Tag Archives: Banks

article 3 months old

The Overnight Report: I’m Still Here, Says Europe

By Greg Peel

The Dow fell 107 points or 1.0% while the S&P lost 1.2% to 1091 and the Nasdaq dropped 1.1%.

Over the last couple of months, global focus has swung squarely back upon the world's largest economy as US economic data have first weakened alarmingly and then more recently picked up a notch to relieve some of the angst. Europe, however, had shifted well out of the spotlight.

It was late July when almost all European banks “passed” the stress tests applied by the ECB which assessed whether the banks were in a sufficiently strong position to weather increased global and regional risk. There was at the time, however, scepticism from a market that saw the tests as being specifically constructed so that nearly all banks passed.

But the strength of that scepticism waned over the ensuing period as the eurozone, courtesy of a weaker euro and stronger German exports, appeared to be putting in better economic data results than the US thus allowing it to slip back out of the fear spotlight. There's been some worry over Irish banks and debt, but the market had long written off Ireland as a basket case.

Well, now the scepticism is back. A report in the Wall Street Journal last night – possibly held back until the end of the summer holidays – suggested the stress tests understated the levels of risky European sovereign debt being held on European bank balance sheets. The WSJ nevertheless admitted exact levels were hard to nail down given the limited disclosure of test results, and naturally the banks in question denied such claims.

Adding to concerns were data released showing German manufacturing orders had fallen 2.2% in July when a 0.4% rise was expected.

The result was that the spread between Irish sovereign debt and benchmark German debt blew out to its highest level since the introduction of the euro, and Portuguese debt also stretched its spread. Markets were also unsettled by demonstrations in the UK and France against austerity measures which reignites concerns that European deficit reduction by austerity will not be tolerated by electorates, leading to sovereign instability.

With no US data releases last night there was little for Wall Street to do other than sell. However, the selling cannot be taken as representative of the intention, in light of the recent rally, of traders and investors returning from vacation. The handful of players who did wander back into the office, dusting the sand off their feet, were not ready to play ball just yet. Volume on the NYSE was back to the depths of a dull August at 800m turnover.

Commentators suggest that while the Labor Day holiday marks the end of summer, it's really another week before Wall Street offices refill. And those coming back on board are not just going to dive in until they get their heads back on a Wall Street wavelength.

So after five days of rally no one was putting too much stake in the Dow's 100 point fall, albeit the counter-trade was also apparent as the US ten-year bond yield lost 10 of the basis points it had been grafting back last week (2.60%).

Renewed European fears also threw a spanner in the works Treasury auction-wise. Wall Street would have been hoping that demand for this week's auctions would ease on a better stock market performance, but last night's three-year note auction met with strong demand and settled at a record low yield of 0.79%.

Underlying demand, we must remember will always be the knowledge that the Fed is (a) rolling maturing mortgage securities into 2-10 year Treasuries and (b) is ready to outright buy more Treasuries if things go too pear-shaped. Renewed concerns over Europe makes things look a bit fruity.

The US dollar index unsurprisingly jumped 1% to 82.89 on euro weakness helping the Aussie to fall 0.8 of a cent to US$0.9099. But the Aussie had already pulled back in yesterday's session when the RBA kept rates on hold and a Labor government ensured some sort of mining tax.

Gold added US$5.50 to US$1255.20/oz.

There was a brief panic on the LME last night when someone started a rumour that the Chinese were selling, but this was quickly dismissed and the metals bounced back from session lows to end the day mixed on smallish moves. Oil fell US51c to US$74.09/bbl.

The SPI Overnight dropped 21 points or 0.6%.

On the subject of the Australian election result, it was hardly a surprise to see the ASX 200 go nowhere as soon as Tony Windsor spilled the beans yesterday, despite warnings from some that a Labor victory would spark a big sell-off in the mining sector. The past two weeks have always suggested, in my mind at least, that a Labor government would be more readily formed than a Coalition government, even as fortunes appeared to swing back and forward.

I'm sure the market generally saw it this way as well, perhaps simply looking at a surprise Coalition victory as a outside-bet bonus. But at the end of the day, the local market rallied last week on Wall Street strength and positive Chinese data and really any election result was neither here nor there. In that context, if you want to nail down what impact a now certain, but perhaps further watered down, mining tax might have, consider this:

At the close of yesterday, shares in Fortescue Metals ((FMG)), self-acclaimed distraught victim of any form of MRRT, closed higher than they did the day before the original RSPT was announced in May.

Go figure.

[Note: All paying members at FNArena are being reminded they can set an email alert specifically for The Overnight Report. Go to Portfolio and Alerts in the Cockpit and tick the box in front of The Overnight Report. You will receive an email alert every time a new Overnight Report has been published on the website.]

article 3 months old

Dull Market Macquarie’s Nemesis

By Greg Peel

At the risk of repeating a metaphor I have used previously, the best way to sum up the recent predicament of the once all-powerful Macquarie Group is to suggest “Suppose they threw a party and nobody came”. That's the way the Mac Bankers are feeling at present, as they stare at the uneaten party pies and watch a solitary couple drift around the dance floor.

The Global Financial Crisis forced Macquarie into two significant actions. One was the abandonment of its “financial engineer” infrastructure fund model and the other was to raise significant levels of fresh capital. But in so doing Macquarie also moved to seize opportunities. This required a re-focus back to its earlier model (pre-1992) in which the bulk of profits were provided by “investment bank” activities, specifically financial market broking commissions, advisory fees and proprietary trading profits.

Macquarie quickly moved to use its now strong balance sheet to acquire smaller firms engaged in such activity, with an emphasis on expanding the Group's international footprint. There was never any suggestion the Group would thus bounce back immediately, but a base was certainly being built upon which an eventual bounce-back in global activity could be exploited.

It was all looking quite good in Macquarie's FY10 (April-March) given the strong stock market rally and associated financial activity, most of which can be accredited to global fiscal and monetary stimulus. But in FY11, the wheels have fallen off. Not because Macquarie has made or is making mistakes, but because its predominant earnings divisions are now Macquarie Capital, Macquarie Securities, and Fixed Income, Currencies & Commodities. To provide earnings opportunities, these three financial market divisions simply need two elements – turnover and volatility.

The following graphs show the movement of the Australian ASX 200 stock index and the US S&P 500 stock index over the past six months. We'll take these as proxies for general financial market activity locally and internationally over the period:

Note that Macquarie's first quarter on a financial year basis is April-May-June. Note that it was this period in which the European financial crisis turned the 2009-10 market recovery on its head. It was a volatile period, and while turnover volumes were down on previous years, they were still reasonable. Brokers and proprietary traders prefer that markets go up, but it doesn't mean they can't also make good money when markets go down.

Nevertheless, while June saw the market rebound, it soon became clear many market participants had simply been scared off. Volumes dwindled. All went quiet.

It was at this point that Macquarie CEO Nicholas Moore provided a first quarter update and warned that there was a risk the Group would not be able to grow earnings in FY11 over FY10 levels if subsequent quarters failed to see any return to more robust market activity. It was also thus at this point that stock analysts cut their earnings forecasts and lowered their price targets.

But all stock analysts qualified their changes, noting that Moore's guidance was applicable only if there was no rebound in activity in subsequent quarters. It was a preemptive, not a retrospective, warning. So while analysts acknowledged that Macquarie was now doing it tough, the general expectation was that market activity would begin to return to more normal levels by the second half FY11 (in Macquarie's case, the December and March quarters). The analysts were split only on timing and degree. But all agreed that whenever the markets were to rebound, Macquarie would benefit handsomely, particularly given its acquisitions.

Hence the agreement was that Macquarie remained a compelling longer term investment, and that a book value of close to 1.0x meant it was simply cheap. The timing factor meant three of nine brokers in the FNArena database kept the Group on a Hold rating, while the other six maintained Buy. (See Don't Write Off Mac Bank To Soon).

But now returning to out graphs, it is graphically evident that both markets have achieved nothing other than to go sideways from June to September. There's been the odd spate of significant interday volatility, but market participants have been staying away in droves. Volumes have been alarmingly low. Volumes on the NYSE, for example, were 30% down in August compared to the prior August.

Which brings us back to our party analogy. You just can't make money as an investment bank when there's no one there to make money from.

This time Nicholas Moore did not wait for the second quarter (July-August-September) to be completed. Yesterday he simply cut earnings guidance by 25%.

This understandably came as a shock to the market, despite the warning Moore had already articulated in July. However, Moore's fresh guidance suggested that first half FY11 earnings would be 25% lower than first half FY10 earnings, not that full-year FY11 would be 25% lower than full-year FY10. Indeed, he reiterated that management still expected the FY11 result to be flat on FY10. In other words, Moore is betting on a second half rebound.

In July, Moore wasn't betting on anything. He was just stating the case that earnings would be flat if things didn't improve. It was the stock analysts who were assuming a second half rebound, and thus suggesting Macquarie would likely produce better than flat earnings growth. But now the case is one of a second half rebound being necessary for Macquarie even to achieve flat earnings growth.

Indeed, RBS Australia points out that the Group's first half FY10 earnings result actually contained various profitable “one-offs”. So on that basis a 25% earnings downgrade in the first half FY11 actually equates to a 40% downgrade on an apples-to-apples basis. According to the RBS analysts' calculations, a flat FY11 result will now require “second half FY11 sequential net profit after tax growth of 90%”, which the analysts believe will “prove a stretch”. This is despite RBS also assuming a rebound in activity in the second half.

JP Morgan is in agreement, suggesting “given ongoing uncertainty we are yet to see sufficient evidence that markets activity will rebound to the degree required to translate into meaningful earnings upside relative to a re-basing of first half FY11 earnings”.

UBS raises another issue, and that is the small matter of Macquarie's significant staff costs and bonus pool. The problem is, notes UBS, that Macquarie is “suffering from asymmetric earnings leverage”. In other words, staff fixed costs are high and solid bonuses can be paid in the busy times, but if bonuses are cut and salaries reduced in the quiet times, staff will be lost. So in cutting or losing staff, Macquarie has to be wary of the fact its staff are its earnings generation machine.

Think of it in comparison to a retailer which has a number of stores but is forced to close several in a recession. When the good times return, there are fewer stores and thus less potential to return to previous earnings levels.

Such considerations aside, the fact remains that stock analysts have not changed their underlying collective view, being that Macquarie offers significant longer term upside potential and at these levels is cheap on that basis. The problem for investors, of course, is that analysts also thought Macquarie was cheap several dollars above today's trading price. It might mean a loss of faith in stock analysis, but let's just say the attitude is that if Macquarie was a Buy before, it must really be a Buy now.

Indeed, five out of nine brokers in the FNArena database believe so. But that's one less than in July. This morning BA-Merrill Lynch decided it was time to pull back to join the three other brokers on Hold. Those three were previously on Hold because they didn't see any meaningful bounce in activity occurring in the short term. Again – a matter of timing.

But Merrills sums its reasons up succinctly:

“Persistent lack of conviction amongst corporate and trading clients has hurt and we don't see that changing soon”.

Speaking of conviction, Merrills' downgrade from Buy to Hold (Neutral) is more significant given Macquarie was previously on the analysts' “conviction list” which in theory elevates a Buy rating to Buy (with your ears pinned back). One might call it a double downgrade.

More notably, analysts have really taken an axe to their target prices this time around, dropping consensus from $49.61 to $43.13 (13%). But we also note that this twelve-month consensus target is 25% above today's trading price.

We also note that target distribution remains extensive. JP Morgan bit the bullet today and downgraded its target by 28% to $33.20 to become the low-marker, well below top-marker Credit Suisse on $50.00. That means the brokers range from expecting MQG to either fall 4% on the one hand, or rally 45% on the other.

The investor, or prospective investor, has every right to be bemused. But realistically the story is simple. If market activity can rebound to more “normal” levels, then Macquarie will clean up. The longer market activity remains subdued, the longer Macquarie quietly bleeds. An investor simply has to weigh that up.

article 3 months old

Troublesome Loans Rising At CBA

By Greg Peel

The recent full-year result from Commonwealth Bank ((CBA)) and accompanying quarterly updates from the other three majors showed a common theme. Margins, for the most part, remained under pressure but lost earnings were offset by reductions in provisions for bad and doubtful debts (BDD).

When everything went awry in 2008 the big banks all moved to protect their balance sheets by shifting earnings into emergency provisions and reducing distributions. Those provisions took two forms – one specifically against a worst case rise in BDD and the other simply a war chest against general economic uncertainty.

The banks have since raised substantial capital and as the dust has settled, Australia has come out of the GFC relatively unscathed. BDDs have not reached the levels feared and the banks have thus brought some of their provisions back onto the bottom line, as well as once again improving dividend payouts. The uncertainty provisions remain in place nevertheless, (a) because some uncertainty still lingers and (b) because the banks assume regulatory changes, when they come, will likely require greater levels of liquidity.

But a reduction in BDD provisions from the omigod emergency levels of 2008 does not alter the fact that credit quality on bank loan books remains an issue. With regards to CBA, the UBS bank analysts this morning question whether the trouble is really gone or is it indeed still coming.

A “bad” debt is one that is written off and a “doubtful” debt is one that looks like it will have to be written off as well. But as we move up the quality scale, we meet the interim levels of “non-performing” and “troublesome” loans. NPLs are stuck in the limbo of perhaps one day being paid off but currently not being serviced, while one presumes troublesome loans are those with somewhat erratic servicing.

UBS notes CBA loans in these categories grew to $13.2bn in value or 4.3% of total exposures in the second half FY10, up from $11.4bn or 3.7% in the first half.

The largest contributor to “troublesomes” is property loans, which saw a troublesome increase to 8.8% of that portfolio in the 2H up from only 5.9% in the 1H. UBS notes BankWest loans are the major culprit. The largest deterioration was experienced in the agriculture portfolio which saw troublesomes grow to $2.5bn or 14.6% from $1.8bn or 10.9%. UBS notes problems in the New Zealand dairy and wine industries are to blame, rendering agriculture CBA's “lowest quality” book.

Small improvements were nevertheless seen in retail & wholesale trade, energy, transport and, of course, mining, which specifically saw troublesomes fall from 4.4% to 1.8%.

Clearly, UBS sees the growth of troublesomes as somewhat troubling, undermining its belief in a “high quality, well capitalised franchise generating a strong 19% return on equity”. UBS thus maintains a Neutral rating on the stock, as do another eight out of the ten brokers and researchers in the FNArena database. It is only Macquarie, which has long been waving the CBA flag, that offers an Outperform (Buy) rating.

At $54.31, the consensus price target among those brokers offers only 4.7% upside.

UBS expects the outlook for CBA to remain subdued subject to the strength of the economic recovery and any move to reprice loans, meaning in particular increasing mortgage rates despite the RBA staying put. Such a move is still likely as soon as Australia has a government.

article 3 months old

Prepare For Double-Dip And QE2, Says BlackRock

By Greg Peel

There have been four recessions in the US over the past thirty years – 1982, 1991, 2002 and 2008. Two years after the 1982 recession, nominal US GDP had bounced back by 15.5%. After 1991 the recovery in the same time frame was 9.2% and after 2002, 6.9%. Is there a trend here?

Unfortunately, yes. We are now nearly two years out from Lehman Bros and the 2008 recession but the US economy has grown by a paltry 0.78%.

It is this number which is critical to the suggestion from leading US fund manager BlackRock that the US economy is likely on its way back into recession (as measured by two consecutive quarters of negative GDP growth), which will prompt an inevitable policy response of renewed fiscal and monetary stimulus. The Fed will need to re-implement quantitative easing (QE2), says BlackRock, in order to unlock the vast amounts of cash on corporate and bank balance sheets to grow real GDP alongside inflation.

FNArena was yesterday invited to attend a presentation by Tom Callan, US-based managing director of the BlackRock's US$12bn Global Opportunities team.

It is not difficult to ascertain just why this time there has not been any sort of meaningful bounce out of recession. The following graph provides a clue:

Clearly the Great Depression saw an unprecedented spike in US total debt as a proportion of GDP as GDP growth collapsed. Not until the US government made the right policy decisions did debt become inflated away. Thereafter followed the consumer boom times of the post-war period, culminating in double-digit inflation during the oil-shocked seventies. It was in the seventies that President Nixon removed the gold standard on the reserve currency which, as the graph indicates, let slip the dogs of uncontrolled borrowing against a supposedly all powerful US economy.

By 2003, US debt to GDP had regained the levels of the Great Depression. By 2004, Fed chairman Alan Greenspan had (he now admits erroneously) reduced the cash rate to 1% in response to the tech-wreck and 9/11. Debt growth continued unhindered, and imported disinflation from the low-wage Chinese manufacturing sector provided a false mask over the bubble that was forming.

The rest, as they say, is history. The US government and Federal Reserve threw all it could at the economy by way of fiscal and monetary stimulus in response to the GFC, but is now clear this only provided for a false dawn. US banks and corporations have moved to reduce leverage and have raised extensive amounts of fresh capital while cutting dividend payments. The result is enormous amounts of cash now sitting on balance sheets. The problem is no one is game enough to use it. In a world of global uncertainty and the deflationary impact of ongoing deleveraging right down to the household level, cash is king.

The Fed's cash rate is effectively zero, but this has not encouraged banks to lend or corporations to invest in growth. As a result, unemployment remains stuck at high levels. Mortgage foreclosures continue to increase, and small banks continue to go out backwards. Without the support of the US consumer who provides for 75% of GDP, banks and corporations remain unwilling to take on risk. For an economy to grow, cash needs to move around the system, passing from bank to corporation to employee to retailer to supplier to producer and round and round we go. If cash merely sits in the vault gathering dust, the economy grinds to a halt. That is what appears to be happening at present. And the following two graphs provide evidence of just how much dust is gathering:

As US economic data continue to paint a weaker and weaker picture, it is clear that the economy is now missing its earlier fiscal stimulus. The Fed is maintaining its level of quantitative easing by reinvesting maturing assets, but treading water is not enough. Neither the government nor the Fed can simply appeal to banks and corporations to lend/spend money in this environment and expect some sort of patriotic response. More direct action is needed. Says BlackRock, as previously noted:

“Coordinated monetary and fiscal policy could help unlock cash on corporate and bank balance sheets to grow real GDP alongside inflation”.

The most obvious policy measure for the government is tax incentives – the sort of supply-side response that was the feature of the “Reaganomics” period which helped drag the US out of the stagflated seventies. Unfortunately such a measure is anathema to Democrat ideology and in contrast to Obama's election platform. But with the mid-term elections looming and his popularity rating slipping precipitously, Obama may be left with no choice. For Main Street it's all about three things – jobs, jobs and jobs.

As far as the Fed is concerned, Ben Bernanke has already outlined at least three monetary policy options which can be implemented were the US economic environment to “deteriorate appreciably”. The Fed can return to buying mortgage securities rather than letting them mature off the books, and it can return to monetising Treasury debt by buying Treasury bonds with printed money. But perhaps the obvious first step is the third option.

Currently the Fed is paying banks 0.25% interest on cash lodged with the central bank by commercial banks. While this policy was originally introduced to encourage banks to rebuild cash it is now working as a disincentive to putting that cash “to work” in the economy through asset building, which simply means lending. Bernanke has suggested that he will drop the Fed deposit rate to zero if the situation warranted.

But Bernanke has also dropped clanging hints that monetary policy alone may still be impotent without coordinated fiscal stimulus. No doubt behind the scenes, Bernanke has been chewing off Tim Geithner's ear. But not all of the members of the Federal Open Market Committee nor all of the Fed regional presidents support QE2 in fear of simply fuelling another asset bubble. There is dissent in the ranks, which is likely why Bernanke has not acted already.

As Tom Callan noted in his presentation, Fed newbie Bernanke outlined in 2003 his suggested policy measures to drag Japan out of its destructive decade of deflation. His proposals included tax cuts for households and businesses coupled with incremental bank purchases of government debt and commitment to reflate the economy. Such measures would increase household wealth, Bernanke intoned, and lift spending.

The US is currently facing down the barrel of its own decade of deflation. Comparisons with Japan are being made every day. Noted Callan:

“Today, policies that aim to change consumption and investment psychology from a belief that cash will become more valuable in the future [deflation] to a belief that it will become less valuable [inflation] might help to mobilise liquidity. An artificially high explicit inflation target could be quite effective in this regard”.

Bernanke is also well known for a 2002 presentation in which he suggested the US possesses the most powerful policy tool on earth – the printing press – which can be used with impunity. There is no simpler inflationary tool than the increased supply of money.

It is BlackRock's belief US authorities are now facing little choice but to fire up the presses once more. Emerging economies pay be growing comfortably but the US economy is stagnating. And while the European economy has been boosted recently by a weaker euro encouraging increased German exports, growth in Europe remains otherwise anaemic and the region continues to face its own debt challenges.

If BlackRock's predictions prove accurate, how should an investor on the other side of the world react?

“We remain confident about the sustainability of growth in the emerging economies of the world,” suggested Australian-based BlackRock investment specialist James Holt, “given low levels of consumer leverage in those countries, and this bodes well for Australia in general.”
“However, precisely how the world’s biggest economy chooses to escape massive indebtedness, and potential debt deflation, has big implications for investors around the world. If the US elects to inflate away much of its debt, investors will need to careful that they are not unwitting victims of money illusion and unanticipated capital losses if they invest in cash and bond markets, which would be adversely affected by rising inflation after decades of dormancy,” Mr Holt said.

In other words, if the QE2 sets sail, don't find yourself stranded on the dock.

article 3 months old

Mel Brooks And The Bankers

By Thorvaldur Gylfason, Professor of Economics, University of Iceland and CEPR Research Fellow

In Mel Brooks’ hit film and Broadway musical The Producers, those charged with making their musical a success instead try to profit from making it a spectacular failure. This column argues that some bankers may have been playing the same game in the run up to the global crisis. If so, just as in The Producers, the perpetrators should be heading to jail.

In Mel Brooks’ brilliant film and Broadway musical The Producers, an over-the-hill Broadway producer, Max Bialystock and his hapless accountant, Leo Bloom recognise two great truths. It is very hard to produce a hit and very easy to produce a flop – and they can make more money by producing a flop than by producing a hit. Max uses his expertise to ensure that the play flops. He selects the worst play ever written (Springtime for Hitler) – an ode to Hitler, a terrible director, and an awful male lead. Max understands critics’ key role in determining the success of Broadway plays, so he pretends to attempt to bribe the most prominent critic in order to enrage him and make sure that he will pan the play.

Max then (literally) seduces his investors, raising a million bucks from “little old ladies” by selling far more than 100% of the potential profits. If the play fails almost immediately, the investors will not expect to receive any money and Max and Leo can run away to Rio with the investors’ money.

The plot fails, however, because the show turns out to be a hit. It is so excruciatingly bad that the audience assumes it is a clever satire. Bialystock and Bloom land in jail when they are unable to pay over 1000% of profits to the investors. In prison, Max and Leo promptly set out to try the same scam. The story ends there because even Mr. Brooks could not imagine what happened next.

Real-life Bialystocks and Blooms

Not all the CEOs running the fraudulent savings and loans (S&Ls) in California and Texas in the 1980s and 1990s saw The Producers, but all of them could have played Max’s role convincingly. They shared Mr. Brooks’ insight into why the massive frauds use accounting as their “weapon of choice”, structure their efforts to fail, and recruit an accountant as their most valuable fraud ally. The fraudulent CEOs and their accounting allies were the real-life Bialystocks and Blooms. They bankrupted the S&Ls, enriching themselves and their friends along the way, at the expense of stockholders, creditors, and taxpayers.

Fraudulent lenders maximise their (fictional) income by making exceptionally bad loans and growing very rapidly. Borrowers that will frequently be unable to repay their loans are numerous (allowing the lender to grow rapidly) and will pay a higher interest rate (yield). The combination of rapid growth and high interest rates produced guaranteed, record income in the near term during the S&L debacle and the current subprime lending crisis.

During the ongoing subprime mortgage loan crisis, the rating agencies and the top tier audit firms played the real life role equivalent to the critic that Max pretended to try to bribe to make sure that Springtime for Hitler received a terrible review. Unlike the critics, who Max realised he could not succeed in bribing, the rating agencies and the top tier audit firms gave rave reviews to toxic subprime mortgage paper. The rating agencies claimed the toxic waste was pristine “AAA” – the safest of the safe. The elites that we count on to advise us on quality in the real world are more corruptible than the elites in the fictional world that Max and Leo inhabited.

In the words of Professor Paul Romer (quoted from Johnson and Kwak 2010), “Over the last fifty years, the Federal Aviation Administration, the airline manufacturers, and the airlines worked together to make a highly complex air travel system more efficient and much safer… in contrast, our financial regulators and banks have made our financial system less efficient and much more dangerous.”

In time, the regulators and the American justice system caught up with the S&L frauds. More than a thousand priority white-collar felony convictions resulted from the S&L debacle. Also, high-ranking politicians who had aided and abetted the S&L operators and accepted donations from them were driven from office and power, including Jim Wright, Speaker of the House of Representatives from 1987 to 1989. The “Keating Five” were deeply embarrassed for their intervention on behalf of the most notorious fraud, that perpetrated by Charles Keating at Lincoln Savings. One senator was reprimanded by the Senate Ethics Committee, another two were criticised for acting improperly, and two more, while cleared of impropriety, were criticised for poor judgment, including Senator John McCain, the former presidential candidate.
Repeated games

But this is a trick you can pull only once, you might think. Well, a few years later the people in charge at Enron thought they might try something similar, and for a while it looked as if they might succeed. Their fraud was exposed as well, however, and they brought down with them Arthur Andersen, one of the big five accounting firms in the US. And then there was WorldCom, and hundreds of others. Prosecutors were able to arraign only the most notorious of these frauds.

The crisis that started in 2007 also contains significant elements of fraud. The crooks still understand Max and Leo’s scam, but this time the regulators and prosecutors appear to be as clueless as the little old ladies that Max conned.

Perhaps we need to send the regulators and prosecutors to remedial showings of The Producers. Alternatively, we could have them become familiar with modern economics and white-collar criminology. Inspired by the experience of regulators who had dealt with the S&Ls and understood fraud – and perhaps also by Mel Brooks – George Akerlof, the Nobel-Prize winning economist, and Paul Romer published in 1993 a famous article entitled “Looting: The Economic Underworld of Bankruptcy for Profit.” In 2005, the white-collar criminologist, economist, and lawyer William Black published a book entitled “The best way to rob a bank is to own one”. Again, the title says it all. In an appendix, the book reproduces a memo from Charles Keating that reads, in part, “get Black – kill him dead.” In the 1980s, Mr. Keating ran the Lincoln S&L Association, running it into the ground in 1989 at a cost to the federal government of over $3 billion and leaving about 23,000 customers with worthless bonds. Mr. Keating, a generous backer of the five afore-mentioned senators, the “Keating Five”, served four and a half years in jail.

Built to fail

Mr. Black has listed the four main characteristics of fraudulent banks.

* They grow very rapidly;
* They make really bad loans at high yields (because only borrowers who have no intention of paying back will borrow at exorbitant interest);
* They pile up huge debts; and
* They set aside pitifully small loss reserves.

This, in a nutshell, is what many of the failed S&Ls in California and Texas did in the 1980s. The key thing to realise is that such banks are built to fail. The owners and operators of the S&Ls could live lavishly as long as their scam lasted, or longer, as many of them, even after serving time in jail, walked away rich at the expense of innocent bystanders.

At some point, though, the threat of getting caught may lead some to try to subvert the law. As Professor James Galbraith put it in his testimony in the US Senate 4 May 2010, “This is where crime and politics intersect.” This is where law and order enter the picture if financial regulation has failed to rein in the banks as it did before the onset of the current crisis in 2007. The National Transport Safety Board investigates every civil-aviation crash in the US. In Europe, national Civil Aviation Accidents Commissions perform this vital role. Their principal concern is public safety. For reasons of consumer protection and public safety, finance needs to be viewed the same way as civil aviation. When things go wrong, there is a clear need for credible crash analysis to secure full disclosure. If laws were broken, the public has a right to know. Mel Brooks would agree – Bialystock and Bloom went to jail.

References

Akerlof, George A and Paul M Romer (1993), “Looting: The Economic Underworld of Bankruptcy for Profit”, Brookings Papers on Economic Activity 2, 1-73.

Black, William K (2005), The Best Way to Rob a Bank Is to Own One: How Corporate Executives and Politicians Looted the S&L Industry, University of Texas Press.

Brooks, Mel (1968), The Producers – A Gay Romp with Adolf and Eva at Berchtesgaden, a film written and directed by Mel Brooks starring Zero Mostel and Gene Wilder. Academy Award for best original screenplay.

Brooks, Mel (2001), The Producers, a Broadway musical based on the film. Three Tony Awards, including for Best Musical and Best Book of a Musical.

Brooks, Mel (2005), The Producers, a film adapted from the Broadway adaptation.

Galbraith, James K (2010), “Statement before the Subcommittee on Crime, Senate Judiciary Committee”.

Johnson, Simon, and James Kwak (2010), 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown, Pantheon Books.

Copyright VoxEU.org - the above story was originally published on www.VoxEU.org - readers reading this story through a third party channel may find that any graphs are not included (our apologies for this technical anomaly) - here's a link to the original story on the VoxEU website: click here 

article 3 months old

Price Charts Paint Bearish Picture For Equities

By Rudi Filapek-Vandyck

Other experts and market commentators have been pointing out there's an apparent divergence between equities and bond markets, while emphasising the bond market is not always a 100% accurate indicator.

This certainly is true, admits the TechWizard, but history shows the bond market has a better track record than equities and thus investors should at least pay attention to scenarios that at present are being suggested by persistent low yields on global bond markets.

It is essentially a bearish sign, he explains, which would fit in well with what appears to be a picture of rapidly deteriorating economic data, in the US in particular.

The bond market's signal also fits in with the appearance of bearish technical signals for equities that are showing up on price charts, reports the Wizard. As everyone can see by looking at daily price charts for equities in Australia and in the US, major indices seem to be heading for a head-and-shoulders pattern.

If confirmed, says the Wizard, such a technical pattern is a very bearish signal.

To make matters worse, his weekly price charts equally show a head-and-shoulders pattern. This would be an even stronger signal, explains the Wizard (the longer time it takes to carve out the pattern, the more powerful and significant it is).

Further adding to the Wizard's bearish view is the fact that the second “shoulder” on price charts tends to be an unusually weak one. A pattern he sees repeated on price charts for (most) banks, such as Westpac ((WBC)). Not a good sign, he believes.

All in all, the Wizard sees enough reasons to now have turned very bearish on prospects for equity markets. Investors should think a dozen times before ignoring the market's message, he warns.

The TechWizard is the pseudonym of Scott Morrison, whose experience in financial markets exceeds twenty years. Morrison operates his own website nowadays at www.techwizard.com.au The views expressed are the TechWizard's, not FNArena's (see our disclaimer).

article 3 months old

The Overnight Report: Trouble At Home

By Greg Peel

The Dow fell 133 points or 1.3% while the S&P fell 1.5% to 1051 and the Nasdaq dropped 1.7%.

With double-dip fears embracing Wall Street, there are three data points this week causing anxiety. One is the first revision of second quarter GDP, due on Friday. Another is July new home sales, due tonight. The third is July existing home sales, and that was released last night.

Economists had expected a drop in sales in July to 4.70m from 5.26m in June to reflect the earlier expiry of the government's tax credits for first-time home buyers. The actual fall to 3.83m (seasonally adjusted) came as a bit of a shock. That represents a drop of 27.2% which is the biggest on record.

Inventories of unsold existing homes rose by 2.5% in July to 3.98m to represent 12.5 months of typical supply. That's the highest level since 1999. The specific level of unsold single family home inventory is now at its highest since 1982.

The double-dip cry is getting louder. The suggestion is that US housing market weakness is entering Phase 2. Phase 1 represented foreclosures based on doomed-to-default subprime mortgages. Phase 2 is all about a simple matter of unemployment. While mortgage lenders can attempt to arrange “work-out” refinancing for mortgagors stuck with unserviceable subprime obligations, they can't provide jobs to those who simply cannot service even a refinanced prime mortgage.

Wall Street is still polarised between those assuming a double-dip is inevitable and those who believe low, slow growth is still the worst case scenario. But a third view is probably more accurate, and that is one which suggests the US economy realistically has been in a continuous recession since 2008. We are not looking at a “double-dip”, merely an ongoing “dip”. Fiscal and monetary stimulus along with the 2009 inventory restocking cycle only served to artificially pump up the US economy into expansion in previous quarters.

A similar impact is being felt in Australia, and one only has to look at recent Big Bank earnings results to see the evidence. I have now long argued that while the Australian resource sector is booming thanks to China, the rest of the Australian economy has been in recession since the GFC. While fiscal stimulus has now mostly expired in both the US and Australia, monetary policy in Australia is back to “normal” in response to mineral export inflation drivers while policy in the US remains as stimulatory as it has been. The Australian housing market is now weakening.

Much is made of recession definitions such as “two consecutive quarters of negative growth” but these are just semantics. The bottom line is that if you feel like you're in a recession, you are. Try telling the 17% of Americans out of work (which includes the 9.5% registered as seeking work) that the US economy is growing.

Last night's home sales number was released before the bell, and on the open the Dow plunged 183 points to dip below 10,000. Recent sessions have featured intra-day turnarounds, such that buying always finds the sellers and selling always finds the buyers. Indeed, last night the Dow spent all session recovering to be only 70-odd down, until the last half hour. This time the sellers returned and affected a close of down 133 as negative momentum gained.

It's still summer-session stuff, and while slightly better than the last few sessions, volume was still low.

Volumes were not, however, low in the financial market du jour – US Treasury bonds. Last night the Treasury auctioned US$37bn of two-year notes which saw solid demand, settling at a historical record low yield of 0.498%. The benchmark ten-year yield fell a solid 11 basis points to 2.49% - the lowest level in 18 months. With Japanese-style deflation being argued as America's greatest current threat, investors are continuing to ignore “bond bubble” calls.

Demand for US Treasuries as a safe haven has a positive impact on the US dollar, but so too does the continuing unwinding of yen carry trades. With Tokyo failing to make any suggestion of currency intervention, the yen also jumped last night. The US dollar index thus only ticked up slightly to 83.32, but the Aussie dollar risk indicator fell 0.9 of a cent to US$0.8821.

The weak home sales number was more fuel to the fire of those expecting the Fed will be forced to step up its quantitative easing program, which is another reason US ten-year bonds were again highly sought after. So too was gold, but it had to battle against the stronger dollar to add US$4.50 to US$1230.40/oz.

Weak data was nevertheless a simple equation for commodities, such that oil fell US$1.47 to US$71.63/bbl and base metals fell 1-3%.

The SPI Overnight fell 57 points or 1.3%.

There were shades of Australian politics in Washington last night as a Republican senator called for the resignation of Treasury secretary Timothy Geithner given his “failure” to manage the US economy. No doubt the posturing has now begun ahead of the November mid-term elections in which the Obama Administration is in danger of losing any control in the Senate. Many of the anti-socialists on Wall Street (ideologically, not behaviorally speaking) are hoping such a result will be the trigger that “saves” the stock market. In the meantime, September-October looms.

It's another huge day of earnings results in Australia today including the biggie – BHP Billiton ((BHP)).

[Note: All paying members at FNArena are being reminded they can set an email alert specifically for The Overnight Report. Go to Portfolio and Alerts in the Cockpit and tick the box in front of The Overnight Report. You will receive an email alert every time a new Overnight Report has been published on the website.]

article 3 months old

ANZ Grows While Westpac Stalls

By Greg Peel

It was near two weeks ago when I last updated the banking sector following a third quarter update from National Bank ((NAB)) and a full-year result from Commonwealth Bank ((CBA)). (See Bank Recovery Remains Some Time Off).

Now ANZ Bank ((ANZ)) and Westpac ((WBC)) have provided their quarterly updates, and it would seem the trends evident a fortnight ago and extensively explained in the above article have been maintained.

The first trend is that all banks have enjoyed a more rapid reduction in bad and doubtful debts (BDD) than either analysts or managements had expected. Bad debt growth now appears to have plateaued post-GFC, allowing the banks to bring provisions for BDD back to the bottom line. All have nevertheless deemed it too early, and unwise, to bring back the less specific “management overlay” provisions against general financial sector crisis.

While the news on BDD is good news, returning provisions have simply served to make bottom line results look good. This is not “new” money, just earnings withheld for a couple of years against the possibility more loans would have to be written off. In terms of “new” earnings, the banks have not fared so well. A once-again weakening global economy and once-again rising funding costs due to Europe et al have slowed growth to a trickle.

The results for all four banks show a definite delineation into two pairs – the larger CBA and Westpac and the smaller NAB and ANZ. The Big Two took on the biggest slice of new home buyer “stimulus” mortgages and indeed the bigger slice of all business after the GFC when bigger did mean safer. The Little Two were not as aggressive initially and customers shied away, but this has proven to be to their benefit. The Big Two had been hoping funding pressures would ease and business credit demand would have begun to return by now to offset an overweighting in mortgages, but neither has proven the case. Hence the Big Two's margins have been eroded.

Now the housing market is under pressure and renewed recession fears are keeping business borrowers away in droves. Treasury and wealth management divisions are no longer making solid profits given a weaker market. With regulatory uncertainty still prevailing, FY11 earnings growth looks difficult. Analysts have agreed following Westpac's update that its earnings growth ahead will be pretty much zero.

The situation is not quite so bleak for the Little Two. While the reduction in CBA and Westpac margins did not particularly surprise, NAB did surprise by keeping its margins relatively steady. Then ANZ rather shocked on Friday by announcing a margin increase.

In an otherwise difficult market, it appears ANZ has hit somewhat of a sweet spot. ANZ is not as overburdened with retail loans as the Big Two (which each inherited further retail bulk with their respective BankWest and St George acquisitions). As the economic outlook weakens retail banking is facing stiff FY11 headwinds, but ANZ was able to pick up margin points by repricing (raising rates on) institutional loans and even New Zealand-based loans. This made the world of difference.

Incidentally, I tipped in the previous article that the banks would move immediately after the election to raise their mortgage rates. This has not happened, probably because in theory the election is not yet over.

On the other side of the coin, ANZ has been the only bank making definitive inroads into the burgeoning Asian market through acquisitions. This has led to a streaming of Asian deposits back into the books in Australia, bolstering tier one capital at a time when the other three are locked in a deposit battle between each other and smaller institutions.

[Note that Westpac is currently offering 6%pa on a six-month term deposit, while Virgin Money will give you 6.75% on four months.]

The offset to this deposit bonanza is rising costs, which did dampen what would otherwise have been a stand-out ANZ result. But all of the banks are currently facing cost increases.

The upshot of the difference between little ANZ and big Westpac is that ANZ is able to exhibit earnings growth and Westpac is not. Ahead of the results season, CBA was showing a 20% premium and Westpac a small premium to the others, but actual results question whether such premiums are still justifiable. Westpac shares have since taken a bollocking, so its premium is now all but gone.

The complete bank reporting “season” brought no upgrades to broker recommendations in the FNArena database, largely because ANZ was already on a sector-leading 8/2/0 Buy/Hold/Sell ratio. The two Hold raters, incidentally, don't see ANZ's leading growth levels continuing into FY11 while the remainder do. There were nevertheless downgrades, and currently only Macquarie still holds a torch for CBA while Aspect Huntley has the only Buy rating on Westpac.

This might change, given Aspect does not change its ratings before due consideration.

On a forecast earnings basis, all of CBA, NAB and Westpac copped downgrades, while ANZ enjoyed small upgrades.

As I noted last time, four members of the FNArena database are in some way involved in the NAB-AXA ((AXA)) takeover offer and are thus restricted from providing a rating. FNArena can only thus ascribe Hold, leading to a 5/5/0 ratio. But analyst rhetoric suggests the true ratio would probably be more positive.

As the following table shows, ANZ is now the definite stand-out in a difficult market. Yet on a consensus basis, Westpac still shows the greatest upside to target. Analysts struggle not to recognise underlying value in the bigger Westpac, but for the time being see little in the way of short-term catalysts.

article 3 months old

ANZ Shares In No Man’s Land, Reports TechWizard

By Rudi Filapek-Vandyck

ANZ Bank ((ANZ)) is now the favourite of most (but not all) banking analysts in Australia, the TechWizard has noted. From a pure technical perspective however, the shares are trading in no man's land, he says.

Thus it is his view that ANZ Bank shares can go either way from here. Key resistance is at $23.60/80 and the Wizard reports a weekly close above this level would indicate the underlying trend has turned positive (bullish). Under such a scenario a return to the $26.00 region should not be considered implausible, he adds.

On the other hand, a fall below the bottom trend line would be very bearish and could see the $20.00 target come back into focus.  At present, notes the Wizard, the shares have carved out a bearish looking wedge on price charts.

The TechWizard has informed us he currently does not own shares in the company.

The TechWizard is the pseudonym of Scott Morrison, whose experience in financial markets exceeds twenty years. Morrison operates his own website nowadays at www.techwizard.com.au The views expressed are the TechWizard's, not FNArena's (see our disclaimer).

article 3 months old

TechWizard Reports Positive Bias For CommBank

By Rudi Filapek-Vandyck

From a technical perspective, shares in CommBank ((CBA)) should trading with a positive bias, reports the TechWizard. He has observed how the shares found solid support at the bottom Bollinger band. They have subsequently risen to higher price levels.

The TechWizard is of the view that as long as $49.52 holds the top Bollinger band at $54.25 should remain the stock's primary target.

The Wizard also observes the moving average is flat (white line in the middle). In addition, the MACD indicator is bullish, but only just.

Combining all of the above he reports a buy the dips approach seems but the correct one.

The TechWizard is the pseudonym of Scott Morrison, whose experience in financial markets exceeds twenty years. Morrison operates his own website nowadays at www.techwizard.com.au The views expressed are the TechWizard's, not FNArena's (see our disclaimer).