Analyzing a Bank - business quality, credit discipline and resilience to losses

If you intend to invest in banks, you'll need to get a feel for how good a bank will be as in investment. I'm going to describe one way you can get a feel for a bank's business strength and its credit quality, and by proxy, whether the bank's management is making good lending decisions. This is especially important in light of the recent reckless lending behavior of some banks, which has already caused a number of "big banks" (like Washington Mutual) to fail.


Assessing the strength of a Bank's business
and investment merits

The value of a bank as an investment is not based on its credit quality alone, though it is an important factor. For example, a bank could be making excellent lending decisions, but be continually losing customers because of lousy service or because of irrational competitors who underprice their loans. Under-pricing to gain market share is a dangerous trap that businesses with long-tail risks and short-term management can fall into. A holistic picture of a bank's value can only come from looking at:

1. the factors and quality of managerial judgment, seen through:
   (a) the bank's propensity to loosen its standards and make bad credit decisions, and
   (b) the bank's willing to prepare for tough times - banking is an inherently cyclical business that tracks underlying economic cycles and cycles of excessive credit and credit shortages caused by competitive behavior - high earnings cause competitors to flood the market with cheap credit, until the credit becomes too cheap to handle normal default rates/or default rates go up, which then causes credit to dry up. The dynamic is similar to what happens in the insurance industry, and also similar to the boom-bust cycles in commodity prices.
   
   
2. competitive position: the bank's ability to cling on to its customers / attract more customers, in the face of rabid and sometimes irrational competition.
   
   
3. macro economics: whether the economic footprint underlying the bank's customers is a deep, broad and self-sustaining one (banks are creatures that depend on the underlying economy).

The latter two are qualitative assessments you need to make. The bank's public financial statements aren't likely to give you enough information to make a proper assessment. A bank's public financial statements can only help you judge a bank's credit discipline, and by proxy, the quality of its managers' judgments. Specifically, you'd have to look at the bank's balance sheet and its accompanying notes for clues on how a bank's loans have performed during the year.

Nonetheless, you should be aware this this is not a perfect indicator of a bank's current management discipline, because:

1. bad loans tend to default only after a year or two. So a bank could have really loosened its credit quality over the last 12 months, and you probably wouldn't see any indication of this in the balance sheet.
   
   
2. a low default rate doesn't mean anything if the economy is doing well and asset prices are rising. In such times, you'll probably see all banks experiencing low loan losses as the rising tide lifts all banks. This is particularly true in a credit bubble, when a borrower who is having difficulty paying off a loan can usually refinance it with another bank - this merry go round will make it look like the loan has never defaulted.
   
   Examining a bank's balance sheet during an economic downturn tends to be more useful, because we we can compare a bank's loan performance against its competitors. As loans start to default during a downturn, and borrowers have no way refinance their loans, you will be able to see which bank has been reckless and which has been prudent in its lending decisions. As they say, it's only "when the tide goes out that you can see who's been swimming naked".

Understanding the Loan Accounts,
in order to assess credit quality

The loan amounts that are shown in the balance sheet refer to (a) the outstanding principal and (b) the accrued interest that the bank's customers have yet to pay off. The accrued interest refers to the interest which the bank has "earned" or "charged" the customer up to the current date. For example, if this is the 5th year of a 10 year loan, then the amount of accrued interest reflected in the balance sheet would only include interest charged up to the 5th year and not yet paid. It would not include the interest yet to be charged for years 6 to 10, since the bank hasn't actually earned the interest. The interest is only earned if the bank continues holding the loan the next year; and there is a possibility the borrower may just repay the whole loan next year.

Loans generally start out as "Current loans". This means that the borrower is paying the installments regularly, and the bank has no reason to believe that this will stop. In the loan books, such loans are treated as current and accruing interest - the bank assumes that it is continuing to earn interest on the loan and hence add this interest, as it is accured, to the loan books. Such loans are carried on the loan books and are a part of the total loan amount shown on the balance sheet.

If a borrower fails to pay an installment within 30 days of when it is due, then the loan becomes classified as a "delinquent loan, 30-89 days past due, still accruing interest". If the borrower still fails to pay the late installment after 90 days, then the loan becomes classified as a "delinquent loan, 90 days or more past due, still accruing interest". The bank generally believes that it won't incur losses on these loans because either (a) the borrower will resume payment on the loan soon, or (b) the bank can seize the underlying collateral (e.g. the house is collateral for a mortgage) and sell it at a price higher than the outstanding balance of the loan. Such loans are still carried on the loan books, and are a part of the total loan amount shown on the balance sheet.

If at any time, the bank believes that the delinquent loan will not be recovered in full, then the loan becomes a "non performing loan, not accruing interest", also known as a "non performing asset". The bank believes that it will incur losses on the loan because (a) the borrow cannot continue paying the installments, for example because he/she is bankrupt, and (b) the market value of the underlying collateral is less than the outstanding balance of the loan. The bank also assumes that it isn't earning any interest on-top-of the principal, since the loan has effectively "stopped working". Even if interest is collected, it will be written off against the principal. Such loans are still carried on the loan books, and are a part of the total loan amount shown on the balance sheet, even though it is likely some part of the value will be lost in future.

During the year, if the bank believes that the borrower won't be able to repay a loan (Delinquent Loans or Non-performing), then the bank will begin proceedings to recover from the loan by seizing and selling the collateral for the loan (e.g. seizing a house and selling it). When it does this, the bank may incur a loss if the sale price of the collateral is less than the amount of the loan that is shown on the bank's loan books. For example, if the outstanding principal and accrued interest on a mortgage is $100,000, but the bank only managed to sell the house at $80,000, it would incur a loss of $20,000. Such losses are charged to the "loan loss reserves"/"credit loss reserves", so that they can be written off the books.

• As an accounting matter, these net charge-offs do not impact the current year's income statement; they only reduce the bank's loan loss reserves. The income statement was affected in previous years when the bank "added/built-up" its loan loss reserves. The reserves are in a sense, off the balance sheet (strictly speaking they are shown in the assets side. You will see it in the "total loans - loan reserves = net loans" item. However, they are conceptually off the balance sheet). When the bank builds up its "off-balance sheet" loan reserves, on the balance sheet what happens is that the net loan amount drops on the asssets side, and the shareholder's equity drops on the equity/liabilities side.
  
  
• The Credit Loss Reserves (Allowance for Loan losses) are reduced by "Net Charge-offs", and increased when the bank makes additional "Provisions for credit losses" (which hit the income statement).

Ways to Assess a bank's credit quality,
and management's credit discipline

There are 2 ways you can observe the banks credit quality, and by proxy, its management's credit discipline:

1. Point in time snapshot: One way to see the bank's credit judgment is to see the non-performing loans as a percentage of the total loans made by the bank. This gives you a snapshot of the credit quality of the loan book at a point in time.
   
   
2. Over the year: It is also important to review the net-charge-offs made over the year, as a percentage of the average loan balance during the year. This shows you the total amount of loan losses charged off during the year, as opposed to a snapshot of the state of the loans currently on the books.

While these are useful indicators, it is also important to look at these numbers with reference to (a) the loan mix, and (b) the overall interest rates charged for the loans. For example, a bank specializing in high-interest loans to low-credit-score borrowers would naturally see a higher rate of loan losses. But this is ok if the bank is able to charge interest rates high enough so that over the large base of customers, the loan losses are more than made up for by the higher net interest income. Just like in insurance, it is ok to take on higher risk business as long as you can price for it. Generally speaking, the most risky to the least risky (in terms of net charge-offs expected) loans are:

1. Credit card and Unsecured loans - these are unsecured loans, and experience higher rates of default. However among credit cards, it appears that affinity branded cards (e.g. alumni, associations etc) tend to have slightly lower loss rates.
   
   
2. 2nd Lien Secured Loans (Home equity and 2nd lien mortgages). In these loans, the bank only has 2nd claim to the underlying collateral, because the 1st right of claim goes to someone else (the holder of the 1st lien).
   
   
3. 1st-Lien Secured Loans (Residential Mortgages, Commercial Real Estate Loans, Lease financing). For such loans, the bank has the right to seize the collateral and sell it, if the borrower fails to make payments on the loan.
   
   

What we're look at is past credit experience,
it's no guarantee of future management behavior

The bank's credit experience gives you an idea of what the bank's management has been doing in the past. However, it says nothing about the bank's credit decisions over the past 12 months, because bad lending decisions often don't show up immediately:

1. The bank may have written a set of bad loans with a low teaser interest rate which only resets after 1-2 years. Credit losses will spike only when the resets hit.
   
   
2. The bank may have written a recent set of loans with higher Loan-To-Value ratios than in the past. So even if the bank continues lending to the same type of credit worthy borrowers, the amount of charge-offs will increase even if the proporation of people who default remains the same. Each individual default will on average, result in more losses to the bank because the loan outstanding is very close to the initial valuation of the collateral. A smaller drop in collateral price will result in losses to the bank.
   
   
3. The bank may have failed to increase its LTV guidelines in the face of a bubble in collateral prices. Simply maintaining a 80% LTV ratio may be insufficient if you are in a housing bubble and you expect housing prices to drop by 30%.
   
   
4. And in general, loans usually don't default until 12-24 months have passed (unless a really really bad lending decision was made and the borrower can't even service his/her first installment)

In other words, the numbers in the accounts give you a clue as to the bank's past practices, but you need to make a qualitative judgment as to whether the bank's management has changed its behavior in the recent past.

Another indicator of management judgment: a Bank's Resilience to Losses
Is the bank conservatively managed?

Generally, you'd want a bank to be managed conservatively, so that it can weather economic downturns and financial crises. The bank's balance sheet should be robust enough to withstand the booms and busts of free market capitalism. So how much losses can a bank take before it goes bankrupt? And how should the balance sheet be managed to weather such storms?

Banks must always have more assets than liabilities, otherwise they wouldn't be able to pay depositors and bondholders/creditors back their money. So conceptually, the maximum amount of money a bank can lose and still remain solvent is equal to the amount in shareholder's equity. Anything more and the bank would be insolvent (bankrupt).

In practice, regulators impose minimum capital adequacy requirements on banks. For example, a country's regulator may require banks to have a minimum equity to asset ratio (leverage ratio) of 4%. Many countries impose capital requirements on banks based on Basel 2 guidelines. For example, in the U.S., banks are required to have a Tier 1 capital ratio of at least 4%, and a Tier1 capital + Tier 2 capital ratio of at least 8%.

The very most a bank can tolerate in losses in one year is a combination of (1) that year's net income and (2) an amount of equity that would not cause the bank to breach its capital adequacy requirements. Banks can incur losses in many ways, such as:

1. Through credit losses when borrowers default, and the underlying collateral cannot be sold at a price to cover the outstanding loan amount.
   
   
2. Through losses in the value of securities it holds as assets. Banks typically invest some of their cash into treasury bills, bonds and other securities. If the securities default or experience a permanent loss in value and the bank is unable to hold them to maturity, then the bank will incur losses. (Note that some securities that are on a bank's books may not be marked to market. Accounting rules allow some securities, known as Level 2 and 3 assets, to be booked at a value determined by the bank's valuation models. Assets carried at mark-to-market values are classified as Level 1 assets)
   
   
3. When business costs rise too fast, for example because of unexpected litigation, a failure to control expenses, pension costs, and so on.
   
   
4. By failing to manage their asset and liability interest rate and forex sensitivity. For example, during the Asian financial crisis when several Asian currencies experienced sudden devaluation, some banks ran into trouble because they had liabilities in foreign currencies.

One way of seeing when a bank is in danger of becoming insolvent from bad lending decisions is to make an assessment of what a probable credit loss rate would be, then see if the bank can withstand that.

Credit Risk Modeling: (Stress testing)
how bad can credit losses get?

It really depends. For example:

• In the 1997 Asian Financial Crisis, some banks in Singapore had up to 7% of their total loans become non-performing (in some countries, up to 25% of total loans were non-performing). Even up to 2001, Indonesia's banks NPLs were estimated at 48% of total loans.
  
  
• In 1976 (the aftermath of the 1974-75 recession) in the US, up to 5.3% of loans (according to the New York Times) were problem loans.
  
  
• In 2005, 8.6% of China's loans were reported to be NPLs (according to Xinhua)

So a large part of estimating NPLs is based on an analysis of the strength and resilience of the underlying economy. This is a macro-economic assessment that you need to make. The long term health of a bank is greatly dependent on the strength of the economy that underlies it.

If you have a view of the underlying economy, then you can make an educated estimate for the credit losses a bank might sustain. For example, if we assume:

• The bank has an average outstanding loan to value ratio of 80% (e.g. mortgaged houses are valued at $100 in the market, and the borrower's outstanding loan is $80). In other words, the bank won't suffer any losses even if the borrower defaults, unless the selling price of the property (or other collateral such as machinery) drops more than 20% i.e. to below $80.
  
  
• Collateral (or housing) prices will drop by 35%. We can make this estimate based on a back-of-envelope analysis of the Case Shiller index (Composite-10 CSXR overall price index). If we assume it will drop back to year 2000 levels, then it will drop 35% from Oct 2008 levels. (October 2008 index value=169.78, Dec 2000 value = 113.56). This means that houses drop from $100 to $65.

Scenario 1: Now, if we assume that all customers will default the moment their house re-sale prices drop below their outstanding loan value (entirely possible if the house was purchased as an "investment", and not for living in), then all customers would default and the bank would have to seize and sell the underlying (mortgaged) property. The bank is owed $80 for each loan, but is only able to sell the house for $65. This implies the bank will suffer a loss of $15 on each loan. In other words, credit losses will be ($15/$80) = 18.75% of the total loan value.

This scenario assumes that all loans that are in negative equity will default. However, this usually isn't the case if the bank has only lent to people who borrowed to buy the house to live in. People who buy their houses to live in tend to continue paying off their loans as long as they are employed and have the means to. This is in part because of the need for a place to stay, a desire to keep a good credit rating, and because of a psychological escalation of commitment to the house. If they default on their loan and give up the house, they will lose the $20 they paid for the house. (From their point of view, even if they buy a new house for $65, they will have paid in total $20+$65=$85 for this new house, excluding interest costs. i.e. they will only save $15)

Scenario 2: If the bank has been lending to people who will only default when they are unable to continue paying because of unemployment, then the bank's losses will be lower. (A similar principle applies for commercial and other loans, even though our example is based on residential mortgages). Let's assume a worst case scenario of 20% unemployment, which we roughly take to mean that that 20% of borrowers will default. Of these customers who default, the bank will, after seizing and selling the houses, lose 18.75% of the loan value because of the lower market prices of the houses. This translates into an overall loan loss of 3.75% of the total loan book.

Summary

This in a nutshell, is how you can approach the task of assessing a bank as a investment. Much of any analysis will involve qualitative factors, as I have described here. Be careful not to ascribe too much importance to the quantitative results of your analysis, without the looking at the qualitative factors that form the backdrop of your analysis.

The current dour sentiment for banks in general ignore the fact that there are a number of good quality banks in the industry. Of course this is a relative statement, no bank will be viable if the entire economic or financial system collapses. But barring such a systemic event, you will be able to find some banks which will weather this storm reasonably well.

Earnings managment and Creative accounting - How pension accounting can be used to boost short-term profits (Investors beware!)

If you are planning to invest in a company with a defined benefit retirement plan, then you'll want to have a close look at the company's pension accounting. Why? Because (1) companies can use pension accounting to smooth out earnings, or even report headline profits when the underlying operations are running at a loss, and (2) companies can report short-term profits even if they have vastly underfunded pension plans, plans which will eventually lower future profits as pension eligible employees retire and the company has to top-up the pension accounts to pay them.

What makes this particularly insidious is that this can be done without violating any accounting rules or principles. How is this done?

It stems from a basic feature of accrual accounting: the need to make estimates and assumptions. Accrual accounting generally requires management to make assumptions, for example, the depreciation period of assets, and actuarial assumptions in their pension accounts. Unfortunately, making "aggresive" (i.e. unrealistic) assumptions in their pension accounting can greatly distort the picture of the company's financial health.

This is because pensions are liabilities that are incurred many years in the future, and affected by many variables which are hard to predict. For example, overestimating the discount factor in accrued pension benefits by just 1% can cause millions of dollars of liabilities to disappear from the pension accounts. The good news is that much of this can be detected by the astute investor, as long as you understand the mechanics of pension accounting.

The heart of the matter: Pension Fund's Assets vs the company's Pension Obligations (off balance sheet item)

At the heart of a defined benefit pension scheme is the pension fund, which is usually made up of assets such as equities, bonds and treasury securities. For the pension plan to work, the plan assets must be sufficient to pay the pensions expected by its employees. These pension plan assets are usually not recorded on the balance sheet, because they are held in a separate legal trust from the company itself, as an off-balance-sheet pension fund.

To know if a pension fund has enough assets to meet the needs of its (present and future) pensioners, we need to know how much money is the company obligated to pay out to its retired employees. This is known as the company's pension benefit obligation. Determining a company's benefit obligation can be complicated. By its nature, the future pension obligations depends on how long its employees live, how much salary they will earn when they retire (if the pension payments are pegged to their last drawn salaries), and how many of its present employees will stay on with the company till they are eligible for pensions. As you can imagine, determining the future pension obligations is an actuarial process - the plan administrator needs to make guesstimates about all these variables, much like the way insurers make guesstimates about how long people will live.

The administrator will also need to guesstimate when the cash needs to be paid out: how much will be paid out next year, how much for the year after that, and so on. For a pension plan to work, the administrator must set aside some money today for the future payouts each year. The amount company needs to set aside is not simply the sum of all expected benefit payouts, because money that you set aside today will earn interest (or it can be invested for capital gains and dividends) until it needs to be used to pay retirees. Because of this interest (or investment gains), the amount of money you need to set aside today is lower. To determine the amount the plan needs to set aside today, the administrator will discount all the future payouts by a discount rate to arrive at the net present value of pension obligations. Under accounting rules, the administrator is free to choose the discount rate that he/she wishes to apply, but as a principle it should be close to the risk-free interest rate or a conservative growth rate of an investment. This net present value of benefit obligations is the figure that is reported in the company's financial statements.

For a pension plan to be viable, two things must happen: (1) its current plan assets must be equal to (or more than) the net present value of its benefit obligations. This means that the money it sets aside today will be enough, after growing with interest or investment returns, to pay out benefits to pensioners when they are due to pensioners. (2) the calculation of the present value of its benefit obligations must be correct. This means that its actuarial assumptions must be accurate, and its plan assets must grow at the rate greater than or equal to the discount rate used in calculating the present value of benefit obligations.

Both the "present value of benefit obligations", and the "fair value of plan assets" are found in the notes of a company's financial statements. (Because these plan assets are legally separate from the company, they are not consolidated on the balance sheet). If a plan's assets are greater than the net present value of benefit obligations, then the plan is considered to be well funded. If the plan's assets are less than the PV of benefit obligations, then the plan is considered to be underfunded.

In either case, the "overfunding" or "underfunding" is calculated as the difference between the value of two accounts on the balance sheet: "prepaid pension costs" on the assets side, and "accrued benefit liability" on the liabilities side. If prepaid pension costs exceeds accrued benefit liability, then the excess amount is the the overfunding. If accrued benefit liability exceeds prepaid pension costs, then the excess amount is the undefunding. This difference between the two accounts is recorded in Shareholder's equity under "accumulated comprehensive income". (Comprehensive income reflect gains and losses e.g. from forex movements, that are recorded directly to shareholder's equity without going through the profit and loss accounts)

(Note 1: the net shortfall in funding may be less than the total shortfall reflected in the comprehensive income account, if it is shown. This is usually because of accounting adjustments and reclassifications.)

(Note 2: you won't be able to tell the net pension shortfall just by looking at the Net Accumulated Comprehensive Income in Shareholder's equity, because this is usually the net amount which includes other factors affecting comprehensive income, such as cumulative forex gains. The financial statement notes usually don't break out the balance of each compoacnent of the Net Accumulated Comprehensive Income in the Shareholder's equity)

How future (long-term) profits can be hit

There are two types of suprises that pension plans can spring on future profits:

1. Obvious danger: If a plan is underfunded, then it means that you can expect the company to need to inject cash into the pension fund sometime in future.
   
   
2. Hidden-lurking danger: If the discount rate used in calculating the PV of benefits is too high, then it is likely that the "present value of benefit obligations" is under estimating the amount of money that needs to be set aside today to meet the future obligations. If this happens, the balance sheet may not indicate an obvious underfunding even though the pension plan is actually in trouble. (The balance sheet amounts are based on the unrealistic discount rate assumption made by management.)

So what you see in the "fair value of plan assets", and the "present value of benefit obligations" accounts, and the discount rate used, will tell you if the company's future reported earnings are going to be hit by costs of funding pensions. These costs aren't seen in current earnings because of the nature of accrual accounting: such shortfalls are only recognized in the income statement (as a "net benefit expense") against earnings when the benefits, and its accompanying sufficient-or-insufficient assets, accrue to the employee as each year passes and his/her pension benefit increases because of the additional year of service. It is only at that point in time that the funding shortfall is moved from "shareholder equity:comprehensive income" to "shareholder equity:retained earnings".

How current (short-term) earnings can be manipulated

Each year, the income statement recognizes the additional pension benefits that accrue to employees for the extra year they have worked (service cost and interest cost), and the increase in plan assets from interest and investment growth. It also recognizes actuarial gains and losses (these are amortized over many years), which come about when actuarial assumptions have to be changed (for example, because employees are promoted faster than expected and become entitled to more benefits). The net difference between the increases in assets and increases in benefit obligations is the "net benefit cost". This is what the company needs to contribute to the pension fund for the year, and it affects the earnings for the year.

Unfortunately the way increases in plan assets are accounted for makes the "net benefit cost" susceptible to manipulation by companies who are trying to boost their headline earnings. Under current accounting guidelines, the increase in pension plan assets that is recognized in the "net benefit cost" each year is not the actual return on the plan's assets. Rather, the plan's assets are assumed to have grown by some fixed amount each year. This amount is the "expected return on plan assets" and is an assumption made by the company. Ideally, this rate would be close to the discount rate used in calculating the "present value of pension benefit obligations", so that the pension expenses recognized would be in tune with the overall pension plan's funded status. However, if a company wants to goose up its profits in the short term, it can simply increase the "expected return on plan assets" and reduce the "net benefit cost" for the year. This has the effect of increasing the company's earnings for the year.

However this earnings boost can only be maintained for the short term, because if the actual return on plan assets is less than the "expected return on plan assets", the the shortfall is booked to the balance sheet shareholder's equity under "comprehensive income". Once this shortfall exceeds some percentage (for example 10%) of the total plan benefit obligations, then any excess shortfalls in the "comprehensive income" account must be amortized to each future year's income statement through the "net benefit cost" under an entry called "gains and losses" or "amortization of actuarial gains and losses".

Useful links:
SFAS 158 (including SFAS87 - Employers' Accounting for Pensions)
SFAS 35 - Accounting and Reporting by Defined Benefit Pension Plans

Singapore's sovereign wealth funds - GIC and Temasek Holdings

Sovereign Wealth Funds being in the news lately, I've gotten a few questions about the difference between Singapore's two SWFs: Temasek Holdings and GIC (the Government of Singapore Investment Corporation).

Here's the summary:

1. They are 2 separate and distinct companies, and from legal structure standpoint, they are incorporated as Pte Ltd companies, under the Singapore Companies Act.

2. Both companies are owned by the Minstry of Finance, who is the controlling shareholder.

3. It looks like Temasek Holdings spends more of its time investing the surplus funds of the Singapore Government, whereas GIC spends most of its time investing Singapore's foreign reserves (the amounts in excess of what MAS needs for use in exchange operations). I've created a diagram that illustrates the difference. It's not a strict division though. In an interview published here, Mr Ng Kok Song of GIC indicated that Temasek Holdings also invests some of Singapore's foreign reserves.

(Click on the image to expand it)

I also use this diagram to explain how the economy works. By necessity, this diagram is a simplified view of the economy, but it does explain the key elements. (The real economy and financial system is vast and complex; I have made simplifying assumptions in the digram)

Preserving the International Purchasing Power of your Savings

There are 3 levels of investment success that investors can achieve:
1 - Preserving the real value of their savings (2-3% pa growth)
2 - Grow the value of their savings in real terms (4-7% pa growth)
3 - Become rich through investing (achieving 8+% pa growth)

Many investors are fixated on becoming Level 3 investors, but the reality is that a large number of investors fail to even achieve Level 1 outcomes. They take on risks and leverage subscribing to the "no risk no gain" mantra. Some succeed (sometimes by luck, sometimes through skill), but others end up sustaining losses which set them back permanently.

Investors should figure out how to achieve Level 1 returns before thinking of higher level outcomes. Then when they decide to go for Level 2 and Level 3 outcomes, they will be able to only undertake "risks" that even if things don't work out, will allow them to achieve a minimum of a Level 1 outcome. This is essential, because inflation is here to stay, and is the enemy that every saver faces. There is nothing more tragic than watching the value of your savings slowly disappear before your very eyes.


Inflation, the enemy of savers, is inherent in contemporary political-economy

Why? Because:

1. In an economy where money supply is free to grow (e.g. in a fiat money economy, or even in a gold back monetary system if it is in a period where new gold is constantly being discovered and dug out of the ground), it is practically impossible for cash savings (stored work) to maintain or grow its purchasing power. Why? Because in contemporary economic systems, there are always new claim checks (credit) being created for which work has not yet been done. The fractional reserve banking system always extends credit (i.e. creates money via the money multiplier effect) before the underlying productive capacity is created to back this new money that has been created. In such a system, purchasing power is highest for people creating economic value in the here and now. The purchasing power of unclaimed stored work done in the past (i.e. cash savings) is bound to deteriorate over time.
   
   
2. Further, in fiat money economies with societies where the interests of all sectors of society are represented by politicians facing periodic re-election, political forces and human nature tend to create inflation over the long run. Money creation will like be invoked repeatedly to hide the true cost of government deficits, and smooth over financial losses incurred at various times by different segments of society.
   

This of course, does not mean that deflation will never occur. It can occur over short term periods of monetary destruction, for example when a large number of banks fail because they made bad loans, or when people withdraw their deposits out from the banking system and convert it into cash which they stuff into their mattresses. Deflation can also happen during periods of major changes in the structure of economic production. For example, the adoption of new technologies like the steam engine which cause the cost of individual items to drop and overall productivity to increase, which general keeps wages constant so that people end up consuming a larger overall basket of goods (in a sense, this isn't “true deflation” - rather it is a failure of measurement - i.e. it only looks like deflation because the price level is the only thing we are measuring).


2 Strategies to Preserve purchasing power of Savings
under two types of Inflationary environments

Because inflation is inherent, the challenge for savers is that they need to become investors in order to preserve the purchasing power of their savings. The way to do it is conceptually simple but difficult in practice: hold cash during deflationary periods, and hold assets (whose nominal value grows in-line with the inflation rate) during inflationary periods.

The former is simpler to do: simply convert all assets to cash during deflationary periods. This requires us to identify inflection points between periods of deflation and inflation, which requires us to apply qualitative judgment.

The latter is more challenging: we need to figure out what kinds of assets will hold their real value in inflationary periods. Inflation occurs when the money supply changes are not in line with changes in underlying economic production, by exceeding the amount needed for the upcoming amount of production. (I subscribe to the theory that inflation is a monetary phenomenon. Inflation occurs where there is a sustained rise in the general price level. We are not talking about changes in relative prices which are caused by localized supply/demand changes, or changes in the demand/supply chains arising from technological or structural changes; for example the advent of containerization made it cheaper to import tropical fruits, and reduced the price of exotic produce in supermarkets.)

Investors need to respond differently depending on the environment in which inflation occurs:

1. Money supply increases in excess of increasing population/economic production. In this type of inflationary environment, one of the safest things to do is to hold a share of the profits accruing to the economy's underlying productive capacity. We can do this either by owning a share of all the companies in the economy, or own the land which is required to house the population and capital assets in the economy. This of course, assumes that the land in the economy is limited, and that you are not in a wild-west frontier town where available land is in abundance. (This refers to actual land on which we can create value; not an apartment or some strata-titled portion of a building whose earning power depends on factors beyond its control)
   
   A passive index tracking fund is the easiest way to buy a representative share of all companies in the economy. It saves you the trouble of having to buy shares in individual companies in the economy. (If you did this, you would have an additional problem: some of the companies would inevitably go bust as their products become obsolete. New companies with new products would come up. You would have to constantly rebalance to get the money from your existing investments to buy shares in these new companies. A stock index, by periodically dropping off declining companies and adding in new up-and-coming companies, solves this problem for you. It is roughly equivalent to only holding companies that are in their middle age. Dying companies are sold off as they shrink, but before they go bust, and the proceeds are used to buy shares in up and coming companies which are past their youthful growth and maturing into middle-aged big company status.)
   
   As the economic pie grows bigger, your assets will not just maintain their purchasing power, their purchasing power will actually grow in real terms. The only thing that will destroy this real return is if you either (a) buy the stock index at an unreasonably high a price, or (b) the economy structurally changes and permanently reduces the corporate sector's profits as a percentage of GDP.
   
   
2. Declining population/economic production; with money supply not declining in line with declining production: Investors in such economies face an insurmountable barrier. Holding cash is futile because inflation diminishes its value, while holding a share of the economy's productive capacity would be futile, since economic production continually declines. To see how this works, imagine that the economy is that of an isolated island. If the people on the island are slowing dying out, then the amount of goods that are being produced will also slowly drop. You could hold 100% of all the profits accruing from economic production, and it wouldn’t mean much over time. Likewise, holding a factor of production like land is also futile, unless you can sell it to foreigners looking for a second home. Investors would do best to move their savings to a country where the population is not shrinking.
   
   Even if deflation were occurring in this dying-out island, investors holding cash would only be delaying their day of reckoning. While their cash holdings would enable them to buy more and more of the local produce, the amount of local produce would eventually drop to a level where it falls below the critical mass needed to support the specialization of labor required for many of the complex products in modern living. Unfortunately, this isn't just an academic exercise - there are many countries in the world where the population is already declining (e.g. Japan) or are soon to decline.
   

The corollary of this analysis is that investing in a passive index-tracking fund, often touted as a simple and safe way to invest over the long run, is actually a bet on macro-economic outcomes. Long term investors of such funds are making macro-economic bets, and it is wise to keep in mind that predicting macro-economic trends is a difficult task.


Investors in small countries need to preserve the
International Purchasing Power of their Savings
by Investing Internationally

Investors living in small economies, where the economy is not broad enough to provide all the goods and services desired for modern living, need to invest internationally to preserve the purchasing power of their savings. (For example, if you are living in a small economy which only produces widgets, it's not a good idea to only buy a share of the profits of local productive capacity, unless you're very sure that widgets will continue to be in demand for the next 100 years. Instead, you'll also need to buy a share of the farming capacity of other parts of the world, a share of the economic production of countries which make bricks, computers etc.)

But investing internationally presents another challenge: foreign exchange exposure. How should we think about this?

Currencies will undergo bouts of over and undervaluation, and in practice, it is incredibly difficult to know whether a currency is over or undervalued, and when this will change. There are a lot of variables involved, and over/undervaluation can persist for decades. For example, growing current account deficits in themselves do not necessarily indicate that a currency is overvalued, since in the world of free flowing capital, the desire for a currency as a safe haven can cause this over valuation which in turn causes a current account deficit by making imports "too cheap". A mercantile explanation for currency movements and current account deficits doesn’t capture the reality of the present economic and financial architecture. With free flowing capital, it's difficult to tell if the tail is wagging the dog or vice versa. (Some would even say that it's hard to know which is the dog and which is the tail!)

There are 2 broad strategies that can be employed to preserve the international purchasing power of savings:

1. Buy the profits of every economy. You can buy a share of the profits of the productive capacity of all countries at the same time, so that over time, overvalued and undervalued currencies cancel each other out. This works as long as long as global production continues to grow (i.e. the global economy continues to grow).
   
   
2. Buy the profits of international products/commodities. You can also buy a share of profits of the productive capacity of an internationally used (and internationally traded/shipped) product or commodity. It is important that the product or commodity chosen be one that will continue to be in greater demand over time. For example, you can buy a share of oil production, but you wouldn't buy a share of natural gas production because natural gas tends to be difficult to transport and is often used locally where it is found (at least until the global infrastructure for handling LNG is built up). For internationally transported products and commodities, the price level is constant across the globe, and real (not nominal) producer profits will generally be unaffected by changes in the value of individual currencies.

There will also be situations where a company operating within a foreign country looks undervalued (or an entire corporate sector, e.g. the S&P 500, looks undervalued). The question then is: is the currency of the country of the intended company undervalued or overvalued? If it is overvalued, then any investment there may be a Sisyphean one - when the foreign currency drops from its overvalued position, any gains in foreign currency terms could be negated in international currency terms. For example, buying a share of the electricity production of an island nation that only exports bananas won't help you if bananas experience a permanent drop in value in the global market (perhaps because scientists discover that eating bananas causes premature aging). You'd be a prominent “tycoon” on that little island and the villagers would fete you like a king to keep their electricity supply on, but it wouldn't give you the means to buy cars from Japan, wine from France, a trip to San Francisco, and so on.

Making investments in a foreign country requires a qualitative assessment of the country: its social, legal and economic structure, and its long term economic relevance to the world. You'll also need to determine the probability that the currency is over or undervalued, the forces driving the apparent over/under valuation of its currency, and what will probably cause this to change.

No country is truly self sufficient, so Investors in big countries should also think about preserving International Purchasing Power

There is a case to be made that no country in the world today is truly self sufficient. Given the extensive specialization and division of labor, and large scale of production needed to support the complex products and technologies that we use in daily life, it is entirely possible that our modern standard of living can only be accomplished if all of humanity is involved in its production (so that we can achieve the needed scale of size and specialization). So preserving the international purchasing power of savings may be a concern of all investors, not just those living in seemingly small economies.

When buying assets (to preserve purchasing power of your savings), only buy at a fair/cheap price

This entire discussion presupposes that investors only buy those assets we've discussed when their prices are at fair-value or lower. No matter how intrinsically good an investment is at preserving real purchasing power, buying it at an overpriced level can make it an unprofitable venture. Buying at a fair price is an essential rule for successful investing.

Image by Martin Kingsley, via Wikimedia Commons, licensed under the Creative Commons Attribution 2.0 License

The 2008 Credit Crisis: Causes and Consequences

What is this Credit Crisis about; What's actually happening to the real economy, and how does it affect investors? The roots of the credit crisis have been in the making for several decades.

What's been happening over the last four decades: Credit has been growing as % of GDP

In a fiat-money fractional reserve-banking economy, the supply of money in the banking system broadly correlates with the amount of credit (loans) that have been extended to companies and consumers.  As you can see from the following data, the money supply in the economy relative to GDP has been growing:

1970: M3 USD 0.6 t; Nominal GDP: USD 1.1 t; M3 to GDP: 54.5%
1975: M3 USD 1.0 t; Nominal GDP: USD 1.7 t; M3 to GDP: 58.8%
1980: M3 USD 1.8 t; Nominal GDP: USD 2.9 t; M3 to GDP: 62.1%
1985: M3 USD 3.0 t; Nominal GDP: USD 4.3 t; M3 to GDP: 69.8%
1990: M3 USD 4.0 t; Nominal GDP: USD 5.8 t; M3 to GDP: 69.0%
1995: M3 USD 4.3 t; Nominal GDP: USD 7.5 t; M3 to GDP: 57.3%
2000: M3 USD 6.7 t; Nominal GDP: USD 9.9 t; M3 to GDP: 67.7%
2005: M3 USD 10.1 t; Nominal GDP: USD 12.7 t; M3 to GDP: 79.5%

An increasing amount of credit has been extended by the banking system to economic participants. In a closed system, the credit can represent three things at a systemic level: (1) increased consumption using the credit, which in turn causes increased capital investment to support the increased consumption; (2) increased funding of capital investments by credit to support increasing consumption; or (3) increased prices of real assets and financial assets as the credit is used to purchase assets. 

Leading to Unsustainable trends: (1) building white elephants;  and (2) increasing financial savings while depleting economic savings

The first two in themselves would not be a problem, since increased economic productive capacity provides the basis for economic growth. However, the fact that the proportion of credit to GDP is increasing means that either (a) the structure of the economy is changing to become more capital intensive, where higher levels of capital are required to produce a unit amount of goods, or (b) that the increase in consumption and productive capacity is increasing at an accelerated rate. Unfortunately I believe that hasn't been the case, which means that society has been  building more capital goods than required - or in other words, we've been building white elephants. (I use the term "capital goods" loosely - it can also refer to housing, which produces "living space" which is captured in GDP as rental income)

The third is a problem if it is sustained for too long, because it drains the economy of real savings. As the price of homes and financial assets go up, individuals believe they have built up savings for retirement and emergencies. However, on a systemic basis, no economic savings are being built up to sustain capital goods creation. What appears to individuals as savings is actually financial savings, which is different from economic savings. In the economy, savings that fund capital goods creation (real productive capacity) can only come about from foregone consumption. Capital goods are created when people work on building machinery and houses instead of making consumption goods. This means that the aggregate amount of consumption goods created (and consumed) is less than the amount of things they have created (income). If the income from work is not forgone to fund the creation of capital goods, then there is no economic savings. If the growth in asset prices goes on for too long, it will cause the nation to appear wealthy as the financial savings and financial wealth appears to be high. But in reality, the economy's underlying productive capacity is deteriorating because no income has been forgone to fund it. At some point, asset prices will collapse for psychological reasons, or because the underlying economic productive capacity cannot produce enough income to sustain the high prices (e.g. when rents cost more than what jobs pay).

The consequence of which is this Credit Crisis

- What's happening in this crisis

The current credit crisis seems to be a confluence of these forces: (a) the build up of white elephants funded by income forgone in other countries (imported capital), (b) the sudden fall in value of financial assets after their prices rose to unsustainable levels, and (c) the diminished productive capacity of the economy.

The result is that people who have borrowed (financially) to invest in white elephants are going to lose their money and default on their debt. This means that there will be significant destruction of money in the banking system, which would lead to banks reducing lending as they work through the losses. This reduced lending is going to crimp economic activity and capital investments for a while, and lead to a recessionary bias. (In the past, before deposit insurance, this might have led to runs on the banking system, which would be enormously destabilizing and could change the psychology of the population to the point where people reduce their living standards by lowering their consumption of goods and services, leading to a deflation and depression as the population demands a lower economic output than what the productive capacity of the economy is structured to produce.)

At a societal level, it also means that the economy does not have the productive capacity to pay back (in terms of goods and services) the people who have spent time building the white elephants. They may not realize this, because they could have already received payment from the people who borrowed money to create the the white elephants. But the reality is that there are more of these dollars, which are claim checks on future economic output, than there are goods and services that the economy can produce in future. (If they had been building needed productive machinery on the other hand, the claim checks could be used to claim the future products produced by those machines). In effect, all economic participants are being shortchanged as their dollars are devalued (through inflation).

This is leading to:

(1) inflation, causing everyone to suffer;

In a society without representative government, this devaluation of claim checks wouldn't be so severe, because the money supply would contract as bad debts are taken onto the banks' balance sheets. This reduction in money supply (manifested as destruction of shareholder's equity and deposits) would reduce the number of claim checks in the economy, to match the actual productive capacity of the economy.

But it would of course, be manifestly unfair to certain segments of the population. The trades people (labor) who invested their time in building the white elephants would be made whole, while persons who have saved their income would be wiped out thanks to the misjudgment of the people who borrowed to create the white elephants.

Politically, this has been hidden through the government's deposit insurance schemes and capital injections. These have the effect of protecting the savings of the savers, and preventing the monetary base from contracting. But the effect of this is inflation, as there are now more claim checks than the economy is able to produce goods and services for in future. Savers are still harmed through inflation - but the inflation creeps up slowly, and is politically more acceptable.

Societal over-investment in white elephants is fraught with moral hazard. Whichever way you look at it, the bad judgment (or reckless attempts at making a profit from creating too many capital assets) of one group causes everyone to suffer. The negative externalities of misinvesting capital into white elephants is simply not priced in when investors borrow money to build capital assets. This is why credit/debt extension needs to be regulated. 

And also leading to:
(2) a Recession; (how is the recession going to play out?)

The economy is going to be recessionary in nature as the reduction in credit squeezes economic activity. The credit squeeze is also going to be difficult for companies that rely heavily on debt financing - they are going to face tough times as their cost of capital goes up, and some businesses that are economically viable in the long-term may go bankrupt. The extent of the recession depends on the amount of mis-allocation of capital (i.e. credit/savings) that has happened. There is also going to be an impact from job losses and company closures in industries that were geared to building white elephants, and servicing the people building white elephants.

A cursory glance suggests that M3 as a % of GDP has at most peaked at 69% of GDP prior to past recessions. Considering that today's (2008) M3 as a % of GDP is probably around 80%-90% (this is a guesstimate, because the Fed stopped publishing M3 data after 2005), it suggests we are going to face a economic recession worse than any since the Great Depression. Conceptually, this is going to happen as society as a whole realigns itself to "forget the debt owed for work done in building white elephants (this debt will never be repaid), readjusts, and gets back to its normal course of living" (unfortunately as we have described earlier, the fallout and impact to different segments of society is unequal). Society as a whole will adjust to lower economic activity than what the previous high level of capital investments suggested the economy was capable of. Practically, this is going to happen through two mechanisms:

(1) The banking system is going to reduce outstanding credit as debts go bad, and this will crimp economic activity. In the short term, this may even lead to deflation.

(2) Because of the Fed's injections into the banking system, and because of the existence of deposit insurance, inflation is going to kick in as the money supply stays constant while the economy's productive capacity contracts, or grows slower than what the prevailing money supply was "intended" for.


This will be a deep recession,
but it's probably not another Great Depression

This is going to be deep recession, probably worse than anything we've seen so far. But I think the odds of a depression (with regular people starving and living off soup kitchens) are low, because:

(a) Deposit insurance now exists, preventing money supply destruction, and preventing systemic bank runs which would send people into a psychological state that would get them to reduce their standard of living and consumption of goods and services, below what the productive capacity of the economy can produce, hence leading to severe economic contraction.

(b) the injections of liquidity by the Fed and Treasury, which help to prevent money supply destruction by keeping banks solvent and allowing them to keep their credit facilities open to economic actors.

(c) as long as free-trade continues to be viewed positively in the political agenda, the United States has products which it can export to countries holding lots of dollars in reserve, of which there are many (countries which the U.S. has trade deficits with). When these countries increase their purchases of U.S. exports, paid for with the U.S. dollars their central banks are holding in reserve, it will stimulate economic production and follow-on economic activity. In a sense, these are an untapped group of consumers which can kick-start economic activity should the domestic mood be so dour that people reduce their economic needs way below economic productive capacity.

(d) the U.S. population is still growing. People getting married will need new houses, consumption goods etc. While some segment of society, especially those got into excessive debt over the last decade, are going to reduce their standard of living, the introduction of new young people into the economic system should bode well for overall production and consumption. (Simply adding young people into a non-functioning/fragile economic base would be useless - look at many countries stuck in 3rd world conditions because the political-economy isn't set up for its young people to participate and create a better life. In the case of the U.S., a growing population helps because the political-economic framework exists to allow everyone to create a better life for themselves.)

We are in uncharted territory;
Living in a Grand Economic Experiment

Nonetheless, it's important to realize that we are in uncharted territory with the 2008 credit crisis, because society now has two tools that weren't present in previous credit-crisis led economic contractions: fiat money, and central banks.

There is a case to be made that many of the depressions since the 1800s were caused by a contracting money supply following a credit boom. Prior to the 1900s there was no central bank in the United States who could manage the money supply in a coordinated fashion. And broadly speaking prior to the 1960s, most countries were operating on the gold standard, which constrained the degree of freedom that central banks had.

We are living in the midst of a grand experiment which will tell us if credit-crisis led depressions can indeed be prevented through inflationary monetary policy, without adversely preventing the economic from making the structural changes needed to compensate for the excessive investments in white elephants. But make no mistake, this recession is probably going to be deep.

Sidebar Observation: Credit crises are a normal part of the human-economic cycle (Long-term investors should expect them)

How should long term investors think about the cycle of oscillating between bouts of "Euphoria Phase", with high valuations of capital goods like houses and companies/equities because of overinvestment / overextension of credit, and the subsequent "Subdued Phase" where the real price of capital goods drop as excess investment/debt is unwound?

My hunch is that the cycles run a duration of one human lifetime or so. The first ended in 1929-33, and the current one is ending in 2000-2008. If you look further back in history, credit led booms were also probably the reason for Panic of 1837, and the Panic of 1873 which led to the Long Depression. In other words, credit-bubble led cycles are likely to be an inherent feature of fiat money economies, and co-exist with the regular business cycles caused by inventory fluctuations. Investors and savers should expect these cycles. 

Investors living today in their 20s and 30s need to work within the framework of a subdued phase. This will probably last for some time, and the implication is that investors today should not rely on the broad conventional investment wisdom built up over the last 2-3 decades during the euphoria phase (such as the rule of thumb that stocks as an asset class will always outperform other asset classes, and the feeling that general stock prices always go up over time)

Post script (14 Mar 2009): For an explanation of the financial crisis from a financial perspective, have a look at this excellent infographic. 

Image by i ♥ happy!! from Wikimedia Commons, licensed under the Creative Commons Attribution 2.0 License.