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Transcript
Perfect Storm or Perfect Nonsense: Rethinking of an Industry Under Siege By J. Rizzi Draft #7, 7/28/2008 Introduction: Where are we? The banking industry is suffering record losses and collapsing share prices. The industry lost over $250B in shareholder value during the first half of 2008 alone. Understandably, institutions are pre-occupied reacting to events. They are focusing on short-term survival actions including dilutive capital raising and cost cutting. They are hoping these actions will allow them to outlast the crisis, and then return to business as usual. The new usual will not be the same as the recent past. The industry, however, faces a long term strategic crisis in adapting to a structurally changed business environment. Old business models and asset combinations have become obsolete. The financial and credit results are merely symptoms of a deeper underlying declining banking business model. Failure to recognize this cause, and develop appropriate responses, will depress long term returns. In fact, short term write-downs are less concerning than long term profitability. The search for a solution to this problem requires a clear understanding of the causes and consequences of what happened. Where Have We Been? The 1990’s technology based stock price bubble was followed by the 21st century residential property boom. Inflation adjusted housing values grew at five times their historical average during the 2000-2006 period. This development fueled the mortgage and construction lending based increase in bank earnings. During this period, banking stocks as a percentage of the overall S&P Index more than doubled to over 20% in the years up to early 2007. Strong GNP growth, moderate inflation, limited regulation, and ample liquidity helped fuel the growth. Equally important were technological innovations. Internet based automated 2 underwriting techniques and structured finance driven distribution ushered in the originate-todistribute (OTD) business model. This model greatly expanded mortgage industry capacity. For example, new nationwide models like Countrywide and WaMu arose, and the number of mortgage brokers grew to over 50,000. This crowded out traditional mortgage originators including community and regional banks, who moved into residential construction and development loans (C&D) as a replacement income source. The OTD model advantage over traditional portfolio lending was based on two factors. First, capital velocity increased. This allowed institutions to release capital for reinvestment. Next, underwriting or warehouse risk concerning individual mortgages awaiting distribution was deemed low. Consequently, it enjoyed favorable regulatory capital treatment relative to traditional portfolio lending. Eventually, competition outgrew market opportunities. Profit margins became pressured, and growth slowed. Preoccupied with continued earnings growth, institutions embarked on a higher risk asset heavy carry trade strategy. This involved taking large concentrations in illiquid, high risk long duration assets. Larger banks focused on structured products like Collateralized Debt Obligations, while smaller institutions concentrated on C&D loans. The excess competition for these products strained margins requiring banks to increase leverage levels to maintain margins. In effect, many banks adopted the failed savings and loan strategy of the 1980’s with predictable results. Institutions moved further out on the risk curve to manufacture nominal earnings growth. Risk was deemed under control based on the twin illusions of liquidity and risk distribution. In fact, rather than distribute risk, they had concentrated risk. Liquidity evaporated once their 3 leveraged positions began losing value in mid 2007. Banks then discovered they had assumed risk beyond both their ability to tolerate and understand. Shareholders, rating agencies and regulators missed the higher risk strategic shift. Earnings were at record levels and risk models failed to register increasing risk levels. Thus, the capital required to support the increased risk was underestimated. The current $150B plus capital raise indicates the level of undercapitalization. Boards failed to recognize the rise in under compensated tail risk exposure by confusing returns with skill instead of higher risk. Where Are We Going? Existing downsizing and recapitalization efforts at many institutions are remedies and not strategies. Capital alone is insufficient as evidenced by the continued stock price declines following record capital increases. Investors require new strategies to generate replacement revenues to offset the declining structured finance business at larger institutions and the regional and community bank C&D business models. These discredited toxic business models had generated the majority of their income growth. Complicating this effort is the reduction of leverage formerly used to maintain and grow returns. Paradoxically, while many institutions are undercapitalized, the industry is overcapitalized relative to available return opportunities. Until this excess capacity is eliminated through consolidating acquisitions or failures, earnings growth will be limited. Community and regional banks are too small to bail out. Large institutions are, however, protected as too big to fail. Consequently, in the near term, banks can only grow by taking market share from others. This promises to make individual banks growth more difficult. This difficult operating environment will reduce short-term returns and constrain already depressed valuations unless, institutions become smaller and more focused. New shareholders 4 who infused over $65B in new capital this year have already suffered significant losses. Besides complicating future capital raises, these shareholders will undoubtedly press governance actions to improve performance including management changes. The market environment, which ended in 2007, favored growth addicts and risk takers. Value creators and risk managers are needed for the current environment. This will entail a substantial human resources change in CEO succession, management development, and executive compensation. An additional development is the decline of the OTD model relative to portfolio lending. The factors underlying the ascendancy of OTD model have been significantly reduced. Velocity is falling as investment opportunities have diminished. Also, regulatory capital requirements will undoubtedly increase given warehouse period losses. Finally, regulatory concerns will cause wholesale funding, including securitization and trust preferred, to decline in importance. This will pressure banks to develop more stable higher cost core deposit funding. The current crisis is more strategic than credit. It represents an ongoing adaptation to a rapidly changing bank environment. This issue had been obscured by undetected risk appetite increases inherent in leveraged asset carry strategies. Subprime may have been the trigger, but it is not the cause of the problem. Thus, we need to move beyond crisis management, and address the underlying strategic issues. 5