating under those old Basel I rules to run at very high leverage. First, government bonds along with cash are considered riskless under those rules, and therefore do not require any capital against them. They are effectively removed from the asset total before capital requirements are assessed. And second, most of the "capital" of the bank may take the form of long term debt securities, rather than stock equity.

    And European banking practices make heavy use of both of those items.

    The long term debt position of the five banks is $3.07 trillion, or fully 30% of all assets. Along with the thin equity cushion, long term debt plus tangible equity rise to a third of their sheet size - the other two thirds being deposits and other short term liabilities. Basically this means they are run with a view to liquidity risk only - there is not the same understanding that equity capital protecting *all* the bank's debts (long or short term) is the best protection, that we have in the states.

    The next thing to understand is that the new Basel III rules adopted by international consensus after the 2008 crisis will change all of that. Under the new rules, banks need a higher capital level, cushions on top of that, and must include sovereigns in assets that carry risk, because in fact they do. And the biggie, the new rules require that most of that capital take the form of common equity - a minimum of 6% of assets, 3 times the minimum level under Basel I.

    This means all the long-term debt capitalized European banks need to shift their capital funding to common equity, and need to do so on a large scale, as Basel III goes into effect.

    Recall that they are trading below tangible book, other than UBS. This makes raising new equity capital by selling shares distinctly unattractive. Basically it is the most expensive capital there is, for the existing shareholders, and it is the worst possible time to be selling new shares.

    So instead what they are all doing is trying to increase their capital out of earnings. And that can happen - they do have earnings, and will continue to do so as long as massive sovereign defaults don't bury them. Some have other issues on a smaller scale - Barclays legal liabilities, BNP some dodgier investments in the southern European periphery, ING both legacy business issues and regulatory oversight stemming from them. DB doesn't face those issues, it just starts from the highest level of leverage to common equity - a whopping 57 times.

    Basel III does not need to be fully in effect until 2019, but it starts phasing in by next summer. It was supposed to start phasing in by January 1, 2013, but regulators are delaying that because of the trouble they fear it may cause.

    Banks can grow their capital by retaining earnings, and without question the financial system as a whole will be safer and sounder when they are all done with the transition. But here is the thing - they won't be growing broad credit in the meantime.

    See, normally a bank leveraged 40 to 1 that grows its net worth by $10 billion through earnings, can support new loans to the amount of $400 billion off that increment to its equity capital. If instead it is only leveraged 12 to 1, it can only expand $120 billion in loans, again if it is already at the desired leverage level. But a bank now at 40 to 1 that needs to retain all the earnings it can just to drop its leverage ratio, won't expand its loans at all.

    The growth rate of overall credit, plus the rate of decline in the leverage ratio as a percentage, added together, cannot exceed the rate of change in the common equity of the banks. If they are earning 10% returns on equity, for example, they can drop to 36 to 1 in one year with no loan growth, then 32.5 to 1 the next year with no loan growth, and so on - or they can stay at the same leverage level and grow loans outstanding as fast as they earn. But they can't do both.

    Since it looks like they will be using every scrap of their earnings to reduce leverage and still will be hard pressed to make even a 2019 deadline for Basel III (recall, their common equity needs to *triple* for the same size sheet, to get there), we can safely conclude they won't be growing their sheets while that is happening.

    Even without additional losses on dodgy European sovereigns.

    The US banks, in contrast, have pretty much already made the necessary adjustments. In come cases, very painfully for common shareholders, by issuing equity even at lousy (low) prices at the bottom of the smash (e.g. Citigroup) - but they have raised their equity, their liquidity, and lowered their leverage ratios already.

    How can the EU banks avoid 7 lean years of no growth, brought on by that deleveraging? The best option I see is some form of debt for equity swaps, arranged with creditors who currently own their long term bonds, to turn their solid total capital in the old sense, into sufficient (equity) capital in the new sense. The prices on those swaps will not be great, given the current level of their share prices. But it is much better that they handle it that way, than that the entire continent suffer through 7 years in which its broad money supply stagnates. EU wide unemployment is already in double digits, and it has hit catastrophic levels, 1930s levels, in places like Spain (25%), and among the younger generation Europe-wide.

    Regulators need to understand the extreme danger of the perverse incentives they have set up and that banks are currently operating under. The sharply increased capital requirements, while desirable in themselves in the long term, are acting much like the increased reserve requirements of 1937 in the US, extinguishing money growth prematurely. All involved need to work out a way to meet the new requirements with deals with bondholders, not by grinding through a lost decade, waiting for retained earnings alone to delever the European banking system.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

    Nov 13 3:39 AM | Link | 13 Comments
  • The Real Value Of The US Money Supply

    The real value of the US money supply

    Among investors and financial commentators we see continued controversy over the Fed's current loose monetary policy of active quantitative easing. My previous post covered the financial sector deflation I see as driving the Fed's actions, which many participants in that debate seem to have missed or to be unaware has been happening. Here I want to examine the question whether the Fed adding money has simply goosed prices in response as so many claimed on theoretical grounds must be the result, or whether it has actually added value. Theory and ideology leads many participants in the debate over policy to expect that all additions to the money supply merely transfer real purchasing power from some actors to others. They then frequently indulge in extreme rhetoric against that supposedly automatic result. There is a strong belief among these observers that increasing the money supply can never actually add value, that instead it merely devalues existing money claims.

    I consider the theoretical case for those propositions to be much weaker than is generally believed. And empirically I think they are demonstrably false. In this post I want to present some of the evidence for my position, from both empirical time series and theoretical argument. I begin with the bare facts, in the form of 2 time series showing the inflation adjusted purchasing power of the US money supply, measured by M1 and by M2. The inflation adjustment is done by the CPI for all urban consumers, with everything turned into current dollars. Here are the resulting charts -

    The first thing to notice is just that the series are increasing and steadily so, particularly the broader M2 measure. This should be completely unsurprising - there is real economic growth, the real value of all assets in the US increases continually. Money is a small subset of those assets, but grows in real purchasing power along with everything else. Over the full period 1959 to now, the average growth rate of raw unadjusted M2 is 7.4% per year, of which only 4.5% is price inflation and 2.8% is real growth in total value. For M1 the raw growth rate is slower, only 6%, with 1.4% real value growth and the rest price change.

    The high portion of the total increase that reflects price changes partly justifies the common intuition that increasing the supply of money increases prices -and other things being equal, it certainly does. The underlying monetarist point that inflation is always and everywhere a monetary phenomenon has a sound basis. But the further, naive monetarist belief that all changes in money supply cause equal and opposite declines in the purchasing power of the monetary unit, is false. The higher quantity of dollars outstanding today compared to 1960 would purchase more in real value, not the same amount of real value. Each dollar exchanges for less, check, that is ongoing inflation. But the total does not exchange for the same amount, it exchanges for more. In the case of broader money including the savings forms in M2, a lot more. The total change in real M1 is more than a factor of 2, and of M2 more than a factor of 4.

    It is also worth noticing that M2 grows considerably faster than M1, and the ratio of M2 to M1 has more than doubled, itself. Less of the total value of all assets in the society are in the form of narrow money than in the past. Greater efficiency of money substitutes and clearing "support" more broad money and more total credit per unit of narrow money base. Moreover, the rate of growth of M2 is in line with total GDP and the value of all dollar assets, as measured by the top line of the household sector balance sheet in the Z.1 "flow of funds" dataset. But the growth rate of M1 is considerably less than that overall growth rate, slower by about 1.4% per year.

    The next important thing to notice about the series and especially the top, real M1 series, are the departures from trend and the changing direction of the series for some subperiods. For example, there is a real peak in December 1972 followed by a downtrend with its minimum in February of 1982. Over this period, the real value of M1 money supply fell by 24%, a decline of 3% per year. Prices were galloping along faster than narrow money. In my analysis, this reflects a declining real demand for money. In the following period, from that 1982 low to late 1993, the real value of the M1 money supply rose 73%, an increase of 4.7% per year. Prices were increasing in this period but modestly, at considerably slower rates than in the previous inflation. Narrow money grew much more rapidly than prices. Demand for money was increasing. This reflects a dramatic reversal in inflation expectations. Most investors are very familiar with that Volcker Fed success story, but many may not realize just how much narrow money supply grew over this period - without goosing prices.

    The next period to notice is that from March 2006 to August 2008. In this period the Fed was standing on the brake, keeping M1 nearly flat while increasing short rates. The real value of the narrow money supply fell by 8.3% over this stretch, a decline of 3.5% per year. Then the emergency actions of the Fed in late 2008 push real narrow money sharply higher, with both M1 increasing and prices briefly falling outright. The real value of M1 jumps by 20.5% in the space of 4 months. And it has gone on increasing since, farther overall though not as sharply as that short period.

    Now a theoretical point, one that seems so counterintuitive to monetarists that I expect its truth will be resisted stubbornly, but that I believe is justified by both the empirical data and sound theory. When the real value of the money supply increases from monetary expansion, real wealth can be and is being printed into existence by fiat. Not a mere reallocation from one holder to another. Not a mere pricing change or monetary illusion effect, but real value added.

    Why do I say that sound theory supports this conclusion, when so many textbooks and monetarist tracts, thinking of the 1970s case and others like it, assert the opposite as a supposedly necessary theoretical proposition? I answer that I am merely applying econ 101 - the revenue maximizing point on intersecting supply and demand curves may occur at a higher quantity and lower price per item - down and to the right on the usual crossing curves - and is always the result of two forces, one of them the demand curve, and not just one, the supplied quantity. When demand for anything shifts to the right, the clearing price of that item would change upward if the quantity did not move. But the quantity moving to the right instead, may very well produce a higher product for price times quantity, or total value.

    In my analysis, that is what happened on the financial crisis. The demand for money including for narrow money specifically, jumped sharply. Every sell order for every kind of risk asset was a buy order for money. The Fed met this panic safety demand by supplying the demanded item in much higher quantity, and the total value of that supplied quantity was sharply higher than previously. If they had not moved its quantity, its value would still have increased on the higher demand, in the form of higher exchange value for money, lower prices for everything else, aka a falling broad price level. But it likely increased by more, by letting its quantity move to meet the higher demand, instead.

    Some reasons monetarist theory might not expect this result, are too glib "other things being equal" handwaving, that effectively assumes that the demand for money is a constant (which I believe the top graphic proves to a demonstration it is not), or the classical economics mistake of predicting something's exchange value from its *costs*. It is certainly true that the marginal cost of a new unit of fiat money is zero, and classical economists might expect that nothing with a zero marginal cost could add real value in anything like a general equilibrium. But in the age of software we ought to know better than that - the marginal cost of an additional copy of Microsoft Office is also essentially zero, but we all recognize it can and does have a positive exchange value. The prices picked for items with very low marginal cost are determined by demand and revenue maximization points, not by their marginal cost. In all such cases there are barriers to just anyone supplying more of the item at its marginal cost, to be sure. But it is a common experience that items with zero marginal cost but in demand, have positive exchange value and supplying more of those items can and does add total value.

    So, one fundamental point - increasing the supply of money can and sometimes does simply print real value into existence. Men's demand for money is not directly inversely proportional to the quantity of it in existence. The demand curve for money is not a straight line, but curves, and also moves with time, as all other demand curves do.

    Cases like the 1972 to 1982 period show that high inflation with increasing inflation expectations can result in a declining real money supply, as prices increase faster than money, demand to hold money falls, and the incentives needed to convince men to hold nominal assets get harder to meet, in the form of higher interest rates and similar. Monetary policy can be too loose, and in such periods it is too loose, and the monetarists are right about the corrective needed in such cases. But that is not the only case that happens. When demand for money is high and increasing, it is possible to create real value by meeting that demand, by letting people hold the asset they want. When the real value of the money supply is increasing, empirically, this is what is happening, not the 1970s inflation case.

    As for the most naive monetarist expectation that the money supply "ought" to remain constant, and that any growth in the money supply simply moves value from some hands to others (unjustly, is the usual subtext), I think this analysis shows it is false empirically. Sometimes creating more money creates net value, and not just in nominal terms. It does so in the usual way, by accommodating a real demand to hold a specific item, in preference to other items. As such, as counterintuitive as it may seem, creating net new money can be a form of production that can and does add real value, as surely as moving goods from locations where they are in lower demand to others where they are wanted more urgently, adds value. Transportation does not create goods but it increases their value. Changing the form of financial claims does not increase the pool of real assets against which those claims run, but it still can increase their value, by accommodating the subjective asset preferences of all participants in the markets, more than an alternative.

    I hope this is interesting, and questions or comments are welcome.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

    Oct 02 12:29 AM | Link | 46 Comments
  • Deflation Of The Shadow Banking System

    Anyone can look at the 10 year breaking below 1.7% to set all time lows and notice that we are in a deflation, not the inflation so many predicted. The predictions stemmed from the high visibility of the sectors expanding their sheets - the Fed and the Treasury, to a lesser extent non-financial corporate business with its famously high current profits and large cash positions, which have also less visibly been adding to their total bonds outstanding. So where is the deflation?

    The short answer is domestic financial sectors. In the Fed Z.1 "Flow of Funds" data released quarterly, we can see the total debt of the US financial sector declining by $3.5 trillion since the end of 2008. This has neatly matched the expansion of the Fed's sheet and of Treasury debt outstanding, resulting in the total dollar credit line not moving at all, despite deliberately loose monetary and fiscal policies. Commentators who have paid attention to this contraction of the financial sector have gotten the basic call on the bond market direction, subdued prices and weak economic growth, correct, while anyone who missed it expected high inflation from the policy response lever-positions, not seeing the condition those levers are reacting to.

    So this is the deleveraging everyone talks about but few seem to understand in detail. OK, broad credit not moving because the financial system has not healed from the damage inflicted by the 2008 crisis (and preceding bubble), check. But where specifically has the contraction occurred? What institutions and line items are we talking about?

    The first thing to notice is that it is not the major money-center banks, nationally chartered or bank holding companies (on balance sheet). Their (direct) debt out has expanded by a little over $300 billion, from $1.4 trillion to $1.7 trillion. (All figures contrast the end of 2008 level to the last quarter of 2011, the last available full quarter of Z.1 data). The smaller savings and credit unions have cut their debt out by $270 billion over the same stretch, so this is really a size consolidation more than any growth of the functional sector.

    The next thing to notice is that it isn't the agencies, primarily, though they are a part of the story. They have taken pool assets back onto their sheets over this period, so the meaningful comparison is the sum of the line items for GSEs themselves and for GSE mortgage pools. Those combined stood at $8 trillion at the end of 2008 and a little over $7.5 trillion now. So this is part of the contraction, $500 billion or about 1/7th of the total, and reflects low mortgage origination activity, loans running off into cash, and defaults.

    The big items are, instead, ABS issuers, which is a Fed category that includes all the private mortgage pools, plus the line items for finance companies and funding corporations. Collectively these are the "shadow banking system" - the whole network of off balance sheet special purpose vehicles, loan originators and securitizers, and the funds holding the paper those institutions create. Specifically, the debts out of the ABS issuers category fall by $2.07 trillion, and of the other two combined, by another $1 trillion.

    What are the internals of those? For that we need to turn to separate releases specifically about the ABS issuers, release L.126 in Fed-speak. On their liability side, we find they retired $500 billion of their commercial paper and $1.6 trillion of their bonds. On their asset side, we see the disappearance of $900 billion in home mortgage assets in the SIV pools, another $100 billion in commercial mortgages, and $530 billion in consumer credit receivables, both CC and other consumer loans. There are smaller reductions in their other line items, like trade receivables, but those are the bulk of the changes. The finance and funding corporations similarly show large run-offs in their own commercial paper combined with asset reductions from consumer loans, car loans, small business receivables credit, and the like.

    These reductions amount to cutting the shadow banking system *in half*, since the crisis. The changes are larger than all additions to the Fed's sheet by a factor of 2, and are larger than the modest reductions in debts of the household sector, by a factor of 5 or more. The ABS market basically is no more, and its existing assets are in run-off. While the rate of decline from the evaporation of these assets and liabilities, both, has fallen since its peak rates of 2009, it remains substantial, on the order of $500 billion per year, about half of it in the ABS issuers line item alone.

    So there is the deflation. This stuff isn't coming back, but as long as it is shrinking, total credit out is not moving higher. Basically the end owners of all of these SIVs are using all available free cash flow from their run off to retire the debts that financed them in the first place. It is hard to see where serious net credit expansion can occur before this stuff has finished being cleaned up, though the headwind from its runoff is diminishing with the remaining size of the sector.

    I hope this is interesting.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

    May 30 8:43 PM | Link | 21 Comments
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