Banking Profits: A Mirage, Not a Miracle

The banks contribution to the economy has been overstated

THE huge sums earned by banks and their employees over the past 30 years is a recurring puzzle. How has finance done so well for itself and why haven’t its returns been competed away?

Andrew Haldane, the executive director for financial stability at the Bank of England, has co-authored another incisive contribution to this debate in a chapter of a new book* published by the London School of Economics on July 14th. Analysing the recent performance of the banking industry, he concludes that it has been “as much mirage as miracle”.

Mr Haldane and his colleagues start with a statistical oddity. The fourth quarter of 2008 almost saw the meltdown of the global financial system, with banks’ share prices falling by an average of 50%. Yet according to the British national accounts, the same quarter witnessed the fastest-ever increase in the contribution of the financial sector to the country’s economic growth.

That suggests there is something wrong with the calculations. The standard measure is gross value-added—the output of an industry minus the costs of production. That is a pretty easy sum to calculate when it comes to manufacturing. In finance, however, a lot of the gross value-added comes from making loans. Economists calculate this by measuring the difference between the rate charged on loans and a “reference rate”, which is pretty much the risk-free rate.

The consequence of this approach is that when interest margins rise for corporate borrowers, as they did in late 2008, the gross value-added of the banking sector appears to go up. But without adjusting for risk, this measure of the finance sector’s economic worth is meaningless. What really matters is whether the interest margin properly reflects the risk of default. As Mr Haldane comments: “A banking system that does not accurately assess and price risk is not adding much value to the economy.” That is a particular problem given that it seems clear the banks systematically underpriced risk in the period leading up to 2007.

You can look at the numbers in a different way. Was the finance industry using a larger share of the nation’s resources? In the British case, the industry’s share of labour and capital has been on a declining trend since 1990. Combine the gross value-added figure with the declining share of resources, and you might assume finance has enjoyed a productivity miracle over the past 20 years. This miracle could explain the very high returns on equity achieved by the banks and the very high wages given to bank employees (an international, not just a British, phenomenon).

But if the value-added figure is driven by a mistaken assessment of risk, a quite different picture emerges. Mr Haldane suggests that banks increased risk-taking by pursuing three different strategies: using more leverage, both on and off the balance-sheet; holding more assets on their trading books, where capital charges were lower and rising asset prices boosted profits; and writing “out-of-the-money” options, in other words selling insurance policies that offered steady returns in good times but disastrous losses in especially difficult times.

These greater risks brought little economic benefit. In the same book Adair Turner, the head of the Financial Services Authority (Britain’s soon-to-be-restructured regulator), points out that only a minority of bank activity concerns the channelling of savings to businesses investing in productive assets, what you might call the classic raison d’être of banking.

Instead, lending is dominated by the residential- and commercial-property cycle. These cycles are self-reinforcing: more lending pushes up property prices, which encourages more lending. At the margin, the property cycles might lead to the construction of better buildings, but such modest benefits are outweighed by the accompanying financial and economic instability.

The financial industry has done so well for itself, in short, because it has been given the licence to make a leveraged bet on property. The riskiness of that bet was underestimated because almost everyone from bankers through regulators to politicians missed one simple truth: that property prices cannot keep rising faster than the economy or the ability to service property-related debts. The cost of that lesson is now being borne by the developed world’s taxpayers.

* “The Contribution of the Financial Sector: Miracle or Mirage?” by Andrew Haldane, Simon Brennan and Vasileios Madouros. Taken from “The Future of Finance: The LSE Report”, July 2010

Published in The Economist

Jeremy Grantham on China's Red Flags

Key Points:

"The trouble is that China today exhibits many of the characteristics of great speculative manias. The aim of this paper is to describe the common features of some of the great historical bubbles and outline China’s current vulnerability."

"Real wages will likely rise if the fl ow of rural labor dwindles, which would allow workers to consume more. But for an export-oriented economy like China, this may be double-edged, since the country’s international competitiveness might be harmed. In recent years, urbanization has been a major source of China’s productivity growth. If this slows, then future economic growth will have to come from a more efficient use of the factors of production."

"Economic theory and history, however, argue against the notion that central planning is the optimal mode of economic development. China has certainly developed rapidly over the past three decades. But under the direction of Beijing’s visible hand, its economy has become lopsided. In the years up to the credit crunch, China’s economic growth was largely dependent on rising exports. China’s exports to the West are already at twice the level achieved by Japan in its heyday. The country cannot continue growing its trade surplus with the West without inviting protectionism. This threat has become particularly acute since the onset of the Great Recession"

"Beijing imposes a GDP growth target on local governments. The problem with targets imposed by a central authority is that they are liable to being gamed. Goodhart’s Law states that whenever an economic indicator is made a target for conducting policy, then it loses the information content that would qualify it to play such a role.16 In China, GDP growth is no longer the outcome of an economic process; it has become the object."

"Roughly a quarter of all investment was government-directed. Many projects, however, were clearly intended to meet the government’s GDP growth target. A news clip on YouTube (originally from Al-Jazeera) shows the newly constructed “ghost town” of Ordos, in Inner Mongolia. An interviewee suggested that building this empty city, with housing for a million, had enabled local officials to meet their growth targets."

"It beggars belief that lending could have expanded so rapidly without some decline in underwriting standards. In fact, many accept that China’s banking system is threatened by another surge in nonperforming loans, as occurred in the late 1990s. However, conventional wisdom holds that if China maintains its phenomenal economic growth, then last year’s loans need not turn bad."

"China’s current situation is reminiscent of the late stages of the dotcom bubble, when investors extrapolated past rates of growth into the future and were bedazzled by the size of the prospective market. As with the Internet frenzy, a surge of investment creates a demand that appears to justify the most optimistic predictions."

"When the China juggernaught eventually stalls... [proponents] will face a rude awakening"

Click here to read this excellent White Paper, written by GMO's Edward Chancellor (registration required)

Equities: Proceed with Caution

High PE ratio = danger

Historically, the market has only spent 15% of its time at a PE ratio of 16 or higher. The market is currently at an un-nerving PE ratio of 17.6. Historically it has only been higher than this level 6% of its time, therefore the market is not cheap if history is anything to go by.

Historically there have been 6 (broadly speaking) periods where the market has broken through a PE ratio of 16 (see Figure 1). We can test the theory of "high PE ratios equate to poor commensurate equity returns" by tracking the performance of the equity market as the PE ratio goes through some predetermined level. Setting the PE ratio at 16 generates some interesting results with regards to equity market vs. cash returns. The subsequent 3 year returns (post a PE ratio > 16) for the All Share Index (yellow) and Cash (red) are plotted in the graph (Figure 2) below.



Briefly what does the graph above (Figure 2) say?

1. Cash has out-performed equities 4 out of the 5 times over a 3 year period.
2. The market has experienced a serious crash within 3 years, 2 out of 5 times.
3. The market has rallied at least 34%, 5 out of 5 times from the point the market PE ratio goes above 16.

In summary the All Share Index has fared poorly relative to cash over a 3 year period when the PE ratio has breached 16. Secondly it is important to recognize that the market can initially perform very well over the short-term even when the valuations look very expensive on a PE ratio basis. Figure 2 and Table 1 highlight this fact with interim returns having reached between 34% and 68.5% before market returns turn sour.

Michael J. Burry: How did nobody see this coming??

ALAN GREENSPAN, the former chairman of the Federal Reserve, proclaimed last month that no one could have predicted the housing bubble. “Everybody missed it,” he said, “academia, the Federal Reserve, all regulators.”

But that is not how I remember it. Back in 2005 and 2006, I argued as forcefully as I could, in letters to clients of my investment firm, Scion Capital, that the mortgage market would melt down in the second half of 2007, causing substantial damage to the economy. My prediction was based on my research into the residential mortgage market and mortgage-backed securities. After studying the regulatory filings related to those securities, I waited for the lenders to offer the most risky mortgages conceivable to the least qualified buyers. I knew that would mark the beginning of the end of the housing bubble; it would mean that prices had risen — with the expansion of easy mortgage lending — as high as they could go.

I had begun to worry about the housing market back in 2003, when lenders first resurrected interest-only mortgages, loosening their credit standards to generate a greater volume of loans. Throughout 2004, I had watched as these mortgages were offered to more and more subprime borrowers — those with the weakest credit. The lenders generally then sold these risky loans to Wall Street to be packaged into mortgage-backed securities, thus passing along most of the risk. Increasingly, lenders concerned themselves more with the quantity of mortgages they sold than with their quality.

Meanwhile, home buyers, convinced by recent history that real estate prices would always rise, readily signed onto whatever mortgage would get them the biggest house. The incentive for fraud was great: the F.B.I. reported that its mortgage fraud caseload increased fivefold from 2001 to 2004.

At the same time, I also watched how ratings agencies vouched for subprime mortgage-backed securities. To me, these agencies seemed not to be paying much attention.

By mid-2005, I had so much confidence in my analysis that I staked my reputation on it. That is, I purchased credit default swaps — a type of insurance — on billions of dollars worth of both subprime mortgage-backed securities and the bonds of many of the financial companies that would be devastated when the real estate bubble burst. As the value of the bonds fell, the value of the credit default swaps would rise. Our swaps covered many of the firms that failed or nearly failed, including the insurer American International Group and the mortgage lenders Fannie Mae and Freddie Mac.

Read the rest of this Op-Ed piece here...

Jim Grant on Alan Greenspan

A Life Assurer's Worst Nightmare - Incorrect Assumptions

Like the sub-prime crisis faced by banks, the risk of people living for up to 20 years after retirement seems to have crept up on an industry using historical data to calculate people's chances of an early death.

Pension funds and insurers say the mounting burden of protracted pension payments is concentrated on a small group of providers: them.

Global private sector liabilities for pensions are at about $25 trillion (R180 trillion), according to a January Pensions Institute report, which cited estimates that every extra year of life expectancy at age 65 adds about 3 percent to the value of some UK pension liabilities.

Several factors - the market crash brought on by subprime lending, new solvency rules for insurers due in 2012 and the stampede of baby-boomers to retirement age - are adding urgency to providers' efforts to spread their exposure.

If that seems like a small group, the evidence is it's the population segment most likely to grow. There are about 450 000 centenarians in the world today and experts estimate that there could be 1 million by 2030.

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Thoughts on New York Excess

A great article by Mark Helprin in the Wall Street Journal.

"When pay-out exceeds pay-in, balance is maintained only by the weight of illusion—as in real-estate bubbles, or welfare states in which benefits vastly exceed contributions. Within such failing systems one finds nevertheless highly visible concentrations of wealth, like lumps in tapioca, that persist in setting a tone that has long gone flat."

Read the full article here.