By Mark S. Garbin, CFA
Twitter: @coherentcapital
What we are seeing now in Europe
is the start date of a dramatic change in the financial world. That is not to say that the accountants
haven’t failed and continue to fail miserably, they have. It isn’t to say that regulators haven’t
failed and continue to fail spectacularly, they have. It isn’t to say that bank capital standards
were and continue to be a complete joke, they are.
However, what is occurring now is nothing less than a change
in the global financial system writ large.
Gone are the days of banks adding assets to their balance sheets in the
$B. Think of bank capital as a ratio: Capital
divided by Assets (risk weighted). To
meet the current and upcoming standards, there has to be an adjustment either
to the numerator (Capital) or denominator (Assets). It is far easier, more politically palatable
and faster to reduce the denominator.
This is what banks are doing.
This has the impact of reducing revenue because banks can
only make revenue on assets. Their
liabilities are costs. Return on current
equity will drop unless governments change their mind and reinstate the fiction
of the current carry trade. Operation
Twist put that one to bed. If the banks
raise more capital, ROE will drop further. However, also gone are the days of banks
making huge piles from prop trading and private equity. So, if no prop trading,
no private equity, reduced assets, reduced bond inventories that facilitate
asset management trades and reduced lending, what does our financial system
look like and how does it evolve?
First, the firms that are truly in a pickle are small to
medium size enterprises. These depend on
local banks to make them loans whether for receivables factoring, working
capital, plant, equipment, etc. It’s not
just the cost of their borrowing that will increase, it’s the (current) reduced
and further reduction in credit availability.
This will prompt private equity to invest in commercial finance companies
who have had difficulty but whose time will come as smart capital compels them
to put risk management on a pedestal.
Second, banks as exclusive product manufacturers to their
captured distribution channels are dead.
Private bankers, inside and outside the banks demand best in breed
execution for their clients. It’s why the
JP Morgan private bank, among others, offers many different products from other
banks. This will expand greatly to
institutional markets. Soon to be gone
are the days where an institutional investor can call their favorite banks to
buy or sell bonds, derivatives, FX, commodities, etc. The new reality is that banks can’t/won’t
warehouse very much capacity. Investors
will go to old fashioned intermediaries to find them the best execution. This favors client execution companies who
don’t have a product ax to grind. Their
business models will be best served by partnering with private equity in a jv
to obtain and recycle product inventory.
It will convert bank capital markets groups to bifurcated
capabilities where mass production like stamping out the latest reverse
convertible for the cheapest cost will matter.
But the other side is the premium that will be paid for ideas that make
consistent money albeit with greater transparency so investors know what they
will be paying. With traditional market
share in trade execution removed, banks that can’t mass produce that which can
be mass produced or banks that don’t deliver creativity, these will be the
dinosaurs moving to corporate extinction.
Where does this leave Mr. & Mrs. Six-Pack? We can take a cynical view that they’re going
to continue to be royally screwed; or we can give the flick to that devil on
our left shoulder and try to see how a family/individual can take advantage of
this situation. First, recognize that
most banks don’t want your deposits.
They are liabilities that put cash assets on the balance sheet i.e. more
capital required. They DO want more
wallet share. The tremendous emphasis on
cross selling is what drove and continues to drive banks like Wells Fargo; set
by the strategy of Richard Kovacevich and continued by John Stumpf. This is where individuals can benefit. By concentrating business in a very limited
number of banks, the global middle class can become more important to those
institutions. They just have to be
careful that in deposit products, they don’t run afoul of money in excess of
government guarantees. Secondly, yes you
will have to pay more for financial planning BUT at least you’ll have some. This is a sorely underused capability and
very much needed in this world.
It also doesn’t mean there won’t be abuses and frauds. But if banks are going to make the best money
by cross selling, it makes their reputations that much more important. If you screw up a client’s plan and steal
their money, your entire franchise will be at risk, you will be sued and no
jury in the world will find for the bank despite all the yada yada disclaimers
and bullshit indemnifications. The great
sucking sound they will hear is their competition ruthlessly vacuuming clients
away.
So, where does that leave the European banks like Monte dei
Paschi di Siena
What about governments?
We start with the utter stupidity and futility of Dodd-Frank where
Congress said “Well, we can’t figure it out, so we’ll give rule making/defacto
law making authority to those regulators who were asleep at the switch in the
first place”. We continue to an
Executive Branch (not just the President but his whole fam damily of a Cabinet)
who can’t seem to realize that, unlike Europe
albeit at the 11th hour, in a balance sheet recession, you have to
take your pain and deal with the fact that assets are worth a whole lot less
than the liabilities. Instead of cash
for clunkers and fiscal stimulus, there should have been and continues to be a
need to recognize and deal with the impairment of the family balance sheet
where wealth is based upon housing.
We have a wonderfully moral and principled man in the White
House. When he sees injustice, unfairness
and market based cruelty, his first instinct is to do something about it
without having the long practical experience in the law of unintended
consequences. Mr. President, a guideline
should be the corpus of the Hippocratic Oath “First, do no harm”.
What about our political parties and process? We can
describe our feelings about the Democrats and Republicans as Shakespeare wrote
in Romeo and Juliet and which encapsulates the mood of the country “A plague on
BOTH your houses”. Thus as we peer into
the future, what does it look like?
First, with approval ratings at an all time low along with consumer
confidence, Americans will have very little patience for the continuation of
failed economic policies but particularly housing policies. Ultimately, it’s not the banks that have the
biggest problem, it’s the GSEs unless of course they try to pin it on the banks
because of their abject stupidity in documentation. But ultimately, like Europe ,
it will be a negotiation between the banks and the government as to the size of
the haircut. As the line in the movie
Full Metal Jacket goes “It’s a huge shit sandwich and we’re all gonna have to
take a bite”. Once we deal with that
problem, we can move forward independent of the daily vituperative spewing that
emerges from Washington
There are a number of Republican candidates who understand
this issue in their core and President Obama, despite some terrible policies
beautifully articulated, is starting to get the fact that housing is the essence
of the American family wealth. He’ll
soon come to realize that he just can’t deal with balance sheet problems by
using monetary/liquidity solutions. There
are things that a President can do by executive decree and by the power of GSE
appointment that is going to fix the problem.
Seeing Europe deal with the balance sheet mess of sovereign bonds will
be a guideline for the USA Europe
will be telling us to get OUR balance sheets in order. There is enough anger in the USA
In summary, I awake this morning with great optimism not
because Europe is “fixed”. It isn’t.
Not because the USA Europe took the first step to admitting and dealing with
the problem. The future is brighter
today than it was yesterday.
Coherent Capital Management LLC
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