Monday, December 28, 2009

Gone with the gearing

Below are three comments about the banking industry made by three individuals. Identify the one that is most prescient and the individual who is the least famous, if not totally unknown, among the three.

Comment 1
“I believe that the tools available to the banking agencies, including the ability to require adequate capital and an effective banking receivership process, are sufficient to allow the agencies to minimize the systemic risk associated with large banks. Moreover, the agencies have made clear that no bank is too big to fail. So that bank management, shareholders, and uninsured debt holders understand that they will not escape the consequences of excessive risk taking. In short, although vigilance is necessary, I believe the systemic risk inherent in the banking system is well managed and well controlled.”

Ben Bernanke, Federal Reserve Chairman and a former Princeton University professor
In an answer to a Senate Banking Commitee question on his first confirmation hearing in 2005

Comment 2
"[G]iven 1990 levels of capital, both Fannie Mae and Freddie Mac had sufficient capital to survive." even when tested against "the financial and economic conditions of the Great Depression." And "on the basis of historical experience, the risk to the government from a potential default on GSE debt is effectively zero."

Joseph Stiglitz, former Chief Economist of the World Bank and a Columbia University professor
In a paper written in 2002 titled "Implications of the New Fannie Mae and Freddie Mac Risk-Based Capital Standard."

Comment 3
"Running a bank is like piloting a warplane. If you alter the steering even a little bit, you end up in a completely different position."

Coskun Ulusoy, a former banker and the CEO of OYAK, Turkey's Armed Forces Pension Fund
On the rationale for selling OYAK's own bank to ING for USD2.7b in 2007

In terms of grey matter, academic credentials and widespread recognition, Bernanke and Stiglitz are far ahead of Ulusoy. But Ulusoy has one essential trait ― the ability to correctly size up the situation and then to use it to discern the key underlying patterns ― that separates those who can rise above the trivia and see the obvious from those blinded by the mass of details. In this, Ulusoy is one of the brilliant few that possess such insight. Certainly getting out of the global banking mess in the nick of time is one thing but to offload a future muck onto ING at a good price deserves acclaim.

While Bernanke and Stiglitz are muddling through one step at a time with the apparent solution at each step being overwhelmed by unintended side-effects, Ulusoy has already leaped five steps ahead knowing fully well the adverse consequences of the slow plodding. Bernanke and Stiglitz do conduct serious analyses and researches but these are all done to confirm their already firmly held beliefs, not to challenge them. This is the fundamental flaw of smart people ― a refusal to admit that they could go wrong.

The whole banking industry has a basic failing which is only evident during a depression ― its high gearing. This weakness is unique only to the banking industry. Practically all bankers except the enlightened few, such as Ulusoy still believe that it's their asset quality that matters. However, in a depression characterised by deflating prices, asset prices will definitely collapse. No amount of money printing can stave off this collapse because such money will be sucked by the black hole of loan write-offs and bank deleveraging. Money printing works only to stem a panic, not to avoid a decreasing money supply which should be allowed to take its natural course.

How does a bank's gearing choke the bank to death? Let's start with the bank's balance sheet. A bank's capital is typically about 8 to 10 percent of its total assets which comprise loans issued out to borrowers. To support the huge asset base, a bank raises the other 90 percent externally in the form of outside liabilities. These consist of money from depositors and inter-bank borrowings. Banks are classic cases of an entrepreneur's dream – use of other people's money (OPM) – that are extremely dangerous in tight liquidity situations. In a depression, asset prices can fall by more than 30 percent and at the extreme can surpass 50 percent whereas the liabilities remain fixed.

How are property prices holding up in the US? For commercial properties, prices have fallen by 44 percent from their peak in October 2007, a fate similarly shared by those in the UK. The median existing house price for the US has fallen by 25 percent from its peak in the 4th Quarter, 2005 with another 10 percent fall forecast for 2010. The Case-Shiller index covering houses in 20 cities in the US reveals a decrease of 33 percent from its peak in July 2006 to its trough in April 2009. Prices then rose for the next five months because of the Obama stimulus before stalling in October 2009. Karl Case, the eponymous co-founder of the index has predicted that prices will fall by another 15 percent. All in all, it won't be surprising if the price collapse exceeds 50 percent, posing fatal threats to the banks' existence.

Because of a bank's gearing, typically from 10:1 to 12:1, it takes only a 10 percent fall in its asset values to compeletely wipe clean the bank's capital. The bank's assets comprising mostly loans are secured against collaterals which can be real properties or other assets, such as machinery financed by those loans. In a deflation, the values of these collaterals will be dragged down with the falling economy. It doesn't take a mathematical genius to figure out that even with loans amounting to only 80 percent of the collateral values, it needs only a 30 percent fall in the collateral values to drag the bank's assets down by 10 percent. The actual situation is much worse because at the peak of the subprime mania in 2006, the loan-to-value (LTV) ratio even exceeded 95 percent. With their collaterals worth less than their loans, the borrowers will simply walk away from their obligations leaving the bank, devoid of capital, holding on to fast depreciating assets.

The severity of such a scenario can only be felt by looking at the impact of the Great Depression in the 1930s. In 1921, the number of banks in the US peaked at 30,456. Thenceforth, the number gradually diminished but the rapid decline occurred between 1929 and 1933, in the midst of the Great Depression, in which 43 percent or about 10,800 of the banks went bust. Even the relatively mild Savings and Loan crisis of the late 1980s and early 1990s led to the closure of more than 1,600 Savings and Loan institutions.

How do the current bank closures stack up against those of the Great Depression? Actually, we haven't scratched the surface. From 2000 to 2008, the US had only 53 bank closures, including two years, 2005 and 2006, the only time in the history of US banking without any closure. In 2009, the pace started picking up with 140 closures. The US now has about 8,000 odd commercial banks. The coming depression which I call the Grand Depression is definitely many orders of magnitude worse than the Great Depression. The credit expansion was many times bigger and, in a regression to the mean, the credit contraction would need to be equally huge. We can expect more than 3,000 banks to shutter for good within the next few years. These zombie banks are still walking because of the foreclosure moratorium which puts on hold the writedowns of their toxic assets to market value.

Would Islamic banking and sukuk bonds be immune to this catastrophe as bragged about by their proponents? In truth, there's no difference between Islamic and conventional banking. They share the same chink in their armour – high gearing. An economic depression doesn't differentiate between Muslims and non-Muslims. Even any other businesses with high gearing will incur the wrath of the depression. And this crisis in banking won't be restricted to the US; it is spreading globally in line with falling commodity and real estate prices. We only have to wait for the other shoe to drop in the US banking crisis to trigger a chain of falling dominoes in other countries.

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