Credit deflation and the reflation cycle to come (part 2)

[janch]

From the Telegraph article above:

 

"every measure restraining public behaviour should be examined for whether it really is necessary, bearing in mind that rules such as the two-metre requirement for social distancing are keeping millions of people from earning money and paying taxes. We urgently need to keep a lid on the recession we are facing. Restaurants, bars, shops, factories, tradesmen and offices are all hampered. If at all possible, they should get back to business. This matters not just for now but for the next decade."

 

The reason for all the absurd rules is because of Health & Safety and companies/organisations frightened they will be sued if anyone catches the dreaded lurgey.  The left have truely put a massive spanner in the works of the economy.

[JMD]

1 hour ago, Loki said:

The original posts from 1997 onwards by 'Another' and 'Friend of Another'

https://www.usagold.com/goldtrail/archives/another1.html

 

Loki, great find. Are the quotes you included recent ones?

I was struck by the description of the CB's, it reminded me of how DurhamBorn describes the CB's, i.e. they are not bad/evil people, instead it is our own politicians who have just blindly pandered to the people and who have created our financial mess.    

[Loki]

2 minutes ago, JMD said:

Loki, great find. Are the quotes you included recent ones?

I was struck by the description of the CB's, it reminded me of how DurhamBorn describes the CB's, i.e. they are not bad/evil people, instead it is our own politicians who have just blindly pandered to the people and who have created our financial mess.    

No, they're from page one! Apparently the posts ran from 1997 - 2001.  I thought that quote might strike a chord here.

[JMD]

1 hour ago, DurhamBorn said:

https://www.telegraph.co.uk/politics/2020/06/02/debt-inflation-union-power-britain-sleepwalking-back-1970s/

Can put in here and read if needed

https://outline.com/

I think this is the same guy who wrote an incredible book called "The welfare state we are in" that is the best iv ever read on the massive problems with welfare and how destructive it is.I think the article nails a lot of whats coming,even if not understanding the real macro drivers.The fact these articles are starting to drip out from people who i would consider having a long term understanding of the economy (also from a social side) is telling.

DB, Loki has just posted a link to the 'Another'/'Friend of Another' blog - are/were you an avid reader of that blog? 

[JMD]

7 minutes ago, Loki said:

No, they're from page one! Apparently the posts ran from 1997 - 2001.  I thought that quote might strike a chord here.

Definitely does strike a chord, but wow!!! page one you say. I'm no expert on the technicals the blog delves into. But I don't know how to interpret it if the posts are so 'old', relatively speaking of course.

Then again, true wisdom doesn't age. Its immutable like gold itself I suppose!

[Loki]

5 minutes ago, JMD said:

Definitely does strike a chord, but wow!!! page one you say. I'm no expert on the technicasl the blog delves into. But I don't know how to interpret it if the posts are so 'old', relatively speaking of course.

Then again, true wisdom doesn't age. Its immutable like gold itself I suppose!

In the timescales of what we talk about, it was only last week 

(1982 for disinflation, 1997> for these posts)

Quote

After a proof read by one from the west this is a start and should help you understand.

For a number of years many persons have tried to invest in gold using the tools of past gold encounters. Even thought the last several upswings in bullion always took the gold stocks along for a ride, this time it will be different!

Ever ask someone if they owned gold. They might say " yes, but only 5% of my capitol is in it for insurance" Was it bullion? "No, my broker is to smart for that, he put me into a good gold mutual fund." "He says, if it really looks like it's going to go up I'll also have you in some comex futures or options "

During the first bull market of the seventies we saw few mining stocks outside South Africa worth owning .

Because they were relativity new to the game most people stayed with bullion. There certainly were no mass gold options and there were even fewer gold coins around. Most just brought whatever bullion bars they could find and as their past European counterparts did, they just waited it out.

Today, the public went "whole hog" for paper gold and has paid a great price. Wall street invented this game from the previous war as a way of keeping customer "gold money " in house! The shame of it is that these tools not only would not work in this new market, but they also gave the street a way to short gold even more effectively. In many cases the public brought little more than "long paper" from the street, with no gold at all on the other side! No one will ever have the truth on this as the falling price made most people close out without ever calling for the goods! A good deal of the numerous mining paper capitol was used to enrich the sellers while the buyers actually had no chance of seeing a profit. That's because the commodity these securities were based on was all but guaranteed to go down as forward sellers were given a green light to sell paper gold to the limit of their financial resources.

To make a long story short, many people who would have purchased bullion years ago have now squandered much of their "safe insurance money" on wall street. It is no wonder that many WESTERN gold investors have now turned bitter on gold. If they knew the truth about this new market they would have turned their bitterness on wall street instead.

Written 4 years before the dot-com crash.  I think by Wall Street he means trading in hot shares rather than investing like we are here.

[sancho panza]

hattip @Errol for posting raoul pal's views on the Italian/Spanish banks and also the people discussing buying HSBC.Made me have a dig around.

 

Often discussed on here,different aspects of a debt deflation as prescribed by Irving Fisher . 

Debt-deflation[edit]

Further information: Debt deflation

Following the stock market crash of 1929, and in light of the ensuing Great Depression, Fisher developed a theory of economic crises called debt-deflation, which attributed the crises to the bursting of a credit bubble. Initially, during the upswing over-confident economic agents are lured by the prospect of high profits to increase their debt in order to leverage their gains. According to Fisher, once the credit bubble bursts, this unleashes a series of effects that have serious negative impact on the real economy:

1. Debt liquidation and distress selling.
2. Contraction of the money supply as bank loans are paid off.
3. A fall in the level of asset prices.
4. A still greater fall in the net worth of businesses, precipitating bankruptcies.
5. A fall in profits.
6. A reduction in output, in trade and in employment.
7. Pessimism and loss of confidence.
8. Hoarding of money.
9. A fall in nominal interest rates and a rise in deflation-adjusted interest rates.

 

Crucially, as debtors try to liquidate or pay off their nominal debt, the fall of prices caused by this defeats the very attempt to reduce the real burden of debt. Thus, while repayment reduces the amount of money owed, this does not happen fast enough since the real value of the dollar now rises ('swelling of the dollar').^[26]'

 

 

There are demand and supply side aspects to Debt Deflations as outlined by Fisher where in simple terms Fishers Paradox occurs whereby the more people pay down debt the more their ability to earn money to pay off debt gets reduced.An obvious part of the problem here is that as consumers save,GDP takes a hit and banks are faced with a hard choice of expanding credit into a shrinking economy or increasing reserves to deal with increasing defaults.

The following paper discusses issues at UK banks but I think it's safe to say the problems UK banks face are actually not as bad as those faced by the banks in places like Italy/Spain.Highlights are mine.I'll be doing it section by section.The aim is for me to reread this just using the highlights.

 

A paper by  a former PRA valuation specialist and  a professor Econ at Durham Uni.Data current as of May 29th 2020

http://eumaeus.org/wordp/wp-content/uploads/2020/05/Can UK banks pass the COVID-19 stress test 6 May 2020.pdf

Can UK Banks Pass the COVID-19 Stress Test?

By Dean Buckner and Kevin Dowd* This version: May 29th 2020 Results currently based on data up to May 29th 2020.

 

                                                                                                                             Abstract

 

As the UK economy enters the COVID-19 downturn, the Bank of England (BoE) continues to maintain that the UK banks are strongly capitalised. Yet there is considerable evidence that they are anything but.

The core metrics of the Big Five UK banks have deteriorated sharply since the New Year, and even more since the end of 2006, i.e., the eve of the Global Financial Crisis. Their market capitalisation is now £140.6 billion, down 61% since December 2006; their average price-to-book ratio is 39.2%, down from 255% at end 2006; their average capital ratio, defined as market capitalisation divided by total assets, is 2.3%, down from 11.2% at the end of 2006; their corresponding leverage levels are 43.3, up from 8.9 (end 2006). By these metrics, UK banks have much lower capital ratios and their leverage is nearly 5 times what it was going into the previous crisis.

These metrics indicate a sickly banking system. If the banks were in good financial shape, their PtB ratios would be well above 100% and their capital ratios well above current levels. Traditional rules of thumb also suggest that leverage levels should be no greater than 10 or 15 to be considered safe.

In addition, UK banks have hidden problems relating to their off-balance-sheet positions, their gameable ‘Fair Value’ Level 3 (or ‘mark to model’) and loan book valuations, and their problematic implementation of IFRS 9, all of which have further adverse consequences for their capital adequacy. The BoE’s ‘Great Capital Rebuild’ narrative about a strongly recapitalised UK banking system is little more than an elaborate, and occasionally shambolic, window dressing exercise. The BoE focused most of its efforts on making the banking system appear strong by boosting banks’ regulatory capital ratios instead of ensuring that the banking system became strong through a sufficiently large increase in actual capital meaningfully measured. The result is that the UK banking system enters the downturn in a worryingly fragile state and avoidably so. Another massive bank bailout now appears inevitable.

 

“On Monday 17 March 2008 I was at the annual conference of the Royal Economic Society listening to a lecture on financial stability by Hyun Shin … Bear Stearns had been bailed out the very day before. … it barely crossed my mind that events were in train that, but for huge government rescues, would collapse the western banking system. In fact the thought did flit across my mind, only to be dismissed, naively, as incredible.

I tell this story to illustrate that the real shock of 2008 was not the shock – of subprime, the drops in property prices, &c – but the system’s lack of resilience to the shock. Put another way, the “it” that few saw coming was not the sharp movement of asset prices, but the fragility of the system. It is a basic proposition of financial economics, and no ground for criticism of economists, that you can’t see sharp asset price movements coming. Failure to anticipate systemic fragility in the face of such shocks is an altogether different matter.

Inadequate equity capital was the basis for that fragility. Of course there were liquidity problems too, but they were often down to (justified) perceptions of capital inadequacy, as Northern Rock itself showed. And there were problems of management conduct and incentives and corporate culture too, but their consequences for the economy are far more severe when capital falls short. Banks’ capital adequacy is a cornerstone of our economic system.” Sir John Vickers (2019, our emphasis) 1

 

                                                                                                                      Section 1. The Big (Divs) Freeze

By late March, it was clear that the UK economy was going into a major COVID19 downturn. Even so, UK banks were still intending to go ahead with their plans to pay some £7.5 billion in dividends to their shareholders. The first payment, by Barclays, was due on Friday, April 3rd.

News of the banks’ intentions triggered a public outcry. Kevin Hollinrake MP, the chair of the all-party parliamentary group on fair business banking, was appalled: “They live in a different world, don’t they? Why on earth would you pay a dividend right now? It’s shocking they could even contemplate this.” Taxpayers had already rescued the banks once, he said, and it would be outrageous if they had to be supported a second time.

As late as Friday March 27th, the BoE was said to be “relatively unfazed” about the dividend payments going ahead, although in private the BoE had been telling the banks ever so gently that it was “concerned about the optics.”

Come the next Monday, March 30th, and the bankers were holding out. To quote a subsequent article in the Financial Times:

'some of the banks argued their balance sheets were strong enough to make the payouts. They pointed out that they had passed the BoE’s stress tests last year, which measured whether the lenders were able to withstand an economic shock on a similar scale to the coronavirus fallout.'

Faced with an offer they could hardly refuse, the bankers backed down. Mr. Woods had certainly raised a few eyebrows.

So why the change of heart by the central bank? The BoE’s decision to play the heavy

'hardly smacks of a considered change of direction; more a handbrake U-turn that left black rubber marks all over the road. No, it is not whether the central bank should have acted: few seriously dispute that the country’s lenders should be conserving their capital given the economic shock Britain is experiencing. Rather, it’s the opposite. Why did it take so long? (Ford, 2020)

 Mr. Ford points out that the official explanation is coronavirus and the pressures that that puts on the banks. He continues

'But the virus did not become news only last Tuesday [March 31st]. What is puzzling is the failure to gate earlier all capital distributions. It’s hard to believe the central bank trusted bank bosses to show restraint, especially when the likes of Barclays’ Jes Staley had big bonuses riding on the payouts.

More likely, the central bank believed its own story that the lenders were super well-capitalised. That has certainly been the mood music from Threadneedle Street, with the now departed governor Mark Carney boasting recently that their balance sheets were now so strengthened that, unlike 2008, the banks could be “part of the solution”.

The next day, the prices of the Big Five UK banks’ shares plunged: 12% for Barclays, 9.5% for HSBC, 11.7% for Lloyds, 5.2% for RBS and 7.3% for Standard Chartered.

There is deeper puzzle, however. If it believed that UK banks are super strong, why didn’t the BoE just let the dividend payments go ahead? The proposed payments were barely 2.1% of the Big Five banks’ book value capital, which, by hypothesis, was super adequate. Allowing the payments to go ahead would have sent the perfect signal of strength to the market, especially at a time of so much uncertainty. The BoE blocking those payments then looks like a panicky overreaction that unnecessarily spooked the markets, because it gave the impression that the BoE was having second thoughts about how strong it thought the banks really were. How else to explain the market reaction the next day?

So the question is, how strong is the UK banking system? Or, more precisely, does the UK banking system have the financial resilience it needs to withstand a major shock and still emerge in good shape?

This article seeks to answer these questions. Our answer is, inevitably, involved, and is laid out in the follow steps. Section Two outlines our main argument. Section Three looks at banks’ current share prices and market capitalisations, and how these have changed since the New Year and since before the Global Financial Crisis (GFC). Sections Four and Five examine banks’ price-to-book (PtB) and market value capital to asset ratios. Section Six discusses how the UK banking system is now bifurcated into two sub-systems – HSBC and the other banks – and discusses HSBC’s exposure to Hong Kong. Section Seven examines off-balance sheet (OBS) and other hidden risk and valuation problems facing the banks. Section Eight examines the uselessness of the regulatory capital framework, section Nine examines the BoE’s claims that the UK banking system is now superstrong and section Ten discusses the BoE’s track record in the GFC. Section Eleven discusses the underlying political economy of bank capital and section Twelve concludes.

[Boon]

Gold seems to be taking a hammering today.

But the indices are doing well. 

Given the newsflow in America it makes no sense at all to me. US have banned Chinese passenger jets (and vice versa). It could get messy. Like everyone else they are dependent on cheap goods from there, can't wean yourself off them overnight. A trade war would be messy.

[sancho panza]

  

 

 

                                                                                                 

                                                                                                           Section 2. Outline of Argument

 

To summarise the main argument, as the UK enters the downturn, the BoE continues to maintain that UK banks are strongly capitalised. However, reliable evidence indicates otherwise. The core metrics for the Big Five UK banks have deteriorated sharply since the New Year, and even more since the end of 2006, i.e., the eve of the Global Financial Crisis (GFC). Their market capitalisations, their price-to-book ratios and their ratios of market capitalisation to total assets have fallen sharply since the New Year and even more since before the GFC. Their corresponding leverage levels have correspondingly increased. For example, banks’ average price-to-book ratios are now 39.2%, down from 255% at the end 2006, and their average leverage, defined as total assets divided by market capitalisation, has soared to 43.3, up from 8.9 at the end of 2006. Few would disagree that banks were already over-leveraged going into the GFC and yet UK banks are more than four times more leveraged now than they were then.

These metrics indicate a sickly banking system. If the banks were in good financial shape, their PtB ratios would be well above 100% and their capital ratios well above current levels. Traditional rules of thumb also suggest that leverage levels should be no greater than 10 or 15 to be considered safe.

In addition, UK banks have hidden problems relating to their off-balance-sheet positions, their gameable ‘Fair Value’ Level 3 (or ‘mark to model’) and loan book valuations, and their problematic implementation of IFRS 9, all of which have further adverse consequences for their capital adequacy.

The BoE’s ‘Great Capital Rebuild’ narrative about a strongly recapitalised UK banking system is an elaborate window dressing exercise. The BoE focused most of its efforts on making the banking system appear strong by boosting banks’ regulatory capital ratios instead of ensuring that the banking system became strong through a sufficiently large increase in actual capital meaningfully measured. The result is that the UK banking system enters the COVID-19 downturn in a woefully fragile state and avoidably so.

Another massive bank bailout now appears inevitable.

The assurances of the central bank about the supposed strength of the banking system must also be weighed against its unimpressive track record from the GFC: the BoE completely failed to see the crisis coming, despite market signals that something was amiss; then, when the crisis did come, the BoE persistently misdiagnosed the true nature of the crisis as being a liquidity crisis (which is not a big deal) rather than the capital or solvency crisis that it was (which is a big deal), despite the fact that markets had been signalling capital problems since 2007. The scale of the losses overwhelmed the UK banking system and blew the UK’s fragile regulatory capital framework out of the water.

Fast forward to the present, markets are again signalling major problems and the Bank of England is again insisting, against the evidence, that all is well. As Deputy Governor Sam Woods reiterated to the Treasury Committee on Wednesday April 15th, “We go into this with a well capitalised banking sector.” 9

We end with some speculations about the underlying political economy of bank capital, i.e., the game that is really going on. In a laissez faire world, bankers who took excessive risk could reasonably expect to bear the consequences of those risks, so they would restrain their risk-taking out of their own selfinterest.

Enter central banks and regulators, who set up lender of last resort facilities, deposit insurance and such like, and associated expectations of bailout. The bankers respond to these incentives by increasing their leverage and taking more risks to boost their returns on equity, which are the basis of bank CEOs’ remuneration. High leverage seeks to maximize the value of the (often implicit) central bank or government guarantees by letting banks borrow at rates subsidised by society at large, thereby privatising profits on the upside and socialising losses on the downside. The bankers’ Social Contract is highly destructive, however. The regulators attempt to rein it in by capital adequacy regulation, the aim of which is to constrain leverage, but the bankers are able to defeat them each time by ‘capturing’ the regulatory system which they then manipulate to their own advantage. Thus, the regulator’s dismal performance, while shocking, is only to be expected.

At some point, there will need to be radical reform to reverse the ever more destructive banksterisation of the economy and re-establish a Social Contract in which the bankers serve the public and not the other way round. To go back to the Vickers quote with which we started, “Banks’ capital adequacy is a cornerstone of our economic system.” A healthy economy – a healthy society, even – depends on banks’ capital adequacy being restored and then protected against those who would knock it down.

[sancho panza]

                                 

                                                                                

                                                                               Section 3 Bank Share Prices and Market Cap

Let’s start with some evidence. Consider the following chart, which gives the changes in the prices of the Big Five banks’ share prices since the New Year.

Between the end of 2006and the close of business on Friday,May29th2020, the banks’ share pricesfell by between 54.8% in the case of the best performer, HSBC, and 98.1% in the case of the worst performer, RBS.

The big five banks’ latest market capitalisation (‘market cap’)is £140.6billion. This number is to be compared to the banks’ total assets, £6,093.3billion,which is 43.3times their market cap. To see how much their market caphas changed, the next table shows the corresponding market cap numbers as of December 31st2006

Banks’ market cap was £360.9 billion at the end of December 2006. Banks’ current market cap has fallen by 61% since 2006.Not much sign here of the Great Capital Rebuild.

[sancho panza]

 

 

                                                                                                        Section 4 Price-to-Book Ratio

Another metric is the price-to-book (PtB) ratio, the ratio of a bank’s market cap to its reported or book capital.9

Theoretical considerations about price-to-book

A healthy bank would have a PtB ratio well in excess of 100%.

Why is that?

Imagine that webuild a factory costing £100. We finance it through some mix of debt and equity, say,£90 in debt and £10 in equity. Shareholders are assumed to operate under unlimited liability, i.e., we are back in early Victorian England. I report the book value of my equity as £10. Shareholders anticipate that ourfactory business will be profitable, so they are presuming a positive franchise value, i.e., that future profits will be positive. Therefore, they value the firm at more than book, say, £15reflecting a franchise value of £5. So the price to book ratiois £15/£10 = 150%. The law is then changed to allow shareholders the protection of limited liability, i.e., they can now walk away from any losses exceeding the share capital they have subscribed. Limited liability is valuable to shareholders, and they value the implicit limited liability put option as, say, £3. The market value of their shares therefore rises to £18 and the PtB rises to £18/£10 or 180%. The lesson is that we would expect a healthy business to have a PtB in excess of £100 because of (a) franchise value and (b) the value of the limited liability put. Substitute ‘bank’ for ‘factory’ and the same applies.

Now suppose that the skies darken and the market anticipates that future profits will be zero, so the whole of the franchise value has been wiped out. Revaluing the franchise value at £0, the market value of the firm’s equity falls from £18 to £13 and the firm’s PtB becomes £13/£10 or 130%.

But wait.

Since the market now takes a more pessimistic view of the firm’s profit prospects, the value of the put option rises from £3 to, say, £4. So the market value of the firm’s equity goes up again, from £13 to £14 and the PtB ratio becomes £14/£10 or 140%.

The question then is what would it take to get the PtB under 100%? Presumably either a perception by the market that the firm is carrying hidden losses or a perception by the market that the NPV of its future cash flows is well below zero. Either way, a PtB less than 100% is a bad sign.

The implication is a strong one: a healthy bank should have a PtB ratio comfortably over 100%. Conversely, if a bank has a PtB ratio under 100%, then there is something wrong

Price to book ratios for UK banks

How do the Big Five banks’ PtBs look? The answer is not so good.

By PtB ratios, the best performer is HSBC at 48.8%, the average is 39.2% and the lowest is Standard Chartered at 28.7%. To point out the obvious: these ratios are well below 100%. Ergo, the market must believe that there is something wrong with the banks.

We are reminded of Merton Miller’s comments about a 50% PtB: “That’s just the market’s way of saying: look at these guys; you give them a dollar and they’ll manage to turn it [or perhaps he meant, burn it] into fifty cents (p. 199).”12

It would appear that UK banks can’t even manage that.

The next table shows the corresponding PtB ratios as of end-2006 and end 2019

The average PtB ratio was 255% at the end of 2006.

By this criterion, UK banks are in considerably worse shape than they were going into the GFC.

As a cross check, according to a BoE spreadsheet, the average price to book ratio for UK banks fell from 211% at the end of 2006 to 85% by November 2015. Unfortunately, that series ends in November 2015 and appears to have since disappeared from the BoE’s website. (Good job we kept a copy. For those who wish to see it, we provide a link to it here, see sheet ‘9. Bank equity measures,’ cell B194.) The Bank’s numbers are a little different to ours, but the story is much the same.1

[Craig]

48 minutes ago, Boon said:

Gold seems to be taking a hammering today.

But the indices are doing well. 

Given the newsflow in America it makes no sense at all to me. US have banned Chinese passenger jets (and vice versa). It could get messy. Like everyone else they are dependent on cheap goods from there, can't wean yourself off them overnight. A trade war would be messy.

About fucking time. If they'd done that three months ago they might not be in the state they are now.

But that's for another thread.

[DurhamBorn]

Amazon is "worth $1.2 trillion,yet needs to borrow $10billion.

https://markets.businessinsider.com/news/stocks/amazon-raised-10-billion-through-record-low-borrowing-costs-2020-6-1029272938

The above is the real reason they are able to crush other smaller companies even though they probably cant make much of a profit in the retail business.

Likely they are looking to buy up other companies with this cash.Shareholders in the targets must not want Amazon stock in payment,wonder why?

[Loki]

@janch @JMD @Fully Detached

The mysterious Another's thoughts on silver

Quote

Silver will always be part of "gold money". But, is far too small a market for large, modern economies. Silver will do far better than any paper asset, only it will serve better as a "personal holding" than as a major money. If it is of your way to balance wealth, then silver will show value.

Metals have not shown their true worth for many years as the world has done very well. This is very good. But, all things do change! As it is our time and place to live this change, our thoughts must view the future as it must be. Who can know the minds of men and countries as paper burns?

Quote

Consider, can they all buy silver?

The most important thing to observe is that Mr. Buffett did NOT use any form of paper to represent his silver. No options on silver, no futures, no options on silver futures, no silver mining stocks, no leased silver deals from mining stocks and no MARGIN! Most of the large buyers of metals are buying the physical, outright. Mr. Buffett had Berkshire

Hathaway purchase silver as part of it's long term "economic investment outlook". Not to be confused with a leveraged, quick profits bet. Understand, that Berkshire plays within the "world paper economy parameters", they are not looking for a currency replacement. What is not seen, are the personal holdings of Mr. Buffett, Mr. Soros and countless other "world wealthy". In those accounts you will indeed find silver, but also, much more gold!

Note, that he was buying thru much of last year. So were a number of others. The one common thought from them all is that, "the real wealth will be held in PHYSICAL form"!

"you may also follow in the footsteps of giants"

 

[sancho panza]

Important thing to note with this section for newer readers (don't mean to insult anyone's intelligence) is that when a bank makes a loan to a consumer,the loan sits as an asset on the banks balance sheet. Which is where Fisher's paradox kicks in as loan defaults beget declining asset ratios. There is a good layman's explanation on Wiki.

Thus when the chart comes up weighing Market Cap versus Total assets,the latter contains mortgages/loans.

 

 

 

                                                                                                   Section 5  Capital Ratios and Leverage

Theoretical considerations

A bank’s capital strength is traditionally evaluated in terms of its capital ratio, the ratio of its capital to its assets, and by its leverage, which is inverse of the capital ratio i.e. the ratio of assets to capital.

We will work on the presumption that the numerator in the capital ratio, capital, should be measured as market cap, and that the denominator, assets, should be measured as total assets.

In defence of the use of market cap as a capital measure, we would point out that if you want to sell an asset, you have to sell at market value and the book value doesn’t matter; if you want to buy an asset, then you would be a fool to pay book value if market value were lower, and you would have to pay market value if market exceeds book. Similarly, if a bank wants to sell its shares, it gets the market value (or less, if it sells via a rights issue) and again the book value is irrelevant.      

We can also think of this market value vs book value issue in terms of loss absorbency. In general terms, we can think of loss absorbency as the ability of a bank to experience losses and still be able to function normally. For a bank, the losses would arise from a fall in asset values. Equity capital is loss absorbing because it is a liability whose value is determined by the level of asset value. By contrast, a bond or a bank deposit is not loss-absorbing because its contractual value, the amount owed, remains the same regardless of fluctuations in asset values. So the greater the bank’s equity, other things being equal, the greater its loss absorbency. The issue then is whether we should measure a bank’s loss absorbency in terms of its market cap or its book value share capital.

Consider two schools of thought. School M says that we should use market cap as our measure of capital. School B says to use book value. Now suppose that the market cap and book value capital are initially the same. Suppose too that the bank reports on an annual cycle and had only yesterday reported its book value. Tomorrow the share price falls. According to School M, the bank’s capital (=market cap, the product of the number of shares outstanding and the share price) then falls. School B however maintains that the bank’s capital (=book value capital, e.g., the book value of shareholder equity reported yesterday) stays the same, market cap irrelevant.

Now suppose that the share price keeps falling. By its logic, School B must continue to maintain that the bank’s capital remains constant, however low the share price goes, so market cap is still irrelevant.

After a few days equity market investors conclude that the bank will never pay them any further dividends, so the share price and market cap go to zero. School M says that the bank’s capital has gone to zero, bank irretrievably bust. School B maintains that the bank’s capital hasn’t changed because the book value hasn’t changed, so (presumably) the market cap is still irrelevant. School M maintains that the capital losses have already occurred, School B maintains that the losses to capital, if there are to be any, will occur or should be deemed to have occurred only when the next annual report comes out in fifty one weeks’ time.

Substitute a dead parrot for the bank and you have a situation reminiscent of a well-known comedy sketch.

To continue. Suppose you are still supporting School B by this point. You reread the last annual report that contains the capital number, book value, that you believe to be the appropriate one to use. You then discover that the bank was planning to move from a one year reporting cycle to a two year reporting cycle. OK, the example is getting a little silly, but logic being what it is, you must now believe that the capital losses that we think have already occurred will now occur or should be deemed to have occurred in almost two years’ time. OK, you say. But what if the new reporting cycle is five years instead of two, or ten years? Are you OK with those too? You can see where we are going here. Book value is irrelevant if it was last reported in 1926. School B does not end up in a happy place.

Still not convinced?

Then ask yourself, what is the bank’s loss absorbency at this point? School M gives a clear answer: zero. The shareholders who own the bank can’t absorb further losses because they have lost their entire investment (i.e., have nothing left to lose) and, because shareholders have limited liability, the bank’s creditors cannot sue them for any further losses that they (the creditors) might experience.

You disagree and continue to insist that loss absorbency is still book value. Then explain to us why purported loss absorbency numbers like book value capital are still the preferred numbers to use even though market conditions have changed drastically since those numbers were released, so those numbers are no longer remotely relevant to current market conditions. What useful information do you think those numbers are telling us? Perhaps they are telling us that the bank will come back from the dead.

There is also the issue of timeliness. Consider the following quote from Morris’ Goldstein’s book Banking’s Final Exam:           

             (a) Note that when former Federal Reserve Chairman Ben Bernanke testified to Congress in 2007 about the subprime crisis, he estimated that it would generate total losses in the neighborhood of $50 billion to $100 billion [over period of years] … (b) But … when Bernanke gave testimony in an AIG court case … he explained that, by September and October of 2008, 12 of 13 of the most important financial institutions in the United States were at risk of failure within a period of a week or two. The question for stress test architects and modelmakers is, How do you make your models generate a transition from (a) to (b) in the course of, say, a year or two? This is not a technical sideshow. In stress modeling, it is the main event.14 (Goldstein, 2017, p. 251)

Goldstein is referring to the lack of timeliness of the Fed’s stress tests, but the same point can be made about the lack of timeliness of book value capital numbers. When a crisis occurs, market prices fall so fast that book values become irrelevant.

For the avoidance of doubt, we are not saying that book value measures have no merit. We are saying that for reasons especially of (a) loss-absorbing capacity and (b) timeliness, market cap is generally to be preferred to any book value measure.

Regarding the use of total assets as the denominator, we would point out that there are two alternative denominator measures, Risk Weighted Assets (RWA) and the Leverage Exposure (LE). These are both highly flawed however.15 The drawbacks of the former are explained in Appendix Five and the drawbacks of the latter are explained in Appendix Six.

Capital ratios and leverage for UK banks The next table shows the Big Five banks’ ratios of Market Cap (MC) to Total Assets (TA) and their corresponding leverage numbers (i.e., TA/MC):

These MC/TA capital ratios vary from 1.4% for Barclays to 3.2% for HSBC, with a weighted average of 2.3%. These are on the low side considering that many experts led by Anat Admati have been calling for minimum capital requirements of 15% or more. If we accept the Admati Capital Standard, and there are compelling reasons why we should accept it), 17 then UK banks’ capital is a small fraction of what it should be, to be considered capital adequate.

The average current MC/TA ratio of 2.3% can be interpreted as suggesting that a loss on total assets of under 2.3% would be enough to wipe out the banks’ entire capital, and that any higher loss would push the banks into technical insolvency.

The corresponding leverage (=TA/MC) numbers vary from 31.5 for HSBC to 72.3 for Barclays, with an average of 43.3. The dangers of high levels of leverage were vividly described by John Cassidy in the FT in 2010:

Leverage kills. In March 2008, Bear [Stearns] had tangible equity capital of about $11bn supporting total assets of $395bn – a leverage ratio of 36. For several years, this reckless financing enabled the company to achieve a profit margin of about a third and a return on equity of 20 per cent; when the market turned, it left Bear bereft of capital and willing creditors. During the ensuing months, the same story was to be played out at scores of other banks and non-banks.18

By the Admati Standard, the maximum leverage should be at most 1 divided by 15% or 6.7.

Alchemists of Loss19 quotes a traditional leverage rule of thumb used in the City:

“The maximum safe leverage is 10 to 1 for banks and 15 to 1 for brokers dealing in liquid instruments.” This Copybook Heading was widely ignored [in the run up to the GFC], most openly by investment bankers operating at leverage ratios of over 30 to 1 by the end of 2007, the sin made worse by banks hiding their risks by pushing assets off their balance sheets by use of “structured investment vehicles” funded by commercial paper that was apt to become illiquid when most needed. This god’s revenge is traditionally very painful and is proving so again.20

As of the end of 2006, the MC/TA ratios varied from 4.6% for LBG to 19% for RBS, and the weighted average was 11.2%.

The corresponding leverage varied from 5.3 to 21.5, and the average was 8.9. Thus, UK banks are considerably more leveraged now than they were going into the GFC, and yet reasonable people agree that excessive leverage then was a key factor aggravating the severity of the GFC. 21

The elephant in the room then trumpets: if the average leverage of 8.93 at end 2006 was too high, why is the current average leverage of 43.3 not way too high?

And what does the Bank of England’s spreadsheet tell us? It tells us that the average market-based capital/asset ratio (it actually uses the term ‘market-based leverage ratio’) falls from 8.31% at end 2006 to 5.28% by Nov 2015 (see cells C87 and C194), and the corresponding average leverage rises from 12 to almost 19. The BoE spreadsheet agrees with us that (market value) capital ratios were higher pre crisis than post, and market-value leverage, lower.

Therefore, the current weakness of the banks cannot be ascribed to the impact of COVID-19 or to the introduction of IFRS 9, because banks were in poor shape well before those came along.

 

[Loki]

Quote

"Also, you are looking for lower short-term interest rates, but skyrocketing long-term rates along with a higher US$"?

Yes, in an effort to maintain the dollar/oil bond. It is well to know that oil holds not long term US debt as backing for it's currency. In the end the CBs will let the long bond plunge in price. That is why most of the US debt is not "long", this change is for that time.

The date this was written - Saturday the 14th, 1998!

[Sasquatch]

4 hours ago, Popuplights said:

Still down 7 % overall. Most of that is from some RDSB I bought a long time ago at over 20.00

Mrs S up 8%. I'm down 10%. My SIPP up 10%. Therefore overall just about up. This is a combo of miners, telecoms, oil, energy, potash, chemicals (BASF doing very nicely), some uranium, tobacco, defence (Babcock and Qinetiq). I was tempted to do some day trading on stocks like easyjet, carnival but resisted in the end. Obviously major gains to be had but it requires immaculate timing - I neither have the skills or time for this.

The share that shall not be named looking rather sick (down 50%)

Best performer has been petropavlovsk. Up 150% on a £1,500 holding!

Went in too early with my HL isa on BT, C******a and Vodafone. Invested Mrs S in more or less same stocks but at a later date. Big reminder about timing!

PM's doing quite nicely despite today's falls.

[Harley]

3 hours ago, Boon said:

Gold seems to be taking a hammering today.

But the indices are doing well. 

The joys of a balanced portfolio!

Gold in GBP looks to have topped on the weekly chart and has entered the doldrums on the daily chart (7% off the last high) so a pullback is possible. Last major high was £1,250 to £1,280 on the various charts so hopefully strong support there or sooner.  Would be nice if we were back to the "wall of worry" it climbed post 2008 until 2011!

[Loki]

https://www.reuters.com/article/us-shell-australia-qclng/shell-weighs-sale-of-2-billion-plus-stake-in-queensland-lng-facilities-idUSKBN23A0T7

Quote

MELBOURNE/SYDNEY (Reuters) - Royal Dutch Shell (RDSa.L) is considering raising more than $2 billion from the sale of a stake in the common facilities at its Queensland Curtis LNG plant in Australia, according to a sale flyer reviewed by Reuters.

 

[Bobthebuilder]

I bought RDSB in March and had a bit left over in the SIPP, so bought some BAT. Its up about the same as RDSB just under 20%, happy days.

My other portfolio that was built before i discovered this thread is currently down 30%. Boy did i buy some shite.

[Harley]

59 minutes ago, Bobthebuilder said:

My other portfolio that was built before i discovered this thread is currently down 30%. Boy did i buy some shite.

Could be worse, you could have bought it after you discovered this thread.......just saying.......!

Thank heavens for PMs!

 

[Popuplights]

Great day today. Up almost a bag. Break even tomorrow maybe?

[jamtomorrow]

5 hours ago, Popuplights said:

Great day today. Up almost a bag. Break even tomorrow maybe?

If you hold assets in the US, worth remembering the US legal and political system is one of your counterparties. Smoke-signals from US top brass showing definite hints of yellow and orange ...

An awful lot of "unthinkables" have become "actuals" of late - stay alert folks!!

[Loki]

The ECB decision is today

The ECB announcement is set for 7:45 a.m. Eastern (which is 10:45 GMT)

https://www.marketwatch.com/story/stocks-in-europe-slip-ahead-of-ecb-decision-2020-06-04

 

https://www.bloomberg.com/news/articles/2020-06-03/ecb-told-to-be-bold-with-more-cash-for-recovery-decision-guide

Quote

The European Central Bank will decide on Thursday whether its already massive monetary stimulus needs to be boosted even more to help haul the region out of its deepest recession in living memory.

With President Christine Lagarde warning that the ECB’s worst-case predictions for the economy are likely to pan out, most economists expect policy makers to increase their 750 billion-euro ($842 billion) Pandemic Emergency Purchase Program and extend it beyond the end of this year.

“The ECB should opt for a bold and pre-emptive response,” said Katharina Utermoehl, senior economist at Allianz SE. “Even if it doesn’t end up having to use all the announced policy space, it’s better to create room for maneuver now to stave off market concerns.”

I'm going with boosted even more. 

[Loki]

I'm very tempted to sell my punts CWR (Up 25%) and AAU (Up 30%) and put it towards some physical gold. 

What do the big brains think?