Friday, February 29, 2008

Why I'm Focused on Capital Preservation

Almost exactly one year ago, I wrote an article predicting that the CDOs on many banks balance sheets (and off of them in SIVs and other conduits) were about to implode and this was going to make for some very tough time for financial companies. Essentially, I argued that banks would find that their balance sheets were overleveraged and be forced to liquidate assets (in many cases at bargain prices) in order to meet

My suggestion at the time was to keep the powder dry, since values were bound to begin popping up, eventually and in extremely unstable markets capital preservation and liquidity were the keys to success. He who has ready cash to deploy when everyone else is running for the hills can purchase terrific assets on the cheap.

A few days ago, I read an article that basically said that my thesis (which is shared by many) is an example of the usual nattering nabobs of negativity predicting the end of the world. The article, entitled How Banks Work, by Nathan Lewis of New World Economics, basically argued that the relative strength or weakness of banks balance sheets is not the major source of financial crises; it is borrowers’ willingness and ability to borrow which matters. Moreover he selected as his example Japan 1989-2003, my favourite example of monetary deflation because it happened with a modern central bank and all of the government statistical analysis available now that was not available in 1929-1933. This had me thinking – do I have it all wrong? Is the market far more resilient than I believe (in which case, I need to rethink my tactics)?

Let’s take a more in depth look at his claims. First, the issue that banks do not stop lending because they lack lending facilities (that is, banks don’t run out of money to lend). He states:

Typically, when banks have capital impairment (losses), there is much hue and cry that lending will shrink as a result, leading to recession. This is based on a very simple multiplication: banks typically have about 10:1 leverage. Their assets (mostly loans) are typically about 10x their capital base. So, this simple line of thinking goes, if capital shrinks by 20%, then loans must also shrink by 20% to keep the ratio in line. And indeed, the BIS capital ratio requirements mandate that large banks not get too far out of line regarding these ratios.

This was essentially my argument. But he counters:

But banks don't really work like that. This is a subset of a broader group of theories, that an economy can be managed by a sort of mechanical top-down monetarist approach. … They are all based on the idea that there is some amount of "money" (or capital), and everyone jumps up and down like puppets depending on this one quantity variable. Thus, if banks have capital, then they create loans according to some sort of inevitable mechanical multiplication function, and if they don't have capital then loans shrink by the same inevitable mechanical multiplication function.

The fact of the matter is that banks have indeed been forced to reduce their balance sheets. In fact, what we discovered in this process was that banks’ balance sheets were far weaker than we had been led to believe due to large off-balance sheet obligations. That the FASB and the SEC continue to allow this is amazing. Banks have been struggling to find means of raising liquidity so that they can continue to meet obligations and make new loans. They are struggling because other banks no longer trust the value of their collateral. So, bank balance sheet weakness does indeed lead to financial instability. It leads to higher rates and tighter credit conditions, under which borrowers may no longer find it attractive to borrow.

He goes on to argue that banks have a variety of ways to raise capital, which means that they will always have adequate funding for attractive investment opportunities. He says:

[W]hat if there were lots of wonderful loan opportunities, but banks today are unable to take advantage of them because of impaired capital? Well, they could then raise some more capital, which is exactly what they are doing. "We need capital to take advantage of this wonderful situation. If you buy an equity stake in our bank, we are sure you will enjoy a wonderful return on equity." … This is also an argument behind the sovereign wealth funds' recent investments in big US banks. "Well, they're having a hard time now, but they have fantastic franchises and have proven to be very profitable in the past. We'll bet on a winning horse, and when the situation turns around and there are more lending opportunities, the bank will make good money again."

This is true, so far as it goes. I for one believe that many large banks will probably be on sale (though smaller banks that rely more heavily on specific kinds of lending will continue to suffer). But the idea that there is plenty of capital outside of the US is belied by the fact that so many global banks are suffering in this crisis. Capital is being wiped out all over the world. (IKB a small German bank that focuses on real estate lending in Germany – IKB stands for Immobilien Kredit Bank, German for Real Estate Credit Bank) has become insolvent due to its exposure.

Of course, capital can always be raised on some terms. The question is, are those terms attractive? Thus when he concludes

[L]ending is not driven by capital, rather capital is driven by opportunities in the lending business

He elides over the fact that “attractive” opportunities are partially defined by the terms upon which one can obtain financing. A project that returns 15% might be attractive, but surely it is not if financing cannot be had for less than 20%.

The point he wants to make is that it is the absence of attractive opportunities that lead to a collapse of borrowing. Without borrowing banks lose out on two major income streams: interest margins and origination fees. He details how this happened in Japan. A collapse in asset prices led to a lack of interest in borrowing and indeed to a general monetary deflation in which aggregate demand failed to match the existing supply capacity in the economy.

Since monetary deflation makes borrowed money extremely expensive and since capacity was already sufficient to meet demand, there was no incentive to borrow. (Actually, operating cash flow is the normal source of investment income under monetary deflation, which is on reason why IT firms tend to hoard cash and not borrow. This is the world they face every day). Even interest rates near zero were insufficient. But this BEGS the question he doesn’t ask: how are banks approaching lending opportunities today?

The answer is not reassuring.

Banks are calling in and reducing all sorts of outstanding financing arrangements, particularly if those arrangements are linked to real estate. There are several examples. This means that many borrowers who have been using home equity as a crutch to maintain spending levels and lifestyle will find fewer options to do so. This suggests that aggregate demand will drop and as that happens, many firms will find that investing is simply unnecessary. Instead the focus will actually be on reducing financial and operating leverage so that supply can be matched to demand. Doing so takes time, so in the short run output is likely to exceed demand and prices will have to fall to clear the market. Monetary deflation is likely to result. Yes, I know that central banks and governments are falling all over themselves to create inflation, but I return to the BoJ and its experience in Japan. Low rates do not guarantee attractive terms.

Why will banks do this? Contrary to Mr Lewis’ thesis, banks do not like to float new capital, even if they can. They much prefer increasing the balance sheet through retained earnings. Having to tap the general markets or strategic investors like sovereign wealth funds, is expensive. Those investors are in a position to demand high returns on their capital. It is the benefit of having capital to offer when no one else does. Beggars cannot be choosers.

This is why my approach has been, and continues to be, to keep cash on hand and scour the markets for attractive opportunities. They need not be stocks. I am myself looking at a few possibilities in common stocks (more on this in anther post). Because of some decisions that I made in 2006, I am not looking at real estate right now, but I will be before long. I see this market as a real buying opportunity – but only for selective purchases.

Mr Lewis is making an argument against a massive federal bank bailout. I support his thesis: banks and investors cannot go to the casino and then only keep the winning bets. They pocketed the fees and got the dividends and the buybacks. Why should taxpayers share the burden (unless the financial system becomes so ossified that the payment system breaks down. This is not impossible. In such a case, taxpayers should be glad to pay the price to prevent the complete implosion of credit markets). But he supposes that the markets and the pundits are being too pessimistic (and that the banks, looking for the losing bet insurance, are the source). Credit markets are indeed becoming much tighter, however, and this means that it is wrong to assume that investors aren’t being rational in their perception of heightened risk.

This credit cycle is going to produce a great deal of pain. No one knows exactly how it will turn out. We have never had so many alternative financial products with various risk profiles as we have today. The models aren’t working, so irrationality is coming to the fore. I continue to maintain large cash balances – and believe me it is no fun earning peanuts on those balances. But I am willing to be patient and selective and purchase from Mr Market those assets about which he is unnecessarily pessimistic.

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