This is a guest post from Mark Garbin, a long time subscriber to my blog. Give him a follow on Twitter, he’s good peeps.
Mark S. Garbin, CFA
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 (“MPS”) and all the other coddled, spoiled and pampered institutions living in a cocoon of a market? It means they have to wake up and drink, forget about smelling, the double espresso. They are first and foremost commercial enterprises. If they can’t survive in their niches, they must merge or be gone. As described yesterday in the Wall Street Journal, even MPS bank (the bank that rejected a loan to Christopher Columbus) recognizes that a new era is upon them and they are taking dramatic steps to change.
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 going forward. In fact, not that they are Johnny on the Spot or anything like that, Europe will be telling us to get OUR balance sheets in order. There is enough anger in the USA to make that a reality. So despite the lack of Congressional term limits, Congress may find itself incapable of making cogent collaborative policy but go back to their successful (by comparison) model of oversight and guardianship.
In summary, I awake this morning with great optimism not because Europe is “fixed”. It isn’t. Not because the USA’s problems are fixed. They aren’t. I am confident that for the first time since the credit crisis began, because a fundamental balance sheet problem was dealt with and there is a plan for the future. That isn’t to say that there aren’t issues. There are. But as any with any addiction, the first step in overcoming the problem is admitting that there IS a problem. Our global addiction was Debt. 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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