In yesterday's post about Cisco, we stated our belief that IT buyers, whatever their justifiable complaints against their traditional suppliers, need them as real partners going forward because of the increasing risks IT leaders face if their systems suffer business interruptions.
In today's Journal, the case of Royal Bank of Scotland made the business pages as RBS paid a fine of $88 million for an IT failure that kept customers from accessing or transacting from their accounts reportedly for weeks.
British regulators opined that there wasn't a underinvestment in IT systems which led to the failure, but rather an absence of adequate software testing systems which led to the outage. Heaven only knows how regulators who were asleep during the global financial meltdown suddenly have become expert in software implementation and testing. This is, however, the world in which IT buyers, particularly in financial services, are going to function from now on.
To save pennies on a project, bring in newer,smaller unproven partners, or to piece together hardware, software and services on an a la carte basis would be a risky way to do business and it wouldn't be good for an IT exec's career.
The Four Horsemen of Tech will continue to have an advantage going forward in the new world of IT, if they can change their go to market strategies and become more customer-centric: they don't have any other options.
Showing posts with label Risk Management. Show all posts
Showing posts with label Risk Management. Show all posts
Thursday, November 20, 2014
Tuesday, November 4, 2014
Dick Kovacevich On TARP and the Financial Crisis
Dick Kovacevich, the retired Chairman and CEO of Wells Fargo & Company is one of the best chief executives of the hundreds I have met during my career in the capital markets, though I never covered banks. I heard him tell the story of Norwest Bank for many years, and it was always the same message about the importance of the retail 'stores' and improving the number of relationships per customer. My savvy banking analyst colleague at Roulston and Company held him in the highest regard also, and he didn't hand out plaudits easily. Mr.Kovacevich's pitch was a model of clarity, simplicity, and focused on a few core metrics. The ROA, with a modest degree of leverage and a portfolio of businesses including asset management, led to a superior ROE: it was beautiful and simple.
When he took on the famous "merger of equals" that was Norwest and Wells Fargo, Kovacevich really stepped on the hornets' nest, but he handled it with brass knuckles in a velvet glove. Having seen him during a few pickup basketball games, he was unassuming and never drew attention to himself. As a board member at Fingerhut, I know that he was always prepared, engaged and focused on getting the company to do the right thing for all stakeholders; when he couldn't meet his own high standards any more, he left the board. It isn't any coincidence that WFC has been one of Berkshire Hathaway's core equity holdings for many years. His piece in the current Cato Journal caught my attention, and whenever Dick Kovacevich talks about banking and financial services, it's compulsory listening for me.
In 2009, in the din of drums beating for more special Treasury/Fed/government rescue plans, we stood along side a relatively small minority writing about letting the capitalist mechanism of bank failure under existing mechanisms do its job, as it had done before. This post, it turns out, is being re-read often today.
CEO Kovacevich was in Washington, D.C. for the 2006 Treasury TARP meeting. He writes,
Fewer than twenty financial institutions precipitated the crisis, in his opinion. Dick Kovacevich writes that "The housing crisis got as big as it did...only because of the existence of quasi-public/private entities such as Fannie and Freddie."
Meanwhile, of the twenty institutions he references, half were investment banks and half were commercial banks, roughly. Citi was a commercial bank acting more like an investment bank. Why, he asks, punish 6,000 commercial banks for the sins of a relative few?
Bear, Stearns, Merrill Lynch, Goldman Sachs, Morgan Stanley and others had liquidity crises. Their funding model where trillions in balance sheet assets were funded by short-term liabilities was toxic, just waiting for the music to stop when short-term funds couldn't be rolled over any more.
When he took on the famous "merger of equals" that was Norwest and Wells Fargo, Kovacevich really stepped on the hornets' nest, but he handled it with brass knuckles in a velvet glove. Having seen him during a few pickup basketball games, he was unassuming and never drew attention to himself. As a board member at Fingerhut, I know that he was always prepared, engaged and focused on getting the company to do the right thing for all stakeholders; when he couldn't meet his own high standards any more, he left the board. It isn't any coincidence that WFC has been one of Berkshire Hathaway's core equity holdings for many years. His piece in the current Cato Journal caught my attention, and whenever Dick Kovacevich talks about banking and financial services, it's compulsory listening for me.
In 2009, in the din of drums beating for more special Treasury/Fed/government rescue plans, we stood along side a relatively small minority writing about letting the capitalist mechanism of bank failure under existing mechanisms do its job, as it had done before. This post, it turns out, is being re-read often today.
CEO Kovacevich was in Washington, D.C. for the 2006 Treasury TARP meeting. He writes,
"I believed at that time, and I still believe today that forcing all banks to take TARP funds, even if they didn't want of need the funds, was one of the worst economic decisions in the history of the United States."
The Sins of the Few, Not of the Many
At some point, all banking crises have at their root, a crisis of confidence. TARP destroyed confidence in the banking system because the public concluded that all the TARP banks had to be in trouble, otherwise why would they have taken the government's money? Kovacevich writes that "...isolated liquidity issues turned into a tsunami impacting all banks and industries."Fewer than twenty financial institutions precipitated the crisis, in his opinion. Dick Kovacevich writes that "The housing crisis got as big as it did...only because of the existence of quasi-public/private entities such as Fannie and Freddie."
Meanwhile, of the twenty institutions he references, half were investment banks and half were commercial banks, roughly. Citi was a commercial bank acting more like an investment bank. Why, he asks, punish 6,000 commercial banks for the sins of a relative few?
Bear, Stearns, Merrill Lynch, Goldman Sachs, Morgan Stanley and others had liquidity crises. Their funding model where trillions in balance sheet assets were funded by short-term liabilities was toxic, just waiting for the music to stop when short-term funds couldn't be rolled over any more.
Abuse of the Term "Systemically Important."
After more than forty years in the banking business, Kovacevich writes,"In my opinion, there was not any systemic reason to not let banks fail over this time."Bear, Stearns which was half the size of Lehman Brothers should have been allowed to fail. Had this happened, he writes that Lehman's assets would have been sold as the BS workout would have provided market guideposts for bidders to price Lehman's assets. Under the secrecy of TARP, there was no transparency, and hence no confidence and hence the Treasury could talk about the lack of bidders for all of Lehman, which is a red herring and disingenuous.
Regulatory Failure and Incompetence
One quarter after being forced to take TARP funds, Wells Fargo reported record earnings, the highest in the firm's 160 year history. In less than one year, the TARP funds were paid back, along with $2.5 billion in bank interest cost of funds borrowed, and warrants required as part of the shotgun package for the unused and unwanted funds, were exercised in-the-money.
When WFC stepped in to rescue Wachovia in the fall of 2008, it took about one week for WFC's auditors and examiners to conclude that expected losses and required litigation reserves would exceed existing reserves by more than $60 billion!
How, the author writes, could have ongoing examinations by the Federal Reserve, Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corporation have failed to turn up this deficiency earlier?
SEC oversight over the Financial Accounting Standards Board failed when it allowed FASB to impose mark-to-market requirements when markets had become frozen (i.e. failed) and unable to generate economically rational prices. All the market participants understood the market failure, but their opposition was cast politically as an aversion to regulation and financial discipline.
The Fed's proprietary risk models overrode those used for the banks' own stress tests, and yet these models weren't shared with the member banks for comparison and testing. The helter skelter regulatory regime required major banks to put forward profit and capital forecasts for the May-November 2009 in early 2009.
The Fed's secret, proprietary risk models concluded that WFC's revenues would be 30% lower than WFC's own internal forecasts! This kind of discrepancy should have set off alarm bells at the Fed, and making the models available for examination would have been the truly 'scientific' thing to do when confronted by an anomalous result like this. Regulatory chutzpah, arrogance and incompetence fuelled by populist, anti-bank sentiments and by their highly paid outside consultants, ran high.
Actual results for the forecast period were 2% above WFC's internal forecasts.
The Office of Thrift Supervision failed in its routine examination and regulation of Washington Mutual, Countrywide, IndyMac Bank, New Century, First Franklin, Option One, Fremont Financial and other sub-prime originators. We have written about WAMU, Countrywide, IndyMac, and New Century in multiple posts. Various reports by Special Masters/Examiners and others have made the egregious abuses available for anyone to see.
Things were dire at the massively mismanaged OTS, yet nobody was banned from their industry or prosecuted on the regulatory side. OTS was folded into the OCC: the regulatory apparatus wasn't held accountable or downsized, it just got swept under a rug with a new name.
A Simple Idea To Make Banks Stronger
Mr. Kovacevich notes that the total long-term debt of the bank and its bank holding company plus equity and reserves are broadly about 30% of assets, which should be more than sufficient to withstand even a black swan scenario.
Debt holders, he rightly observes, contribute more capital and can impose more financial discipline than equity holders through either a bridge bank or through the bankruptcy mechanism. If one felt that this cushion might not be adequate, the author says that an additional 5-10% holdback on uninsured deposits could be imposed; this proposal has been offered by many academic researchers on the banking system, such as Chicago Booth School of Business or the Columbia Business School.
Dodd Frank Doesn't Make Our Banking System Better or Safer
25,000 pages of new law have not been translated into workable regulation even after more than four years after passage. Regulators have completed only about 52% of the 398 proposed new rules under Dodd Frank, according to the law firm of Davis, Polk.
More than 100 highly trained and paid regulators office at, or work full time on the specific accounts of the largest banks on a routine basis.
Fannie and Freddie are still around, not being wound down. They have once again received the charter, just before the election cycles, to turn on the spigots and make home ownership accessible to all. Have we learned anything? No, but that's not the point in politics.
I'll be posting on a fascinating book by Charles Calomiris (Columbia Business School) and Stephen Haber (Hoover Institution at Stanford University), "Fragile by Design." It is a must read for any students of money, banking, financial economics and regulation.
Friday, October 10, 2014
The Strange Tale of UBS
UBS, as a global bank, has enjoyed a cachet among its high net worth customers in the wealth management and asset management businesses, while U.S. investors have never warmed to its name as a core holding in their institutional portfolios.
Today's New York Times has a disjointed piece on UBS which does nothing to make the investment case for the 'new' UBS, and it shows the continuing disjunction between traditional banking businesses and investment banking.
We learn that in 2011, the current CEO Sergio Ermotti embarked on a strategy to reduce risk-weighted assets that was mandated by Basel regs. A foundation for accomplishing this was to cut costs, exit capital intensive businesses, and to focus the portfolio on businesses like wealth management and asset management, alongside a smaller, more focused investment bank.
In 2012, we learn that the CEO recruited Andrea Orcel, a long-time Bank of America executive, to head up its investment banking operation. Here is Morningstar's take on the recent history of the investment bank's contribution to consolidated UBS financial results:
Morningstar notes that for the fiscal 2014 second quarter,
We learn that an activist shareholder with 1% of the equity, wants to have two securities, one for the investment bank and the other for the wealth management and asset management businesses; the shareholder could then decide which business they really wanted to own and sell the less desirable one.
The CFO responded, “We have zero intention of changing our strategy,” said Tom Naratil, UBS’s chief financial officer. Of course not. The current deal is unbelievably cushy for the entrenched management and board, and it's unlikely that given the regulatory scrutiny on the combined entity along with the history of prior management turnover, another change would be countenanced by shareholders. The company's presentations assert that financial results would be stronger in a rising rate environment that could come by mid-2015, if Fed watchers are right.
So, investors have a Wealth Management business with extremely attractive returns, According to Morningstar, returns on attributed equity in the Wealth Management business are regularly in the 40% range, and even during the heart of the crisis they were in the mid-teens! This is a business to own. Investment Management is also a fine business with excellent margins and sticky customers.
Investment banks should be run as partnerships, as they were in the good old, white spats days. This would, of course, shrink their global reach and risk-based prop trading, but for the public shareholder these aren't attractive businesses to own because of their high fixed costs, volatility, and capacity for major surprises, not to mention a heightened regulatory scrutiny.
Morningstar's Stewardship rating for UBS went from Poor to Standard. I guess that's progress.
Today's New York Times has a disjointed piece on UBS which does nothing to make the investment case for the 'new' UBS, and it shows the continuing disjunction between traditional banking businesses and investment banking.
We learn that in 2011, the current CEO Sergio Ermotti embarked on a strategy to reduce risk-weighted assets that was mandated by Basel regs. A foundation for accomplishing this was to cut costs, exit capital intensive businesses, and to focus the portfolio on businesses like wealth management and asset management, alongside a smaller, more focused investment bank.
In 2012, we learn that the CEO recruited Andrea Orcel, a long-time Bank of America executive, to head up its investment banking operation. Here is Morningstar's take on the recent history of the investment bank's contribution to consolidated UBS financial results:
" Investment banking is a risky activity that can cause very large losses. Between 2007 and 2009, UBS lost nearly CHF 30 billion and required a government bailout as a result of its investment banking losses. In addition, losses in investment banking indirectly affect the private bank. UBS was among the banks hardest hit by asset write-downs, which has damaged its reputation as a competent asset manager, and the 2011 rogue trader scandal set back its recovery. UBS suffered nearly CHF 400 billion of net asset outflows as a result of its damaged reputation. UBS' move away from the riskiest investment banking activities, especially those with long tail risks, should help to reduce the risk of further damage."Naturally, the investment banking business had the normal global, economic cycle rebound in worldwide fee revenue, and it led to Mr. Orcel becoming the highest paid corporate executive in the bank, despite the fact that apart from some some timing and cost-cutting he hadn't done anything very extraordinary. We've written about cultural problems when global investment banks are put together with more traditional banking activities, like client wealth management services. Shareholders haven't done well, even recently.
Morningstar notes that for the fiscal 2014 second quarter,
"Return on equity was disappointing at 6.4%, and excluding the litigation provisions doesn’t help much--we estimate that pro forma return on equity was 8.1%, well below UBS’s 12% cost of equity."So, no EVA inside this combined operation.
We learn that an activist shareholder with 1% of the equity, wants to have two securities, one for the investment bank and the other for the wealth management and asset management businesses; the shareholder could then decide which business they really wanted to own and sell the less desirable one.
The CFO responded, “We have zero intention of changing our strategy,” said Tom Naratil, UBS’s chief financial officer. Of course not. The current deal is unbelievably cushy for the entrenched management and board, and it's unlikely that given the regulatory scrutiny on the combined entity along with the history of prior management turnover, another change would be countenanced by shareholders. The company's presentations assert that financial results would be stronger in a rising rate environment that could come by mid-2015, if Fed watchers are right.
So, investors have a Wealth Management business with extremely attractive returns, According to Morningstar, returns on attributed equity in the Wealth Management business are regularly in the 40% range, and even during the heart of the crisis they were in the mid-teens! This is a business to own. Investment Management is also a fine business with excellent margins and sticky customers.
Investment banks should be run as partnerships, as they were in the good old, white spats days. This would, of course, shrink their global reach and risk-based prop trading, but for the public shareholder these aren't attractive businesses to own because of their high fixed costs, volatility, and capacity for major surprises, not to mention a heightened regulatory scrutiny.
Morningstar's Stewardship rating for UBS went from Poor to Standard. I guess that's progress.
Monday, September 22, 2014
The Chinese Government as Partner for Alibaba.
In yesterday's post, we made the point the smartest thing Alibaba CEO Jack Ma did was to cut the Government of China in as a partner, but we also cited the risk of their exercising a Godfather-like call on shareholder assets at a time in the future.
Today's Wall Street Journal, coincidentally, picks up that very same point and expands it.
Watch for that unanimous panel of Buy/Strong Buy reports from Wall Street. Look for significantly under valued assets like the payment system and the opportunities of building their own fulfillment system in China. Expect the same investor behavior as in the halcyon days of Mary Meeker and the earlier dot com frenzy.
Today's Wall Street Journal, coincidentally, picks up that very same point and expands it.
Watch for that unanimous panel of Buy/Strong Buy reports from Wall Street. Look for significantly under valued assets like the payment system and the opportunities of building their own fulfillment system in China. Expect the same investor behavior as in the halcyon days of Mary Meeker and the earlier dot com frenzy.
Monday, May 26, 2014
Exxon Ships LNG From Papua New Guinea
Exxon Mobil's massive $19 billion LNG project in Papua New Guinea, begun in 2010, has shipped gas ahead of schedule. It is a complex project because of the physical and engineering connections among resources in the Southern highlands and underwater transmission and pipeline infrastructure, ending in an export terminal, with the first output going to a Tokyo power utility.
PNG's government has always had a complicated relationship with the Australian government, multinational corporations, and with its own citizenry's various special interests. The nominal, lifetime production volumes of this first project are 9 trillion cubic feet of natural gas over the 30 year project life. An economic impact study of the project was commissioned and published.
Without second level, or multiplier, effects the project is estimated to produce 3-6 billion kina of annual net benefits to Papua New Guinea over the project life. These benefits are the government's take from public and private taxes, royalties, development levies and charges, and return on equity form a 19% stake in the project, which was funded by a controversial loan from UBS. The costs are the additional expenditure for providing public services to the project environs and residents, both local and expat. 7,500 jobs will be created, of which 20% will be filled by local citizens.
The idea of putting the net cash flows into the creation of a sovereign wealth fund, on the Norwegian model, has been discussed ad nauseum. Were the government able to pull this off, without letting the surplus evaporate or be spent foolishly, this would be a great example for other developing countries looking for a new model for commercializing their natural resources. Other projects linked to this one are waiting in the wings. A new energy exporter has been born! Let's hope it turns out really well.
PNG's government has always had a complicated relationship with the Australian government, multinational corporations, and with its own citizenry's various special interests. The nominal, lifetime production volumes of this first project are 9 trillion cubic feet of natural gas over the 30 year project life. An economic impact study of the project was commissioned and published.
Without second level, or multiplier, effects the project is estimated to produce 3-6 billion kina of annual net benefits to Papua New Guinea over the project life. These benefits are the government's take from public and private taxes, royalties, development levies and charges, and return on equity form a 19% stake in the project, which was funded by a controversial loan from UBS. The costs are the additional expenditure for providing public services to the project environs and residents, both local and expat. 7,500 jobs will be created, of which 20% will be filled by local citizens.
The idea of putting the net cash flows into the creation of a sovereign wealth fund, on the Norwegian model, has been discussed ad nauseum. Were the government able to pull this off, without letting the surplus evaporate or be spent foolishly, this would be a great example for other developing countries looking for a new model for commercializing their natural resources. Other projects linked to this one are waiting in the wings. A new energy exporter has been born! Let's hope it turns out really well.
Tuesday, May 6, 2014
Target CEO Change Was Long Overdue
Retailing industry stocks were my institutional research bread and butter for many years, and I followed Target when it was a budding business within Dayton Hudson. It has been a remarkably successful business, carving out a distinctive niche, while tweaking its merchandise offerings to adapt to changing consumer tastes and trends.
Like many early department store companies, whether public or private, Target is a merchant driven company. Any initiative that serves the merchants is a good investment from the corporate management, and it was usually good for earnings too. Merchants don't know, or care, about data security. That is why the notion of spending millions on data security, which insiders felt was needed as the credit card portfolio expanded, was never considered important.
This attitude is amazing, because in many fundamental ways, Target's success came from being heavily programmed and systematized in things like store formats and their roll-outs. Nothing was left to chance or to local improvisation. No detail was too small for corporate attention. Data security should have been on the radar screen for the board.
Post-data breach, the way Target has handled it has been so abysmal even for a bad retailing company; for an industry leader, it is shocking. Aside from a full page ad in the Wall Street Journal, and from commiserating with other customers, Target has, to my knowledge, never sent out letters to all their private label and bank debit card customers telling them what happened, how serious it might be, and offering them solutions to protect their accounts. We never got any communication, and our family spends a lot of money at the store; and we replaced our bank cards on our own and received no notice of free credit monitoring, as alleged in newspapers. I doubt that a large proportion of their customers, excuse me "guests," read the Wall Street Journal.
Unlike the press characterization of the intrusion as being high tech, it seems that it was decidedly low tech. In fact, one of the Target systems actually detected it, but the culture of Target either placed no confidence in their own systems, or the IT department's processes for communicating upward don't work.
Canada has been written about, but these kinds of execution shortfalls in an adjacent market is inexcusable.
The stock price spent much of 2013 in the seventies, before languishing downward to the low sixties in the face of a market fleeing to big capitalization, high quality names.
The problem going forward is this. Bringing in a retailing star from another company, like Walmart for example, isn't guaranteed to work because of the huge differences in the business models and management cultures. The new CEO would have to spend time sorting out her team while learning where the bodies were buried. Elevating a top merchant sounds fine, except merchandising is where some of the fundamental mistakes have been made, like going too far upscale with programs that had to be closed out. Target is having a bit of an identity crisis, and it has been going on for some time.
Financial engineering with real estate and returning money to shareholders wasn't a solution when Pershing Square beat its chest, and that is the same story today, if the company wants to remain a major league player. At least this change gives the board the opportunity to get things right. The question will be "Have they left it late?" A dead stock for a while?
Like many early department store companies, whether public or private, Target is a merchant driven company. Any initiative that serves the merchants is a good investment from the corporate management, and it was usually good for earnings too. Merchants don't know, or care, about data security. That is why the notion of spending millions on data security, which insiders felt was needed as the credit card portfolio expanded, was never considered important.
This attitude is amazing, because in many fundamental ways, Target's success came from being heavily programmed and systematized in things like store formats and their roll-outs. Nothing was left to chance or to local improvisation. No detail was too small for corporate attention. Data security should have been on the radar screen for the board.
Post-data breach, the way Target has handled it has been so abysmal even for a bad retailing company; for an industry leader, it is shocking. Aside from a full page ad in the Wall Street Journal, and from commiserating with other customers, Target has, to my knowledge, never sent out letters to all their private label and bank debit card customers telling them what happened, how serious it might be, and offering them solutions to protect their accounts. We never got any communication, and our family spends a lot of money at the store; and we replaced our bank cards on our own and received no notice of free credit monitoring, as alleged in newspapers. I doubt that a large proportion of their customers, excuse me "guests," read the Wall Street Journal.
Unlike the press characterization of the intrusion as being high tech, it seems that it was decidedly low tech. In fact, one of the Target systems actually detected it, but the culture of Target either placed no confidence in their own systems, or the IT department's processes for communicating upward don't work.
Canada has been written about, but these kinds of execution shortfalls in an adjacent market is inexcusable.
The stock price spent much of 2013 in the seventies, before languishing downward to the low sixties in the face of a market fleeing to big capitalization, high quality names.
The problem going forward is this. Bringing in a retailing star from another company, like Walmart for example, isn't guaranteed to work because of the huge differences in the business models and management cultures. The new CEO would have to spend time sorting out her team while learning where the bodies were buried. Elevating a top merchant sounds fine, except merchandising is where some of the fundamental mistakes have been made, like going too far upscale with programs that had to be closed out. Target is having a bit of an identity crisis, and it has been going on for some time.
Financial engineering with real estate and returning money to shareholders wasn't a solution when Pershing Square beat its chest, and that is the same story today, if the company wants to remain a major league player. At least this change gives the board the opportunity to get things right. The question will be "Have they left it late?" A dead stock for a while?
Saturday, March 15, 2014
Insurance Risks and Capital Markets
It's almost impossible to make a persuasive case that insurance industry companies were responsible for systemic risk in the last financial crisis. Organizations like the OECD took that position way back in 2009.
Today, perhaps on the argument that regulation is looking forward, certain insurers, like Met Life and Prudential, are being bandied about as "systemically important financial institutions." Size would be the obvious measure to bring these companies under the microscope. Met Life's assets in 2012 were $562 billion, number one in the industry. Number two was Prudential at $491 billion, both from the ACLI. But, the business model, management capability, board oversight, and corporate cultures are what drove the bad actors in the last crisis to put the financial system on the brink. Size, for the insurance business, was neither germane nor predictive.
John Cochrane of Chicago Booth and other scholars have talked about the fundamental importance of "runs" in financial crisis. We know how banks have runs on deposits. We now know how runs can create panic selling in asset markets, as they did in the last crisis. Life insurers, with very long term liabilities, are unlikely to be be affected by policy holder runs, by the insureds demanding payment of cash values all at once. Fees and surrender charges provide insulation and disincentive, respectively. Life insurance industry policy reserves were $1.3 trillion in 2012, and their share of policy reserves in total has been declining over recent years. These reserves are built for mortality and longevity issues, not for unlikely or immaterial runs on policies.
What about AIG, though? It is number four in assets of the life insurers in 2012, with $247 billion. But, as we know, but sometimes forget, AIG's losses were caused by one, nominally small, unregulated, misunderstood, unmonitored renegade business called AIG Financial Products Group, a capital markets business.
Indeed, going forward, it will once again be the capital markets where the risks will be uncovered, after the fact. The incentives and pressures for systemic riskiness are created by the continuing, artificial low interest rate environment which now cannot be unwound as quickly as it was put into place.
The low interest rate environment has put pressure on life insurers who have written variable life products with higher guaranteed crediting rates than today's levels. The risk can be inferred from the composition of industry policy reserves. Policy reserves for annuity products were $2.9 trillion in 2012, more than double the level for life policies, and 65% of policy reserves.
For pension fund sponsors, particularly in the public sector, enormous pressures are building from mismanagement, poor investment decisions, and mortality and and longevity risks.
Signs of a locus for the next crisis may be seen in some recent capital market and reinsurance market deals.
Today, perhaps on the argument that regulation is looking forward, certain insurers, like Met Life and Prudential, are being bandied about as "systemically important financial institutions." Size would be the obvious measure to bring these companies under the microscope. Met Life's assets in 2012 were $562 billion, number one in the industry. Number two was Prudential at $491 billion, both from the ACLI. But, the business model, management capability, board oversight, and corporate cultures are what drove the bad actors in the last crisis to put the financial system on the brink. Size, for the insurance business, was neither germane nor predictive.
John Cochrane of Chicago Booth and other scholars have talked about the fundamental importance of "runs" in financial crisis. We know how banks have runs on deposits. We now know how runs can create panic selling in asset markets, as they did in the last crisis. Life insurers, with very long term liabilities, are unlikely to be be affected by policy holder runs, by the insureds demanding payment of cash values all at once. Fees and surrender charges provide insulation and disincentive, respectively. Life insurance industry policy reserves were $1.3 trillion in 2012, and their share of policy reserves in total has been declining over recent years. These reserves are built for mortality and longevity issues, not for unlikely or immaterial runs on policies.
What about AIG, though? It is number four in assets of the life insurers in 2012, with $247 billion. But, as we know, but sometimes forget, AIG's losses were caused by one, nominally small, unregulated, misunderstood, unmonitored renegade business called AIG Financial Products Group, a capital markets business.
Indeed, going forward, it will once again be the capital markets where the risks will be uncovered, after the fact. The incentives and pressures for systemic riskiness are created by the continuing, artificial low interest rate environment which now cannot be unwound as quickly as it was put into place.
The low interest rate environment has put pressure on life insurers who have written variable life products with higher guaranteed crediting rates than today's levels. The risk can be inferred from the composition of industry policy reserves. Policy reserves for annuity products were $2.9 trillion in 2012, more than double the level for life policies, and 65% of policy reserves.
For pension fund sponsors, particularly in the public sector, enormous pressures are building from mismanagement, poor investment decisions, and mortality and and longevity risks.
Signs of a locus for the next crisis may be seen in some recent capital market and reinsurance market deals.
- In 2011, Rolls Royce transferred some $3 billion in pension fund liabilities to Deutsche Bank, which in turn transferred them to a group of insurers and reinsurers. RR pays fixed premiums for coverage if an agreed upon longevity index exceeds a cap, in which case RR receives payment from its insurers.
- Aegon hedged its annuity portfolio by transferring 12 billion euros of longevity risk to Deutsche Bank in a swap.
- Aegon completed a second deal in 2013 through a more complicated structure created by Societe Generale's CIB business.
If one goes to the current financial disclosures of these companies, it is almost impossible to find much discussion of these new types of businesses and their risks. While some observers have said that there are only $2-3 billion of U.S. deal volume in mortality and longevity transfers done annually, they also say that worldwide appetite for these structures could be as high as protection for $21 trillion in assets. This kind of deal market would strain the capacities of even the giants like Berkshire Hathaway.
Keep an eye on the capital markets players and these business structures, if you can find them, understand them, measure the risks and track them back to the counter parties.
Wednesday, January 15, 2014
JP Morgan Looks Like It's Positioned Well
Let's think back to the beginning of Bob Paulson's plan to save the global banking sector from itself, when the nine CEOs were invited to sign the famous one page deal injecting $250 billion of taxpayer money into their banks. On top of that, Wells absorbed Wachovia, JP Morgan absorbed WAMU, and Bank of America absorbed Merrill Lynch. WWE-style chest thumping and outrage was shown by most of the participants, except by JP Morgan CEO Jamie Dimon, according to the newspaper. He apparently did the cost of capital calculation in his head and saw the Feds as a cheap source of funds.
Fast forward and we've concluded with the Feds now raiding the JP Morgan treasury for some $30 billion in fines for originating and selling bad mortgages to the GSEs and for not blowing the whistle on the Madoff Ponzi scheme.
So the fourth quarter of 2013 capped a pretty miserable year compared to 2012, but the fourth quarter showed all the signs of the bank being well positioned for an improving U.S. and global economy and for the concomitant steepening of the yield curve.
On a managed basis, 2013 corporate revenue of $99.8 billion was flat with 2012 revenue. Reported, diluted EPS of $1.30 was down compared to $1.39 in the prior year, on the same basis. However, excluding extraordinary items, 2013 diluted EPS was $1.40. During this long waiting period for the economy to show a lasting rebound, banks like Morgan and Wells have been pulling out all the stops to generate some semblance of earnings stability. JP Morgan has taken allowances into income in prior quarters, to the consternation of some analysts, but based on some of the underlying trends in credit cards, business loans, mortgages and deposits, the turn may be coming.
JP Morgan's efforts to position the bank for an economic rebound look like they've put the bank in a strong position,
JP Morgan's Consumer and Community Banking business now serves 43% of U.S. households, and its increased penetration has most certainly been helped by the acquisition and build-out of the old Washington Mutual branches. What seemed like poison at the time may turn out to be honey for the shareholders. The base of 5,600 or so branches will not be expanded in the near-term as much as it will be reshaped and optimized for better productivity.
The CaCB business grew deposits in the fourth quarter of 2013 to $461 billion compared to $426 billion in the prior-year period, a solid 8% increase. Allowances for loan losses, non-performing assets, and the net charge-off rates are all down year-over-year in the quarter, and its looks like the charge-off rates are near historic lows.
Fourth quarter 2013 provision for credit losses was $72 million, compared to $1.1 billion in the fourth quarter of 2012, a decline of 93%; the full year provision for Consumer and Community Banking declined similarly to $335 million compared to $3.8 billion in 2012.
The Mortgage Banking business, to no one's surprise, fell out of bed. Full year 2013 net revenue of $10 billion was down 28% from 2012 revenue of $14 billion. Provisions for credit losses benefited 2013 pre-tax income by $2.7 billion compared to a benefit of $0.5 billion in 2012. Non-interest expense declined 17% for the full year, driven by the large headcount reductions. Net income of $3.1 billion declined only 8% in 2013, year-over-year.
Mortgage production revenue was down 78% in the fourth quarter, and 54% for 2013, yielding $2.7 billion in production revenue. According to a slide in a recent analyst presentation deck, the current mortgage underwriting standards look pretty strict, with average FICO scores of around 750+.
The credit card, merchant services and auto businesses had good solid quarters, and delinquencies on the card portfolio have been on a ski slope downward and the portfolio has been cleaned up.
A slide talking about earnings sensitivity to a rising rate environment back in June 2013 modeled earnings gains of $2.1 billion and $3.8 billion, respectively, from a 100 basis point and 200 basis point parallel shift in the yield curve.
The investment bank made gains in various underwriting segments, and the compensation levels ended the year so as to give opportunity should the global IPO and acquisitions cycles continue to heat up.
The one truly eye-watering item was the prevalence and magnitude of the legal expenses all over the financial statements. The "Other Expense" category for 2013 showed expense of $19,761 million compared to $14,032 million in 2012. Of these amounts, legal expenses comprised $11 billion (56%) in 2013 and $5 billion (36%) in 2012.
Legal expenses are also buried in some of the mortgage production operation results. I couldn't follow the CFO's rapid fire presentation about reserves for litigation, but it sounded like large amounts. Because she is a British physics major by training, she has real command of numbers and of the Basel and mark-to-market modelling issues. The speed of her delivery made me think of the classic Fed Ex commercials.
Fast forward and we've concluded with the Feds now raiding the JP Morgan treasury for some $30 billion in fines for originating and selling bad mortgages to the GSEs and for not blowing the whistle on the Madoff Ponzi scheme.
So the fourth quarter of 2013 capped a pretty miserable year compared to 2012, but the fourth quarter showed all the signs of the bank being well positioned for an improving U.S. and global economy and for the concomitant steepening of the yield curve.
On a managed basis, 2013 corporate revenue of $99.8 billion was flat with 2012 revenue. Reported, diluted EPS of $1.30 was down compared to $1.39 in the prior year, on the same basis. However, excluding extraordinary items, 2013 diluted EPS was $1.40. During this long waiting period for the economy to show a lasting rebound, banks like Morgan and Wells have been pulling out all the stops to generate some semblance of earnings stability. JP Morgan has taken allowances into income in prior quarters, to the consternation of some analysts, but based on some of the underlying trends in credit cards, business loans, mortgages and deposits, the turn may be coming.
JP Morgan's efforts to position the bank for an economic rebound look like they've put the bank in a strong position,
JP Morgan's Consumer and Community Banking business now serves 43% of U.S. households, and its increased penetration has most certainly been helped by the acquisition and build-out of the old Washington Mutual branches. What seemed like poison at the time may turn out to be honey for the shareholders. The base of 5,600 or so branches will not be expanded in the near-term as much as it will be reshaped and optimized for better productivity.
The CaCB business grew deposits in the fourth quarter of 2013 to $461 billion compared to $426 billion in the prior-year period, a solid 8% increase. Allowances for loan losses, non-performing assets, and the net charge-off rates are all down year-over-year in the quarter, and its looks like the charge-off rates are near historic lows.
Fourth quarter 2013 provision for credit losses was $72 million, compared to $1.1 billion in the fourth quarter of 2012, a decline of 93%; the full year provision for Consumer and Community Banking declined similarly to $335 million compared to $3.8 billion in 2012.
The Mortgage Banking business, to no one's surprise, fell out of bed. Full year 2013 net revenue of $10 billion was down 28% from 2012 revenue of $14 billion. Provisions for credit losses benefited 2013 pre-tax income by $2.7 billion compared to a benefit of $0.5 billion in 2012. Non-interest expense declined 17% for the full year, driven by the large headcount reductions. Net income of $3.1 billion declined only 8% in 2013, year-over-year.
Mortgage production revenue was down 78% in the fourth quarter, and 54% for 2013, yielding $2.7 billion in production revenue. According to a slide in a recent analyst presentation deck, the current mortgage underwriting standards look pretty strict, with average FICO scores of around 750+.
The credit card, merchant services and auto businesses had good solid quarters, and delinquencies on the card portfolio have been on a ski slope downward and the portfolio has been cleaned up.
A slide talking about earnings sensitivity to a rising rate environment back in June 2013 modeled earnings gains of $2.1 billion and $3.8 billion, respectively, from a 100 basis point and 200 basis point parallel shift in the yield curve.
The investment bank made gains in various underwriting segments, and the compensation levels ended the year so as to give opportunity should the global IPO and acquisitions cycles continue to heat up.
The one truly eye-watering item was the prevalence and magnitude of the legal expenses all over the financial statements. The "Other Expense" category for 2013 showed expense of $19,761 million compared to $14,032 million in 2012. Of these amounts, legal expenses comprised $11 billion (56%) in 2013 and $5 billion (36%) in 2012.
Legal expenses are also buried in some of the mortgage production operation results. I couldn't follow the CFO's rapid fire presentation about reserves for litigation, but it sounded like large amounts. Because she is a British physics major by training, she has real command of numbers and of the Basel and mark-to-market modelling issues. The speed of her delivery made me think of the classic Fed Ex commercials.
Monday, June 4, 2012
Systemic Risk and Sovereign Defaults
An interesting 2011 paper from Andrew Ang of Columbia Business School and Francis Longstaff of UCLA Anderson Business School, develops useful findings which apply to current discussions about sovereign risk.
The authors take the U.S. and the ten largest states (CA, TX, NY...) and compare them to the Eurozone countries, using CDS spreads as a measure of changes in sovereign risk. Their goal is to get a feel for how much of sovereign risk is truly systemic. An underlying principle of the statements of most international public officials is that global systemic risk is the bugaboo behind real risks to the system. Ang and Longstaff use CDS spreads as their market-based measure for pricing risks and changes in risk. They then partition the overall risk into systemic risk and idiosyncratic risk.
In the U.S., they find that California as a sovereign issuer has 5x the average risks of the other 9 U.S. states in the sample. New York, by contrast, has surprisingly almost no systemic risk: risk associated with its securities are almost all idiosyncratic. So, New York's securities could be held in a diversified portfolio of U.S. sovereign securities, reducing the portfolio risk. Applying the same reasoning to California paper wouldn't yield the same risk-lowering benefit.
For all ten of the largest U.S. states in the sample, the average systematic risk percentage is only 12.2%. California's systematic risk percentage is 36.8%, certainly well above average. However, in somewhat of a counter intuitive conclusion, systemic risk for U.S. state issuers is significantly lower than idiosyncratic risk specific to the issuer in question.
Europe by contrast shows results which suggest that the nature of sovereign systemic risk is quite different between Europe and America. The average systemic risk percentage for all Eurozone nations is 30.9%, 2.5x higher than the average for American issuers. The country with the highest proportion of systemic risk in total risk is France at 53.2%.
Even as macroeconomic discussions today focus on the relatively small size of the Greek economy in the Eurozone, the authors find that the Greek systemic risk component is 3x that of Portugal, Spain and Belgium, the other weak sisters in the Eurozone. All of them, however, carry much more systemic risk than does German paper.
What factors best explain changes in systemic risk? What might constitute a transmission mechanism? Changes in VIX and variations in overall equity market returns are the major factors explaining systemic risk in the EU and in American sovereign issuers.
Think about the findings here and ask yourself again, "Why would Germany be sanguine about moving towards fiscal union?"
The authors take the U.S. and the ten largest states (CA, TX, NY...) and compare them to the Eurozone countries, using CDS spreads as a measure of changes in sovereign risk. Their goal is to get a feel for how much of sovereign risk is truly systemic. An underlying principle of the statements of most international public officials is that global systemic risk is the bugaboo behind real risks to the system. Ang and Longstaff use CDS spreads as their market-based measure for pricing risks and changes in risk. They then partition the overall risk into systemic risk and idiosyncratic risk.
In the U.S., they find that California as a sovereign issuer has 5x the average risks of the other 9 U.S. states in the sample. New York, by contrast, has surprisingly almost no systemic risk: risk associated with its securities are almost all idiosyncratic. So, New York's securities could be held in a diversified portfolio of U.S. sovereign securities, reducing the portfolio risk. Applying the same reasoning to California paper wouldn't yield the same risk-lowering benefit.
For all ten of the largest U.S. states in the sample, the average systematic risk percentage is only 12.2%. California's systematic risk percentage is 36.8%, certainly well above average. However, in somewhat of a counter intuitive conclusion, systemic risk for U.S. state issuers is significantly lower than idiosyncratic risk specific to the issuer in question.
Europe by contrast shows results which suggest that the nature of sovereign systemic risk is quite different between Europe and America. The average systemic risk percentage for all Eurozone nations is 30.9%, 2.5x higher than the average for American issuers. The country with the highest proportion of systemic risk in total risk is France at 53.2%.
Even as macroeconomic discussions today focus on the relatively small size of the Greek economy in the Eurozone, the authors find that the Greek systemic risk component is 3x that of Portugal, Spain and Belgium, the other weak sisters in the Eurozone. All of them, however, carry much more systemic risk than does German paper.
What factors best explain changes in systemic risk? What might constitute a transmission mechanism? Changes in VIX and variations in overall equity market returns are the major factors explaining systemic risk in the EU and in American sovereign issuers.
Think about the findings here and ask yourself again, "Why would Germany be sanguine about moving towards fiscal union?"
Monday, May 14, 2012
Enterpise Risk Management: JPM and AIG
A post which has had a long, steady readership is one relating to AIG's risk management czar. It relates very closely to the latest kerfuffle at JP MorganChase.
The whole notion that the JPM unit was hedging its dealer bond portfolio is implausible. For the sake of argument, let's say that is what Bruno Iksil was doing. Since he was using the abstruse synthetic index, then he would have had some sort of hedge ratio and not have been hedging dollar for dollar. The size of his bets are implausible for a hedge. If this wasn't proprietary trading, then we'll never be able to define it, which is why the whole Dodd-Frank regulatory wordsmithing is a waste of time.
The next thought is that Iksil's trading strategy itself was naive and incompetent. He ventured into what had been a relatively obscure part of the fixed income market place, which is where one might go to find and exploit market inefficiencies. Except, once the size of his book ballooned, the relatively small club which populates this corner of the casino knew something was up and the name "London Whale" was born. As one market participant said, Iskil had committed a fatal error, in an inefficient market, he had "become the market."
What happened next seems unclear in journalists accounts. Someone at JPM said to reverse the trades. Now the real problems began, because the same JPM brokers who had called hedge funds and others about his initial position now made called the same market players about the opposite position in size. That could only mean one thing: the whale had been harpooned. Now it was a freebie opportunity for playing the other side.
Inside JPM, no internal controls or proprietary risk management systems had prevented this position from becoming so out sized. The bank can claim that they were always in touch with the New York Fed, and that they jointly decided to take action. One small thing: someone forgot to let the outspoken CEO know about it. His chagrin is palpable in every photograph. It's impossible for any CEO to have his hands this close to a business whose risk profile changes by the hours.
Iksil's boss, who made $14 million last year will fall on her sword and move to a hedge fund. Nothing in the yet to be minted regulations will ever break this vicious cycle of big bets, big wins, big compensation, big bust, and move to the next casino.
Financial innovation is not doing anything to lift the world economy out of the global slowdown. Then, why is this such a valuable, highly compensated function? As imperfect as the Volcker Rule is, if it leads to the bifurcation of commercial banking and investment banking, with its proprietary trading that's progress. Regulation, ERM, and better board governance are pie in the sky, delusional thinking.
If we really and truly want less systemic risk, then normal commercial banking has to become much more like a utility, and investment banking has to find a way to operate without implicit guarantees which will always produce risk seeking behavior.
The whole notion that the JPM unit was hedging its dealer bond portfolio is implausible. For the sake of argument, let's say that is what Bruno Iksil was doing. Since he was using the abstruse synthetic index, then he would have had some sort of hedge ratio and not have been hedging dollar for dollar. The size of his bets are implausible for a hedge. If this wasn't proprietary trading, then we'll never be able to define it, which is why the whole Dodd-Frank regulatory wordsmithing is a waste of time.
The next thought is that Iksil's trading strategy itself was naive and incompetent. He ventured into what had been a relatively obscure part of the fixed income market place, which is where one might go to find and exploit market inefficiencies. Except, once the size of his book ballooned, the relatively small club which populates this corner of the casino knew something was up and the name "London Whale" was born. As one market participant said, Iskil had committed a fatal error, in an inefficient market, he had "become the market."
What happened next seems unclear in journalists accounts. Someone at JPM said to reverse the trades. Now the real problems began, because the same JPM brokers who had called hedge funds and others about his initial position now made called the same market players about the opposite position in size. That could only mean one thing: the whale had been harpooned. Now it was a freebie opportunity for playing the other side.
Inside JPM, no internal controls or proprietary risk management systems had prevented this position from becoming so out sized. The bank can claim that they were always in touch with the New York Fed, and that they jointly decided to take action. One small thing: someone forgot to let the outspoken CEO know about it. His chagrin is palpable in every photograph. It's impossible for any CEO to have his hands this close to a business whose risk profile changes by the hours.
Iksil's boss, who made $14 million last year will fall on her sword and move to a hedge fund. Nothing in the yet to be minted regulations will ever break this vicious cycle of big bets, big wins, big compensation, big bust, and move to the next casino.
Financial innovation is not doing anything to lift the world economy out of the global slowdown. Then, why is this such a valuable, highly compensated function? As imperfect as the Volcker Rule is, if it leads to the bifurcation of commercial banking and investment banking, with its proprietary trading that's progress. Regulation, ERM, and better board governance are pie in the sky, delusional thinking.
If we really and truly want less systemic risk, then normal commercial banking has to become much more like a utility, and investment banking has to find a way to operate without implicit guarantees which will always produce risk seeking behavior.
Saturday, September 17, 2011
AIG Enterprise Risk Management: Tougher Than It Sounds
AIG has a new "risk czar," Peter Hancock, an economist by training I'm happy to see, who heads up the Chartis unit charged with doing "enterprise risk management." I have yet so to meet a public company director who can describe in concrete terms what this means for their company, and especially so for financial companies.
One of the operational problems generally, and especially for financial companies, is that risk is generated in silos. An example of a large silo would be proprietary trading, and a sub-silo might be what's called Delta-1, where the latest rogue trader has surfaced at UBS. Every profit center will have its own system of reporting, especially for the purposes of calculating bonuses and incentive compensation. Lots of magic takes place when financials are rolled up for the purposes of external reporting.
Since risk is being generated in large numbers of relevant silos, how can a person at one desk look at a chart, report, or dashboard and monitor risk on an enterprise-wide basis? I don't believe its possible for an investment bank, which is why we've had rogue traders since way in the early days of MBS trading in 1987. Howard Rubin generated $377 million in losses which were not discovered until he left Merrill Lynch, and somebody found the unreported trade confirms in his locked desk drawer; he was banned from the industry for nine months and eventually joined Bear Stearns. Joe Jett was another prominent "profit center" for Kidder Peabody who created some fictional profits of $350 million and paid himself a $9 million bonus before being discovered. A Japanese trader for Royal Dutch Shell lost $1 billion in unauthorized commodity trading. Nick Leeson was a recent example who lost $1 billion for Barings, and apparently Kweku Adoboli of UBS has hired Lesson's attorney to defend him in his court action. Sounds like a prudent move for the trader.
The point is that rogue traders are nothing new, and the ones in the news are really a subset of those who are out there and undiscovered, or who had big exposures that reversed themselves before they were found out.
Bonuses, like those that Joe Jett generated for himself, are done in the profit centers themselves and on a basis that is too fast for any effective risk management, except well after the fact.
Managers in the profit silos will complain to risk czars that rigorous systems of oversight and reporting will negatively impact their ability to recruit superstar trading talent. Guess which side is going to win this argument? Not somebody like the man in the picture above.
Now AIG is supposedly a simpler business than before, with the demise of their specialty financial businesses. If this is true, and it has gone back to its traditional insurance and reinsurance businesses, then it might be possible that a risk management system could be devised and operative. I can't conceive of how this can be done for a traditional global investment bank.
Dodd-Frank does not give any degree of comfort. Banks will have to divest their prop trading desks, but the problem is that nobody can agree on what constitutes a prop trading desk. Witness the confused discussion on whether or not Adoboli's Delta 1 desk constituted a prop trading operation, or one that worked on behalf of UBS clients! The more things change, the more they remain the same.
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