Too big to manage

Forget about too big to fail, how about too big to manage.
There are six banks in the world with assets in excess of $2 trillion each and perhaps another twelve with assets of between one and two trillion.
Banking has become incredibly complex.
If a bank has a trillion dollar balance sheet, operating in perhaps thirty countries, with trading desks, loans and proprietary trading books all over the world, it becomes immensely challenging.
In the financial business, risk grows exponentially with the size and complexity of your balance sheet and I think many of these banks just became too big to manage and they lost control.
That’s what the record shows.
I learned long ago not to expand your business beyond your ability to closely and tightly manage. I think a strong case can be made to break up these big global banks into smaller, more focused and more manageable institutions. I think it’s going to happen.
In fact, it has already started.

Too big to fail

Many today say that Lehman, with total assets of $700 billion, should not have been allowed to go bankrupt.
Ladies and Gentlemen.
Lehman deserved to go bankrupt.
Capitalism is the freedom to do outstandingly well and make a lot of money and it’s also the freedom to go bankrupt and that has to be demonstrated from time to time.
There has to be at least some discipline in the market place.
It is unfortunate indeed, that many more like Citi, AIG and RBS were too big to fail because of systemic risk but make no mistake - - they all deserved the same fate as Lehman – to go bankrupt because they all mismanaged their businesses and had lost the confidence of the market place.
One thing to think about. If some banks in the U.S. were too big to fail before this crisis, with all the mergers and acquisitions, they are going to be much bigger still after the crisis. While in the U.S. there will always be thousands of banks, the system is gradually reducing down to three or four super giants which are going to be so big and so highly regulated, they will operate almost as arms of the government.

Where the heck were the Economists

Thomas Carlyle, who died in 1871, called economics the “dismal science”. How right he was. Jacoline Loewen said that “banks and dealers should have as many economists on staff as possible to increase their chances of having one that’s right”.
Along with Wall Street, it is quite incredible that central banks and the IMF, with all the firepower they devote to economic analysis and forecasting, did not pick up on this credit bubble and a possible crisis.
The second largest financial crisis in a hundred years wasn’t on the radar screens.
Worse still, since the crisis first started, policy makers have vastly underestimated its rapid spread and devastating impact every step of the way.
Actually, all of us in the financial business should be wondering why we did not see this crisis coming. All the signs were there. We should have picked it up.
There were a small handful, probably less than one-half of one percent of all economists and market participants, who did foresee some of these major problems. But when everyone is making money, no one wants to listen to a naysayer.
In the future we must do a better job of forecasting.

The TSX is only down 50% - great!

I don’t think even today that we truly comprehend the incredible magnitude of what has happened, and what is happening, to the global banking and financial business.
With so much government involvement and government ownership of big banks in both the U.S. and the U.K., we won’t know the full impact of all of this for a decade. The stock market impact has been significant.
- the Standard & Poor’s diversified bank stock index is down 72%
- the financial index is down 76% and
- the insurance composite index is down 72%
The TSX Bank Stock Index is only down 50% - isn’t that wonderful – (we have outperformed).
I am not going to dwell on the causes of this crisis because they have been extensively and well covered in the press.
They include;
- Major public policy failure in the U.S. in the housing area.
- Far too low interest rates and easy credit under Alan Greenspan.
- Failed financial innovation on a massive scale.
- Almost complete regulatory failure in the U.S., U.K. and Europe – it was the age of deregulation.
- Total rating agency failure - - for the tenth time and
- Finally, too much leverage everywhere you look.
You could write a book on each of the above but for business owners, I recommend you pick up a copy of Money Magnet to find out about the new money - private equity.

The old model for Finance is dead

The collapse of this twenty-five year credit bubble made 2008 a year for the history books. I never thought I would see the day when the likes of Citigroup, AIG, Royal Bank of Scotland, UBS and B of A, the biggest names in the banking world, had to be bailed out by their respective governments and partially nationalized – to forestall collapse.
I never thought I would see the likes of Merrill Lynch, Wachovia, Washington Mutual, and Countrywide Mortgage, all huge financial institutions, being forced to sell to forestall bankruptcy. In particular, the five big investment banking firms in New York, which a year ago had total assets of $4.2 trillion, blew themselves out of the water.
- Bear Stearns, with total assets of $350 billion, forced to sell out for a pittance and Lehman, with assets of $700 billion, bankrupt.
- Merrill forced to sell to Bank of America which over-reached itself and is now in trouble.
- Morgan Stanley and Goldman forced to raise equity at distress prices and convert to bank holding companies to get federal aid.
For these five big investment banks, this has been a complete and unmitigated self-inflicted disaster.
As I said in my book, Money Magnet, the old model of investment banking for these five big firms on Wall Street is dead. The new era will have private equity race ahead with its focus on relationships and its manageable size.

Quite a Laundry List - Bubbles

Look at U.S. household debt as a percentage of GDP – a huge rise in just the last ten years.
Look at the incredible decline in the U.S. personal savings rate over the last 20 years.
Look at the acceleration of U.S. housing prices starting in 2000 (existing houses doubled 2000 – 2006).
Globally, from 2002 to 2006 there grew a euphoric feeling that low interest rates, easy credit, vast liquidity and rising house prices would last forever.
It was a classic example of herd mentality, “when everyone is thinking alike, no one is thinking”.
Commodity prices took off, and the private equity and hedge fund industry exploded on cheap money. Borrowing and spending were in vogue and saving was out.
It was obvious the trends on these charts were unsustainable, but where was the tipping point.
A credit bubble is like blowing up a balloon – it gets bigger and bigger and bigger and you never know when it’s going to burst. This bubble could have broken three years ago, or it could have broken two years from now.
But now we know, this bubble broke in the Spring of 07.
(One thing investors should learn about investment bubbles and manias – “it’s much better to leave the party an hour early than two minutes late”.) Every bubble is different, but in many respects every bubble is the same. The difference this time is that we have an all encompassing credit bubble and it’s global. This was a bubble;
1. In housing prices and mortgage debt
2. In consumer debt
3. In new and untested financial products
4. In commodities and
5. A bubble in bank lending, private equity deals and hedge funds

Quite a laundry list.

Twenty-Five Year Credit Bubble

So what sort of mess have we gotten ourselves into this time?
Well, over the past two years we have witnessed the bursting of a twenty-five year credit bubble of monumental proportions.
The epicentre of the bubble, of course, has been in the U.S. sub-prime mortgage market.
Contrary to almost all forecasts, it spread quickly to all sectors of the banking and credit markets and now to the real world economy – main street.
This economic contraction is the first synchronized global downturn since the 1930s.

What is the new risk?

I think that systemic risk in global financial markets has increased quite dramatically.
- What is the long term impact of one to two trillion dollar deficits in the U.S. annually for the next few years?
- Who will purchase all these treasury bonds”?
- Will the Federal Reserve ultimately resort to printing money?
- Will some of these big banks have to be nationalized.
- Do we have now, in effect, a bubble in U.S. treasuries?
- Will all the credit creation lead to major inflation three or four years out?
- Will we have a major crisis in the U.S. dollar over the next year or two?
This is all uncharted water and, no one on the face of the planet knows how it will play out.

Dr. Bernanke explains quantitative easing

Finance deep freeze

We are now in a deep freeze of credit. It is trickling down that it is no longer business as before. There are new rules and it's back to the basics.

So, what does “back to basics” mean for the financial business. To me, it means.
-running a more conservative business across the board
-reining in your growth expectations to more realistic levels.
-reducing leverage
-much less financial innovation and much less financial engineering
-more focus on client business
-more organic growth and fewer grandstanding acquisitions and
-for the world’s biggest financial institutions it means downsizing your business and scraping your plans to rule the world.

Of course, running a more conservative business, with less leverage, will mean somewhat lower profitability than we have been accustomed to in the past. That’s the price of running a more conservative business but at least, over time, you will be in business.