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"Banks eat like a
hummingbird ... and shit like an elephant," some bankers are known to
say.
Well that is some macho
he-man financial speak for sure! What does it mean? (And does it help to pick
up girls?)
First, review last week's
primer on How Banks Work. You will remember that
our sample bank, Wells Fargo, only made a return on assets of 1.77%. That's
not bad for a bank -- better than some German and Japanese banks -- but, you
have to admit, a 1.77% return doesn't exactly sound like an investment
jackpot. On a pretax basis, it was 2.64%. That means that for every dollar
Wells Fargo lent out, it made a profit of $0.0264, and that's before the
government takes their share. Over twelve months! That's pretty skimpy. Sort
of like the way a hummingbird eats.
It also means that, if
the value of Wells Fargo's assets fall by only 2.64%, over twelve months --
for example if 2.64% of its loans become worthless -- then the bank didn't
make a damn cent. And, if the bank's assets fall in value by, say, 5% or so,
then that big 10:1 leverage kicks in and the losses are enormous! Sort of
like the way an elephant shits.
Since banks are the
elephants of the economy, when they take a shit it's not only the banks'
problem, it becomes everyone's problem.
Remember, it's the 10:1
leverage that turns the 1.77% return on assets into a 17.7% return on equity.
It works the other way as well. A 2% loss becomes a 20% hit to equity.
A bank's assets are
mostly loans. These loans have credit risk -- sometimes they don't get paid
back. (Do you think?) Or, they could be delinquent, or be partially paid
back, or paid back in full at a later date, or be restructured on new terms,
or sold to a third party, or many other things. Usually, the value of a loan
doesn't just collapse to zero. Many loans are collateralized, for example. A
mortgage is collateralized by a piece of property. Even if the homeowner
stops paying completely, the bank gets the house, and can sell the house.
Banks are not allowed to make a profit on the sale of a foreclosed property.
They can only get back $1 for every dollar they lend. (If there's a profit,
it goes to the previous owner.) However, it is not hard to see that banks can
often sell a foreclosed property for as much or more than they lent, so even
if the borrower goes bust, the bank might not take a loss at all.
If the bank sells the
property and gets back $0.50 for every $1 it lent, then obviously the loss is
50%. This is known as the recovery ratio. A 30% loss is a 70% recovery ratio.
There are other kinds of
collateral as well, such as companies and their assets, which back corporate
loans.
Auto loans are
collateralized by the automobiles. If you can't pay, your car gets
"repossessed" by the bank. Maybe they can sell the car for more
than you owe on it. Maybe not.
Even an uncollateralized
loan, like a credit card loan, might have some recovery value. The loan could
be sold to a credit collector, maybe for $0.05 or so. The collector then
tries to make a profit by squeezing $0.10 out of the deadbeat borrower.
Now, bankers know that
some loans are going to go bad, at all times. Because of this, they set aside
"provisions" against loan losses. These provisions are added to the
"allowance for loan losses" or loan loss reserves, sort of like a
piggy bank against the losses which are sure to come. You can see these
provisions on the income statement as a "provision for credit
losses." It was $2.204 billion for Wells Fargo in 2006. Thus, Wells
Fargo already has the first $2.204 billion of losses covered. Over time, this
piggy bank is added to (via more provisions) and subtracted from (via real,
actual losses). We see on the balance sheet that, at the end of 2006, there
was $3.764 billion in Wells Fargo's loan loss reserves piggy bank. Thus,
Wells Fargo could lose $3.764 billion and it wouldn't even affect income.
This loan loss reserve is
not very big. Since there were $319 billion in loans, it is only 1.18%. Thus,
the first 1.18% of losses are already covered by the loan loss reserve.
Provisions are recorded
as an expense. So, they reduce net income. Since most banks are publicly
traded, the management has to answer to (typically impatient Wall Street)
shareholders. These shareholders usually like the biggest profits possible,
as reported by accountants on a quarterly basis. Thus, they like the smallest
expenses possible. Thus, bank managements tend to minimize provisions, in
good times.
Also, in good times, the
banks simply don't have a lot of losses. When property values are rising, and
people are getting good jobs and making more money, and businesses are doing
well, usually borrowers can pay their loans. Even if they can't, often
recoveries are high, because the collateralized assets (propety
especially) are rising in value.
So, year after year, the
bank recognizes that it doesn't have a lot of loan losses. If losses have
been 1% of loans, year after year, why provision at 4%?
A bank could do this. The
management could say: "Things aren't always going to be so good. In
fact, the present situation looks dangerous. We're cutting back on our
lending to lower-quality borrowers, and we're going to start building up our
loan loss reserves." They could take more money, each quarter, and put
it in the loan loss reserves piggy bank. If everything works out fine, the
money is still there in the piggy bank. You can take it out again. This is
called "de-provisioning." A privately-held bank might work this
way. They could later say, "Our provisioning for loan losses has proven
to be overly conservative. This quarter, we enjoyed a profit of $1 billion
from de-provisioning." (Since provisions are expenses, a de-provisioning
is a negative expense, or a profit.) However, such are the pressures on bank
managements today that this sort of behavior is very unusual. Bigger
provisions mean lower profits, according to the standard accounting.
When the bad times hit --
very predictable, but never predicted -- then you have people losing their
jobs, businesses fail, and asset values fall. Default and delinquency shoot
higher, and recoveries plummet. Losses become huge. Last year's provisions
and loan loss reserves don't cut it anymore.
A bank has a duty to
admit that loan quality has deteriorated, even before the actual, real losses
are known. For example, a bank might not know how much it actually loses on a
mortgage until the collateral property has been foreclosed and sold. This can
take a year or more. When a borrower stops making the payments, then you know
right away that there's a problem. The accountants demand that the bank
recognize this problem right away. They say: "Recoveries are
deteriorating badly. You need to raise the provision on these defaulted loans
to 30%. Also, the number of delinquent loans which go into default is rising.
Provisions on delinquent loans need to rise from 5% to 10%." Which is to
say, they make an estimate of how much the bank will ultimately lose, which
is $0.30 on the dollar for defaulted loans. The bank needs to put aside this
$0.30 right away in the provisions piggy bank, and write down the value of
the asset to $0.70. More provisions mean less profit, so profits decline, and
maybe the bank is reported to have made a loss.
In some cases, especially
in large-size commercial loans where the bank monitors the financial
condition of the borrower closely, a bank may even declare a loan impaired
(not worth its full value) if the borrower (a company) has made all the loan
payments, but is in deteriorating financial health. The bank must provision
against the risk that the company, some time in the
future, may default on the loan. A bank sets aside a "general
provision," but it may also set aside provisions on specific loans,
particularly large-size commercial loans.
These loans that the bank
provisions against, particularly the ones with loan-specific provisioning,
are labeled "non-performing loans," or just "bad loans"
or "bad debt." Now, the funny thing is that many of these "bad
debts" might be paid in full. This was particularly the case in Japan. I
recall that about 70% of all the "bad debts" at banks were loans to
companies that had made all the payments, but were suffering some
difficulties. Which is not too surprising in a recession, no? That's why (see
the FT op-ed I linked to last week) the solution to Japan's so-called
"bad debt problem" was to cause the economy as a whole to recover,
via monetary reflation and tax cuts. If a loan to a
company -- which had made all its debt payments -- was simply recategorized from being a "loan at risk"
(they were called "type II" loans) to being a "regular
performing loan", then 70% of Japan's "bad loans" would
vaporize. And, in an economic recovery fueled by reflation
and tax cuts, this would be a very natural thing. Maybe 1 in 10,000
non-bankers had figured this out, even though the banks reported the
statistics quarterly. Do you see why I say that it is important to understand
how banks work, and why I say that hardly anybody does?
If they had read the
banks' financial statements, slowly and with curiosity, they would have
figured this out. Which tells me how many people actually read banks'
financial statements. Which is why I insist that you do so, at least once in
your life.
We'll have more on how
banks lose money next week.
* * *
Is the "tax
rebate" just an advance on your 2008 tax refund? It appears that the
$150 billion "rebate" plan is, essentially, a loan on your regular
2008 (paid in 2009) tax refund. Most people's withholding is a little
excessive, so they get a refund. Basically, the government is paying your
2008 refund in advance! CNN reported this on their website as follows:
The package, which passed
the Senate 81-16, will send rebate checks to 130 million Americans in amounts
of $300 to $600 for people who have an income between $3,000 and $75,000,
plus $300 per child. Couples earning up to $150,000 would get $1,200.
The checks are an advance
on next year's refunds, and most, if not all of the money, will be deducted
from taxpayers' refunds in 12 months' time.
This was later modified to read:
Do I have to pay the
rebate back?
No. And here's why.
Your rebate is a one-time
tax cut - an advance on a credit you'll receive on your 2008 return.
It's based on your 2007
income initially. If it turns out that your 2008 income and number of
children would have qualified you for a larger rebate than the one you
received, you'll be sent the difference. If it turns out your 2008 income was
lower than in 2007 and you should have gotten a lower rebate, you get to keep
the difference.
"If you were
supposed to receive a larger payment than you did, you will get the extra
money," said Treasury spokesman Andrew DeSouza.
"If you received more than what you should have gotten, you will not be
penalized."
This is more confusing,
but it basically says the same thing. More commentary on the "phony
rebate" is here.
MSN Money reports that:
"It's Not Really Free Money"
Remember, this is your
money you're getting back, and the rebate checks are basically an advance on
your 2009 refund. When similar rebates were sent out in 2001, said tax expert
Mark Luscombe, "a lot of people were upset to
see their (next) refund reduced."
Well, that's pretty
funny! Usually the government is a litte less
sloppy than that. They should have just recapitalized the banks. That might
have accomplished something. Now, nothing has changed except that even Subaverage Joe is aware that he is being governed by
criminal knuckleheads.
The halfpasthuman.com Web
Bot project (see urbansurvival.com for more
details) indicates a "tax revolt" coming in the spring. Indeed,
when a government loses all legitimacy it sometimes finds that tax payments
plummet. It happened in Argentina, for example, just before the economic
collapse in 2001. Americans, who like to think they're
"independent-minded" but actually act like medieval serfs, would
not normally be ones to simply not pay taxes. However, this display of
government arrogance, combined with the "just walk away" boom for
all kinds of financial obligations, might prove the Web Bot
right in the end.
* * *
There has been a lot of
hoopla in recent days about "borrowed reserves." We haven't talked
about this too much, but you should nevertheless be able to figure out the
difference between a bank's "reserves" (a somewhat archaic item
that doesn't really exist anymore in a functional sense) and its capital
base. Carolyn Baum of Bloomberg gives a decent tutorial here.
Nathan
Lewis
Nathan Lewis was formerly the chief international economist
of a leading economic forecasting firm. He now works in asset management.
Lewis has written for the Financial Times, the Wall Street Journal Asia, the
Japan Times, Pravda, and other publications. He has appeared on financial
television in the United States,
Japan, and the Middle East. About the Book: Gold: The Once and Future
Money (Wiley, 2007, ISBN: 978-0-470-04766-8, $27.95) is available at
bookstores nationwide, from all major online booksellers, and direct from the
publisher at www.wileyfinance.com or 800-225-5945. In Canada,
call 800-567-4797.
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