Preface: It is a
pleasure to welcome back my old friend Rory Laughna to the readers of the blogosphere.
Rory is one of the best credit guys that I have ever known, and I appreciate him
sharing some thoughts regarding the wild (and paradoxical) new world of cheap
money and tight credit. I hope that you enjoy his insights as much as I do.
Musings of a Roaming Buffalo
Where Have You Gone Mr. Drysdale?
May 27, 2013
In days gone by, aspiring credit analysts were schooled in the 5 C’s of Credit: Character, Capacity (cash flow), Capital, Collateral and Conditions. 4 of the 5 are quantitative factors, while Character assessment is more of art, but an art that must be mastered to support effective quantitative analysis. The data supporting valid analyses must be provided by people of integrity. Technology has enabled very sophisticated analyses, but all too often analytical tools are employed without diligent Character vetting. The results may be thorough and logical, but misleading in the absence of management integrity. It is certainly the case that even senior individuals’ influence is diluted in large companies, but Character still must be assessed in the context of the management culture, and validated by management performance over time. So assessment of Character, or management quality remains the core foundation for effective credit judgment. It is also instructive to recall that in bygone days, the banker’s impeccable personal Character was a given. Logically, the banker’s Character, and the culture of the bank itself, must be beyond reproach to enable credible Character assessments of customers. Over the years, the banking environment has progressively grown more volatile, and banks have responded in various ways, including acquiring a much broader range of personnel with varied skills. A pertinent question then is whether such changes have systemically impacted bankers’ integrity and the culture of the institutions they represent? To get the answer, the context must be understood.
The Federal Open Market Committee’s May 1 Policy Announcement included the statement, “fiscal policy is restraining economic growth.” Widely viewed as direct criticism of Congress, I found it most remarkable for its rarity. It is a useful reminder of how fiscal negligence has burdened the Fed’s mission. The journey to the current state has been well documented, most prominently the loss of a shared commitment to fiscal responsibility with 1960s guns and butter budgets, leading to the 1971 abandonment of the Bretton Woods system without an alternative anchor, culminating with the 1978 Humphrey Hawkins dual mandate effectively conscripting the Fed into financial debauchery. Subsequent bipartisan actions to push the limits has created shameless deficits and crushing obligations on future generations. The national debt is approaching $17 trillion (approximately $140,000 per household), exceeding this year’s likely GDP in the $16 trillion range. Still, this pales in comparison to future entitlement obligations. Although not subject to disclosure convention, analytical assessments suggest $50 trillion+ and growing (another $425,000 per household). Political polarization is commonly blamed for governance failures, but fiscal irresponsibility is a great testimony to bipartisan collaboration.
Last July’s spectacle of Senator Chuck Schumer directing Chairman Bernanke to “get to work” to mitigate Congress’ impending fiscal cliff failure, is sadly reflective of the fiscal culture. Dallas Fed President Richard Fisher’s recent remark that “the Fed is basically underwriting Congress for not doing its job” is on point. Our policy makers’ culture is bereft of fiscal rectitude, leading to recurring instability which intensifies financial risk factors. While some of us may clamor for the Fed to revert to a more classical role, the burdens created by the culture render such hopes purely academic. The fiscal environment is the environmental starting point, so the Fed and in turn all financial intermediaries must adapt.
Harkening back to the immediate aftermath of World War II, the golden age of economic policy, fiscal rectitude was a shared cultural value that facilitated effective governance notwithstanding partisan rancor. At the operational level, financial intermediaries’ corresponding shared value was capital preservation, supporting a broad consensus regarding tolerable risk thresholds. Commitment to capital preservation was a key component demonstrating bank and banker integrity. It continues to be most visible when managers take ownership of their units’ risk performance. Globalized commerce has sparked a secular swelling of financial risks heightening faced by large global financial institutions. This is a healthy bi-product of progress and rising living standards, but this development alone fosters challenges to a capital preservation commitment, making a consensus on acceptable risk limits is increasingly elusive. It is sufficiently difficult without layering on politically motivated instability. In any case, banks’ adaptation to this breadth of challenges affects the culture as well.
Historically, recessions’ silver lining has been a cleansing through unproductive asset liquidation facilitating capital redeployment to more productive uses. I leave it to others to assess whether TARP unnecessarily preserved substandard assets, impeding the pace of recovery. A related question getting less attention is whether the financial crisis had a cleansing impact on the risk culture. Given the severity, the timing would seem ripe for reform. A number of regulatory and legislative actions intending to correct deficiencies and excesses were implemented, the most visible being the 2010 Dodd Frank Wall Street Reform and Consumer Protection Act. The bill remains contentious with factions claiming it goes too far and others finding it insufficient. One certainty is that regulators charged with documenting detailed rules are way behind schedule. My suggestion is instead of getting lost in the esoteric details, step back and consider that this highly prescriptive legislation was passed by a body with limited applicable core competencies, and a deepening contempt for fiscal rectitude. Would it make more sense for Congress to focus on the cultural foundation more appropriately within its purview? Develop a more appropriate environment to enable effective regulation? Is my skepticism unfair and should be welcoming a reformed culture? Recent events are informative, so let us explore examples of the good, the bad and the ugly.
The Good: Community Banks
According the FDIC classification, there are approximately 6800 community banks, comprising 92.4% of all banks and holding 14.2% of banking assets. Generally, bank assets are $1 billion or less. The community banking sector weathered the financial crisis better than the large global institutions. The sector certainly was not spared the consequences of the resulting severe recession. Community bank assets include approximately 15% of residential mortgages so they competitively encountered housing excesses. In many cases their avoidance of the subprime market enabled market share penetration at the expense of impaired larger banks. Still, without the Too Big to Fail safety net, painful bank failures increased in depressed regions with significant real estate exposure. However, the community banks did not drive the excesses, and the extent they persevered while dodgy mortgages populated their larger brethren’s securitization activities demonstrated attention to prudent risk standards. Minimally, commitment to capital preservation was demonstrated, if not superior poker skills.
Much of this can be explained by structural market differences between community banks and the larger sector. Community banks are in the business of taking deposits and lending money within the communities they serve. Although increased economic instability heightens both credit and interest rate risks, and further intensifies concentration risk management, there is muted trading, market-making and investment banking activities that more intensively impact global institutions’ risk environment. Community banks’ perceived commitment to preserving deposit safety is a competitive imperative. This sensitivity reinforces capital preservation as a value and an essential cultural element. While fundamental differences from global institutions inhibit direct transference of community banking risk practices, it does seem to reinforce the value of emulating the culture to the extent practicable. Certainly, policy steps should not weaken the community banking culture….
Unfortunately, the gratitude for community banks’ superior risk performance includes a near zero interest rate environment and increased regulatory burden. Large banks basically lend at a spread over money market rates, while the operational expense of gathering deposits more significantly influences Community Bank cost of funds. Large banks’ traders can arbitrage interest rates and capital rules and benefit from current Fed policy. Community banks deal with compressed lending spreads that motivate managements to pursue higher margin and riskier products outside the traditional core. The Consumer Finance Protection Board and a likely trickle down from Dodd-Frank will require increased systems investment and staffing, increasing incentives on mergers that potentially dilute the commitment to home communities. I can see regulatory field examiners applying the statutes to enhance risk control, but can we expect likewise from the political class? Recall the Community Reinvestment Act being manipulated to induce more aggressive mortgage underwriting. All things considered, do you bet on Community Banks exporting the capital preservation culture, or increased instability imported into the community bank sector? Deuces may be wild for all hands but for those held by the community bankers.
The Bad: Citigroup Alternative Investments
Our current Treasury Secretary, Jack Lew, was once Chief Operating Officer of Citigroup’s Alternative Investment Unit. This unit reportedly suffered massive losses, disclosed to exceed $500 million in the first quarter of 2008 alone, while published reports speculated losses ultimately aggregated well over $1 billion. If accurate, this contributed to Citigroup’s need to be bailed out with approximately $45 billion of TARP funds. Although the losses occurred on his watch, it is possible the causes were established before his appointment, but detailed understanding of causes is reasonably expected. Prominently during his confirmation hearings, attention focused on the unit’s performance and his lucrative compensation package. Republicans probably scored a few political points in a relatively smooth confirmation process so what did we learn? Political hypocrisy associated with a Cayman Island account? Alternatively, a legal Cayman account evidences keen personal insight into tax code deficiencies? Inconclusive financial crisis culpability?
More specifically, was insight gained into Mr. Lew’s view of the culture and of appropriate remedial actions? Recall one of Mr. Lew’s very specific responses that is revealing of the large bank culture, his experience therein, and the focus of political overseers. In the context of the unit’s substantial losses, Senator Hatch questioned whether he was a competent manager or someone who held “a political trophy position”. While it seemed Senator Hatch may have broached much needed examination of conflicts of government officials migrating into and out of the banking sector, the words were unconstructive and the follow up wanting. Mr. Lew’s response was to the effect that while he had been aware of the unit’s operations, he was not responsible for them, clarifying that he did not make individual investment decisions. Did this response not hoist a cultural red flag? Risk is so integral to any bank’ operations, should it not be a broadly shared responsibility, and ultimately a core Chief Operating Officer accountability? Does Citigroup routinely extend seven figure compensation awards to its senior operating managers without requiring risk ownership? Tea Party, hello!!! Did you notice? Better to demagogue lost causes with no risk of accountability?
My observation is not offered as an objection to Mr. Lew’s appointment. For various separate reasons I think he was a good choice. However, given that the Treasury Secretary may have the most critical role addressing rampant hazards, and that his personal experience was so fresh, the failure to explore his view regarding the culture is both a lost opportunity and continuing evidence of our policy makers’ misguided focus. If Congress prefers to conduct inquisitions to assign blame, at least make connections to its own culpability. Citigroup, and large institutions broadly, encountered severe risks and largely failed to contain them. A culture where senior executives can play Sergeant Schultz and disavow knowledge of consequential risk practices suggests capital preservation is an afterthought.
The Ugly: London Whale
A very embarrassing black eye for JPM Morgan and Chairman/CEO Jamie Dimon who had been enjoying a well-deserved run viewed as an exception to reckless stewardship. Certainly, in the midst of the nascent banking recovery, a single unit, ostensibly with a risk mitigation role, incurring a reported $6 billion loss is damaging. It was further compounded by the appearance of disregard for the Volcker rule concept embedded in overseers’ expectations. Still, the hyperventilating may be overdone. The loss was caught by Morgan’s controls at a level largely absorbed within one quarter’s earnings, while Mr. Dimon admitted responsibility and provided very candid and informative testimony in senate oversight hearings. Such testimony is constructive to banking oversight and economic policy more broadly.
Significant loss events are part of the business, and somewhat routine in periods of instability. The manager of the unit, Ina Drew, was a high profile casualty with much attention paid to her significant eight figure compensation package. I submit that neither I nor any other third party possesses sufficient knowledge to pass judgment on appropriate compensation. However, I contend that since risk is inherent in the unit on a large scale, it follows that risk responsibility must be a significant component of both the compensation level and structure, including personal risk. Chase’s enforcement of clawback provisions and the termination action suggests such responsibility was assigned.
But what did the incident convey about the culture more broadly? Forbes reported Ms. Drew told the Senate Permanent Subcommittee on Investigations that members of the CIO’s London office “failed to value positions properly and in good faith, minimized reported and projected losses, and hid from me important information regarding the true risks of the book.” It was further reported that Senators Levin and McCain found that hard to swallow. Question, is not the senators’ specific bout of indigestion beside the point? Is it not sufficiently alarming that in an oversight hearing, a senior banker’s justification is to deflect blame to subordinates for a severe risk management failing? And that the oversight reaction seemed to be focused on testimony credibility and not the implications of the justification itself? It seems that the testimony was culturally informative regarding ownership of risk and commitment to capital preservation, not to mention misguided senate oversight.
The People Our Parents Warned Us About
Don’t try to describe the ocean if you’ve never seen it
Don’t ever forget that you just may wind up being wrong — “Mañana” by Jimmy Buffett
The foregoing examples were deliberately chosen partly because they are familiar, but also because they involved very capable people and influential policy makers. It reinforces the vulnerability of even capable executives to risk events in an unstable environment, while also illuminating the cultural condition. I started by reemphasizing the fundamental need for Character assessment in credit analysis. I further emphasized the banker and banking culture must establish the Character standard, which further must be enabled by the appropriate stable environment. Much work remains to be done.
The legacy of fiscal profligacy is easy to assign to the political class which has diligently earned it. But who enables them by reliably reelecting the perpetrators? Consider a couple of recent developments. Our President, no paragon of fiscal responsibility, floats a budget deal concept to consider chained CPI to enhance tax revenues and slow spending. His core supporters led an eruption that he had morphed into Genghis Khan. Have the hysterical voices taken the time to reflect on what chained CPI does? In my simple mind it simply means social security recipients’ quid pro quo for inflation protection becomes accepting the same burden of economic choices as the average household; similarly, the quid pro quo for tax bracket creep protection is the identical burden of economic choice. Seems fair and relatively inconsequential. Are the objections thoughtful, are we too busy to think, or is it just another symptom of the absence of shared values?
Paul Ryan initially gained prominence for his federal budget reform passion. His “Road Map for America’s Future” is a very detailed proposal to return to fiscal rectitude. Sharing such commitment to fiscal responsibility does not require agreement with all or any part of Mr. Ryan’s proposal. However, even the President, momentarily slipping from the grip of political handlers, complimented it as a serious proposal and constructively noted the need for a serious debate on the points of disagreement. Honest and thorough absorption of the proposal should prompt similar constructive engagement across the spectrum. Equivalent efforts to validate or rebut his points logically would be highly productive and reflect a much healthier culture. Alas, apathy, simplistic platitudes and thoughtless demonization are more common reactions.
Regarding both chained CPI and the Road Map for America’s Future, if you denounce them without understanding them, don’t ever forget you just may wind up being wrong. The point is if we expect to have an environment with better risk decisions and reduced exposure to financial catastrophe, a cultural foundation must be restored, and that requires widespread commitment including critical but honest engagement, reinforced by consistent accountability. The financial world has grown more complex and Messrs. Drysdale and Mooney no longer bolt for their 3:00 p.m. tee times, but fundamental principles of their era should be revived to enable effective remediation. Likewise, even our most sincere policy makers have limited capacity to prescribe detailed corrective solutions even in the best of times. It seems more sensible to insist and make them accountable to focus on discharging their responsibilities to stabilize the environment in a more easily understood manner. Just maybe, this can lead to more comprehensible regulatory standards, and they can restore their own credibility to exercise effective oversight.