By Kelpie Capital

For me, one of the largest red flags in the market has been the continued poor health of the Financials. The reason, of course, is that they are struggling to shrink their balance sheets, “extend and pretend” on their loan books and earn their way out of impending Japanization. I’m not sure where I got this little piece of wisdom from (and if you can prove it wrong please let me know); There has never been a bull market in history that hasn’t been lead by financial stocks. A sobering thought.

Banks are, despite all their crimes, still the veins and arteries that pump credit around the body of the economy which acts as a lifeblood to economic activity.

It seems easy to say as someone who entered the industry in 2008 but I can’t understand why people want to bother with financials. Buffett says he puts Technology stocks in the “Too Hard Pile”, well given that banking is no longer a “3-6-3” Game (take deposits at 3%, lend at 6%, be on the Golf Course by 3pm), I think banks fall into that pile for me. I like businesses I can understand, it’s not even possible that the CEOs understand all that goes on within these large banks.

They are so incredibly complex and their balance sheets so huge and opaque that they are completely impossible to analyse. RBS at one stage had a balance sheet larger than the entire UK economy, talk about too big to fail! I also find the economics entirely underwhelming – let’s say a bank can achieve an ROE of 15%, which is in excess of where most banks are currently aiming for. Is that so impressive when you consider that they are leveraged somewhere between 10 and 50x!? That means their unlevered return is only 1.5% at most.

It is my personal opinion that banks on the whole are run not for shareholders or even for clients, but instead for employees. Banker remuneration is a much maligned topic but it’s perhaps most succinctly described by the old Wall Street book “Where Are the Customers Yachts?” I’d rather own businesses where my interests were better aligned with the staff.

Balance Sheets

The obsession with complicated ratios and “Stress Tests”! The most recent set of European Stress Tests modelled how banks would react in negative tail risk scenarios, however it failed to envision even the possibility of a Sovereign Default, that was deemed too stressful to be a reasonable assumption. This shows how fast things have deteriorated and how “Unstressful” Stress Tests are pointless. The other closely watched number is “Tier One Capital Ratio” – I barely understand what this even is despite my modicum of financial knowledge; what I DO know is that it doesn’t matter! Barclays, for example, are quite proud of their strong balance sheet and 11% Tier One Capital Ratio. Dexia had a Tier One Capital Ratio of 12% when it went bust last month. Go Figure! These figures mean nothing when nobody understands the assets on the balance sheet.

Banks have a nasty habit too – they are consistently profitable on the income statement, not that hard since all they have to do is borrow short from depositors and lend longer to businesses and mortgages. But unfortunately, these profits tend to lend to hubris at peaks in the business cycle which lead to an almost inevitable, although seldom as spectacular as 2008, blow up on the balance sheet. Some of their loan assets fail to be paid down and some of their bull market investments are shown to have been folly. There is a strong pattern of this repeating, profitable on the income statement and then a balance sheet blow up.

 

What Price Extreme Uncertainty?

In the current climate banks are a speculation on future economic, legal and political action or inaction. At the weekend, banks were forced to take a “voluntary” 50% haircut on their Greek Debt holdings (politely termedPrivate Sector Involvement!) so that it didn’t classify as a Credit Event to trigger CDS payouts. See video below for a reality check on the nonsense of this latest stop gap….

http://www.valuewalk.com/videos-with-text-summary/european-bailout-explained/?utm_source=feedburner&utm_medium=email&utm_campaign=Feed%3A+valuewalk%2FtNbc+%28Value+Walk%29

The problem with this latest sticking plaster for the EuroZone is that it will have multiple unintended consequences, which most likely won’t become apparent until they smack us in the face. If CDS payouts can now be adroitly circumvented at a political whim then what is the point of the market existing? We only buy insurance so that it pays out when the house burns down – what point if the contract is voided as you stand amongst the ashes?! There is a $62.2 TRILLION (read it twice to check!!) market in notional CDS globally. This is larger than the cumulative economic output of Planet Earth in any one year – there is now a huge question mark over the viability of this entire product.

1)     Many CDS are used for legitimate hedging purposes rather than speculation. These legitimate corporate/pension/endowment hedgers will now be very fearful for their exposures – this will kill any animal spirits or willingness to take risk/proactive business decisions.

 

2)     Remember all those banks and insurance companies who have been falling over themselves to tell investors and the press how they have “slashed European Sovereign Exposure”? Well….what’s the fastest way to do that? You certainly couldn’t liquidate all those bonds because there aren’t any buyers! You just bought CDS on the bonds and you’ll be fine in the “unlikely outcome that there is a credit event”. Uhoh, seems the Euro Leaders have decided that CDS “speculators” don’t deserve to be made whole despite them paying up front for a legally binding, arms length insurance contract between consenting parties. This means that all those banks who thought they had hedged their “Euro Problem” are infact just as naked and long as they were before.

As Ben Davies of Hinde Capital termed it, the EFSF has become the “European FUBAR Slush Fund”. (If you don’t know what FUBAR means then google it!)

 

Earnings Hocus Pocus

Banks have been reporting earnings this last week or so and there is a worrying trend. Circa 100% of earnings reported by Morgan Stanley and UBS and a further 60% of earnings reported by Barclays can be attributed to something which I would politely term an accounting “finesse”. Banks have embraced the option to use these so-called “Credit Valuation Adjustments” for the past 4 years, under the Financial Accounting Standards Board’s FAS 159 rule.

See below a few choice quotes from people far more insightful than I on the subject, plus my 2 cents where I feel it might add something….

“It’s worth observing that a number of banks reported positive “earnings surprises” last week. If you look at those results for any of the major banks, it is immediately clear that the bulk of the earnings were of two sources: further reductions in reserves against potential loan losses, and an accounting gain known as a “Credit Valuation Adjustment.” Those two items, for example, were responsible for nearly 90% of Citigroup’s reported “earnings.” The Credit Valuation Adjustment (CVA) works like this: as the bond market has become more concerned about new financial strains, the bonds of U.S. banks have sold off significantly in order to reflect higher default probabilities. Under U.S. accounting

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