SERIOUS MONEY:The financial sector has been the architect of its own downfall as its lust for growth and higher returns resulted in ever greater risk, writes CHARLIE FELL
DANTE ALIGHIERI, the celebrated 14th-century Florentine poet, outlines an imaginary voyage through the nine circles of hell in his most enduring work entitled, the Divine Comedy, in which he placed usurers or bankers "on the extreme edge of the seventh circle".
He wrote that “their grief was gushing from their eyes – they kept flicking away the flames and sometimes the burning dust, on this side or on that, with their hands no differently than dogs do in summer, now with their muzzle, now with their paws when they are bitten by fleas, by gnats or horseflies”.
Dante’s contempt for bankers is understandable in a modern context given the tumultuous events in the world’s capital market during 2007 and 2008 that stemmed largely from the sins committed by the financial sector and ultimately brought the global economy to its knees.
Investors’ memory spans appear at times to be as short as goldfish. So it seems in the current climate as, before this week in any case, financial stocks have been all but forgiven and prices have jumped more than 150 per cent from their March low.
However, prices have made little headway in recent weeks and appear to be rolling over. Perhaps investors have become savvy to the inscription on the gate of hell in Dante’s allegory – “Abandon all hope, ye who enter here”.
The financial sector has been the architect of its own downfall as its lust for growth and higher returns resulted in ever greater risk that culminated in a collapse of industry profitability through 2007, 2008 and the current financial year.
The errors committed were not as complex as many analysts suggest but reflected primarily egregious mismanagement of bread- and-butter banking business. This is an important point to appreciate as the primary culprits, the large financial conglomerates, look to return to their value-destroying compensation practices while the casualty list of smaller banks jumps above 100 and is sure to exceed 300 before this crisis is complete.
The first unforgivable error was the industry’s lust for growth. Data collected by the Federal Deposit Insurance Corporation show that net loan book of commercial banks grew at a rate of more than 9 per cent per annum from 2001 to 2007, or four percentage points in excess of the rate of nominal GDP growth over the same period.
The aggressive lending contributed to a more than 30 percentage point increase in non-financial private sector debt relative to GDP and the overhang suggests that revenue growth through increased lending will be muted for several years to come. Indeed, recent flow of funds data for the second quarter show that non-financial private sector debt continues to grow as a share of GDP in spite of deleveraging efforts and, at 174 per cent is almost 50 percentage points above the level that prevailed during the mid-1990s.
The second unforgivable error was the industry’s increasing dependence on real estate for growth. Real estate lending grew at double-digit rates from 2001 to 2007 or more than twice the rate of economic growth.
The love-affair with real estate saw exposure increase by roughly 10 percentage points as a share of total loans over the six-year period to more than 55 per cent. Furthermore, the thirst for yield in a low nominal-return world saw the banks reduce their holdings of risk-free Treasuries in favour of mortgage- backed securities, which jumped to almost two-thirds of total bank securities.
The supposed diversification of risk throughout the financial system via asset securitisation simply never happened as the securitised mortgages found their way back onto bank balance sheets through their securities portfolios.
The third unforgivable error was the industry’s changing loan mix towards higher risk assets. Commercial banks, in their efforts to meet loan growth targets and return objectives, increasingly lent to borrowers of dubious creditworthiness at questionable low rates that were predicated upon continued economic and financial stability.
The fall-out is now plain for all to see as non-performing assets continue to emanate from home equity loans, non-prime residential mortgages, residential construction, auto loans and credit cards, while problems begin to surface in commercial and industrial loans, and in commercial real estate.
Loan losses continue to climb and weigh on the industry’s capacity to lend and, though capital ratios have improved through new share issuance from the historically low levels apparent in both 2007 and 2008, balance sheets are still nowhere near sufficiently strong to support a new lending cycle while private sector balance sheets remain stretched and in no position to add further leverage.
The evidence speaks for itself, with more banks failing this year than in the previous 15 years combined. The major financial conglomerates may well have been among the casualties, had they not been deemed “too- big-to-fail” and allowed to adopt mark-to- model accounting that hides the true extent of their losses.
The actions of both the financial and non-financial sectors, however, speaks louder than words. Federal Reserve data shows that outstanding bank credit has shrunk for 18 consecutive weeks, bringing the cumulative contraction to a record $400 billion or a 15 per cent drop at an annual rate. Meanwhile, the banking sector’s cash reserves continue to expand at a breathtaking pace and amount to more than 10 per cent of total bank assets. The banks are injecting much of this extraordinary liquidity into Treasury bonds and benefiting from the classic yield curve carry-trade while incremental lending is notably absent.
Financial stock prices have more than doubled from their March lows but their balance sheets are in no condition to propel a V-shaped economic recovery that is implied by their valuation at roughly 15 to 16 times normal earnings. Disappointment looks set to follow and the unrepentant sinners are sure to lag.
