Last week I wrote that the forward calendar of to-be-issued government and mortgage related debt isn’t going to swamp the economy.
Since I wrote my article Paul Krugman wrote an article citing research done by Brad Setser that supports my thesis. Setser’s analysis predates my article and is really high quality work.
I am certain that Krugman didn’t have any idea what I wrote when he published his article but, just the same, Krugman’s subsequent writing is a helpful addendum to my “why not to worry about the debt tsunami” theme.
Basically, according to the analytical work done by Setser, the amount of public borrowing is being offset by a fall off in private borrowing. Less private borrowing is another way of saying that the savings rate has risen. Below is a graph from Setser’s article illustrating how the rise in government borrowing is more or less being offset by a drop in private borrowing.
Krugman concludes “We’re actually borrowing less from foreigners than we were before.”
Setser, on the other hand, worries that “…the challenge…will be to bring down the government’s borrowing as private borrowing resumes.“
It looks like in the next few years newly issued Treasury and agency guaranteed residential mortgage debt may create a debt tsunami that will swamp the economy. Fortunately, looks can be deceiving.
While interest rates are likely to rise for both long maturity Treasury notes and bonds and agency guaranteed residential mortgage debt, rising rates are not because of a lack of investment demand or failing confidence in the U.S. Government. Instead, as I have written for months, the all-in cost of capital for most domestic institutional investors is higher than the net yield on Treasury and agency guaranteed mortgage debt. The inability of domestic institutions to earn a profit at current interest rates isn’t the same thing as a lack of desire, capacity or confidence.
But of course yields are too low for private market investors to make money. After all, since December the Federal Reserve has been executing a program of open market purchases of Treasury and agency guaranteed mortgage debt designed to drive interest rates below market clearing yields. So, it shouldn’t be a surprise that among private investors there is an upward interest rate drift that can only be offset with more aggressive Federal Reserve intervention.
Private institutions can’t make money buying Treasury and agency guaranteed mortgage debt because the operating expenses of most institutions are very close to the investment yield on the Treasury and agency guaranteed mortgage debt. Unless the Federal Reserve is somehow able to magically force operating expenses of domestic institutions downward, market clearing yields are going to rise. At higher interest rates the private market won’t have any trouble absorbing the forward calendar of debt issuance.
To understand whether or not the volume of newly issued debt will swamp investor demand each type of debt needs to be broken down and analyzed individually and compared to sources of investment liquidity.
Residential Mortgage Debt
The amount of new mortgage debt isn’t a problem because basically there is no net new mortgage debt being created.
There are two ways to create new mortgage debt; (i) refinance existing mortgage debt and (ii) finance home sales.
Refinancings, by definition, result in a repayment of old mortgage debt held by investors. For every dollar of refinanced mortgage debt that is issued there is a dollar of old mortgage debt that is retired. As a result, old mortgage debt investors receive cash that they recycle into newly created mortgage debt (or other investments like Treasury securities).
Mortgage debt created by home sales falls into two categories: new home sales and sales of existing homes.
The proceeds from purchase money mortgage debt created from sales of existing homes generally are used to pay off mortgage debt of the selling home owners. So, mortgage debt created through existing home sales is like refinancing debt, generally it doesn’t create net new mortgage debt.
If for some reason the debt tsunami worriers are agonizing about increased mortgage debt created from new home sales that should be the least of their concerns. If new home sales weren’t stuck in the mud there wouldn’t be a credit crisis or a deep recession which are the underlying causes of the debt tsunami. The United States should only have the problem that new home sales are so high it isn’t clear how they are going to be financed.
There is plenty of demand for long term Treasury notes and bonds, just not at current interest rates. The natural buyers for Treasury debt are domestic banks, thrifts and insurance companies. These institutions have more than $1 trillion of excess liquidity which continues to grow every day. The pool of domestic cash sitting on the side lines gets bigger every day because of a combination of increased U.S. savings and accommodative Federal Reserve policy.
However, domestic financial institutions are sitting on the sidelines and not buying. The problem is that domestic financial institutions know that they can’t make money buying Treasury securities at current interest rates and no matter how much they would like to own long term Treasury notes and bonds they can’t invest.
When interest rates on long term Treasury debt rises above 5% domestic institutions will start to be large scale buyers. These institutions will start to make a reasonable profit without taking on unreasonable risk or leverage from purchasing long term Treasury notes and bonds.
Debt tsunami worriers need to pick something else to anguish about, at least for a while. Obviously, the current deficits can’t last forever but they aren’t in danger of swamping the economy for a long time. And, interest rates are inevitably going to rise but then again long term interest rates aren’t being set by the marketplace. Rising interest rates aren’t a source of worry but rather the beginning of the end of the great recession.
I have been an outspoken critic of too much leverage in the financial system for the past several years. On CNBC and Fox Business Network I have spoken out against the dangers of bank and brokerage over leverage and suggested that such over leverage could cause a repeat of the Great Depression. Like a giant oil slick, the financial services sector of the United States has been an inch deep and a mile wide for years. Clips of some of those interviews can be found at http://www.firstcapital.com/financial_news.html. Regulators don’t seem to care about management strategies that have driven the economy into the ditch and shareholders don’t seem worried about managers that lack both common sense and basic financial training.
The events of the last 12 months have seemed so unbelievable to me that I have started to wonder if there are ANY minimum standards of knowledge and training to be the CEO or CFO of a global United States based financial institution.
Many jobs in the United States have minimum educational and training standards. Doctors attend medical school and get licensed. Lawyers are trained in law school and take the Bar Examination. Even the people that take care of our pets, fix toilettes and build our houses have standards that they must meet before they can hold themselves out as experts.
But, what about the executives of large banks and brokerages? What are their minimum educational or competency standards and do they meet such standards?
It turns out that pretty much the answer is CEOs and CFOs do not pass any examination, are not licensed and have no minimum educational standard. Who is qualified to be a bank CEO or CFO has been pretty much left up to the Board of Directors of each institution.
With no “national standard” for bank and brokerage CEOs and CFOs I decided that I would create my own standards and benchmarks for measuring competence. So, this blog is about the standards that I think should apply to the leaders of global financial institutions and whether or not CEOs/CFOs meet such standards.
Education. I think that educational standards fly in the face of this country’s “Horatio Alger” ethic and are “elitist”. After all, Abe Lincoln only had about 1 year of formal education and was perhaps the greatest President of the United States (http://showcase.netins.net/web/creative/lincoln/education/glance.htm). Lincoln probably could have run a bank or brokerage (after all he ran a civil war). Vincent McMahon, CEO of World Wrestling Entertainment, is able to run a large and successful corporation and he probably doesn’t have any formal educations (other than perhaps in pharmacology). If McMahon can run wresting he can run a bank. George Bush went to college (and graduate school) but pretends that he didn’t. President Bush runs a whole country!! And, Howard Hughes didn’t graduate from college even though he was pretty smart. I am certain Mr. Hughes could have been a banker in today’s environment.
And, since college isn’t required neither should knowledge of economics, finance, accounting or economic history. Nor will requirements include higher level math such as Algebra, calculus or statistics. CEO/CFO candidates shouldn’t be expected to master more than basic addition, subtraction, multiplication and division (with a calculator).
Work experience and/or apprenticeship requirements. Abe Lincoln didn’t have a lot of executive experience before being President, so neither should bank CEOs/CFOs. Hedge fund managers, i.e., the “Kings” of corporate finance, don’t need any prior experience (and many of them don’t have any). So why should a higher standard be imposed on CEOs/CFOs of global financial institutions?
Minimum reading and general knowledge and where to find it. There are some standards that I think should apply in terms of general knowledge and minimum reading material. However, given no real education, work experience or apprenticeship requirements, these standards need to be “reasonable”.
After rejecting the local public library as a source of reading material for high level financial executives (remember I want to have reasonable standards for our nation’s financial leaders and most books in the library have “big words”), I decided to go to Barnes and Noble. If it is important to know it is probably found in the extensive selection at Barnes and Noble.
In the business section of Barnes and Noble I found two business books that seem perfect. Neither book used big words or a required lot of math, and to understand them an advanced degree (like an Associate’s Degree from Palm Beach County Community College) wasn’t required.
The first book I chose, The Little Book of Value Investing is part of the “Little Book” series published by Wiley.
In the dust cover the publishers ask “Do you care about your money?” Well, bank and brokerage CEOs and CFOs are suppose to care about money. The publishers claim that that only an IQ of 125 is necessary to understand the book. In fact, The Little Book of Value Investing says that that any IQ greater than 125 is “wasted.” Well, an IQ requirement was a new concept but one that I decided is reasonable. But what “sealed the deal” for The Little Book was the fact that the publishers claim that the reader will “[learn] to put your money to work like a banker” (and since we are searching for proper standards of knowledge for bank CEOs and CFOs….). And, for readers that have trouble reading, there is an audio version of this book. Barnes and Noble features The Little Book of Value Investing on their web site at http://search.barnesandnoble.com/booksearch/results.asp?WRD=the+little+book+of+value+investing.
The second book, Value Investing for Dummies, is even more natural for money center bank CEOs/CFOs. Value Investing for Dummies claims to teach how to “detect hidden agendas in financial reports.”, “understand financial statements” and “assess a company’s value”. The book explains “fundamentals and intangibles”, has “tear-out cheat sheet(s)” and features “a dash of humor and fun”.
The Dummies series of books are well known reference books for discerning readers and learners. After all, the Dummies series has mastered such esoteric and difficult topics such as seasonal addictive disorders in their Seasonal Addictive Disorders for Dummies (a must read for all mental health professionals), the conundrum of the human genome in their groundbreaking Genetics for Dummies work (I understand it is required reading at most medical schools), the mystery of the 1980s personal computer in their newly revised DOS for Dummies (finally an easy to understand reference book for people with a computer phobia) and how to kill time while waiting in an airport in the seminal work Su Doku for Dummies (if only I had this on my last trip to Asia). The most authoritative list of Dummie books can be found on the Barnes and Noble web site at http://browse.barnesandnoble.com/browse/nav.asp?visgrp=nonfiction&n=1000005131&ne=1000005131&Ns=SERIES_NUMBER.
So, what about those minimum standards for the global financial leaders?
What should they know about leverage?
According to The Little Book of Value Investing quite a bit.
In the “Little Book” chapter titled “Sifting Out the Fool’s Gold” I learned
“The first and most toxic reason that [companies don’t do well] is too much debt. In good times, companies with decent cash flow may borrow large amount of money on the theory that if they continue to grow, they can meet the interest and principal payments in the future. Unfortunately, the future is unknowable, and companies with too much debt have a much smaller chance of surviving and economic downturn.”
The Little Book chapter titled “Give the Company a Physical” continues to teach and illuminate in terms that everyone can understand.
“Much as a doctor consults patients’ charts to see what condition they are in, look to the balance sheet to see what shape the company is in. The doctor needs to know all the vital signs to make a diagnosis. A balance sheet is effectively a company’s medical chart….”
Readers are told that they
“….want to make sure that the company is not overly burdened with debt, and that there is enough capital to stay in business during bad times.”
Leverage trends are identified as important in the Little Book when it continues to state
“…it is useful to observe trends over the past few years. Are liabilities growing faster than assets? This could be an indication that the company has to borrow more and more money just to stay afloat…”
However, Mr. Browne (the author of the Little Book) appears to be a purest (which is perhaps a controversial position) when he states that he
“…prefer(s) to subtract intangible assets from [equity]” when calculating the amount of debt to equity because equity less intangibles gives him “…a better picture of how much actual equity there is in a company that could potentially be realized if needed.”
The Little Book of Value Investing continues to warn
“In general a high debt-to-equity ratio means that a company has been financing its growth by borrowing. Leveraging the company by increasing debt levels is a double-edged sword….there is a real danger of default and bankruptcy down the road. The less debt on the balance sheet, the grater the margin of safety.”
In conclusion the Little Book points out
“A strong balance sheet is a good indicator of a company’s stamina, its ability to survive when the going gets tough.”
Value Investing for Dummies has similar lessons for CEOs/CFOs when in “Fundamentals for Fundamentalists” it asks and answers the “age old” question of “How much [debt] is too much?”
“[The] excessive use of debt signals potential danger if things don’t turn out the way a company expects them to. Leverage is a good thing when things are going a company’s way. Debt financing can be used to produce more ….profit and, in the end, a bigger business….But as everyone knows, this can work the other way….Industry standards and common sense apply to debt-to equity ratios.?”
Later in Value Investing for Dummies the reader is again warned that
“Financial leverage can be a good thing – to a point, and as long as things are going well.”
So, how do the CEOs/CFOs some leading banks and brokerage firms stand up the standard of knowing and applying the information found in The Little Book of Value Investing and Value Investing for Dummies?
Let’s start with the management team from Bear Stearns. As it turns out, when it failed Bear Stearns had the highest debt levels of any of the major brokerage firms. At 33.53 to 1 at the end of 2007 Bear Stearns was massively overleveraged and apparently didn’t understand that with so much debt “there [was] a real danger of default and bankruptcy down the road.” (from The Little book of Value Investing). And the trends for the past 5 years of leverage were bad. Management didn’t realize that they were increasing the risk of a failure and up until the very end had little idea of the trouble that they were in. Moreover, common sense would suggest that when the company was “burning down” playing tournament bridge probably wasn’t the best crises management strategy. Clearly, the management team at Bear Stearns needed to spend some time at Barnes and Noble honing their skills and as a result failed the competency test (not a big surprise).
The Lehman Brothers team in place during 2007 also failed the competency test. With leverage at approximately 30.70 to 1 (and having added material amounts of additional leverage during 2005, 2006 and 2007) they only seem to have a marginally better understanding about risk and leverage than the Bear Stearns team (maybe that is why Lehman Brothers almost failed like Bear Stearns). However, Lehman’s new CFO Erin Callan seems to pass the competency test. Since she took over as CFO the firm has been reducing its debt burden while at the same time increasing its equity and improving its “Net Leverage” ratio by almost 25%. By the way, Erin understands that when calculating Net Leverage she is supposed to deduct goodwill and other intangibles from equity as suggested by The Little Book. Erin appears to be the star of the Lehman Brothers executive suit.
At Citigoup the team headed up by Chuck Prince clearly didn’t know what was in either the Dummie or the Little Book series and were appropriately terminated. However, the new team lead by Vikram Pandit seems to have the “right stuff.” He is raising capital and reducing debt as fast as humanly possible. I guess his team has been hanging out at the Starbuck’s in his neighborhood Barnes and Noble.
What about First Capital? First Capital operates at a Net Leverage Ratio of about 3 to 1 (which is about 1/10th of Lehman Brothers’ ratio after Ms. Callan began to perform her magic and 1/15th of Citigroup’s Net Leverage Ratio at December 31, 2007). We didn’t increase our leverage over the last 5 years and are careful to manage both debt and equity to maintain what is considered to be a “fortress” balance sheet. I guess we pass the leverage competence test.
In future blogs I will discuss additional CEO/CFO competency tests using criteria found in The Little Book of Value Investing and Value Investing for Dummies. I am confident that First Capital will continue to pass the test but less confident about others.
Today the Wall Street Journal reported that Fed officials have been in contact with the British Bankers Association regarding potential manipulation of the LIBOR rate.While the Fed is once again pursuing a “better late than never” strategy of protecting the integrity of the banking system, the rest of Washington seems to have gone AWOL and believes in the “never is better than ever” policy of regulation and enforcement.
The problem is that LIBOR is supposed to represent the market cost of borrowing for high quality banks in the wholesale money markets, i.e., the marginal cost of money for good banks.However, instead of reflecting the inter-bank market it appears that LIBOR is an arbitrary rate that is determined by a cartel of 16 banks in an opaque and manipulated process.
LIBOR is by far the most popular interest rate index that is used to set commercial and consumer interest rates in the United States.According to the British Bankers Association approximately $150 trillion of debt is indexed to LIBOR.
It was noticed a few weeks ago that LIBOR appeared to be understating the cost of borrowing of many banks in London.As soon as these reports circulated, LIBOR spiked upward approximately 0.30%.This sudden and pronounced increase in LIBOR all but confirmed the non-market and manipulated nature of the index.
While the increase in LIBOR suggests that United States borrowers were getting “a good deal” from the banks because they were underpaying their interest, it is hard to imagine that for most of the last 20 years LIBOR wasn’t set just a little higher than the actual market rate of borrowing of banks and a long term and material fraud was perpetrated on American consumers and businesses.
So, what’s the real “deal” with LIBOR?Below are a few questions and answers, as well as commentary that I think maybe useful to understand the issue.
The web site continues “…because BBALIBOR rates are calculated daily from the rates at which banks agree to lend each other money, it is accepted as an accurate barometer of how global markets are reacting to market conditions.”
Unfortunately, while the BBA states that it is the rate that banks lend to one another, in fact it is the rate that banks say that they lend to one another.And unfortunately what they say isn’t really what they did.So, LIBOR isn’t an accurate barometer of interest rates.
According to the British Bankers’ Association web site “The BBA is the leading association for the UK banking and financial services sector, speaking for 223 banking members from 60 countries on the full range of UK or international banking issues and engaging with 37 associated professional firms.”
The BBA web site banner states that “The BBA is the voice of the banking industry for all banks who operate within the uk (sic)”.
·Why is the voice of banks that operate in the UK being used to determine interest rates in the United States?Isn’t the United States a different country?Shouldn’t the rate that United States banks lend to one another in the United States be used as the benchmark for interest rates charged to businesses and consumers in the United States?
I don’t know why what banks say in London is used to determine interest rates in the United States.
Ever since the American Revolution the United States has been a different country from the UK. By the way, in London they don’t call it the American Revolution. Children are taught that the American Revolution is really the American War of Succession. Just another example of the fact that the United States is really a different country than the United Kingdom.
The rate that banks lend to one another in the United States should be used to determine benchmark interest rates in the United States rather than the rate that banks lend to one another in the UK being used to determine benchmark interest rates in the United States.
·How is LIBOR calculated?
According to the BBA web site “The BBA uses Reuters to fix and publish the data daily, usually before 12 noon UK time. It assembles the interbank borrowing rates from 16 contributor panel banks at 11am, looks at the middle eight of these rates (discarding the top and bottom four) and uses these to calculate an average, which then becomes that day’s BBALIBOR rate. http://www.bba.org.uk/bba/jsp/polopoly.jsp?d=139&a=13631&artpage=2
This process is followed 150 times to create rates for all 15 maturities (ranging from overnight to 12 months) and all 10 currencies for which a BBALIBOR rate is quoted.”
·Does the LIBOR calculation have transparency?Can a citizen of the United States go to a data site and do the calculation themselves to check on the accuracy and fairness of the BBA calculation?
The calculation isn’t transparent and everyone just “trusts” the BBA and the banks that participate in the LIBOR calculation to be fair and honest.
Past behavior would indicate that this trust is misplaced.
·Which banks are surveyed by the BBA when they set United States dollar LIBOR, i.e., which banks determine interest rates in the United States?
Bank of America
Bank of Tokyo – Mitsubishi UFJ
Barclays Bank plc
Deutsche Bank AG HBOS HSBC JP Morgan Chase
Lloyds TSB Bank plc
Royal Bank of Canada
The Norinchukin Bank
The Royal Bank of Scotland Group UBSAG
·Doesn’t the Federal Reserve and the inter-bank market in the United States determine interest rates in the United States?
·How many of the banks are United States banks and how many of the banks are foreign banks?
3 of the banks are United States banks.13 of the banks are foreign.
·What is the relationship of the funding cost of the foreign banks in London to most banks in the United States?
Not a lot other than foreign banks and banks in the United States both pay interest.Any other similarity of funding cost seems to be coincidental.
·What oversight do United States regulators have over the setting of LIBOR?
Not a lot.
·How do we know that the rate set by the British Bankers’ Association is actually the “market rate” for borrowings in United States dollars for the banks that are surveyed?
We don’t and as it turns out the banks were providing false information to the BBA earlier in the year.
·Why did the banks mislead the BBA by understating LIBOR?Such a misstatement seems counterintuitive to most observers.
It has been speculated that the banks didn’t want the marketplace to know how expensive borrowings had gotten for themselves.They also didn’t want their shareholders to know that they were having trouble obtaining funding.
The majority of the banks surveyed took large losses in the sub-prime crises and it is widely believed colluded to mislead their shareholders and the marketplace.By the way, “mislead” is nice way of saying “lie”.
However, most banks in the United States didn’t take large sub-prime losses and many banks have not experienced a material deterioration in credit quality anywhere in their portfolio.As such, the experience of these 16 LIBOR setting banks in London is foreign in more ways than one to the experience of most of the United States banking community.
·How do we know that the LIBOR rate set by the BBA in past years (or even currently) doesn’t result in “overcharging” of interest?
We don’t.And, it is a pretty good guess that if the banks provided a “made up rate” to lie to the market in 2008, they did the same thing in prior periods.It is pretty likely that at least during some periods in the past 20 years they overcharged. They just didn’t overcharge enough to be noticed.
·How do we know that they banks just don’t call each other up and decide what to tell the British Bankers Association, i.e., collude, to rip off borrowers?
We don’t know that they aren’t currently colluding and based upon the evidence it is reasonably likely that they in fact they did collude in the past.
·Who appointed the British Bankers’ Association the “arbiter” of interest rates for United States borrowers?
The banking community in the United States gradually adopted LIBOR as the benchmark rate for loans in the United States.It was generally considered a fair and honest market rate even though we have now learned that it wasn’t fair and isn’t honest.No one ever considered that the “bill of goods” being sold regarding LIBOR wasn’t correct.
·What should the government do?
Federal and state governments and governmental entities should enforce the laws of the United States that are designed to protect its citizens and ensure fair and transparent competition and markets.
The Federal Reserve should mandate that LIBOR be replaced on all new loan agreements with a real market rate that reflects the true cost of funds for banks in the United States.Interestingly enough, either the Federal Funds Rate or the Discount Rate would actually work well for this purpose.The Federal Reserve should also investigate whether or not consumer protection rights were violated.
The Justice Department and the Federal Trade Commission should immediately begin investigations to determine if there was collusion and conspiracy by the banks involved in setting LIBOR and if criminal or civil sanctions are warranted.A full investigation as to both anti-trust and anti-competitive behavior should begin immediately.
The SEC should examine whether or not there was adequate disclosure on the part of the banks that file registration statements with the SEC as to their role in setting LIBOR and the potential criminal or civil violations that occurred.
And, the various state Attorney Generals should examine whether or not state anti-trust and consumer protection laws were violated.
·Should we trust the banks to fix the LIBOR mess?Is this an example of banking integrity in action?