Thursday, February 18, 2010

Bill Miller on Financial Reform

This letter entertained me (Bill Miller's April 2009 market letter):
In addition to the well-deserved shots at Frank, Dodd, Shelby, Stiglitz and Krugman, it also outlines a) the appropriate goals of financial reform and b) why government regulatory oversight is going to have a lot of trouble improving the banking system over what it currently is. My favorite excerpts below:
"I believe policy with regard to banks remains the greatest risk to market confidence and stability, and therefore to economic recovery. Until the late fall of last year, most efforts to deal with the crisis served only to accelerate it, destroying confidence instead of enhancing it. Think of the pre-emptive seizure of the government sponsored enterprises (GSEs) with the attendant wipeout not only of common shareholders but also the completely gratuitous evisceration of preferred holders. By prohibiting the payment of dividends to preferred holders, the government managed to blow a further hole in the banking system's capital (Fannie and Freddie preferreds counted as Tier 1 capital for banks) and at the same time, to shut down the market for capital raising via the issuance of preferred stock, which had previously been an important vehicle for private capital to invest in banks. The decision to let Lehman fail has been widely derided as a complete disaster...

Policy has improved since then, as it became clear to at least some authorities that policies that wipe out private capital (in obeisance to some idea about moral hazard or some other equally inane supposition) and are punitive to investors in financial institutions are hardly likely to lead private capital to invest in those institutions, which is the stated objective of the policies: to restore confidence so that private capital can do the investing, and not have the government putting taxpayer money at risk.

There are a few who have been voices of reason during this crisis, people who understand how the banking system works and how confidence can be restored. These include Ricardo Caballero, head of the economics department at MIT, Bill Isaac, former head of the FDIC, hedge fund manager Tom Brown, veteran bank analyst Dick Bove, Anatole Kaletsky of GaveKal Research, Eddie Lampert of ESL Investments (and controlling shareholder of Sears), and as usual, Warren Buffett, who in a recent interview pointed out the intellectual vacuity of the favorite new ratio the bears are using to beat up on banks, the tangible common equity ratio. These voices of reason appear, though, to be in the distinct minority, as the other side commands the likes of Nobel Laureates Paul Krugman and Joseph Stiglitz, politicians Barney Frank and Christopher Dodd on the left, George Will and Senator Richard Shelby on the right, most sell side bank analysts, Tom Friedman and a plethora of political and economic commentators in the U.S. and abroad...

...Banks are, broadly speaking, in the business of collecting liquid short-term assets in the form of deposits and turning them into illiquid long-term assets in the form of loans. Not only do they take our liquid assets and make them illiquid (they do retain enough liquidity to meet anticipated demands from depositors for cash), they create many more loans than they have capital to support if too many of the loans go bad. This leverage is about 10 to 1. Since the assets are 10x the capital supporting them, it doesn't take more than third-grade arithmetic to conclude that if the value of the assets they hold fall more than 10 percent on average, they are "insolvent" (the quotation marks are there because the whole argument of those who support some kind of nationalization turns on confusing the different predicate logics of the single term "insolvent")...

The notion of insolvency, as typically understood, means you don't have the wherewithal to meet your obligations as they come due. But that is certainly not the case with the banking system as a whole, or with any major bank. Banks, in fact, are flush with cash, have deposits flowing in, and have $800 billion of EXCESS reserves on deposit at the Fed. Most of the big banks that have reported results recently are profitable... Not surprisingly, the same analysts who expected the banks to report losses in the first quarter dismiss the earnings as due to nonrecurring items, unusual market conditions (very wide spreads) and accounting gains. Of course, when those same conditions led to large losses being reported last year, those losses were considered all too real.

Remarkably, those who so worried about the financial condition of banks have decided that accounting conventions should trump economic reality. Accounting conventions seek to present the financial condition of businesses — they are not themselves that condition. The underlying financial condition of banks depends on confidence and cash flows. The cash flows are robust, the system has record liquidity; it is clear thinking about the accounting that is wanting.

Consider the issue of mark-to-market accounting, which has been the subject of so much controversy. Supporters say it serves the goal of transparency and helps illuminate the true financial condition of the enterprise. Opponents say it does no such thing, just the opposite, in fact, confusing market prices with underlying values, and injecting needless volatility and confusion into bank financial statements.

The irony is that we have been here before: the same arguments were made in the 1930s when for most of the decade banks marked assets to market. As asset values fell, depositors fled, banks collapsed, and the depression wore on. In July 1938, the Federal Reserve bulletin announced that mark-to-market accounting was being suspended, and that bank assets should be valued on long-term safety and soundness, and not daily price fluctuations. That was also the time the uptick rule was instituted to slow down short selling. Coincidence or not, those two policy measures coincided with the end of the vicious bear market of 1937 and 1938. It is eerie how the relaxation of mark-to-market accounting rules a few weeks ago and the announcement that some form of uptick rule would be reinstituted also coincided with the bottom of this bear market. Policies and rules matter.

A couple of other points on mark-to-market: Showing market values, or estimated market values, for assets is a good thing. But requiring bank capital ratios to be adjusted accordingly is not. Leaving aside the current controversy, consider that whenever we have another asset bubble and irrational exuberance returns, banks will have to mark up their assets, no matter how absurdly overpriced they are. It is also telling that the bears appear to want only those assets that can be marked down marked to market. None are calling for buildings built years or decades ago whose value is far in excess of carrying value (as was the Bear Stearns headquarters  building) to be marked up. And none has ever been heard to call for the deposit bases of major banks to be marked to market, which would generate billions of excess capital for those banks if the deposit franchises were carried at market... [Trevor's input for readers who don't breathe banking systems, if they're actually reading this: if you think leverage was ridiculous now, that'll just make things a billion times worse, because you could LEND AGAINST that stuff]

The major design flaw [with government stress testing] comes in that the government has indicated that banks that are currently well capitalized will be required to raise even more capital just in case things get a lot worse, to provide an additional cushion, as the saying goes. This pre-emptive capital raise is exactly backward. It ought to be the case that if things get a lot worse, and banks' capital ratios fall enough, then they will have to raise additional capital. If they cannot do so privately, then the government will need to put more capital in, diluting, perhaps substantially, existing holders. But pre-emptive dilution is the first cousin of pre-emptive seizure, which was so disastrous with the GSEs.

There is another, broader point: here again policy is backward. Capital should be raised in good times and drawn down in bad times. To require capital to be raised pre-emptively creates perverse incentives that work against policy goals. The easiest way to raise capital is not to lend, and to force borrowers to repay when loans come due. Assets decline and capital ratios improve, and we are all a lot worse off as the economy sinks because credit is not available. Keynes made this point in the 1930s: Actions that seem individually rational can be collectively irrational.

It has been reported that the stress tests will also look to see if the banks have the "right" kind of capital, which is taken to mean tangible common equity. This new requirement is conceptually incoherent, despite its now being adopted as the gold standard of capital by sell side analysts and hedge funds who are short. They appear to have persuaded regulators it is important. It is idiotic. The argument is being made that tangible equity is the first line of defense against losses. Other equity, like the preferred equity the government got for TARP (Troubled Assets Relief Program) money, is somehow not as good. But equity is equity. The cash the government exchanged for preferred stock could have been exchanged for common equity, but the government wanted taxpayers to be in senior position to the common shareholder, which seemed sensible then, and still seems so now.

Now, it is being argued that preferred equity should be converted to common, as this will be somehow "better." No one seems to have noticed that no new capital is being created by moving from preferred to common; the equity has just been rearranged (dividends saved do create capital, but only later). It is impossible to understand what economic or political benefit the government gains by moving from a senior to a subordinate position in the capital structure, forgoing substantial dividends in the process. No new equity is created; accounting typology trumps economic reality...

Warren Buffett noted recently that he never looks at tangible common equity in assessing banks' financial strength (and neither should regulators). As he noted, Coca Cola has very little tangible common equity yet is highly profitable and financially strong. You don't make money on tangible common equity, he said, you make it on the difference between your cost of funds and the return on your assets net of credit losses. Losses can be absorbed at banks through loan loss reserves, and through all forms of capital, not just tangible common equity. That is why regulators settled on Tier 1 capital, core capital, and leverage as the way to assess banks, and not tangible common equity. Sound policy would do the same. Changing the rules in ways that make banks seem weaker than they are, or requiring them to raise capital when they do not need to do so, is bad policy and is destructive of confidence."

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