More on Roubini....

With regard to the stress test being consistent with the IMF estimates, consider the following from the blog Alea:

Still, it is useful to know whether our estimates are consistent with what has been found by others. Two studies released within the last few weeks essentially bracketed the supervisory estimate. The International Monetary Fund estimated lifetime losses that would imply a loan loss rate for U.S. banking firms of about 8 percent in a stressed scenario. One of the major rating agencies estimated an annual loan loss rate of about 4-3/4 percent in a stress scenario for the next two years.  More broadly, our informal survey of the results of a considerable number of private-sector studies and analyst reports published over the past several months generally placed our projected loss rates for key portfolios near the midpoints of the ranges of these independent estimates.

Major Roubini Goof

Professor Roubini stated that: 

The IMF recently estimated that retained earnings (after taxes and dividends) for all US banks – not just these 19 ones – would be only $300 bn total over the 2009-2010 period. The stress tests – instead – assumed much higher retained earnings - $362 bn - for these 19 banks alone for the 2009-2010 period in the more adverse scenario. Since these 19 banks account for about half of US banks assets if one were to use the IMF estimate of net retained earnings for these 19 banks their net retained earnings for 2009-2010 would be $150 bn rather than the $362 bn assumed by the regulators. While the IMF may have been too conservative in its estimates of net retained earnings it appears that regulators may have been too generous to these 19 banks in forecasting their earnings in an adverse scenario.

Professor Roubini should realize that you don't pay taxes on losses, and the funds available for loan losses are much higher than $362 billion.  The IMF figure includes dividends, which you don't pay if you are in financial difficulty and loss provisions.   In 1Q2008, BAC had about $18 billion in loan losses and pre tax, pre dividend earnings and Wells had about $10 billion. That's $28 billion for the two per quarter or or $224 billion over the two years from these two banks alone. This figure may be way too optimistic, but $150 billion from the two banks certainly isn't.

Some of the banks may have to book huge portions of their pre tax, pre provision earnings but that is a big number.  Just consider the $8 trillion in RWA and use a conservative net interest rate margin (say 2% per year) and you end up with $320 billion over the two years.  

More on the Stress Test

As the only blogger that had anything close to unequivocally favorable to say about the stress tests, I did manage to get a few hits, but not many.  I suppose people are just sick to death of yesterday's news.

There is no upside in saying anything favorable and to appear to take it seriously is to risk seeming hopelessly naive.

However, I think betting against the Fed/Treasury is a bit naive.  

The way to read it is to start backwards.  Total 2 year losses of $600 billion.  Together with the $400 or so that have already been booked, thats $1 trillion.  If these financial institutions have 1/3 of the assets exposed to the "crisis" -- that would put the total at $3 trillion.  Or big enough to be in the range of plausibility.

The next step is looking at how the $600 is going to be "funded."  I already went through this in the last post, and it seems reasonable.  

I read a bit of the RGE monitor (Roubini) and he is heavily invested in his scheme to do a "good bank/bad bank" reorganization.  Not a bad idea, but I have a feeling that he simply doesn't understand banks.

In fact, most of the disagreements seem to be people who equate banks with New York investment banks and see the rest of the financial sector as simply an appendage of New York.  I tend to see New York and investment banking as a separate business.  A lot of it could disappear with no consequence.  It already has.  The flip side is that the majority of abuses were associated with investment banking and they managed to almost blow up the world financial system.  

Investment banks don't make normal loans.  The only stand alone investment banks are GS and MS.  they have a lot of exposure to securities but not much to loans.  They don't do credit cards.  They don't deal with retail lending customers.  They did facilitate a lot of lending, but no one wants to buy these sorts of products anymore.  The so called originate to distribute model.  

As far as banks that make loans -- they seem to be making them.  I am at a loss regarding whether they should lend more or tighten standards, but they seem to be doing about the right thing.  That is, no more really stupid loans.  They do seem pretty aggressive about loaning to people that can pay them back -- but those people don't especially want to borrow.  

The general playbook of the Treasury/Fed is to subsidize interest rates and force people to either accept zero returns or start taking some risk.  This is all they can do and they are doing it in every way imaginable.  It is also directionally right as a policy move.  In fact, you have fiscal stimulus via deficit spending to go with the liberal monetary policies.  

That is the right thing to do directionally, and they seem to be doing a lot of it, which is, for lack of a better word, good.

Berkshire's 1Q Earnings Announcements

First the basics on how earnings are reported in US GAAP.  This is a big picture, non accountants overview.  They get split into two parts -- one labeled net income and the other labeled other comprehensive income (OCI).  The idea is to put normal stuff in the first bucket or items that have some finality -- like cash losses.  The other bucket gets things like unrealized capital gains and losses, which will fluctuate and make it more difficult to see how the firms operations are trending.

This treatment of unrealized capital gains and losses is not in the least controversial.  For Berkshire, the infamous long term put options would logically fall into OCI (other comprehensive income) -- since they are intended to be held for over a decade, and quarterly movements are noise.

Instead of trying to change accounting, Berkshire has developed a very simple non GAAP metric that it refers to as operating earnings.  Every quarter it puts out a statement opening with operating earnings and reconciling to GAAP.  Operating earnings exclude derivatives as well as other financial "bets" like currency trades.  They are, in fact, operating earnings, which is really what GAAP net income would like to be, if it weren't trying to be uniform across all businesses.    

Right now the volatility of the derivative book they totally overwhelms the changes in the core business earnings.  The Berkshire release saves investors and the media from having to make these adjustments themselves.

This quarter was a bit different.

1.  The earnings release was a week after the annual meeting.

2.  A "preview" of earnings was released, with the emphasis on operating earnings. They were down modestly from $1.9 billion to $1.7 billion.  Given the economy, not bad.

3.  The final published figures contained additional losses of $2 billion ($3 pre tax).  This is based on unrealized capital losses, but since Berkshire has announced that it will sell enough COP stock to get a $600 million tax refund, it labeled these losses as OTTI (Other Than Temporary Impairment) losses.  This means that they can be booked in net earnings BEFORE the stock is sold.  

4.  This huge OTTI clears the decks regarding realized capital losses for the remainder of the year.

The headline numbers should really be Berkshire's non GAAP 'Operating Earnings'.  It is the best way to make sense of the results, and any competent stock analyst would perform a similar set of adjustments.  

The press never seems to read and report on Berkshire's released operating earnings.  This year, it's all that was available when the quarter was discussed at the annual meeting.

Plus, Buffett threw in the kitchen sink by booking the OTTI when 1Q is old, old news.   This is as close as you are going to see Buffett come to spinning bad news. Nothing misleading about it, and in fact, it gives a more accurate picture.  At least the operating earnings.  Taking the OTTI losses as early as possible is something that most CEO's would like to do and Buffett can afford it.  Equity markets hate uncertainty and booking bad news ASAP tends to be good for the stock price.  Buffett may not care very much, but now the foundations have to sell some Berkshire on a regular basis, and there is an economic motivation to keep the stock price at a fair value. 

Ten Reasons the Stress Test doesn't SUCK

Before anyone gets too critical, they should actually read it. And review the spreadsheet.   A good list of the flaws can be found at naked capitalism: Yet More Stress Test Doubts.

This is an alternative point of view.

1.  After the extra extraordinary measures taken in the fall, especially the passage of the $700 billion TARP bill, the public needed some documentation. Something beyond Paulson's single sheet of paper.  Even if this is just an elaborate back of the envelope estimate, it is a single set of figures in a single document.

2.  Define "To Big To Fail"?  It has now been done.  Any "bank holding company" meaning financial institution with a banking license that has over $100 billion in assets.  It's 19 and it includes an auto finance sub (GMAC), a Life Insurer (Met), and a credit card company (American Express).  Two investment banks, two hybrids with investment and commercial banking (C, BAC).   

3.  What do the big 19 have in common?  Nothing other than size.  Most of the public outcry has been over excesses in New York Investment Banking.  Anyone think that USB's Minneapolis based bankers routinely get million dollar bonuses?  People should chill with the generalizations.  Or maybe just quit calling New York financial activity banking and the people that do it bankers.  There is an important distinction that has been deliberately blurred, and community bankers aren't happy about it.   

4.  It is a very big chunk of the traditional banking system. The two biggest, BAC and WFC have well over 20% market share of insured deposits.  I don't mind size as long as it is just vanilla banking scaled nationally.  Like the old Bank of America, when  they avoided investment banking.  A firm like Wells should think about splitting out it mortgage servicing business.   

5.  Maybe the traditional banking system really isn't the problem.  They are only involved with 20% of total lending. Per Jamie Diamon:

Traditional banks now provide only 20% of total lending in the economy(approximately $14 trillion of the total credit provided by all financial intermediaries). Right after World War II, that number was almost 60%.

 We have reps for all the players in the 'shadow' banking system.  Investment banks that did securitizations.  A credit card firm.  Brokerages that underwrite bonds.  

6.  A sense of how things could really play out.  People will either agree or disagree, but at least they have some numbers to talk about that are ground up rather then the economic aggregates tossed around by the economists.  

7.  $8 trillion in assets.  An estimate of $600 million in losses.  Two numbers that tie into published financials of specific firms.  Remember that a lot of assets were sold to non banks.  If this is 20% to 25% of the total assets exposed to losses, that corresponds to $2.4 to $3 Trillion that the economists talk about.  A lot of the worst stuff was sold off, so the $600 billion figure is big enough to be more than plausible. 

8.  What about the zillions in level 3, toxic CDO's?  Less than 2% of the total.  

At the end of 2008, the 19 BHCs held $1.5 trillion of securities, more than one‐half of which were Treasury, agencies, or sovereign securities, or high‐grade municipal debt, and so are subject to no or limited credit risk. Only about $200 billion was in non‐agency mortgage‐backed securities (MBS) and only a portion of these were recent vintage or were backed by riskier nonprime mortgages.

How much hand wringing has there been over this topic when discussing banks? Way too much, it seems. It isn't like there aren't problems, but most of the problem assets aren't owned by banks, and those that are were pretty much written down over the last year and a half.  It is a big problem, but one that was sold around the globe.  The banks thought they held the best CDO's and they definitely sold stuff that was materially worse then they kept.

9.  Just like Japan?  There are $60 billion or about 10% of the estimated total losses that have already been booked via purchase accounting adjustments associated with the larger mergers.  This includes WB, MER, WM, CW and a few others.  

You work through $600 billion in big chunks over a couple of years.  As noted above, 10% is done.  There is capital in excess of regulatory requirements right now, if needed.  This was done using 12/31 data, and over $100 billion has been done during that period.  We have 7 more quarters of earnings to use for loss provisions.  Finally, there is the $75 billion of additional common equity that is required to be raised.  

10.  Everyone can apply their own judgment against these figures.  However, I think that it isn't the banks.  It's the real economy.  People might be able to chill about banks and start thinking more about jobs, etc.  

Maybe it is just too optimistic.  If so, a next step could be to relax capital requirements IF there is strong evidence the economy has turned.  The economy is cyclical and there are lags.  Do we need to have banks that are capitalized above the regulatory level at the trough of a monster recession?  Capital is there for a reason and there are times that you relax the requirements and let the levels drop.  If you can NEVER use it, why have it in the first place.  

Buffett Succession Issue

Per Reuters:

Shareholders expressed confidence that Buffett has the succession issue well in hand. Yet, some admit that Buffett is a reason they bought the stock in the first place, and that when he leaves, they might too.

"That will be a time of real terror for a lot of people, and I don't know what I'll do," said Clifford Glassel, 68, a retired product engineer from Red Oak, Iowa who was attending his sixth meeting.

He is splitting his job into three parts. The Chairmanship goes to son, Howard, who will be there to keep tabs on the CEO and CIO. He is currently getting the same sort of training that Michael Corleone got prior to the demise of the Don.

The CEO job is to make sure that the zen form of management remains in place. A single guy with a very small staff to act as an intelligent owner. The CIO's won't get to decide how much capital to invest, just given the excess cash.

However, I expect to see another change. The first thing would be a substantial buyback the moment Warren steps down for whatever reason. The second is a rational dividend policy.

Or better yet, let the stock crater for a week or two and then announce the policies, giving a substantial break to long term, buy and hold owners.

Remember. Buffett outsourced his philanthropy to Bill Gates. Anyone that thinks he will do something stupid with a transition isn't thinking clearly.

Berkshire Meeting - Below the Radar

The most interesting comment was the following regarding the index equity puts:

He added that the company recently restructured two of its so-called equity put contracts - agreements that give an investor the right though not the obligation to buy a bucket of stocks from Berkshire at a specified date in the future. Those contracts have emerged as a subject of some debate since the stock market's plunge last fall.

Under one of the restructurings, the S&P 500 would have to rise just 13% over the next 10 years for the put to expire worthless. Before that deal, the S&P would have had to rise 72% over 18 years to preclude Berkshire from having to make a payout.

This means, among other things, that the original puts were written at the top -- 1.72 x S&P is getting close to 1500.

More interesting is the backstory. I can only speculate, but lets start with the assumption that no cash changed hands as a result of the restructuring. This would mean that the time value of the puts is negative. Or at least the last 8 years of the puts.

In addition, it would seem like the motivation to do this must have been from the mystery buyer. I don't think Berkshire would initiate restructuring deals that would be advantageous to the counterparty. They do too many deals to go around and ask to renegotiate in a way that is economically disadvantageous to the counterparties.

What it sounds like Buffett is saying is that the strike price was negotiated significantly downwards -- from close to 1500 to below 1000. In exchange for lowering the strike price, Berkshire moved the expiration date forward by 8 years.

The only thing that comes to mind is that the counterparty must have gotten an accounting benefit for the change. The Black Scholes value would surely decrease. Perhaps they are using the derivatives as a partial hedge on, for example, annuity guarantees. If the change in expiration date aligned the derivatives with the underlying risk, maybe there was an accounting benefit.

If the counterparty is a US company, I would think there would have to be some disclosure.

It would also be interesting to know notional value of the derivatives. If they are a significant piece of the total, the Black Scholes value would decrease - falling directly to Berkshire's operating earnings.