Friday, June 1, 2012

The Banks' Real Nightmare

Interest rates are plunging yet again in the U.S., and there is talk now of QE3 again.  I'm happy to see things being done to help the economy, but one thing I fear about QE3 is that it will destroy the banking industry.

What Worrys Me Most About Banks
The JPM trading loss doesn't worry me at all.  The multi-trillions in derivatives outstanding doesn't worry me. Dodd-Frank and Volcker Rules don't bother me too much.  A double-dip recession where housing prices go down again?  Nope.  Doesn't worry me too much.  After the crisis, I think loans are written at much better standards and with better loan-value ratios etc.   So I don't worry about bad loans on a double dip recession as much.  Banks also have much more capital and their risk management is much better than pre-crisis.

So what worries me more?    Take a look at Japan.

Japanese Banks
Check this out.  This is some data I pulled from the 20-F filings of Mitsubishi UFJ Financial Group (MTU)  in Japan, which I think is the largest bank there now.  It's pretty much regarded as the best bank, kind of like JPM or what C used to be.

Profitability Ratios of Mitsubishi UFJ 1999-2011

ROAA is return on average assets, ROAE is return on average equity, NII is net interest income to average interest earning assets and average equity / average assets is exactly that (average shareholders' equity to average total assets).

This data only goes through the year-ended March 2011 because they don't file their 20-F until July or so, and they only publish U.S. GAAP results in the 20-F, I think.

You can see why Japanese banks are cheap.  The ROE averaged 1.1% since 1999 and even being generous and starting in 2003 (eliminate the loss years of 1999-2002), the ROE averaged only 4.4%.

The years with large ROE are years where they had big gains in investments, foreign currency or some such other non-recurring things (as far as I can tell from a quick reading). 

Their ROE is low because their ROA is low.  Their return on assets since 1999 has averaged 0.03%, and since 2003 (again, being nice and using a favorable time span) has averaged only 0.14%. 

So why is ROA so low?  Of course, because interest rates are so low over in Japan and has been for many years there.

Net interest margin since 1999 has averaged around 1.2%, and it's been pretty consistent.  Notice that Mitsubishi is more than two times levered than U.S. banks too, having an equity to assets ratio of less than 5%.  U.S. banks are more like 10 times levered now.

So let's look at some of these figures for large U.S. banks.  I'll just look at a couple as they are more or less the same.

                                     ROA        ROE         NIM               Equity/assets
Wells Fargo                  1.25%       11.9%       3.9%                9.9%
J.P. Morgan                  0.86%       11.0%       3.3% (core)      8.2%
M&T Bank                   1.16%        9.7%        3.7%               11.9%

Look at this and compare it to MTU's above.

It Can't Happen Here
I remember having many discussions in the late 90's and early 2000's about the U.S. bubble and how we can follow Japan.   The usual response was that something like Japan can't possibly happen here.  Bernanke also said it can't happen because the U.S. Fed will respond differently.  Everything in the U.S. is way better than it is in Japan (disclosure, regulation etc...)

If you said that short term interest rates will be zero or near zero in the U.S. like Japan for an extended period of time a few years ago, people would have laughed at you.  In fact, I didn't predict anything, but people did laugh at me when I suggested that it could happen.

If you said then that long term treasury rates would go below 2%, nobody would have believed it. 

The Fed will print money like crazy, causing inflation and interest rates would go up, not down.  So a sub-2% interest rate is impossible, they said.

During the financial crisis, the 0% short term rate was deemed a short-term, panic/fear driven interest rate that won't last too long.  But here we are, years after the worst of the crisis with short rates still down here and long term rates much lower and hedge funds still trying to pick the top in the bond market.

This is so reminscent of Japan all throughout the 90s.  Shorting JGB's must be one of the deadliest hedge fund trades ever done (on a cumulative loss basis).  The U.S. treasury short trade is looking a lot like that now.

10 Year Government Bond Rates
So anyway, even though most would have thought it impossible even a year ago, here we are with U.S. 10-year treasury rates at 1.46% or so.

The Japanese (JGB) 10-year rate was 1.26% as of March 2011.  Look at that rate, and then look at the net interest margin of Mitsubishi Bank.  Now the JGB yield is 0.82%.

Now look at the U.S. bank net interest margins.  Hmmmm....

There are factors that is better in the U.S. than in Japan.  Demographics, for example, is favorable in the U.S. while it is a negative in Japan.   I think (despite the financial crisis) that U.S. banks are generally much better managed in the U.S. than in Japan (look at how the subprime blowup occured in the U.S. and Japan avoided most of the U.S. problems, but MTU still lost a lot of money in 2008 and 2009 while JPM didn't even have a single quarterly loss).

Dimon has been asked about this on conference calls, and he feels that although he can't predict interest rates, he thinks it will eventually get back to more 'normal' levels.  I think Buffett said the same thing; he feels that the bond market is the biggest bubble of all time.

This sounds right to me, but I just can't get over the Japanese JGB bubble that has been ongoing for 20 years!  And if it continues here for longer than many think, what happens to the banks?  Don't even open up an income statement of a U.S. bank and try to plug in a 2.0% or 1.5 net interest margin to model potential earnings (or losses).  Your blood pressure will go up.

This is not my primary, base-case scenario.   But to me, this is a bigger risk factor than what most people worry about; risk of European exposure and all that.

Inflation is Inevitable
Everybody keeps saying that inflation is inevitable, but this Japan scenario keeps bugging me.  I know they say Japan is different (debt internally funded etc.), but each time we say it can't happen here, it seems we take a step closer.

Many hedge funds are positioning themselves for inflation but I think Prem Watsa of Fairfax is the only one I know of betting outright on a Japan-like deflationary scenario.  (Of course, all bond investors are betting on deflation even if they are not actually thinking about it and buying bonds by default).

Maybe the tail hedge here is actually long treasury zeros instead of long gold.  As they say in the trading world, if it's obvious, then it's obviously wrong.

Anyway, I don't know how this inflation/deflation resolves itself.  I suspect both sides will be right over the next few years; it's just going to be tough to know when which one happens first etc.  (deflationary collapse followed by hyper-inflation, or maybe we just muddle through...)


  1. So far the inflationistas has been proven wrong every step of the way. Its surprising to see all the early predictions of mass inflation due to QE have not come true. Also surprising how vehemently and aggressively believers of upcoming inflation profligate their ideas. Its very obvious that people like Krugman have been right all along, and the chorus of inflationistas have been utterly wrong .

    On a side note, What to you is worse having QE that destroys the profitability of banks or no QE and assuming the risks that comes with that. To QE or not to QE that is the question...Isnt what we need right now a higher inflation target and thus more QE?

    1. I don't know. But QE3 would work if the problem was interest rates that are too high on the long end, or if there wasn't enough money. That is probably not the case anymore with rates down here.

      We need reform elsewhere; the Fed can't keep printing money and think it's going to solve our problems.

      The inflationistas may eventually be right, but the markets have a tendency to wipe everybody out first so by the time they are right, they won't be around (just like when everybody *knew* that the internet bubble is unsustainable... by the time it popped, many of the shorts were long blown out).

  2. Long term rates at these levels are indeed a very ominous portent of economic prospects.

    That the US is very different from Japan is unarguable but it doesn't mean it can't have a similar experience. I do believe though that much of the reason rates are so low are due to non-US reasons, principally Europe.

    1. Good point. A large driver of these interest rates is the economic climate where U.S. Debt seems to simply be the best option of all the ugly options.

  3. Great post. I thought maybe it was time to go back and review. You are certainly right about NIMs coming down; the big money center banks are now around 3% or below (though Wells is still above). That said, part of what is keeping them depressed is the force feeding of federal funds into the banks in order to create the dollars to perform QE. The Economist had a good post on this:

    I admire that you are just trying to think of possible outcomes, not make predictions. We have to think about deflation and inflation. I think hyperinflation was covered by Munger at the BRK AGM this year when he said that in the Weimar Republic it killed the banks and insurance companies. High inflation would probably not be deadly, but as Wells stock price in the late 70s and early 80s shows, it would not be great either—it would probably lead to stagnation at best for bank earnings. As for deflation, Japan is one model we can turn to. However, Japan never recapitalized its banks and allowed them to stagger on like zombies. So, is that really a fair comparison to our banking system which was recapitalized by the tax payer? It seems more akin to what is happening in Europe today. Also, Buffett has always avoided investing in Japan because, despite cost of funds at 1%, they have notoriously low ROEs — about half the level seen in Europe or the US:

    Just trying to continue the debate and thinking on this one.

  4. FYI, in this interview Lacy Hunt seems to suggest that long-dated Treasuries may be heading toward long-dated JGBs:


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