Tag Archives: capital

Make Banks Safe Again

Are the big banks finally safe?

Picture: New York Fed

The Financial Crisis put bank safety and soundness fully in view. The serial bailouts or failures of Bear Stearns, AIG, Fannie and Freddie, Lehman, Merrill, and Washington Mutual put the global economy at risk. The problem was systemic: all the big banks were affected, because investors weren’t certain where their money would be safe. Bank stocks fell about 70%, and yields on their bonds rose about 4%.

When this happens, banks cut back on their lending, which slows the economy because businesses can’t borrow the money they need to grow. What the banking system should do at this point is raise more capital so they can keep lending. But there’s little incentive for any company to do this: the economy is weak, levered institutions are more risky, and stock prices are low. Why sell more stock when the price is low? That’s a good way to get your owners angry.

According to Fed data, the banking system is better capitalized than it has been in years. Of course, the data showed that just prior to the financial crisis as well.

Source: St. Louis Fed

If individual banks chose to keep their equity levels high all the time, that would prevent us from having a banking crisis, but there is little incentive to do this. A higher equity level means a lower return on equity, and lower returns for shareholders.

Because of this, Fed officials have considered whether subsidizing equity issuance could help. That is, for every dollar in capital the banks raise, the government would kick in 50 cents of its own money – into bank capital. Such an approach would reduce the chances of another financial crisis and improve future economic growth by as much as 1% per year. That’s a lot of growth: imagine how much better the world would be if we never went through the Great Recession.

But subsidizing bank capital is a non-starter, politically. Bankers aren’t very sympathetic characters. If you cruise the comments section of any prominent newspaper, people still wonder why the executives in charge of the big banks during the Financial Crisis were never put behind bars. The last time a banker was portrayed positively in the movies was George Bailey in “It’s a Wonderful Life” (1946), and he was considering suicide when his capital fell short.

Banks are essential – they provide the capital that the modern world needs to grow. But they are subject to booms, busts, and periodic panics. The only way to have a risk-free banking system would be to regulate their returns. And then you wouldn’t have enough banks – or enough capital to grow.

Douglas R. Tengdin, CFA

A Brief History of Bubbles

What’s wrong with bubbles?

Photo: Michelle DiNocola. Source: Morguefile

Sir John Templeton once famously noted that the four most expensive words in the English language are, “This time it’s different.” It’s easy to get caught up in the excitement of the moment, to believe that the latest innovation will lead to a new era. But human nature doesn’t change. That’s why it’s so fascinating.

Before the first documented financial bubble—the tulip crisis in 17th century Holland—there were other markets that were manipulated and distorted. In ancient Rome, currencies, bonds, and investments changed hands in the Forum, with little regulation or security. When the emperor ran short of cash—often due to war—he would debase the currency, adding base metal to the coinage. This led to inflation, currency speculation, and economic chaos.

Speculation in Rome was followed by speculation in Holland (tulips), speculation in France (The Mississippi Company), speculation in London (The South Sea bubble, which captured Sir Isaac Newton), speculation in Brazil (Encilhamento), and speculation in New York. They all follow the same pattern: a genuinely new development takes place; prices begin to adjust, investors notice the price movement and jump on board, eventually using leverage to increase their holdings; prices become increasingly divorced from reality; finally, the bubble bursts and prices revert—suddenly—towards a more economically rational level, given current financial conditions.

Photo: Koan. Source: Morguefile

Bubbles cause economic harm in two ways: during the boom they waste resources on over-building that could have been employed productively; and the bust can cause financial retrenchment when borrowers default on underwater asset-based loans. This can lead to a systemic loss of capital in the banking sector causing banks to pull back on lending. When loans contract across an economy, a burst bubble can lead to a recession—or even a depression.

Do we have any sectors of the economy that look like bubbles now? I haven’t noticed any. But one feature of bubbles is that they’re hard to see. We fool ourselves into thinking that a new era has arrived, or is about to: a “new normal.” Hmm, maybe we’re in danger bubble-thinking after all.

Douglas R. Tengdin, CFA

Chief Investment Officer

The New Capital

What’s causing capital income to grow?

Source: Pixabay

Ever since Thomas Piketty’s Capital in the Twenty First Century came out last year, economists have been discussing the role of capital income in the economy. The debate centered on Piketty’s simple but profound formula, r > g. That is, the rate of return on capital—r—is greater than the growth of the economy: g.

Continue reading The New Capital

On Capital and Fairness

“That’s not fair!”

That’s our instinctive reaction when we see people without skill, talent, or hard work get ahead, seemingly at the expense of everyone else. It’s why we root for the gritty underdog in sports contests. And it’s why Thomas Piketty’s recent critique of growing inequality in our economy strikes a chord.

Piketty looked the real net worth of 65-74 year olds in 1990 and 2010 (from a Fed survey) and found that it had grown by 2.8% per year over these three decades—significantly more than the mere 0.7% of the average family. He concludes that these people are benefitting from a high real return on capital, and that in a few years a few families will dominate our economy. We’ll all be wage-slaves for the Zuckerbergs.

To put it simply, this is nonsense. First off, his data suffers from survivorship bias. Older folks’ wealth didn’t grow by 3%–that age cohort got richer, but most of the elderly in the 1990 cohort had died by the time the 2010 group was measured. It’s like measuring the average height of NBA players in 1990 and 2010, finding it was 3 inches higher in 2010, and then concluding that playing NBA basketball makes you grow taller.

Second, nothing makes capital “grow” by itself. Wise investment and hard work can create wealth, just as foolish choices and lavish spending can disperse it. That’s why so few of the richest folks on the Forbes 400 list are there 20 years later. Instead, the list is dominated by entrepreneurs: people who have a great idea and make it part of our everyday lives—like Henry Ford’s automobile, or Sam Walton’s store, or Bill Gates’ operating system. But they don’t stay there forever. There’s an old proverb: “From shirtsleeves to shirtsleeves in three generations.”

Inequality can be a problem when it leads to social disruption—like the race-riots of the ‘60s. But punishing hard work and innovation won’t improve the plight of the very poor. Instead, it will probably make it worse.

Douglas R. Tengdin, CFA

Chief Investment Officer

Lehman Lessons (Part 1)

It’s been five years. Have we learned anything?

Five years ago Lehman Brothers filed for Chapter 11 in the largest bankruptcy filing ever. The bank was insolvent, and couldn’t meet the huge demands for funds coming from customers, lenders, and investors. In the aftermath of its bankruptcy, the global financial infrastructure was stressed almost to the breaking point. There was a real risk that hundreds of millions of workers worldwide could see their paychecks bounce.

Congressional inquiries and more than 300 books have identified dozens of villains–overleveraged homeowners, syndicated subprime mortgages, conflicted ratings agencies and regulators–but three fatal flaws stand out: too many illiquid assets funded by too much short-term debt without enough capital to back them up in an opaque, globally interconnected financial system. The failure of a critical node in that web meant that the entire network almost failed.

It’s no good saying that greed caused the financial crisis; that’s like saying that gravity caused a plane crash. The condition is necessary but not sufficient. Rather, an over-levered system didn’t–and still doesn’t–have enough cushion to deal with a significant asset-price shock.

Some say it couldn’t happen again. After all, the world looks pretty benign right now. But it always does until it doesn’t.

Douglas R. Tengdin, CFA

Chief Investment Officer

Capital Thinking

What are capital controls, and why do countries have them?

Capital controls are restrictions on money flows. Countries enact them to control the flow of cash into and out of their economy. They can take the form of alternative exchange rates, market regulation, and sometimes outright prohibitions. Most countries have some kinds of rules around money flows. In the US, we regulate cash movements into and out of the country, and we take special note of large cash transactions by bank customers, primarily to fight drug trafficking and terrorism.

But capital controls are usually associated with developing economies. In a hyper-connected always-on world, they have a kind of fusty “past-the-expiration-date” sort of feel to them. In Continue reading Capital Thinking