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Economics: Bankrupt!
New York: May 26, 2008
By John R. Stephenson

Banks used to be stock market leaders, but today, they are acting like laggards. Banks and investment banks, once home to the smartest guys in the room, are now looking pretty stupid. Union Bank of Switzerland ("UBS"), an investment bank, has written down an astonishing $38 billion in the past nine months and is now referred in jest as "Used to be Smart." So how did people so smart end up looking so dumb?

They were greedy! And to satisfy that greed, they needed to book some big profits fast. And there was no better way when asset prices were rising to book a boatload of profits than to use a lot of leverage to maximize returns. In 2007, Bear Stearns' leverage ratio (ratio of total assets to shareholders equity) stood at a whopping 32.8 times. But leverage is a double edge sword and when things turn sour, leverage can take a big bite out of you — and fast!

Figure 1: That Sinking Feeling!

Source: Bloomberg and The Economist

What preceded the bust was a boom. A boom driven by a rising housing market in the U.S. and a strong desire among pension managers and other yield hogs to find a place to park their money and at the same time earn a decent return. The always enterprising investment banks were all too willing to lend a helping hand — for a hefty fee.

To make it all work, the banks needed a steady stream of cash flows to turn into their new investment products.

For a steady stream of cash, residential mortgages were a pretty savvy bet. Or so the bankers thought. Everyone was a potential homebuyer — even those with crappy credit. But the real trick was in the special blending of a whole variety of mortgages. Some were excellent credits and some were, well — awful. But who knew? No one, even the rating agencies were fooled by this strange new product where everyone seemed to win!

Bankers were getting fat, happy and rich, with many senior investment bankers in the structured product area making a cool million or two a year. Pension funds had an investment grade rate product with a decent yield to it and there were legions of new homeowners.

But in order to keep on dancing, the music needed to keep on playing and that meant more mortgages. To keep bringing out a steady stream of new offerings (investment banking revenue) to satisfy the demands of pension fund managers and the like, more and more Americans needed to have a mortgage, even those who really shouldn't have been homeowners in the first place — illegal aliens, or the unemployed! But heck, real estate was on the rise.

And then it wasn't. With real estate prices starting to tumble, the fix was in. Many of the banks that were hardest hit with this credit crisis were the ones that ate their own cooking. The worst-hit banks often used their own money to invest in mortgage-backed securities, further compounding their misery. Add in the impact of enormous leverage both within the mortgage-backed products and within these institutions themselves and presto, you have the makings of a full-blown rout on the banks.

By March of this year, the turmoil in the banking sector had already wiped out nearly six quarters of the industry's profits and it is likely to get worse before it gets better. One problem for the banking sector is that so much of their business model is dependent on confidence. Lose the confidence of depositors and there is a run on the bank. Lose the good faith of investors and suffer a similar demise. As well, much of the banking system is interlocking in nature, so the misfortunes of a competitor could quickly become a problem for others in the sector.

So far, the banking sector has responded to the crisis by selling off assets and cutting back on lending activities. The more desperate financial institutions have sought equity infusions from the Middle East and Asia. According to research from the economists at America's Policy Forum, $200 billion in write-offs at the banks would cause credit for businesses and households to contract by more than $900 billion. A credit contraction of this magnitude equates to a reduction of GDP in the following year of 1.3 percent. When banks lose, we all lose.

The economic effects of a banking crisis are indeed widespread. According to work by Carmen Reinhart of the University of Maryland and Ken Rogoff of Harvard, the worst banking blow-ups reduce growth by 5 percentage points from their peak and it takes over three years for growth to regain the pre-crisis levels. With so much at stake, is there a solution to what ails the banking sector?

Perhaps, but fixing the system won't be easy. For starters, it is a highly visible and extremely profitable industry. Over the last twenty years, the financial-services industry in America has grown from a mere 10% of corporate profits to a whopping 40% of total corporate profits. According to McKinsey Consulting, 2006 profits at American banks dwarfed those of the global retailing, automotive and pharmaceutical sectors combined. Wow!

And to keep those ideas flowing, you need plenty of bright, hard-working and well compensated employees. Sure, capping investment bankers' incomes is an appealing thought, but in a world where headhunters don't flinch about poaching a star for another firm, how can investment banks win the war for talent paying below the median wage?

Regulation could be one solution, but it is generally backward looking in nature. In a world which is constantly evolving, is a backward looking regulatory framework an advantage or a disadvantage? Who knows, but the jury is certainly out.

For now, banks are out of favor. Bonuses will likely be lower across the board and activities such as structured finance and proprietary trading likely in the doghouse for a while. But they, too, will once again be on the rise.

North America's banking and investment banking industry has seen booms and busts and likely will again. It is an industry that is extremely competitive and dynamic and while its effect on the whole is a concern, our open, loosely regulated system is probably preferable to more centralized systems such as in China and elsewhere.

Since August of 2007, the S&P 500 financial index is off more than 20% from its highs. Picking the bottom of any sell-off is always hard, but in this case I would recommend investors remain on the sidelines for a while to come.

Analysts are still ratcheting earnings forecasts down and the write-offs are nowhere near over. It will take the banks some time to fully de-lever and to put the worst behind them. In the meantime, savvy investors should consider an investment in equities of commodity producers which have been on a tear. Their growth is all about a demand-hungry world that is desperately short of supply.

StephensonFiles is a division of Stephenson & Company Inc. an investment research and asset management firm which publishes research reports and commentary from time to time on securities and trends in the marketplace. The opinions and information contained herein are based upon sources which we believe to be reliable, but Stephenson & Company makes no representation as to their timeliness, accuracy or completeness. Mr. Stephenson writes a regular commentary on the markets and individual securities and the opinions expressed in this commentary are his own. This report is not an offer to sell or a solicitation of an offer to buy any security. Nothing in this article constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur profits and losses. We, our affiliates, and any officer, director or stockholder or any member of their families may have a position in and may from time to time purchase or sell any securities discussed in our articles. At the time of writing this article, Mr. Stephenson may or may not have had an investment position in the securities mentioned in this article
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