Inflation, Bank Stocks & Hedge Funds June 26, 2006
Inflation, Bank Stocks & Hedge Funds
The appearance of low inflation
and�the reality of�low interest
rates have pushed risk taking to new extremes on Wall Street over the past
decade, this�even while raising�the nominal�value of mainstream industries
beyond levels where profits�and stock prices make sense.��The recent�revival of
investor interest in�General Motors (NYSE:GM)
confirms the optimism which�comes from excess
liquidity.� With CDS market spreads for GM�now trading through Ford Motor
(NYSE:F), one might
be tempted to believe that Detroit's operational fortunes are changing.� Would
that it were true.
Witness the announcement Friday by Anadarko
Petroleum (NYSE:APC) to buy Kerr-McGee
(NYSE:KMG) and Western Gas
Resources (NYSE:WGR
)�in two separate all-cash deals amounting to $21.1 billion and each with premiums above current market in mid-double digits. Even $70 per barrel oil does not fully explain such valuations.�
Then look at�a
low-growth�sector like banking.� Is it not remarkable that, several years into a Fed
tightening, US banks still are routinely�being purchased for 3, 4 or even 5
times book value?� When the $34.8 billion acquisition of MBNA by Bank of America (NYSE:BAC) was announced last year, the financial media dutifully
reported that the deal�grew income and revenues for the combined entity,
but few members
of the press�bothered to ask whether the transaction created value. Slam two balance sheets together and of course�the resulting totals for assets and earnings are higher. The real question is whether shareholder value was created or destroyed. (Note: MBNA is still a separate subsidiary of BAC, thus subscribers to�the IRA Bank Monitor may observe its performance).
BAC filed an 8-K
on April 10 which outlined the accounting effect of several acquisitions, in particular MBNA
Corp and Fleet Bank. On�page 21 of BAC's 8-K, here's what you find. Of
the $34.579 billion in total consideration paid by BAC to the shareholders of MBNA, some $13.4 billion went to purchase the existing equity capital and another $8 billion was allocated to "identified intangibles." In total, some $21 billion or some 60%�of the consideration was allocated to existing intangibles and the new goodwill resulting from the MBNA purchase, a stark illustration of the�accounting reality behind the�stratospheric valuations prevailing in the banking market.
The issue of bank valuation is all
the more pressing when you note how bank earnings and revenue growth�stalled over the past
year as the Fed raised the price of credit.� Even though US interest rates remain low by historical standards, CAPCO
wrote in April that while some�analysts�maintain that the banking industry "is experiencing positive momentum, closer examination
reveals an issue of fundamental macro profitability concealing a dangerous shift away from sustainable profitability."� This view tracks the data elements�in�the IRA Bank Monitor, which show banks�attempting to readjust business models away from reliance on mortgage origination and securitization income.
Despite
clear evidence that the financial sector�is in a stall, this with Fed funds just�shy of
5%, why do valuations�for banks generally remain�at levels�which
seemingly make no economic sense?��Remember, this is a business where
you are�lucky to do over one and a half�percent�on assets and
mid-to-high teens in terms of ROE, even�for the best mainstream
performers.� The average bank performs around 1.35% ROA and 13%
ROE�according to the latest report from the FDIC, better than the
average hedge fund, but not by much.
The answer to the valuation
conundrum is inflation;�too many dollars chasing too few real opportunities. For example,
in the acquisition of Golden West Financial (NYSE:GDW) by Wachovia Bank (NYSE:WB),
we see much the same story as the MBNA
acquisition by BAC.� The $25 billion in consideration�to be paid when the
deal closes in Q4 2006 represented a 15% premium to current market when
the announcement was made, but is some 2.7x GDW's tangible equity.� WB has
yet to release a breakdown of how the consideration will be allocated in the GDW
transaction, but looks to us like $15 billion in purchased goodwill.� Maybe
the lawyers will try to attribute some of�the purchase premium above book
value�to core deposit intangibles!
Hedge Fund
Regulation
The asset inflation visible�in�the valuations
for�many�US bank�stocks�and�in�other industry
sectors�also affects�the books of private
funds of all
descriptions.� Hedge funds bear the greatest
risk from the secular increase in nominal asset prices
because�the use of leverage�that magnifies equity returns can�also magnify losses.� This is�just�one
reason why we were disappointed in�last week's�decision by the DC
Court of Appeals regarding SEC regulation of hedge funds.�
It�is clear to us that hedge funds should be under the direct supervision of the SEC.� But�we�think
that Chairman Cox and the other commissioners�should use the opportunity afforded by the Court's
remand of the hedge fund�rule to extend registration and inspection requirements
to all private�funds operating in the US.��Such a
course was suggested by David Goldstein of White & Case
(Financial Times,
6/23/06),�who
said�it was possible the court's ruling would cause a rewriting of the
regulatory requirements in such a way to expand the scope of the government�s
jurisdiction to include private equity funds
.
We believe that SEC Chairman Cox and his fellow
commissioners�need to engage the Congress and other
regulators�immediately on this issue, framing the discussion, as it is, in
the national interest.� Meanwhile the SEC should�move forward with a
new rule�which goes as far as�current law allows.� To us,
the�need for public disclosure of financial statement and counterparty risk
data from hedge funds�is one of the�glaring�shortcomings of
current US financial regulatory policy. It is high time for the hedge fund and private equity fund�communities to take a seat at the policy
table.
Of course, the SEC�can�wait and do nothing --�until�the
sudden�closure�of a hedge fund is large enough and
messy enough to surprise the capital markets and precipitate a systemic event.�
For example, also�in the
FT last week,
Gillian Tett reported that a large BD was trying
to offload its loans to hedge funds onto, you�guessed it, hedge funds. One
combatant close to the matter provides this illustrative
dramatization�involving an investment banker, his minion, and two
customers,�Mr. Market and�Mr. Hedgefund:
iBanker: "We have some�loans�in our bank that are risky and costly to
administer.�Let's bundle them�up in a CDO structure�and off-load
it on Mr. Market."
Mr.�Market:��"Sure! I'll take it.� Ship it in --
except for that equity trash."
iBanker: "Hmm...what can we do? I know, let's sell�the equity piece�to Mr. Hedge Fund.
He'll�buy anything!�
Jr.
iBanker: "But, wait, Mr. Hedgefund doesn't have enough money to buy
it."
iBanker: "Hmmm... ��I
got it.� Let's lend�Mr. Hedgefund�the money
to buy it. That'll solve the problem!"
Jr. Banker:��"Voila! No more risk at the bank because it
has been transferred to�Mr.
Hedgefund."��
iBanker:�"But no, wait, I got an
inspiration!��Let's re-package the loan to Mr Hedgefund in a CLO and sell it back to
him.� We can repeat the same transaction over and over, and
collect a fee each time!�"
Mr.
Market: "Hey!� I'll�take
a piece of that deal."
Keep in mind that Mr. Market is probably
another
bank,�BD�or maybe�even
an insurance company; maybe the underwriter who�provides
your home�owners�or�life insurance.� And Mr.
Hedgefund is, on average,�having a down year and is desperate to "make something
happen."�
Lewis Ranieri told Jody Shenn of the American Banker
(6/16/06): "When you start
divorcing the creator of the risk from the ultimate holder of
the risk, it becomes an issue of, 'Does the ultimate holder truly understand the nature
of the risk that you've redistributed?' By cutting it up in so many
ways or complicating it by so many levels, do you still have clarity ... on
the nature of the underlying risk?� It's not clear that we haven't gone, in
some ways, too far -- that we have not gone beyond the ability to have
true transparency."��
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