Variant Perceptions

Category: bubbles

Charting Banking XIX: history of financial crisis

Via Barry Ritholtz we get precisely the information we were looking for: how recurrent are financial crisis. I only have one question: where is the Latin American debt crisis in this chart? OK, American banks  suffered and their stress appears just there at the beginning of the 80s, but where are Mexico, Argentina, Brazil, Chile, Bolivia, etc. At least it does not change the point that these crisis are very frequent.

FSI: Financial Stress Index; Source: IMF Direct

This point is very much related to Martin Wolf’s question: must large capital inflows always end in crisis?

Capital inflows can distort loans to deposits ratios and end in underwriting terrible loans. And every time the banking system is compromised there are consequences. The excellent book by Kenneth Rogoff and Carmen Reinhart shows how pervasive are these occurrences.

I am not an economist and will not dare to attempt to answer Martin Wolf’s question. However, as an investor I wonder:

  • Given that not even a sophisticated American financial system managed to isolate the banks from these inflows, what chances other countries have of avoiding a financial crisis?
  • Given how recurrent are these episodes, is not there a possibility of waiting for the next episode, profit from it, move then to safe investments, and wait for the next crisis?

Charting Banking XVIII: historic ROE and ROA

How fast can a bank profitability recover after a deep recession? If the experience of the US at the end of the 80s (and Latin America 1982, Scandinavia 1992, Mexico 1994, Asia 1998, Argentina and Brazil 2000) is any guide, it can happen pretty fast. Japan is probably the only modern deposits-guaranteed exception to the rule  and we will get to discuss eventually Japan, that very misunderstood and important case – other possible exemptions are welcomed.

How can this be the case? The thing is that most banks while they are solving their issues they are still doing their business: pooling deposits to loan while earning a spread. The moment you end reserving for your past sins and you made it to the finish line with enough capital

  • deposits are still there
  • most assets are still there
  • most loans are still there
  • many competitors are not there

This does not mean that several banks will not go bust and capital should not be infused. After all bad loans were made and someone has to pay for them. But you can also pay them through the so called extend and pretend, that can work up to a certain extent if  assets are performing and your sins are not so bad. With a business that is still a going concern, 4 years of no returns (USA 1990) can pay for 10% of total assets going bad (assuming a conservative 50% recovery of bad loans and 1.2% ROA)

What is counter intuitive for many people is that banks in these bad harvest periods are also seeding  the good harvest years. Lot of competitors are out so banks are making the best loans ever and taking over these competitors deposits.

The risks of investing in banks are very high when bank hot money chases yield, lower  their standards and the costs of those overstretched loans are unknown. That is not what is happening today.

Charting Banking XVII: loans to deposits history

Now that we are on the subject of loans to deposits, I could not resist sharing this historic data from the gold standard era. For those of you that know what happened in 1920, maybe some Ben Graham fan out there, check the high 1919 levels.  The panic of 1907 was another famous episode. As I said, a high loans to deposits ratio is a good prognosticator of an overextended banking system. In the era when the banking system was just banks this was even more true.

Figure 1. Graphic Chart Showing Ratio of Loans to Deposits of New York Clearing House Banks

Figure 1. Graphic Chart Showing Ratio of Loans to Deposits of New York Clearing House Banks

Source: Banking Principles And Practice, Ray Westerfield

Charting Banking XVI: loans to deposits

Traditional banking is easy, you pool deposits and loan them. Hopefully to a productive use so you get paid back.

In 2008, most American banks were not over-extended. They didn’t depend on the frailties of wholesale funding.  In contrast, banks in countries suffering a balance of payments crisis like Greece, Italy or Spain and you will see loans to deposits ratios of 120% and more.

Source: Federal Reserve Board

The most severe abuses were not by banks but by shadow banks with the now infamously famous CDOs and other alchemists inventions.  Initially it seemed that investors were going to take losses but for the most part commercial banks were isolated and in consequence also the real economy. The crisis was confined to these shadow banks housing malinvestments. (Wink to the libertarian friends … but the spellchecker still does not recognize the word.)

Until September 2008.

The shadow banks were caught dependent on wholesale funding and their issues reverberated to the rest of the financial system. The moment a few large commercial banks were thought compromised, and Citicorp indeed was a large shadow bank attached to a small domestic deposit base, the crisis reached another tone.

From September 2008 over the next year, a staggering $700 billion in loans dried up despite the government efforts to stabilize them with TARP. And remember that this is traditional banking, it doesn’t included the trillions in shadow banking assets (CDOs, CLOs, CMBS, ABS) which were decimated. The run also affected productive loans, unrelated to the housing issues, and came back to the banks  affecting their pricing of real assets  securing a large percentage of their loans.

The good news is that banks started loaning again at then end of 2009, supported by the initial positive outlook from the FED survey of lending practices. However, we are is still significantly under-loaned and suffering fits and starts.

Be greedy when others are fearful, Wells Fargo edition

In this blog we have shown a certain fondness for banking, commercial real estate, and debt. Well this is a trifecta, Wells Fargo is rebuilding what used to be Wachovia’s commercial mortgage backed securities business. It is a fantastic story. With all the talk of a bond bubble and the lack of safe instruments, CMBSs are rallying and there is simply no supply. These are the same instruments that were considered toxic waste one year ago and I can still remember the comments on how structured finance was not coming back.

“We believe there is going to be a resurgence of CMBS, and we are investing in anticipation of it,” said Blakey, head of commercial-mortgage lending and servicing. “Our pipeline is growing and we intend to be a leader of this market.”

Wells Fargo is pushing ahead in a market Wachovia controlled before it reported more than $2.1 billion of losses tied to CMBS in 2007 and 2008. Wachovia was the No. 1 underwriter from 2005 to 2007, with $81 billion of commercial mortgage-backed bonds, data compiled by Bloomberg show. Wachovia, based in Charlotte, North Carolina, structured the largest CMBS deal in history, a $7.9 billion bond that included financing for the 2006 purchase of Stuyvesant Town- Peter Cooper Village, Manhattan’s largest apartment complex. The buyers ceded control of the property earlier this year after failing to make debt payments.

Certainly there are advantages in issuing loans after a bubble collapse with a decimated competition.  Lending conditions and underwriting standards are much better.

Commercial property values have declined 39 percent from the 2007 peak, according to Moody’s Investors Service. The decline has made underwriting loans less risky, and banks can dictate more conservative terms and choose the most creditworthy borrowers, said Shrewsberry, head of the company’s securities and investment group.

“It’s a nice time to be originating loans, because you’re at a lower price point on the collateral, you can impose the right structure and there isn’t the frenzied competition” of a few years ago, Shrewsberry said.

I have no position in Wells Fargo, though I am certainly surprised that this great franchise is priced at 1x book value and 52w lows. What really attracts me to this story is that the securitization market comeback could have a positive impact in commercial real estate valuations trickling down to refinancings and banks’ capital ratios.

Starwood Property Trust Inc. Chief Executive Officer Barry Sternlicht said during an Aug. 10 conference call that “CMBS markets are wide open” and suffer from too little supply rather than lack of demand from buyers.

“There’s been good demand for the CMBS issues that have come out so far in 2010,” said Matthew Anderson, managing director at Foresight Analytics, an Oakland, California-based bank and real estate research firm.

Banks will aim to take advantage of loans maturing over the next five years, Anderson said. Almost $1.5 trillion in commercial mortgages on the books of banks or bundled into securities come due between 2010 and 2014, he estimated.

“The market possibilities have re-emerged in a way that’s conducive to doing some business,” Shrewsberry said. “This is a rejuvenation.”

Charting Banking VIII: more on construction and development loans

Some interesting data collected by for banks under $2 billion in assets: construction and development (C&D)  non-performing loans percentage by state. Let’s start with the worst offenders.

Nevada, Washington, Hawaii, District of Columbia, Idaho, Puerto Rico, Georgia, Illinois and Oregon all even worse than Florida and California that have saturated the media. Sure, they are smaller economies but I would not underestimate the economic importance of Georgia, Illinois and Washington. And if you run screens, cheap banks from these states pop up all over the place.

The information is not perfect: some banks loaned cross states and does not disclose how large a percentage of total loans was C&D. What I can tell you though, is that almost every potentially cheap Nevada, Washington, Hawaii, District of Columbia, Idaho, Puerto Rico, Georgia, Illinois and Oregon bank that I have analyzed had some big non-performing loan issues triggered by C&D loans. To reiterate, and I am sure it will not be last time I say this, construction and development loans are bank killers.

It is not difficult to see why. If 20% of your loans are C&D and 20% of them are  non performing, right there you have 4% of your loans non performing with some of the worse potential severity.  If you add home mortgage, helocs, CRE, consumer credit loans… there is not margin of safety buying a bank with more than 6% of non performing loans whatever its capital ratios, but I would raise the bar even higher if the bank has a large C&D percentage.

And when C&D are pervasive in a whole  region, things get much worse. Think Ireland. Banks desperately trying to sell their real estate owned from foreclosures while their competitors are doing the same, driving real estate prices lower and lower well below the replacement cost that in theory should have been the long term equilibrium. But in the short and medium term capital ratios suffer so banks do not lend making things even worse … if government does not intervene. A depression.

What about the well behaved, any surprises there?

Texas and New England? Home to some of the worst offenses in the 80s? For those who think that this crisis is completely new just read Peter Lynch’s “Beating the Street” and how he makes fun of New England bankers and warns about buying banks just because they reached new lows (how low can it go!):

How many people lost substantial amounts of investment capital when they  bought on the bad news coming out of the Bank of New England after the stock had already dropped from $40 to $20, or from $20 to $10, or from $10 to $5, or from $5 to $1, only to see it sink to zero and wipe out 100 percent of their investment – Peter Lynch

It is almost as if they  learned their lesson twenty years ago but I would not bet on it. And this is a good introduction to the next part of Charting Banking because we are going to review an indicator invented from the difficulties of Texan banks in the 80s that is used to anticipate those troubles: the Texas Ratio.

Insurance Sector Price to Book

While reviewing the presentation of a new reinsurance company, I run across some interesting data on historic price to book multiples for insurance companies.

In the context of also low banking multiples, it seems like the financials is one interesting place to look for ideas. There are several P&C insurance companies with good track records below 1x book value. But before getting too excited let me remind you the warnings about investing in banking and in financials in general:

  1. Black Box: you will never be 100% sure of its balance sheet quality
  2. Leverage: no perfect margin of safety
  3. Thin margins: usually no competitive advantage and bad performance pays
  4. Macro matters: you just can not ignore it. Deflation, inflation and interest rates have an impact
  5. Leadership matters: more than in any other sector, good management is crucial to control risk and allocate capital. This is not Coca Cola that can survive a series of bad CEOs

Part of the reason for the low insurance valuations is the soft pricing environment discussed at length in several articles by the StreetCapitalist and RationalWalk. Insurance is a cyclical business, where commercial pressures drive uneconomic pricing, that destroys capital, leading no the next hard market. As Peter Lynch mentions in his books, one way to invest in the sector is to anticipate these waves. Not an easy thing to do if you are not a card carrying member.

Let me also remind you the critical questions when using book value multiples in financials:

  1. How conservative is that book value?
  2. Is it improving?
  3. How are capital ratios and the need for value destroying new capital or a reorganization?

An excellent blog to read for an inside view of the sector is the now classic David Merkel’s Aleph blog. He posted recently an excellent analysis of reserve practices of several insurance companies that is tightly related to question #1. Very recommended.

Charting Banking IV: construction and development

With all the talk over the last year and a half about commercial real estate (CRE) being the next shoe to drop while not dropping, this post is about reminding us of what was really the issue. This can give perspective of the relative order of magnitude of future problems and their consequences.

The real bank killer has been construction and development loans (C&D) with the next possible culprit not even close. This is a chart detailing the type of collateral for real estate loans of closed banks.

SFR: Single Family Residential


Careful with those construction and development loans:

  1. they are large
  2. with short term maturities
  3. no cash flow to soften the blows
  4. collateral price has collapsed
  5. and no demand in the near term for all that construction

So the problem with C&D loans is part the probability of default but even more consequential its severity. Other types of loan problems can be mitigated by refinancing but it is much more difficult with C&D in the middle of a recession.

For most of the banks that I have stumbled upon with recent non performing assets surprises their issue was still related to C&D (ie: CBNK a couple of days ago). And most of their C&D loans were residential since the size of the commercial C&D market is dwarfed by the residential market.

Concluding, as an investor you have to be really sure of a bank underwriting standards (LTV in particular) when they have 20%+ of their portfolio in C&D loans even with good capital ratios. And reading 10Ks will probably not be sufficient so I personally much rather avoid those banks.

Alpha Magazine Hall of Fame – The Traders

This is the second part of excerpts from Alpha Magazine Hall of Fame 2008 from interviews with some famous hedge fund managers. In the first part we review the more familiar fundamental investors. Now we go to the more esoteric stuff: macro traders (Louis Bacon, Bruce Kovner, George Soros, Michael Steinhardt and Paul Tudor Jones). I would emphasize a couple of things.

  • There is a lot of hogwash in the macro traders’ camp, but these managers are the best and if we learned something the last few years is the need to understand bubbles and how to ride them
  • I was very surprised with the few mentions of leverage or shorting or risk management. Is it part of the fabric already?
  • Paul Tudor Jones seems like a lot fun and reasonable. Not sure if I want to be a slave of the tape the rest of my life though.

Institutional Investor’s Alpha Magazine – June 200

The Industry

  • The crowded nature of the hedge fund community has changed the character of trading so that you can see waves of risk-taking and derisking coming from the hedge funds themselves – Kovner
  • But a hedge fund is a superior way of running money -or it has been. But as the industry gets bigger and bigger and takes up a larger and larger segment of the market, it renders it more difficult to outperform and to justify the fees – Soros
  • They go for size and are less interested in absolute performance. They are more interested in relative performance – Steinhardt
  • I was very sensitive throughout my career to the idea that the bigger you are, the bigger your risk is – Steinhardt


  • Fundamentals might be good for the first third or first 50 or 60 percent of a move, but the last third of a great bull market is typically a blow-off, whereas the mania runs wild and prices go parabolic – Tudor Jones
  • Many of the successful macro guys today, they’re all kind of in my age range. They came from that period of crazy volatility of the late 70s and early 80s, when the amount of fundamental information available on assets was so limited and the volatility so extreme that one had to be a technician – Tudor Jones
  • I lost my stakes a couple of times which taught me risk control and risk management. Losing those stakes in my early 20s gave me a healthy dose of fear and respect for Mr. Market and hardwired me for some great management tools. Oh, incidentally and by necessity, I became a pretty good fundraiser – Tudor Jones
  • The macro space will be great. I think we’re going into one of those slow or zero-growth periods in the US, which will give us a lot of volatility. – Tudor Jones
  • While I’m a staunch advocate of higher education, there is no training –classroom or otherwise- that can prepare for trading the last third of a move, whether it’s the end of a bull market or the end of a bear market. There’s typically no logic to it; irrationality reigns supreme, and no class can teach what during that brief volatile reign. The only way to learn how to trade during that last, exquisite third of a move is to do it, or, more precisely, live it – a sort of baptism by fire – Tudor Jones


  • He gave me an ongoing tutorial in disassociating oneself from the results of the trade, yet still have passion about it. – Bacon on Tudor Jones mentorship
  • The prevailing paradigm underestimates or disregards the element of uncertainty. I consider myself an insecurity analyst, not a security analyst – Soros
  • I see the younger generation hampered by the need to understand and rationalize why something should go up or down. Usually, by the time that becomes self-evident, the move is already over – Tudor Jones
  • Being a hedge fund manager is particularly suitable for the pursuit of truth – Soros
  • When I got into the business, there was so little information on fundamentals, and what little information one could get was largely imperfect. We learned just to go with the chart. Why work when Mr. Market can do it for you? – Tudor Jones
  • When I was investing, I measured it one way – which was raw performance – Steinhardt


  • The view I started with and embodied in Caxton’s fund was that business cycles were very important and that they occurred all over the world, and it was useful to observe them and to advantage of the opportunities across four different asset classes (equities, fixed income, commodities and currencies) – Kovner
  • When it comes to trading macro, you cannot rely solely on fundamentals; you have to be a tape reader, which is something of a lost art form –Tudor Jones
  • While I spend a significant amount of my time on analytics and collecting fundamental information, at the end of the day, I am a slave to the tape and proud of it. – Tudor Jones
  • One of the most important skills you need is to constantly reinvent where you put resources. Commodities markets were quiet for years, Now they’re very strong – Kovner
  • We feel that we are versatile enough that we can move into a number of different strategies, and if doing that means that we’re global macro, then we’re not going to argue with that label – Bacon
  • The lesson was that picking the right investment will trump any lousy trading around it – Bacon
  • We tend to make top-down, interest-rate-driven investments. We’ve been pretty U.S. and European –centric throughout most of Moore’s history, and we have been pretty closely focused on what happens with the interest rate cycle and the reactions that it drives around the world – Bacon