This will be a revealing week on Wall Street, with earnings reports due out from some of the big brokerage firms and major money-center banks.
As we have said previously, even the CEOs and CFOs of the biggest investment banks don't seem to be able to gain a clear picture of their own balance sheets right now. The reason, as we explained in that post, is that their "manufacturing" department (the underwriters who were eagerly creating CDOs and other instruments in order to rake in investment banking fees while the Fed-induced mortgage boom lasted) cranked out so much product that they couldn't sell it all. This excess product, we said, ended up stuffed in "the warehouse" of their own inventory, "so much so that management inspections keep turning up more of it squirreled away in dark corners and underneath old shelves in the back, and a lot of it has been discovered to be rotten."
At every earnings report, we get a new look at the balance sheet of these companies, as closely as their leadership is able to determine. Over the past six months, it has become clear that they cannot determine their balance sheet picture at all clearly, because they keep announcing emergency capital raises right after declaring confidently that they are done with raising capital for the year.
But why were these investment banks cranking out so much of this product when their own salesforce was saying that they couldn't possibly sell it all? The reason is that they were "making hay while the sun shines" and raking in banking fees, and that those in charge of the departments that were doing it were getting paid big bonuses in cash compensation. The damage to the shareholders (and to the many employees in other departments whose compensation was tied to the stock price) would only happen later, after they had already made their money.
This situation is akin to the way some hedge funds operate, finding a certain market situation that they can exploit for great advantage while it lasts. For instance, if a hedge fund decides we are in a certain long-term trend, such as a declining dollar, they can make money by betting against the dollar. They won't just bet their own money against the dollar -- they will load up on as much leverage as they can get to bet against the dollar, and as long as the dollar continues to decline they will make huge returns.
A common-sense question to ask would be, "What happens, Mr. Hedge Fund, when the dollar finally turns around, and you are leveraged to the hilt and short the dollar?" The answer will be, "I will go out of business, plain and simple, but I will have made a huge amount of fees and bonuses from my investors in the meantime. And, judging from the current direction of the dollar, the good times for betting against it won't run out tomorrow -- I still have a lot of time to make hay while the sun shines." Eventually, the investors in that fund will be left holding the bag, but those running the fund will have made a fortune before the inevitable end comes.
This is exactly what has happened in some of the biggest investment banks in the land, because their management decided that they wanted to behave more like hedge funds. They incented those who were creating tremendous profits for the firm by underwriting asset-backed securities and other synthetic instruments such as CDOs, and now that the inevitable end has arrived, it is the common shareholders who are left holding the bag, analogous to the investors in the hedge fund described above.
These firms should go back to doing the kind of business they are supposed to do: if the investment banks would get back to making money by taking companies public and by doing merger and acquisition deals, and the commercial banks would get back to making money by underwriting responsible loans instead of trying to juice their returns with irresponsible loans, they would have a perfectly operable business model that would allow them to make profits.
At the bottom of this whole situation is the Federal Reserve, which created the conditions for the explosion in lending activity in the first place, by holding rates too low from 2003 to the present. It is astounding to hear the calls for an expanded role for the Fed as a solution to this problem!
We would add as a footnote that, although many are saying that the "current crisis" makes it impossible for the Fed to raise rates, it would help many of the banks if the Fed would raise rates, since the revenues of commercial banks are directly tied to the difference between what the bank pays depositers for funds and the bank earns from borrowers on loans. It is very difficult for banks to lower the rates they pay on deposits any further from the low level they are at right now. Higher interest rates would help these banks earn better returns from the "spread."
The conclusions to the current financial mess should be clear: if the investment banks would stick to their proper business (rather than trying to be hedge funds), and the commercial banks would stick to their proper business (rather than trying to be FHABA or HUD), and the Fed would stick to its proper business (providing a stable currency, rather than trying to steer the economy), then "making hay while the sun shines" would not end up as "settin' the woods on fire."
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