If You’re So Rich Why Aren’t You Smart?

The FDIC recently reported that bank profits were at the highest level since 2007 in its latest quarterly profile.  [BizJ] [FDIC link]

“FDIC-insured commercial banks and savings institutions reported $35.3 billion in net income for first quarter 2012. This represents a $6.6 billion (22.9 percent) improvement over first quarter 2011 results, and is the highest quarterly net income reported by the industry since second quarter 2007. The average return on assets (ROA) rose above the 1 percent threshold for only the second time since second quarter 2007 (third quarter 2011 ROA was 1.03 percent). Quarterly net income has now improved year over year for 11 consecutive quarters. More than two-thirds of all institutions (67.5 percent) reported year-over-year improvement in their quarterly earnings, and only 10.3 percent were unprofitable, the lowest level since second quarter 2007.” [FDIC]

The investment banking sector doesn’t seem to be doing too badly either, as the following two charts from the Wall Street Journal would indicate.

There’s even happy news in the mergers and acquisitions for middle-markets:

“The market for Mergers & Acquisitions (M&A) is clearly improving in valuations, financing availability, and deal volume and will continue to do so throughout 2012 according to a survey conducted by MBA students and Professor Kevin J. Mulvaney at Babson College in collaboration with members of The Association for Corporate Growth and Exit Planning Exchange.

Looming clouds on the horizon may include variations in the capital gains rate, estate changes, and uncertainty about economic growth and the effect of world events on the global economy. This is the 4th year of the Babson survey which has delivered “extremely accurate” projections in its previous years said Mulvaney.

Findings That Impact Business Owners
The environment for exit continues to improve. Valuations are rising and are projected to continue to rise. The market to sell a business or restructure capital is very good. Key is getting the company’s revenue growth and EBITDA (earnings before interest, taxes, depreciation, and amortization) to acceptable standards vs. the industry average and the expectations of the buyer.”  [PRNewswire]

Note that one of the things that troubles the people engaging in the M&A trade is how much they might have to pay in capital gains taxes — let’s be clear — you don’t worry about capital gains taxation levels unless you stand to earn beaucoup bucks in investment banking.

So, if the commercial banks are experiencing the best profits since things on Wall Street started to unravel in 2007, and the mergers and acquisitions are doing nicely thank you very much — then why have the Financialists been so far behind the curve?

We’re learning more about the debacle at JPMorganChase, enough to know that their $2 billion and climbing blunder stemmed from a failure to learn some of the lessons of 2007.  One lesson unlearned appears to be that price doesn’t always equate to value, and all the accounting treatments in the world won’t help you if one unit isn’t sharing accurate information with the others.  To wit:

The JPMorgan Chase & Co. (JPM) unit responsible for at least $2 billion in losses on credit derivatives was valuing some of its trades at prices that differed from those of its investment bank, according to people familiar with the matter. [Bloomberg]

Recall, if you will, it was not so long ago the CEO of JPMorganChase, Jamie Dimon, was moaning loudly about the capital requirements under new regulatory regimes.   In September 2011, Dimon “exploded” during an IMF conference about “growth killing capital requirements.”  [BusInsider] This wasn’t Dimon’s first confrontation.  He questioned Federal Reserve Chairman Bernanke about capital requirements in June 2011:

“The substantive issue that seems to be bothering Dimon is capital requirements, and particularly the news that the Fed is leaning toward making large banks, such as JPMorgan, hold a 3 percent capital “surcharge” (a complete misnomer; the requirement for more equity financing relative to debt would be a buffer against losses, and not a tax.)”  [Bloomberg]

Lo and behold — what would have prevented the Balaenoptera musculus* sized losses at JPMorganChase?   Reliance on larger capital reserves against risks.

“Those bets, which led to $2 billion of losses, wouldn’t have been necessary if JPMorgan did what banks once did: rely on bigger capital buffers rather than credit-default swaps to hedge against souring loans. One hundred years ago the equity of U.S. lenders was about 20 percent of total assets, compared with 9 percent now, according to data compiled by the Federal Reserve. For JPMorgan, it was 7 percent last quarter.”  [Bloomberg]

One finance professor summed up the problem: “Only equity capital is the true protection against losses, whether from loans or other risks,” said Admati, who has written about bank capital. “Dimon and other bank CEOs lobby against rules that would force them to reduce leverage. Then they try to hide risks through derivatives that offer more ways to borrow and speculate.” [Bloomberg] (emphasis added)

Quick translation: Dimon and other bankers are lobbying against rules that would require their banks to maintain more capital reserves, and rely less on borrowing.  Instead, they played in the Wall Street Casino hoping to cover potential losses in ways that would generate more revenue.  It didn’t work.   All it took was one London Whale to create a multiple billion dollar mess.

All the king’s Quants and all the king’s computer models couldn’t accurately value the risk JPMorgan was taking and without an accurate account of the risk, and without adequate capital reserves which would have obviated the need for the swaps dealing, the London Whale sank the bank to the tune of at least a tidy $2 billion.  There’s nothing like a little obscurity to enhance the chances of exotic deals blowing up.

“The source of JPMorgan’s problems is an obscure group of indexes that track the performance of corporate bonds. One of the indexes, the Markit CDX NA IG Series 9 maturing in 2017, is essentially a portfolio of credit default swaps – basically contracts that protect against default by a borrower.  This particular index is tied to the credit quality of 121 North American investment-grade bond issuers, including such names as Kraft Foods and Wal-Mart Stores .  JPMorgan used that index, and others, to bet that credit markets would strengthen. Because that position is widely known on Wall Street, many traders are betting the opposite way in the hope of profiting as the bank’s losses increase. The index has been moving against JPMorgan in recent days.”  [Guardian]

Surprise?  If memory serves it was trading in exotic swaps that got several large financial institutions on Wall St. in a bit of trouble in 2008?  And, why were they trading in exotic swaps until their wasn’t a single stand-alone investment bank left on Wall Street?  Because they chose to hedge possible losses with swaps rather than maintaining higher capital reserves.

The merger & acquisition crowd may moan to the moon that such things as increased capital requirements are “growth killing,” BUT what really kills growth are investment banking practices which reward engaging in swaps dealing rather than more conservative practices like keep the piggy bank sufficiently filled to hedge against potential sour deals.   Additionally, if we want another look at what’s really “growth killing” all we need is another Wall Street investment banking fiasco generated by banks that aren’t accurately calculating their risks and aren’t doing such a hot job of hedging them either.

In short, if they’re so rich — why aren’t they smart?

*Blue Whale

Word Salad Shooting At The Volcker Rule

The Big Banks don’t like the Volcker Rule.   For reference, and so we’re all talking about the real thing, here’s the little culprit: The Volcker Rule “separates investment banking, private equity and proprietary trading (hedge fund) sections of financial institutions from their consumer lending arms. Banks are not allowed to simultaneously enter into an advisory and creditor role with clients, such as with private equity firms. The Volcker rule aims to minimize conflicts of interest between banks and their clients through separating the various types of business practices financial institutions engage in.”  [investopedia]

Prepping

We can simplify this further.  A bank, insured by the FDIC, may not combine their proprietary trading activities with their consumer lending ones.   And, why do we need the Volcker Rule?

“The Volcker Rule seeks to keep activities essential to banking within a safety net, while excluding other, riskier, activities from this safety net. There are a variety of special regulations, and protections, banks get, ranging from federal deposit insurance (known as FDIC) to access to the Federal Reserve’s discount borrowing window, designed to keep the system working through panics. Banks currently engage in a wide variety of non-banking activities with safety net protection. For example, they speculate in currencies and run hedge funds and proprietary trading desks for their own benefit. These activities made the financial crisis worse; one estimate has the major Wall Street firms suffering $230 billion dollars in prop trading losses a year into the crisis. And right now, these activities are subsidized by access to the banking safety net.”  [Nation]

So, the message to the Big Banks is relatively clear:  Your consumer lending activities on behalf of your clients are covered by the “safety net” (FDIC coverage or access to the Fed’s discount window) BUT your hedge funds and proprietary trading desks aren’t.

Slicing and Dicing

Opponents of the implementation of the Volcker Rule make some basic points, all of which deserve more scrutiny.  (1) They argue that the rule making process is creating “uncertainty” because we don’t know what the final rules will be.  The word “tautology” comes to mind because this argument circles back on itself nicely, as in ‘ we can’t make rules because while we’re drafting the rules we don’t know what the rules are.’  If we applied this argument to any other phase of life there would never have been any rules.

Here is an example of the tautological thinking:

“Since neither the banks nor the regulators have any idea what the final regulations will say, they will have no idea what constitutes good faith efforts to comply. Because of the continuing confusion and its effects on the financial system, Congress should immediately begin a serious re-examination of the Volcker Rule’s likely effect both in this country and abroad and repeal it as quickly as possible.”  [Heritage]

Why bother to “seriously re-examine” the rule if the initial purpose is to quickly repeal it?  Imagine for a moment waiting for Moses to return from the mountain.  If our moral judgments aligned with the Uncertainty Proponents we’d not necessarily know that we shouldn’t dispatch each other because we’d have to know in advance if the Almighty intended to incorporate justifiable homicides or excusable homicides, manslaughters or negligent homicides, within the proscription of killing each other — and, further, we couldn’t have a Rule until all of these nuances had been properly phrased and found to be acceptable to all the stakeholders.

(2) A more cogent argument against devising regulations pertaining to the Volcker Rule asks:  How do specific short term banking services apply to the separation of traditional banking and modern client services?   At this point we get into the “liquidity” swamp.

Suppose the executives of SlamBang Corp. want to purchase some stocks for the purpose of generating some revenue for the firm by going to its banker and asking the bank to make the purchase, hold on to the stocks, and if the price of the stocks goes up then selling the stocks, and returning the proceeds of the sale to the SlamBang Corp?  (Less, of course, the fees, commissions, etc. for the bank)  Would this be a violation of the Volcker Rule?

Now we’ve waded into the edges of the Liquidity Swamp, liquidity being “The degree to which an asset or security can be bought or sold in the market without affecting the asset’s price. Liquidity is characterized by a high level of trading activity. Assets that can be easily bought or sold are known as liquid assets.”   And, our next step takes us into “leverage.”

Leverage means the extent to which a company is operating on borrowed money.   The good news is that if the company isn’t too far in debt it will be financially stable and lenders will want to make loans to it for a variety of very legitimate purposes.  The bad news is that if it’s as underwater as a Sand State homeowner with a NINJA loan it will be bankrupt, and no one will want to lend the corporation another nickel.  (Think Lehman Brothers)

Life can get messy if and when the SlamBang Corp. gets its revenue from making something tangible AND from making speculative bets in the equities markets — with borrowed money (like asking the bank to hold on to the “stuff” it bought until the price goes up.)  The more the SlamBang Corp. is leveraged — borrowing money to make money — the riskier the entire proposition.  Where will our SlamBang Corp. go to borrow more money to make more money?

Bankers, having set up sizable trading desks, or having once been one big trading desk (Goldman Sachs), were only too happy to transform themselves into bank holding companies for the benefit of their very own social safety net (FDIC coverage, Fed Discount Window, etc.) when they were collapsing like Macy’s Thanksgiving Day Parade balloons in a shooting gallery — now that they have returned to profitability they aren’t the least bit interested in returning to “core banking activities,” and divesting themselves of the revenue generating proprietary trading functions.

Re-enter the financial officers of the SlamBang Corp.  into the lobby of the Big Bank.  Under the terms of the Volcker Rule the Big Bank may not act BOTH as their adviser AND their creditor.  What Big Bank fears at this point is that SlamBang Inc. will take its “speculation in liquid assets for the purpose of leveraging its position” elsewhere, to a private equity or hedge fund for example.

It’s important to notice at this point that SlamBang Corp. isn’t hurt by the Rule, it can easily send its business to an alternative source of credit or financial services — it’s the Big Bank that wants a fork in every plate on the table.    Advocates of Big Bank say:

“The situation becomes even more confused if the bank serves as a “market maker” for a security. A market maker plays a vital role in ensuring the efficient running of financial markets by both buying and selling that security so that others can be assured of buying and selling opportunities, an activity that requires the bank to own a certain inventory of the security.” [Heritage]

Translation:   Banks are now market-makers and market-makers have to own securities in order to be market-makers.   The problem for our economic system is that when the “markets” are made by the banks, and those “markets” are extraordinarily speculative, AND the Big Banks expect the FDIC or the Fed to rescue them if the speculation goes south — then how best can we sustain the traditional functions of our financial sector in a capitalist system without allowing the Big Banks to put us all in jeopardy?

The Volcker Rule.