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Congress sat idly by while US banks ‘overdosed on steroids’

January 14th, 2010

Congress from Commons Wikimedia

Mike Mayo, an analyst and managing director at brokerage CLSA, yesterday delivered a memorable diagnosis of what went wrong with the US banking sector. In his testimony to the US Congress’s Financial Crisis Inquiry Commission, Mayo also prescribed some cures (to be outlined in a future blog post)

Mayo is appalled by the economic illiteracy of most bankers and the complicity of third parties including government, rating agencies and the accountancy profession in creating an environment where a blind eye was turned to the taking of performance-enhancing but life threatening “steroids” by reckless and greedy bankers. He said:

“Performance was enhanced by excessive loan growth, loan risk, securities yields, bank leverage, and consumer leverage, and conducted by bankers, accountants, regulators, government, and consumers. Side effects were ignored and there was little short-term financial incentive to slow down the process despite longer-term risks.”

“We are now paying the price in what will likely be the biggest taxpayer bailout of US financial firms in history and, given government borrowing, the biggest wealth transfer to the current generation from future generations, that is, my children.”

“I’m shocked and amazed that more changes to banks have not taken place. There seems to be an unwritten premise that a healthy Wall Street as it is constituted today is necessary for the economy to work. Yet, the economy worked well before inventions of exotic instruments such as CDOs and with risk that was more obvious and easy to see.

“Wall St. has done an incredible job at pulling the wool over the eyes of government and others. Perhaps this relates to the size of the banks. The four banks that presented this morning have annual revenues of $300bn, or close to the GDP of the 30th largest country, Argentina.

Mike Mayo then listed ten reasons why the US banking sector had brought itself to the brink of destruction. These were as follows.

  1. Enhanced performance with excessive loan growth: Banks and the financial industry grew loans twice as fast as the natural rate, approaching 8% or 10% plus adjusting for securitization (pre-crisis), above nominal GDP of 5%. We strongly believed that nominal GDP would slow for the past decade, but banks still pushed for loans that should never have been made. This difference is even greater after adjusting for securitization of loans, or when banks packaged and sold loans, often with little if any “skin in the game” with regard to the loan’s performance.
  2. Pumped up profits with higher yielding assets: Higher yields means higher interest rates and – for banks – higher interest rates mean higher profits. To pick two higher-risk loan categories, for the last decade, banks had over 20% average annual loan growth in home equity and over 15% average annual growth in construction loans, areas with higher than typical yields. In securities, banks reduced the percentage of low yielding treasuries from 32% in the early 1990s to under 2% in favor of more risky securities. In the extreme, the ability of a bank to make higher profits in the short-term is as easy as making a phone call. The issue is that higher yields get realized immediately but it comes with higher risk that gets paid later.
  3. Side effects ignored with concentration of assets: The rush in real estate was no secret. Of the 11 loan categories listed by the FDIC, all five of the fastest growing loan categories were real estate related. This is as simple as the old banking adage, “if it grows like a weed, maybe it is a weed” or, perhaps more generally, “don’t put all your eggs in one basket”.
  4. Hiigher dosage with higher balance sheet leverage: By 2006 – before the problems hit the industry – U.S. banks had the highest level of leverage in a quarter of a century. There are many ways to look at this, but I took tangible capital and reserves for loan losses (source: FDIC). This data was also not a secret since the data comes directly from bank regulators. Similarly, leverage in the brokerage industry steadily increased from 20x in the 1980s to 30x in the 1990s to almost 40x in the past decade until shortly before the crisis (source: SIFMA).
  5. Investment banks originated more exotic dosages: By this, I mean instruments such as CDOs, CDOs-squared, etc. that amplified leverage in new and untested forms. It is always hard for us analysts to know what type of risk banks have on their balance sheet. These forms were so complex that not even CEOs, directors, and auditors fully understood their risks. As a reminder, some of these products were created by experts with PhD’s in mathematics. This type of complexity is often used as a reason to pay people massive salaries. The argument goes that if you don’t pay the salaries, good people will go elsewhere in the economy. Isn’t that a good thing? The exotic securities are a clear example of several where Wall Street needs to shrink in
    importance. The protection from monoline insurers also proved much less than met the eye. Innovation often outpaces regulation, but in this case it was more than usual.
  6. Consumers went along for the ride: Consumer debt to GDP has reached a record level of 100%, versus only 50% 25 years ago. This leveraging created a false illusion of prosperity that allowed for the purchase of homes, cars, and other items, many of which should have never been financed and
    purchased. It is no secret that everyone from kids, pets, and dead people received solicitations for loans.
  7. Accountants assisted with performance enhancement: In 1998, the SEC required banks to move closer to a pay-as-you-go approach when accounting for losses on their loans. This was wrong. The result was that banks made more risky loans with better profits but set aside even less reserves for future problems. The banking industry saw a steady decline in reserves for problem loans from the time of the decision in 1998. The move by the SEC was well intentioned since it came at a time of concern about “cookie jar reserves” but misguided since it failed to reflect the unique situation related to banks when it comes to conservatism and reserving for future loan problems. This is only one of several accounting examples.
  8. Regulators facilitated performance enhancement: Banks pay insurance premiums for the coverage that they give on deposits at banks. Banks have paid this fee since the FDIC was established after the Great Depression. Yet, banks paid zero deposit insurance for the decade ending 2006 because the insurance fund was deemed fine. This was a ridiculous insurance model that is analogous to an auto insurance company not charging premiums until somebody has an accident or a life insurance company not charging premiums until somebody dies.
  9. The government doled out some of these steroids: Government supported enterprises such as Fannie Mae through their role in the mortgage market helped to accelerate the growth in housing related securities via subsidies to banks and consumers whose absence would have meant less of a housing bubble. The government created more of a command economy model that had the effect of allocating an excessive amount of capital to the housing sector.
  10. Incentives encouraged the behaviour: To still further the analogy, the system shunted the “doctors”, that is, those whose job it is to report on the financial health of companies and the industry, in lieu of those with more
    positive outlooks. Compensation of banks steadily tracked revenues for all of last decade. The problem is that compensation only tracked profits until losses increased later in the decade, highlighting that prior compensation was far above normal after incorporating losses that were attributable to prior year revenues. I saw issues first hand. First, in the past decade (2000-2008), the stocks in the bank index (“BKX”) declined by over 40% but industry compensation failed to decline in a similar amount. Yet, when I wrote about compensation issues a decade ago, the reaction about me was that these issues were none of my business. Second, only 7 months after I testified to Congress in 2002 about the backlash against analysts who provide unflattering research, I faced what I saw as backlash by a large bank against me and my critical views when I had lack of management access similar to others. It reached a point where I put a disclaimer about this lack of access in my research reports. My point is that if I face a backlash even after I testify to Congress on backlashes, how can a loan officer who is under pressure to produce loans realistically say “Maybe we should sell less loans?” and keep their job.
  • To read the full testimony of CLSA’s Mike Mayo, click here

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