The famous short seller, who identified basket cases such as Sino-Forest announced yesterday that he is short Standard Chartered Bank’s debt. The reason he is short is because of the questionable quality of the bank’s loan book- particularly its mining sector exposure.
Readers of the book Stories in Credit Analysis would recognize that we have never been fans of this bank and never bought the bank’s emerging market story. Most recently, its earnings have been driven by underprovisioning. We have also highlighted the bank’s poor internal controls (which has resulted in the bank paying huge fines to regulators in many countries- the most recent episode being payment to US regulators for money laundering). The root of Standard Chartered bank’s problems is the bank’s management structure. The CEO is a non-playing captain who operates out of London, while the different emerging market units do pretty much what they like. Now non-playing captains are alright for a country’s Davis Cup tennis team- not for an international bank.
For the same reason, we have deep doubts about the sustainability of HSBC’s earnings and fear an orgy of explosion of contingent liabilities into actual liabilities
am thinking of putting together a collection of essays on Risk Management from first principles. The essays would have minimal quantitative application and maximal use of common sense. Readers of this blog are requested to contribute.
Equity analysts in the US are gushing about the recent trend of buoyant earnings per share (EPS) of US companies. Unfortunately, that is not something for creditors to cheer about. The rising EPS, in many cases, is not due to strong operating earnings, but due to share buybacks which reduce the number of outstanding shares. The buybacks in many cases have been funded through debt. These shenanigans effectively make equity senior to debt and creditors who are sleeping on the wheel are in for a nasty surprise.
Deutsche Bank’s A+ credit rating from S&P has finally been placed on rating watch with negative implications. The points highlighted in the S&P release are some of the points we had highlighted exactly two years ago in our detailed piece on Deutsche Bank (http://crediteye.wordpress.com/2011/03/29/deutsche-bank-creditor-concerns/). But not all the concerns we had raised have been addressed in S&P’s review and the rating agencies continue to be woefully behind the curve. We would go so far as to say that Deutsche Bank, through its global linkages, is the biggest risk to the global financial system. Not the Italian banks that will soon fail. Or the doddering Spanish and UK banks.
One of our key assertions on sovereign credit assessment in the book Stories in Credit Analysis is that a creditor should not draw comfort from the protection afforded by institutional structures in a country. Institutional structures will fray during a crisis. We had asserted that is better for creditors to forecast the likelihood of a crisis occurring than trying to forecast what happens after that- things will not go as per the script. This thesis has been amply confirmed by the happenings at Cyprus. Creditors who drew comfort from the institutional mechanisms of the EU would have been shocked to see a solemn contract in the form of deposit insurance being torn apart during the current crisis. The same thing happened in the US when the US government screwed the creditors of General Motors during the GM bankruptcy episode. Noble notions such as “property rights” were given a quiet good bye.
Hence our quarrel with rating agencies who in their sovereign rating exercise give considerable weightage to the institutional framework of a country. Our belief: it does not matter if the country is the US or China- when a credit crisis happens, creditor rights will be chipped away. So, instead of drawing foolish comfort from institutional structures, a creditor is better off predicting the likelihood of a crisis happening and basing his investment decisions based on that assessment.
Many moons ago, we had expressed skepticim at the Federal Reserve’s bank stress tests (https://crediteye.wordpress.com/2011/11/29/the-feds-new-bank-stress-test/). The latest stress test just confirms that these stress tests are pointless Keynesian hole digging. The stress tests are based on a scenario prevalent during the credit crisis of 2008. The next credit crisis will be very different. Assets that were most liquid during the last crisis (US government securities) will not be so during the next crisis. To satisfy various liquidity requirements, banks have accumulated government securities, which they will all try to sell at the same time, thus making them illiquid.
How much better it is to force the banks to disclose far more on the true state of their loan, trading and the investment books? Market players can then conduct their own stress tests under scenarios which they deem likely. Based on actions of informed market players, through the share price, a quick feedback is provided to bank management. Without these disclosures, big bank stock valuation of the brokerage houses is a wierd guess at best and fraudulent at worst.
For quite a long period of time, the only business of Barclays that earned an appropriate return on capital was its “tax structuring” (tax avoidance to you and me) business. It was the only place where Barclays added value to its clients, even if the business had dubious ethical and legal overtones. To create a refurbished Barclays, the new CEO is getting rid of this business. That is a signal for creditors to this institution (particularly the sub-debt holders) to bail out from this bank. This bank will now produce a serious of sub-par returns, which at some point might cause the UK bank regulator to order the bank not to service its Tier II debt (banking regulators have the power to prevent the servicing of Tier II debt if they feel that the bank needs to conserve resources).
UBS announced that they are handing out bonuses in the form of high-trigger Contingent Convertible (CoCo) bonds that get written down to zero if UBS’s regulatory capital falls below 7 percent. This is a big positive for the credit. If traders take foolish risks which blow up the company, they will be the first to get hit. In fact, now the incentive for traders is not to think like shareholders (in a leveraged institution such as a bank, that itself induces high risk taking) but to think like creditors (since the CoCo bonds have limited upside but unlimited downside). Credit Suisse also has come up with a similar instrument though with a slightly different payoff structure.
This means that the Swiss banks are on the road to redemption, at least in the eyes of the creditors. This structure will also keep away personnel with more criminal proclivities from seeking employment at these banks.
Yesterday the US reported that its 4Q 2012 GDP shrank. What was really amusing was seeing US analysts come on CNBC (another reason why CNBC is best watched on the “mute” mode) to say that the GDP actually grew by x%, if you ignored this item or that item. That made this analyst realise that the next holy grail in Economics is coming up with a GDP metric ex this or ex that. Just like companies do with their one time charges (it is a different matter that these one time charges, particularly at the big banks, occur every quarter and with greater certainty than real earnings). Or pro-forma earnings. Or non-GAAP earnings. Or as the fraudsters at the Federal Reserve define the so-called “core inflation” which ignores the rising food and energy prices in the US over the last four years.
If only the whole world, whether companies or countries, could shift to the Groupon School of Accounting! All the unhappiness about poor GDP growth or poor EPS growth would disappear. But wait a minute…did not the former Soviet Union have such metrics in place before the harsh reality could no longer be brushed under the carpet?
Basel III requires banks to have a certain amount of liquid assets linked to their short-term liabilities. This liquid asset cover is supposed to provide liquidity to a bank in a crisis when market liquidity disappears. We opine that things will turn out quite different in a crisis. All the banks will be selling the same assets which qualify as liquid assets. This in itself will cause those liquid assets to lose value sharply and become illiquid. Whenever there is a systemic liquidity crisis, there is no alternative to central bank action. Liquidity Coverage could only be useful when problems are confined to few institutions (say during the Bear Stearns crisis). It is less useful during a systemic event such as the Lehman bankruptcy. But liquidity issues at a single institution, as we have argued elsewhere (https://crediteye.wordpress.com/2011/07/07/is-liquidity-of-assets-relevant-to-a-bank-creditor/ ) are due to deep doubts about the institution’s solvency. One moment Bear Stearns was drowning in liquidity. The next moment, when there were doubt’s about Bear’s solvency, Bear Stearns was just drowning.