As I've said a number of times in other entries on this blog, equity holders of banks have a responsibility to take the hit they deserve for the lack of intervention into the standards corporate governance exhibited by the executive boards of the vast majority of banks in various parts of the western world. As part-owners, they had the responsibility to voice their misgivings, pressurise the executive board or, at the very least, sell their shares if they didn't agree with the strategy or direction. If they did none of the above, they should shoulder the burden and feel the pain that their falling share price brings. This stance I maintain, and reiterate, to a certain point. Also, I realise now, this stance is based upon a certain assumption that the equity market understands why stock prices are falling fast and the potential circumstances in which a banks solvency can be stabilised and the potential for future profitability revived. I now fear this is not the case.
The current panic in most European banks stocks is predicated upon a lack of confidence in the short-term money markets, where financial institutions extend and take short-term cash funding to facilitate the day-to-day operations of the bank. It is based upon the obvious circumstance that some banks can find themselves with more money than they need at the end of any business day, and other with not enough. However it has also expanded into a market that banks have come to rely upon for short-term funding of their operations into which funds with a specific investment strategy to lend money for short periods and (usually) a small yield over Libor. Over the years, banks came to invest some of their cash into these funds in order to support its expansion so that it would (theoretically) become a very liquid and easy source of cash. The problem we are now realising is that it is completely predicated upon the assumption of complete faith in the borrowers over very short periods. which has now broken down.
The astronomic increase in the yield above Libor that some of these institutions are having to pay in order to get short-term cash is easily explained by the increased risk of their default in the near-term. The increased cost of this funding is obviously crippling for the profit margin of the banks and, in most cases, results in a day-to-day running loss from the operations.
The Irish Government's extension of a full guarantee of Irish bank debts and deposits resulted in a dramatic reduction in this overhead and, the UK government's extension of a blanket £250bn guarantee of short-term bank lending has also had a similar effect. So, this solves one problem, and stabilises the ship so that the clean-up can begin. The cost of clean-up will obviously have to be footed by the bank's shareholders however, what is the extent of the clean-up...? This is less clear.
The expected pain for bank shareholders has happened and, in my opinion, gone way too far. The lack of understanding of basic finance fundamentals by many within the equity markets has become a field day for the equity market speculators who have begun taking advantage of the lifting of the short-selling ban. The lack of leadership within the equity market investment community, and to a large extent, the pain already felt, has given the short-sellers free reign to push the equity markets down as no one is prepared to stand up and lift the banks out of the range of their ugly sticks. In the land of the blind, the man with one eye is king... Or, even the man who claims to have one eye.
The big problem with the extent of this sell-off is that it erodes the capitalisation ratios of the banks. This is the basic concept of owner equity vs debt in the company. A bit like the deposit vs debt ratio of your house and its mortgage. If the house is reducing in value, this erodes the equity you have in the house. For banks, the regulators require them to have a certain amount of equity at all times in the operation. So, if the stock price continues to erode, the capitalisation of the bank begins to come under threat. We have gone well past this stage on a lot of the bank stocks in Europe.
The short-sellers are banking upon the fear, of the regular equity investor, that these mortgages and leveraged loans, that occupy the most toxic positions on the balance sheets, will leave a huge hole once they are sold, come to refinance, or default. Within the UK and Ireland, the main worry is buy-to-let mortgages, non-conforming mortgages and, loans to property developers. These are now looking very risky and will probably end up costing a pretty penny in write downs but, the option value in owning the stock of the company with regards to future potential profits once the cycle turns again seems to have been completely forgotten. Also, there is the effect of overly negative opinions of conditions of the various bank balance sheets, versus some positive comparison for others. Sometimes these can be very polarised and a tad out of whack. But, perception is the key.
Take Goldman Sachs as a good example. Last year they rolled out their star-trader of the year as a mortgage trader called, Michael Swenson, who apparently was allowed to amass a short position (negative to the direction of the US mortgage market) so large that it contributed $4bn in profits to the Goldman record bottom line in 2007. At the same time, they were gathering an ever-increasing collection of illiquid assets that reached, in August of this year, $68bn in value. These assets occupy a space in the bank's balance sheet that is called the Level 3. This group of assets are deemed to be so illiquid that the bank is allowed to mark their value to an internal model and simply declare the value to the market with only cursory details as to the type of exposure they represent. So, was this short position an inspired punt or, was it simply a hedge for the toxic skeletons in the Goldman closet that is Level 3...?
For a long time, the exemplary reputation that Goldman enjoy held investors' confidence. Only in the last couple of months has the pandemic fear spread to their good selves. While Morgan Stanley scurried to find an equity investor and finally leaped at Mitsubishi UFJ, Goldman Sachs were playing it cool and talking to Warren Buffet. Buffet has been widely chronicled to have always craved to acceptance and acknowledgement of Wall Street. Especially, its golden boy, Goldman Sachs. It is quite possible that during negotiations Goldman, knowing Buffet's aversion to highly complicated financial risk, declined to show their balance sheet and made Warren realise that such was his reputation and theirs, that his investment of $5bn in their equity would be a self fulfilling prophesy in itself. No one would ever again doubt the financial nous of Goldman Sachs and they could side-step the worst of the financial meltdown.
Such is the decline in some of the European banks' stock prices that, there now exists a massive opportunity to take control of the future of European banking. However, in the midst of the blind panic, it would take a suicidal maniac to just invest in the stock. The only solution is to take the banks out of harms reach and off the stock market. So the short-selling speculators can no longer profit from the confusion.
The current market capitalisation of Bank of Ireland is about €2bn, and that of Allied Irish bank is about €2.5bn. The Irish government has kept their powder dry and now is the time to pounce. Take them private and nationalise them so they can be recapitalised in safe distance from the madness that has encapsulated the equity markets. Those equity lads simply haven't a clue what's going on.
WNgC
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