Tuesday, September 22, 2009

Supermassive Black Hole

A reader writes in response to my most recent jeremiad on the proper size of investment banks in our Brave New World:
I couldn’t agree more with the notion that what the world needs is more, smaller financial firms that have less ability to dominate the capital markets with their large balance sheets. But I must take issue with the following:
If I had to pick one decision which played the pivotal role in the financial crisis, it would have to be the SEC's agreement to waive leverage limits at the biggest investment banks in 2004. From traditional levels in the low teens, leverage ratios at banks like Lehman Brothers and Bear Stearns skyrocketed to the mid thirties and higher.
This statement is repeated over and over and couldn’t be farther from the truth. Look at the Bear Stearns financial statements for the 20 years they were publicly held and you’ll see that the firm was leveraged between 25 and 35 times for over a decade prior to 2004. Lehman was the same, made worse by the fact that their leverage came despite the fact that they did massive quarter-end window dressing to reduce their reported leverage; intra-quarter they were close to 50 times leveraged. And neither of these numbers nor the leverage numbers of their competitors even included off-balance sheet leverage on derivative transactions, foreign exchange and the like.

So please: the SEC has more than enough responsibility for our current crisis without dumping on them something that wasn’t of their making. Moreover, when we simplify the notion of leverage as being simply total assets divided by total equity without looking at the character and risk of the assets we ignore the real failure of the banks and investment banks to manage their risk.

Now, notwithstanding my employment in an industry which is not known for strict adherence to the facts—especially when those facts might interfere with the collection of a nice, juicy fee—I do somewhat idiosyncratically aspire to membership in the reality based community. Therefore, faced with cogent and forceful criticism such as this, I do what any self-respecting investment banker does: I force some pathetic sleep-deprived analyst to do some quick and dirty research.1

This is what he found.

* * *

The balance sheets of the five largest "pure" investment banks2 did indeed swell over the last decade. From fiscal year end 1999, total assets controlled by these banks grew at a compound rate of 16.3% per year, from $1.27 trillion in 1999 to $4.27 trillion in 2007. Given that the general economy was enjoying no such heated expansion, I find it rather remarkable that my elephantine peers almost quadrupled their asset bases over a period of eight years. This can be read as pretty clear and damning evidence that these investment banks, at least, strayed pretty far from their traditional mission as the handmaidens of capitalism and began to act like they owned the place.

And, pace my interlocutor's reasoned remarks, I find it telling that the balance sheets of the big five began to swell at an accelerated pace after the April 2004 SEC ruling I alluded to in my previous piece. The line graphs for total assets at each of the investment banks in the following chart mark a noticeable inflection point after fiscal year end 2003:

I am not dim enough to claim that correlation equals causation, but this data is intriguing, no?

As far as leverage ratios, however, my correspondent scores some valid points. First of all, my prior claim that investment banks toodled along modestly with leverage ratios "in the low teens" before the shift in SEC policy is clearly false. I apologize for my error, which I blame on a particularly fine Amontillado which unaccountably became corked during the composition of my earlier piece. (You didn't think I would accept full blame, did you?) Put it down to wishful thinking, if you choose.

Mr. X is also correct that the leverage ratios I bandied about in my post, and which are commonly used in the mainstream press, are incomplete and misleading. They do not include off balance sheet liabilities, most derivatives, and many other obligations which investment banks (and others) thought they had cleverly divested themselves of in their asset-gathering frenzy. (Thought incorrectly, it turns out.) However, full data on these non-disclosed items is not forthcoming from any source I know about. Therefore, even though I concede that the ratio of total assets to shareholders' equity is incomplete and simplistic, I would rather use it and its limitations to at least dimension the situation, rather than not speak at all.

Doing this, we discover some interesting results:

In fact, it does seem there was a noticeable pickup in leverage across all the major investment banks around the time of the SEC ruling. The five major investment banks seemed to maintain pretty consistent ratios of total assets to shareholder equity prior to 2004, ranging on average from the high teens to the high twenties, according to their different business models and appetite for disaster risk. (Note particularly that the two earliest victims of the crisis, Bear and Lehman, were also the two banks which maintained the highest leverage ratios historically.)

But note the material pickup in year-end leverage from pre-2004 averages at each of the five banks by year-end 2007:

 Average Percent
 1999–2003at FYE 2007in ratio
Bear Stearns (BSC)27.633.521.5%
Goldman Sachs (GS)19.222.416.6
Lehman Brothers (LEH)25.830.719.2
Merrill Lynch (MER)18.532.073.2
Morgan Stanley (MS)21.733.453.8

Based on this, the Vampire Squid everyone loves to hate looks almost diffident, but the rest of its peers look downright suicidal. Forget the hidden IEDs and unexploded ordnance squirreled out of sight by investment bank executives in off balance sheet waste dumps, these guys were on a tear. Strangely, I do not remember legions of diligent public shareholders banging on the podia at these banks' annual meetings demanding execs dial back their firms' risk profile. (Perhaps they were too fat and happy counting the excess equity returns these leveraged time bombs were generating to bother.)

The picture painted above does not even approach the full extent of operational leverage employed by some (all?) of the banks above in between audited reporting periods. My new best friend and pen pal writes in a follow-on note that:
The really fascinating story—and one with almost no discernable evidence—is what the balance sheets looked like intra-quarter. I once met someone from Lehman whose business card showed her to be part of the Office of Balance Sheet Management and whose role was to cleanse the balance sheet for the 4 quarter-end public financial statements so that they’d look less leveraged.


* * *

So, based on this back-of-the-envelope historical analysis, I am disinclined to let the SEC off the hook for the relaxation of leverage limits as my correspondent urges me to do. Even if the SEC's action was not the primary reason that investment banks levered themselves up to ultimately ruinous levels, it certainly added fuel to the fire or, at the very least, did nothing to dampen it. Furthermore, a re-reading of the excellent piece in The New York Times about the fateful SEC hearing on leverage limits—complete with full audio recording, for the obsessive-compulsive among us—clearly indicates the Commissioners approved leverage relief on the understanding that the SEC was going to actively monitor and manage the situation. For various reasons, it did not.

Whether relaxing leverage limits for already highly-levered large investment banks and essentially allowing them to regulate themselves under their own recognizance was wise or not—and you might suspect how I feel about that, Dear Readers—it was clearly a massive dereliction of duty by Christopher Cox, the SEC Commissioners, and the SEC staff to undertake such a material change of the regulatory system without following through. Had they done so, and had the SEC Commissioners paid attention to the information generated by such close supervision, we might very well have slowed the speed at which the financial industry plunged over the cliff, if not stopped it entirely. The fact that they did not is borderline criminal.

The more I read about the SEC, the more I agree with those who would scrap it altogether and start over. Failing that, I think I will take my copy of the Times article on the 2004 decision with me the next time I visit Washington, D.C. and staple it to Mary Schapiro's forehead when I see her.

Maybe that will get her attention.

Ooh baby don't you know I suffer?
Ooh baby can't you hear me moan?
You caught me under false pretenses
How long before you let me go?
I thought I was a fool for no-one
Ooh baby I'm a fool for you
You're the queen of the superficial
But how long before you tell the truth?

— Muse, Supermassive Black Hole

1 It's good to be the king, no?
2 These are the five firms which petitioned the SEC for relief from previous leverage limits. I do not speak of universal banks like Citigroup, BofA, and JPMorgan, which also play a major role in the investment banking industry. We will save their sorry asses for another day.

© 2009 The Epicurean Dealmaker. All rights reserved.