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future valuations of too-big-to-fail banks


ERICOPOLY
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The Basel III requirements for BAC (and others) are such that it will be nearly impossible to blow it up in the future.  Lower mix of risky assets coupled with massive Tier 1 capital levels more than 2x what was previously required.

 

Future financial panics will just never be the same (unless they loosen the requirements again).

 

The markets valued BAC at 10x earnings in the past -- and in those days the balance sheet was far riskier.  Tier 1 capital requirements have more than doubled, and you have those risk weighting deductions for some types of assets.

 

Adjusted for risk, shouldn't it trade at a richer valuation in the future?  Maybe 12x or 13x?

 

These banks will be viewed as extremely conservative.  A financial panic hasn't yet come along that could wipe out a bank with such a structure.

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Eric, what's the % of your portfolio invested in Big US Banks?

 

BeerBaron

 

Downside -> 40% of notional.  Upside is twice that -- hedged though.  I have $5 strike BAC puts for example.  I wrote puts on other companies to finance the BAC puts.  Some of my BAC is unhedged, but I wanted to make that upside exposure bigger so I did, but then spread the downside risk around.

 

Here's a funny fact.  So far here are BofA's losses to common shareholders:

2008 earned $2.5b

2009 lost $2.2b  (but they paid about $7b in preferred interest costs to the government)

2010 lost $3.6b

2011 lost $3b (estimated)

 

That's a cumulative loss across this entire crisis of only $4.3b if you exclude the government's loan.

 

Imagine, all this real estate collapse and only $4.3b loss without the government's "help".  True, they will take more losses in the future but it's manageable against the earnings.

 

Without the bailout: $4.3b loss.

With the bailout:  $11.3b loss

 

Then regulators panicked and made them dilute the crap out of shareholders.  That's where the real losses came from.

 

Next time around, they'll be carrying around all that extra capital so it won't come to that.

 

(yes I realize that's just the reported "realized" losses, and GAAP ones at that... but spreading losses over several years is just fine with me.  They're still losses and get taken eventually).

 

 

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Isn't it fair to say that the US government has bailed them out by a whole lot more than that, at the expense of many others in the ecosystem, by things like QE1, QE2, operation twist, etc. keeping interest rates so dead-low?

 

You borrow at x and lend at y.

 

The Fed is desperately trying to drive Y into the ground.  Currently the spread between x and y is tight.

 

That's bad for business.

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Maybe, but those valuations represented a severe underestimation of balance sheet risks pre-2007, as well as an underestimation of the potential volatility of collateral. We'll see what happens in a few years when regulators lift their MOUs and the banks can attract the cash flow fetishists and the yield pigs. It's tough to be sanguine about future volatility of asset prices with current interest rates and possible exchange rate craziness.

 

 

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why higher x? I think big banks will become more like utility companies in the future?

 

I was just figuring that if long term returns in the stock market are going to be 7%, then it seems odd for banks to be priced for 10% returns if so much of the risk to common shareholders has been mitigated by these Basel III rules.

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Another thing to consider about Basel III is that it rewards "checklist" motivated capital allocation, as seen with EZ banking allocation to sovereign bonds. There might be a period of market complacency resulting in more generous valuations even as the removal of market handcuffs weakens balance sheets. It's fairer to say that it's unlikely that banks will collapse for the same reasons they collapsed in '08.

 

I'm overweighted on financials and insurance but there are only a handful of banks that I would feel comfortable holding to a 1.25 book premium.

 

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Keep in mind that Basel III is in the pipe & that it will require capital against operational risks. Most would also suggest that there may well be a Basel IV taking capital for credit risk, & possibly a Basel V laying out the composition of the capital cushion against a VaR model breakdown. In short, significant & material additional capital requirements for at least the next 10 yrs, & widespread industry consolidation.

 

Once its done - global banks will be super stable, their back-office operations systems will be state-of-the-art, & they will all have material incentive to keep their systems current (no legacy systems). Profitability may modestly improve but the return on capital will be rock-bottom. To get there ..... the banks will need to overcome years of underinvestment at the same time they need to put up additional capital. Significant & material dilution risk.

 

Long term you might be willing to pay a higher multiple, but only on much lower earnings. If you did it today, you'd also discount by maybe 50% in anticipation of future dilution over the next 10 yrs or so. Put bluntly you're paying for brand name - not the earnings.

 

Not the conventional wisdom ....

 

Numbers example: Assume you have a $3000 portfolio, BAC is $5, you compound at 15%, have a 10yr horizon, & on average you weight 33% of your portfolio to banks. As the portfolio doubles every 5yrs, your $1000 allocation should be $4000 at the end of yr 10. Of the expected $4000, you might invest just 15% ($600) in BAC today, & the remaining $3400 over the next 10 yrs as dilution presents itself.

 

SD

 

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Banks in a fractional reserve system will never be stable over the long run.  Those banks, by definition, are designed to push the envelope of credit expansion.  They have ALWAYS gamed every regulation that has been put in front of them.  And after reforms, people have always declared that banks will be forever stable and a financial crisis won't happen again.  It's the nature of the industry and always has been since someone figured out that they can put more notes into circulation than the amount of gold they had on hand.

 

Even arguably the best bank in the US (WFC) has taken it on the chin twice in 20 years.  Almost every major US commercial bank was insolvent during the LDC crisis according to the Federal Reserve. 

 

So the evidence is that every 10-20 years, even the best banks are basically blowing up in one way or another.  And it has always been that way. 

 

The only way to play them seems to be buying the most capitalized banks during a crisis and exiting your investment during peak credit expansion. 

 

In short, pessimism is high for the banking system right now and people project that pessimism into the future.  But, eventually, people will be optimistic again and project optimism into the future.  That includes not only valuation projections but also regulatory perceptions.  So everyone can claim all these new regulations are going to make banks ultra-stable, push down valuations, etc.  But my view is that's a load of bull.

 

Once the music starts playing again, bankers, regulators and Congress are going to start dancing again.  They ALWAYS do.  Just be sure to exit before the music stops again.

 

 

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On the issue of gaming the system, I recently watched the movie "Inside job". The SEC under pressure from Hank Paulson (GS CEO) to allow increase of leverage, convened the board meeting. One member said, "we asked the industry what the appropriate leverage should be", another commenting, "these are sophisticated investors.." and unanimously approved the leverage limit increase.

 

It is like jailers getting the help of inmates to design the security system. The fact of the matter is that the wall street owns the government. we are yet to see the fallout and the political ramifications. I see a slow backlash brewing, it may amount to nothing too. We would know the outcome in a decade or two.

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Even arguably the best bank in the US (WFC) has taken it on the chin twice in 20 years.  Almost every major US commercial bank was insolvent during the LDC crisis according to the Federal Reserve. 

 

So the evidence is that every 10-20 years, even the best banks are basically blowing up in one way or another.  And it has always been that way. 

 

In 2007 BAC had a Tier 1 common ratio of 3.5%, under Basel 1.

 

Today it's 9.17% (reported), and it will become 9+% under Basel III rules over the coming years.

 

Going from 3.5% to zero will be like going from 9% to 6.5%.  And that 6.5% would still be considered grossly overcapitalized by 2007 standards.

 

You probably need to roughly triple the severity of the crisis to completely wipe out the Tier 1 common.

 

WFC will reportedly be required to hold 8% under Basel III.  These crises of the past 30 years simply aren't crises anymore for these banks when they hold that much capital.  They're more like minor headaches.

 

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Even arguably the best bank in the US (WFC) has taken it on the chin twice in 20 years.  Almost every major US commercial bank was insolvent during the LDC crisis according to the Federal Reserve. 

 

So the evidence is that every 10-20 years, even the best banks are basically blowing up in one way or another.  And it has always been that way. 

 

In 2007 BAC had a Tier 1 common ratio of 3.5%, under Basel 1.

 

Today it's 9.17% (reported), and it will become 9+% under Basel III rules over the coming years.

 

Going from 3.5% to zero will be like going from 9% to 6.5%.  And that 6.5% would still be considered grossly overcapitalized by 2007 standards.

 

You probably need to roughly triple the severity of the crisis to completely wipe out the Tier 1 common.

 

WFC will reportedly be required to hold 8% under Basel III.  These crises of the past 30 years simply aren't crises anymore for these banks when they hold that much capital.  They're more like minor headaches.

 

I just wish I felt like I could really trust the numbers they report.

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Even arguably the best bank in the US (WFC) has taken it on the chin twice in 20 years.  Almost every major US commercial bank was insolvent during the LDC crisis according to the Federal Reserve. 

 

So the evidence is that every 10-20 years, even the best banks are basically blowing up in one way or another.  And it has always been that way. 

 

In 2007 BAC had a Tier 1 common ratio of 3.5%, under Basel 1.

 

Today it's 9.17% (reported), and it will become 9+% under Basel III rules over the coming years.

 

Going from 3.5% to zero will be like going from 9% to 6.5%.  And that 6.5% would still be considered grossly overcapitalized by 2007 standards.

 

You probably need to roughly triple the severity of the crisis to completely wipe out the Tier 1 common.

 

WFC will reportedly be required to hold 8% under Basel III.  These crises of the past 30 years simply aren't crises anymore for these banks when they hold that much capital.  They're more like minor headaches.

 

Not to sound blunt, but this means nothing.  IndyMac had 8.1% Tier 1 the quarter before they failed.  How did Lehman's balance sheet look before they failed? Lots of equity there!  WaMu had 8.44% the quarter before they failed too.  What a cushion! The point being that these banking ratios are the most gamed thing around.

 

There is no way to predict the future but going forward, I think you'll find that any Basel III requirements are going to get (a) watered down, (b) gamed to hell and © pretty much useless.  Banks will come up with creative ways to classify non-conforming assets as capital.  They'll figure out ways to get the Big 4 to sign off on transactions, swaps and off-balance sheet tricks to inflate assets and hide liabilities.

 

Now, I am not saying that banks will be bad investments, I am just saying that I think they will figure out ways to hide their risks as they always have.  Ways that we can't think of in the present because they haven't even been invented yet.  They will have entire teams of bankers and accountants whose sole purpose is to figure this stuff out and still take massive risks to goose their compensation. 

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Even arguably the best bank in the US (WFC) has taken it on the chin twice in 20 years.  Almost every major US commercial bank was insolvent during the LDC crisis according to the Federal Reserve. 

 

So the evidence is that every 10-20 years, even the best banks are basically blowing up in one way or another.  And it has always been that way. 

 

In 2007 BAC had a Tier 1 common ratio of 3.5%, under Basel 1.

 

Today it's 9.17% (reported), and it will become 9+% under Basel III rules over the coming years.

 

Going from 3.5% to zero will be like going from 9% to 6.5%.  And that 6.5% would still be considered grossly overcapitalized by 2007 standards.

 

You probably need to roughly triple the severity of the crisis to completely wipe out the Tier 1 common.

 

WFC will reportedly be required to hold 8% under Basel III.  These crises of the past 30 years simply aren't crises anymore for these banks when they hold that much capital.  They're more like minor headaches.

 

Not to sound blunt, but this means nothing.  IndyMac had 8.1% Tier 1 the quarter before they failed.  How did Lehman's balance sheet look before they failed? Lots of equity there!  WaMu had 8.44% the quarter before they failed too.  What a cushion! The point being that these banking ratios are the most gamed thing around.

 

There is no way to predict the future but going forward, I think you'll find that any Basel III requirements are going to get (a) watered down, (b) gamed to hell and © pretty much useless.  Banks will come up with creative ways to classify non-conforming assets as capital.  They'll figure out ways to get the Big 4 to sign off on transactions, swaps and off-balance sheet tricks to inflate assets and hide liabilities.

 

Now, I am not saying that banks will be bad investments, I am just saying that I think they will figure out ways to hide their risks as they always have.  Ways that we can't think of in the present because they haven't even been invented yet.  They will have entire teams of bankers and accountants whose sole purpose is to figure this stuff out and still take massive risks to goose their compensation.

 

How close do you reckon WaMu comes to those numbers on a fully phased in Basel III basis?  Even after BAC has already done a lot of work to shed risk they are still penalized somewhere between 200 and 300 basis points.  I don't think you get any credit at all for MSRs.

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Purely based on psychology I think there is much less likelihood of a crisis at the big banks in US

 

1. Penualtimate preparedness as Peter Lynch calls it. Preparing for the last crisis that we did not see coming. Never again seems to be the motto of many investors to be blindsided by such financial shocks.

 

2. Think about bank regulators and bank examiners at the individual banks. At least at the bank I work, I know we have swung to the other extreme in terms of awareness and attitude to risk. It is perfectly understandable of course. Think of the incentives for a bank examiner. Anything that blows up after he has examined that bank would reflect very badly on him and his career just after taking so much critique for not doing a good job in a crisis a couple of years back. Same goes for many senior managements.

 

3. Banks essentially seem to embody the sum of all fears for investors. They have a very valid reason of course to be fearful. I would be much more worried about things that no one is worried about. If so many people are worried about something and especially people high up who are in power are also worried about it, I sleep much more peacefully about such risks.

 

Vinod

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Purely based on psychology I think there is much less likelihood of a crisis at the big banks in US

 

1. Penualtimate preparedness as Peter Lynch calls it. Preparing for the last crisis that we did not see coming. Never again seems to be the motto of many investors to be blindsided by such financial shocks.

 

2. Think about bank regulators and bank examiners at the individual banks. At least at the bank I work, I know we have swung to the other extreme in terms of awareness and attitude to risk. It is perfectly understandable of course. Think of the incentives for a bank examiner. Anything that blows up after he has examined that bank would reflect very badly on him and his career just after taking so much critique for not doing a good job in a crisis a couple of years back. Same goes for many senior managements.

 

3. Banks essentially seem to embody the sum of all fears for investors. They have a very valid reason of course to be fearful. I would be much more worried about things that no one is worried about. If so many people are worried about something and especially people high up who are in power are also worried about it, I sleep much more peacefully about such risks.

 

Vinod

 

I thought this was a great post.  Regulators and legislators are very good at making sure the last crisis doesn't occur again.  Not so good on known unknowns or unknown unknowns, but that isn't really what people are worried about.  Everyone is worried that we will have another 2008 financial crisis.  It's living and investing by looking in the rear view mirror.  Anything can happen of course, but doubtful it will be the same thing that just occurred or what is staring us in the face (i.e. Europe). 

 

My experience is similar to Vinod's in terms of how the banks are operating today.  I know from several wealthy friends who have sought mortgages or refis recently that it is an insane process these days.  And these are people who don't need the mortgage.  They could use cash, but choose not to.  They make millions and it is still a multi month process.  It seems to me that once all the bad, pre-2007 mortgages fall off the books (and according to Berkowitz, etc, we are more than 60% of the way through it) banks will have some of the strongest loan books they have ever had.

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Keep in mind that Basel III is in the pipe & that it will require capital against operational risks. Most would also suggest that there may well be a Basel IV taking capital for credit risk, & possibly a Basel V laying out the composition of the capital cushion against a VaR model breakdown. In short, significant & material additional capital requirements for at least the next 10 yrs, & widespread industry consolidation.

 

 

Sharper - Basel II and III both require capital for operational risk as well as credit risk so I'm not sure a Basel IV would add anything there.  Maybe refine it a bit but it's not something new.

 

It's really a case of apples vs. oranges to compare the capital levels under the old Basel I to the newer Basel II and III.  The whole purpose of Basel II and III was to introduce increased capital for increased credit risk.  Under the old Basel I capital requirements a loan to MSFT or JNJ (AAA rated entities) required the same capital as a loan to a CCC rated entity - which is obviously nuts.  It incentivized banks to move way down the credit curve.

 

Basel II/III helps but it's certainly not a cure all.  I think the biggest problem is that it puts the fox in charge of the henhouse.  Higher capital is required for lower rated assets but it's based upon the bank's internal ratings for the asset.  So if you want to keep your capital down you just put a higher internal rating on the loan.

 

The other thing I think it will do is re-incentivize and grow the securitization market.  Because of the high capital cost of asset (and especially lower rated assets) banks will want to underwrite for the fees and then get it off the balance sheet to reuse that capital again.  Holding loans will be quite expensive.  For retail banking it means higher fees since the capital requirements are higher and therefore spread income lower.

 

Just my opinion of course.

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We did not have any banking crisis from the end of great depression until the early 1980s. We had a pretty boring banking system for 4 decades after the trauma of GD.

 

Vinod

 

I wholeheartedly agree with this sentiment but, in my view, we did not learn the same lessons from the GR (Great Recession) as we did with the Great Depression (GD.)  Following the GD, speculative banking was pretty much busted to dust.  Wall Street was opened wide by the Pecora Hearings, securities regulators became the new "Untouchables", FDR made sweeping social reforms, etc. 

 

None of that has happened.  The best ERICOPOLY can mention is a tweaking of capital ratios which, in the end, are meaningless anyways.  Consumers are still addicted to consumption and credit as much as they can be.  Wall Street is still operating in the dark (did anyone predict an MF Global this soon after the crisis? I thought we learned.  I thought banking was boring now.  Lessons learned?  I guess former Goldman CEO Corzine just didn't get that memo.)

 

The banking system today has not been reformed.  That doesn't mean the banking system isn't healing or the consumer isn't healing.  Nothing of the sort.  But what it means is that these major bankers are waiting for the music to start again.  People hated the music from 1930-1980.  But today's banker and consumer can't wait to hit the dance floor again.

 

I am with Klarman on this one.  Unlike GD, the GR has not been a good teacher.

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Not to harp on about it too much but the other issues that get my goat are: 

 

a) under Basel - most developed countries sovereign debt gets a zero capital weighting.  Zero.  So those Italy bonds?  Same capital requirement as US gov't bonds - none.  If you're going to credit weight capital for other assets, why not credit weight them all. 

 

b) the accounting provision under which you to mark-to-market your own debt obligations (liabilities) - and then take the markdown as a gain!!!!  I get the argument that if you're marking to market the assets why not the liabilities as well but come on.  To be able to show a strong equity cushion because your own bonds have dropped from 100 to 70 is ridiculous.

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The best ERICOPOLY can mention is a tweaking of capital ratios which, in the end, are meaningless anyways. 

 

Okay now I'm resting easy.  They don't really have to retain any earnings to get to Basel III. 

 

They can just tweak sum numbers and mail it in next quarter that they are at 9% on a fully phased in basis.

 

So everyone is wrong -> they really won't be required to hold far more capital for a rainy day.

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The banking system today has not been reformed.  That doesn't mean the banking system isn't healing or the consumer isn't healing.  Nothing of the sort.  But what it means is that these major bankers are waiting for the music to start again.  People hated the music from 1930-1980.  But today's banker and consumer can't wait to hit the dance floor again.

 

I disagree with you here wholeheartedly. There are more regulations, examinations, fees, and other changes making its way through the system right now that making a statement like the one you made is very much premature.

 

The landscape is changing and the risk levels taken by banks are declining. There will always be bad actors and higher risk institutions that fail (reminder MF Global was not a bank). The key is to make sure they do not take the system down with them.

 

The regulatory environment is rigorous right now. I believe the system is being reformed.

 

Buy now, sell when the economy is growing again and loan demand is increasing for four or five consecutive quarters.

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