I Like Bankers, But

Bankers Lacking In Risk Analysis

I very much like bankers as a profession and as people. As a general rule, persons in the finance industry are well educated, well spoken, and well dressed. Some have a great sense of humor – it always seems that they are inventing clever new terminology for what they do. Investment bankers in particular always seem to know the latest jokes. They also present themselves as highly expert in valuing the quality of investments and how to make money, which is one of the supreme skills.

If that image is wrong, then the actions they take can have dangerous consequences that affect us all. While the industry has a reputation of being conservative and low risk, the reality is quite different. Let me give some examples.

Precisely a year ago, in mid-2007, the major banks throughout the world seemed to be in wonderful shape. Company and individual reputations were unusually high and profits and executive compensation were at record levels.

Since that time, there has been quite a reversal. The seven major U.S. financial companies (Bank of America, Citigroup, JP Morgan Chase, Lehman Brothers, Merrill Lynch, Goldman Sachs and Morgan Stanley) had combined profits for 2004 through mid-2007 of US $254 billion. Since then, however, they have thus far written down the value of their assets by US $107.2 billion, and it seems clear that actual losses will be more than half of all those profits over that 3.5 year period. (Citigroup has already exceeded that level.) Worldwide, the losses in this part of the financial industry exceed US $380 billion and may ultimately, according to some experts, exceed $1.3 trillion. Much of this is due to losses in the “subprime mortgage” investment market, discussed in the last issue of this magazine (Fuji Diary 24), but defaults and write-downs are spreading to other forms of debt.

How could such a huge decline happen so quickly? Bankers are supposed to be good at knowing how to make profits and to value assets. It is those skills that justify the extremely large compensation they receive. If they are actually bad at such valuations, how can that compensation be explained?

In their defense, some would argue that this latest crunch in the world financial system was an extremely unusual event that could not have been anticipated. In reality, however, the events of the last year are not unusual for the finance industry. They occur with regular frequency. Failure to anticipate them is simply bad management. One cannot ignore the inevitable likelihood of “bank runs,” which occur when a loss of investor confidence leads investors to seek to withdraw from an entity whose assets are insufficiently liquid to permit such withdrawals. That likelihood increases when a bank makes more risky loans, as did Bear Stearns, just one recent example. Assessment of overall risk, if it is to be valuable, must include the chances of such events occurring.

What activities do banks and the finance industry do? Basically, they accumulate capital by taking deposits and then they redistribute it for use by others in large and small businesses, in return for profits in the form of interest and fees.

They also deal in more risky financial “products” such as securitized subprime mortgage obligations and other collateralized debt obligations (CDOs), hedge contracts, currency and debt swaps, other derivative securities, etc. These products are more profitable because the risks are greater––and they seem to require greater analysis and evaluation. A large portion of the current finance industry is devoted to dealing in these higher risk products. Presumably, greater skills are required for that, justifying greater individual compensation packages.

Such risk analysis, if it is to be valuable, should allow for “unusual” events, particularly those that occur reasonably frequently. However, it seems that compensation packages have not succeeded in distinguishing between those who were wise enough to avoid losses from the events of the past year, and those who were not so wise. Even those whose work resulted in great losses were extremely well rewarded.

Part of the reason for this is due to human nature. Part is institutional culture and lack of memory. Part is readiness of governments to rescue bad performers to maintain economy levels. And part is greed and stupidity.

In fact, big bank losses occur so disturbingly often that it is hard to believe that bankers could be viewed as a model of integrity or knowledge. I myself can recall at least four such events over the past 40 years, not including the Plaza Accord of 1985, when the United States dollar was instantly devalued by 50 percent against the Japanese yen, with a dramatic effect on trade. One was so big that it dwarfs that of the past year. According to calculations by Nassim Nicholas Taleb in The Black Swan, the Impact of the Highly Improbable, the best-selling non-fiction book for 2007 on Amazon.com:

“If they [bankers] look conservative, it is because their loans only go bust on rare, very rare occasions. . . . In the summer of 1982, large American banks lost close to all their past earnings (cumulatively), about everything they ever made in the history of American banking––everything. They had been lending to South and Central American countries that all defaulted at the same time––an event of an exceptional nature.”

To lose all profits ever made by one’s firm throughout history is an extraordinary accomplishment. One wonders how those banks maintained any reputation for investment capability.

Yet another “unusual” example (with which I have great personal familiarity) involved the U.S. savings and loan industry and occurred in the early 1990s. Taleb describes it this way:

“In fact, the travesty repeated itself a decade later, with the ‘risk-conscious’ large banks once again under financial strain, many of them near-bankrupt, after the real estate collapse of the early 1990s in which the now defunct savings and loan industry required a taxpayer-funded bailout of more than a half a trillion dollars.”

I have previously written about the massive, sudden losses of Long Term Capital Management in an article about financial derivatives in this magazine. (Fuji Diary 19) That event occurred in 1998.

These few examples demonstrate that crashes in the financial industry take place surprisingly often. My personal benchmark is to expect one about every six to eight years, since that is the period I have come to expect that it takes for investors to forget the last one. Realistically, one needs to remember the history of risk taking of particular institutions. Generally the big international banks have not been very impressive in terms of risk analysis.