Friday, October 22, 2010

BofA's Dismal Performance

Bank of America announced a $7.3B loss this week. By way of explanation of the gigantic lawsuit involving mortgage servicing, the firm's spokesman informed investors,

"We're not responsible for the poor performance of loans as a result of a bad economy."

True, but doesn't the bank pay a high-priced economist to forecast economic conditions? And shouldn't underwriting standards have allowed for less-than-rosy economic conditions for the next 30 years?

Of course, if the excuse is that the loan loss-related servicing issues came from purchased portfolios, well, that would suggest other management mistakes. But mistakes, none the less.

The huge loss apparently came from writing down credit-card business goodwill.

As is so often the case, the bank and, I assume, analysts will urge investors to view this as an 'exceptional' item.

Too bad that making questionable acquisitions wasn't all that exceptional for BofA a few years ago. One suspects they'll have a lot more 'exceptional' losses in years to come, thanks to Ken Lewis' misguided strategic moves.

The nearby price chart for BofA and the S&P500 Index shows how far the former has declined since late 2007. That was the last time that BofA's rate of return neared that of the S&P.

Now, it's down about 70% while the S&P has more or less flattened over the period.

Hardly the type of performance that makes investors cheer, is it? I suppose there are those that will believe it's the perfect time to bottom fish.

But with BofA and its checkered recent past, I would think that investment decision would come with substantial risk.

Henry Kaufman's Excellent WSJ Editorial

I haven't thought much of most of Henry Kaufman's Wall Street Journal editorials over the past few years. You can read my posts discussing them under the label 'Henry Kaufman.'

However, I like to believe that I criticize the thoughts, not the person. And Mr. Kaufman outdid himself yesterday with a superb piece entitled Bernanke's Inflation Target Misses the Mark.

He lists six reasons why Bernanke's recent speech indicating that the Fed will accept a 2% inflation target is a serious mistake. The more salient reasons are,

"Third, the Fed will use as an inflation target the core index for personal expenditure, excluding the cost of energy and food. The exclusion of food and energy from the inflationary indices dates back to the 1970s, when Arthur Burns was Fed chairman. Burns did this to minimize perception of the outbreak of inflation at that time.

Fourth, the chairman tries to support his recommendation by stating that "an inflation rate modestly above zero is shared by virtually all central banks around the world." That advocacy should hardly be considered a powerful endorsement, in view of the poor performance of many central banks abroad.

Fifth, through the use of inflation targeting, Mr. Bernanke believes that the Fed will have greater latitude, as he said last week in Boston, "to reduce the target federal-funds rate when needed to stimulate increased economic activity and employment." However, there is no evidence to suggest that under dire future economic circumstances the funds rate would not have to fall to near zero, where it is now.

Sixth, the Fed's inflation-targeting process is to be hinged to the Summary of Economic Projections, which the Fed now publishes four times a year. These projections span three years ahead and include projections for the rate of economic growth, unemployment and inflation. The chairman made no comment about the accuracy of these projections since their initiation three years ago. The fact is that they have been off the mark."

I find the third and sixth reasons particularly, shall I say, "on target," pun intended? This idea of exempting the major sources of inflation in an inflation index is preposterous. One which CNBC on-air staffer Rick Santelli, as well, routinely criticizes. Then Kaufman sensibly notes that the Fed's own projections are not all that accurate. Not comforting at all, is it, for anyone who lived through the great inflationary period from LBJ to just after Paul Volcker began to wring inflation from the US economy?

Along those lines, Mr. Kaufman next asks reasonable questions. Things seldom turn out perfectly. What about imperfect, vexing combinations of inflation and unemployment,

"Now that an inflationary bias will be introduced in monetary policy, market and economic uncertainty will heighten. How long will the Fed allow inflation to breach the 2% level before it pulls back on the monetary reins? Will the breach be allowed for one or two quarters or longer? Suppose the unemployment rate falls to 8.5% but the inflation rate reaches 3%. What then?

Do we trust Helicopter Ben & Co. to manage such situations better than our prior, not-Paul-Volcker Fed Governors?

Kaufman lastly turns to what I think is the curiously missing but incredibly fundamental, important fact in all of the Fed's misguided inflation targeting speak- the debauching of the value of the dollar.

"More importantly, if a 2% annual increase in inflation becomes an acceptable target, Americans will be forced to accept a substantial depreciation in the purchasing power of their currency. A 2% annual depreciation equals a compounded loss of 22% over 10 years, and the loss would total 34% if the inflation rate averages 3% annually. That's a target we can afford to miss."

Pretty stunning figure, isn't it, that 22% purchasing power decline in a decade? The mathematics of compounding get scary at surprisingly low rates.

Consider what global investors must be contemplating as they read Mr. Kaufman's editorial. How comfortable are the Chinese at watching the value of their large dollar-denominated holdings being announced to decline in value by nearly a quarter in the next decade- if they are lucky?

Thursday, October 21, 2010

Banks Begin To Exhibit Consequences of New Regulations

Yesterday I wrote this post concerning David Malpass' recent insightful Wall Street Journal editorial, and his subsequent defense of it, if that's the right word to describe the one-sided conversation Malpass had on CNBC that day with the network's faux-economic reporter Steve Liesman.

My mind had more or less blocked out the details of that discussion, until I read two articles in yesterday's Journal concerning bank earnings and capital requirements.

The two articles concerned Goldman's recent earnings, which were down 40% from last year. It's not a big secret what happened. In the anticipation of the eventually-passed Congressional financial regulation bill, the firm trimmed its proprietary trading activities and began to keep capital more liquid, earning less, in reaction to the looming regulatory and capital requirement uncertainties.

Right underneath that article on page C3 in yesterday's Journal was one entitled Banks Confront Weight of Risk. That piece discussed the consequences of the new Basel III bank capital rules. In Goldman's case, the firm's CFO explained that regulatory capital would need to rise from $451B to $750B. Elsewhere in the article, it was explained that the new Basel rules increase capital ratios on risky assets, while simultaneously reducing the types of liabilities which are allowed to count as capital. One example of the first effect was an estimate that "Morgan Stanley's risk-weighted assets will jump 80% under the new Basel rules."

Any way you look at it, Basel III alone will begin to rein in decades of profligate, risky banking behavior by many firms which either were, or became, federally-backed institutions.

This isn't a bad thing, in my opinion. As I've contended in earlier posts, banking, in its totality, should never have become a growth industry. Sure, individual businesses, such as mortgage lending, consumer finance, or various structured instruments, might grow at elevated rates for short periods of time. But overall, banking is an economically derivative sector. It can't, in total, over time, grow faster than the economy it serves, without essentially taking more risks.

Again, as I've written in prior posts, there are and, now, will certainly be cases in which bank managers can't profitably deploy all the risk capital assigned to their positions, when capital costs are included in those profits. In short, properly risk-adjusted returns will fall, capital will shrink, and aggregate bank total returns will probably become appropriately more sluggish.

If anything, this regulatory change will push more risky finance business into the privately-held sector. Which, if you think about it, is a regulatory response to the decades-long trend of investment and commercial banks taking excessive risks while selling the ownership of such risk to the public. Looks like riskier financial business is headed back to private partnerships, as it was prior to the 1970s.

What does this have to do with David Malpass and yesterday's post?

Well, as my memory of his comments recovered, I recall his arguing that it isn't high interest rates that is holding back US economic recovery, but, rather, uncertainty on many fronts- regulatory, legislative, fiscal and monetary policy. In response, the economically unschooled Liesman repeated various platitudes about 'no double dip,' gradual recovery, etc., etc., etc.

Goldman's explicit statements about reining in activity in anticipation of greater regulatory burdens, the exact nature of which is as yet uncertain, supports Malpass' positions. Especially as they accompany such a precipitous fall in net income.

How's that for empirical evidence of an economist's contentions?

The Spreading Mortgage Foreclosure Mess

Things has certainly gotten out of hand in the mortgage foreclosure processing mess, haven't they?

With the NY Fed weighing in on a lawsuit against BofA, things have escalated to an unprecedented level.

Yet, at root, it continues to appear to be much ado about nothing. A tempest in a proverbial teapot.

According to a Wall Street Journal editorial which ran yesterday, the number of inappropriate foreclosures they could find numbered no more than dozen, in a nation of over 300 million people.

So the bottom line is that almost nobody who has not been delinquent on their mortgage is being foreclosed.

Meanwhile, I listened to a Fox News report yesterday which included an interview with the owner of a home with a modified mortgage. I won't get the numbers exactly right, but the woman's mortgage declined from about $1,800/month to something in the neighborhood of $700/month after modification.

Talk about injustice! This is why so many people resent those who made unwise home purchases, then receive generous modifications which leave them in homes they can't actually afford. Rather than putting those homes on the market at the market-clearing, lower prices which others could afford.

To me, the allegations of robo-signed foreclosures is a red herring. The real issue remains that politicians have been improperly leaning on and coercing banks to suspend legitimate foreclosures since the presidential primaries of 2008.

Wednesday, October 20, 2010

David Malpass, WSJ & CNBC

David Malpass, the economist and former Deputy Assistant Treasury Secretary, wrote an excellent editorial in yesterday's Wall Street Journal entitled How the Fed Is Holding Back Recovery.

Malpass contends that Bernanke's easy money, low-interest rate policy is destroying US jobs and causing significant, difficult-to-reverse shifts in the US economy.

Specifically, he wrote,

"Corporate and government jobs are faring better than small business jobs, another major structural change that Fed purchases will exacerbate by channeling cheap credit to big entities.

Jobs are moving to Asia as Washington's weak-dollar policy causes trillions of dollars to move abroad to protect against the risk of U.S. inflation and dollar debasement. Investors put their money into foreign factories, mines and workers, creating a boom there. They avoid long-term job-creating investments here, instead buying short-term IOUs from our government.

The damage is substantial. Near-zero interest rates are hammering savers, while transferring hundreds of billions of dollars annually to bond issuers- mostly governments, banks and bigger corporations. The weaker dollar is pushing risk capital away from this country and toward Asia and emerging markets."

No longer a candidate for the US Senate, from New York, Malpass is once again appearing on CNBC, and he did so yesterday in support of his Journal piece. As usual, he articulately advanced his theses.

The comedy, to be charitable, came when the co-anchor introduced CNBC's senior economic idiot Steve Liesman to debate Malpass' recent editorial.

It would be different if the network had retained the services of, say, Alan Reynolds, Greg Mankiew, Joseph Stiglitz or some other well-known and -respected economist for these sorts of discussions. Even hiring a lesser-known economist who at least has a PhD, has published some relevant macroeconomic research, and perhaps worked at the Fed, Treasury or for a major corporation or economic consultant would make sense.

But Liesman has no economics degree. He's a journalist with a misguided interest in economics.

Having Liesman debate Malpass would be like me, with my interest in physics and mathematics, debating some physicist with an endowed chair from MIT, CalTech or a similarly well-regarded institution. While I might be capable of understanding the physicist's remarks, and asking some questions, I would be out of my depth advancing a separate explanation for some phenomenon under discussion.

And that's pretty much how it went for Liesman. He babbled nonsensically, using a variety of terms and measures which he evidently thought mattered. The worst was when he summed up his differences with Malpass, using language to the effect that 'in his opinion,' blah blah if anyone cares what that would be.

To return to my analogy, if I were to be debating a physicist, I would probably have prepared by asking other noted, well-regarded, perhaps prize-winning physicists what they thought of my opponent's ideas. That way, I wouldn't be presuming to put my own undegreed, untested physics ideas on a par with the real physicist, but, rather, I'd be standing in for other physicists of note and representing their questions, concerns and rebuttals.

But that wasn't what Liesman did. He has been in the job with CNBC for so long that he apparently believes he's an economist, and capable of advancing his own independent economic constructs against real economists with Phds and experience in responsible, real-world positions in the field.

The longer CNBC employs Liesman in any economics-related capacity, the longer it damages its own credibility on economic matters.

Tuesday, October 19, 2010

Pension Funds, Equities & Equity Market Performance In The Near Term

Yesterday's Wall Street Journal featured a long article detailing how US corporate and union pensions have taken dramatic steps to limit their exposure to and investments in equities.

Even as the percentage of funded pension obligations among S&P 500 companies fell from over 100% in 2007 to less than 75% this year, there's evidently a stampede among them to more closely fund expected pension payments and stop focusing on longer term total returns.

Of course, long term total return-focused investing has been, for years, synonymous with large percentage holdings of US equities.

In a chart comparing 2005 equity investments to 2009, major company pension funds exhibited declines from the 60-70% range down to 30-50%.

That's a stunning drop for such large institutional investors. One assumes that union and other pension funds have behaved similarly.

The reason, of course, is the so-called 'lost decade' in equity performance from 2000-2009.  The Journal piece states that state and local governments "oversee $2.8 trillion in assets," while corporate pensions assets are roughly $2 trillion.

Another solution is a move to cap and close current defined-benefit plans, shifting to 401K plans held by individuals for future pension obligations.

With this excellent article as fresh information on the motivations, current and planned moves of some $5 trillion of institutional assets from equities to fixed income, my question is this.

Will the rush of so much money reputed to be 'on the sidelines,' about to pour into US equities in order to catch up to the current year S&P's ~4% return, still occur?

With US pension funds holding back from equities, will hedge funds alone be sufficient to cause the prophesied, magical lift in the fourth quarter for US equity indices?

If one believes the Journal article, a very large amount of assets are shifting away from US equities in a secular fashion. It doesn't mean shorter-term trends won't still be intact, but it would seem that the levels at which those trends occur will be lower.

Various estimates of the current US equity markets capitalization range from $35-40 trillion. At that level, $5 trillion in wary institutional assets represents between 1/8 and 1/7 of the market. That would seem to be a non-trivial chunk of assets which aren't going to be rushing into a rising US equity market.

Perhaps, regardless of employment or US corporate earnings, equity indices such as the S&P500 and Dow Jones are going to experience muted rises in the next few years, as fewer assets stream into rising markets.

Monday, October 18, 2010

Electric Cars- Yes or No?

This morning's Wall Street Journal, being the immediate post-weekend edition, was characteristically light on news. So the edition's major Marketplace section focus on electric/hybrid cars was not surprising.

What was surprising is the evolving split between auto makers concerning growth for the pure electrics. Ford's management is reticent about jumping into the segment, foreseeing greater opportunity in hybrids.

Meanwhile, Nissan's Carlos Ghosn predicts fast growth for the vehicles, worrying aloud "that this market is going to grow too fast" and require additional investment in plants."

It's always exciting to see two such divergent views on the potential growth of a product/market segment.

Reading the entire article, I was struck by how heavily dependent the vehicles are on massive federal government subsidies. The most commonly stated number is $7,500/car. That's a shockingly high offset. One wonders, with the current US fiscal situation, and the prospect of an imminent change in party control of Congress, how long such a staggering per/vehicle subsidy will remain in effect.

Then there's the risks of mistakes in calculating range for an electric-only vehicle. And the need for one's travel patterns to precisely match the vehicles' recharging requirements. While hybrids may gain favor, the electric-only vehicles are seen, by most of the industry personnel interviewed in the piece, as being confined to market for "short-distance commutes."

It appears that you have GM and Nissan pushing the EVs, as electric-only vehicles are called, for short, while Ford, Toyota and various suppliers see a much less robust future for them, even ten years out.

Given GM's notoriously tin ear for consumer sentiments and preferences, it almost makes you side with Ford and Toyota, doesn't it?