Sensational ... but true

Photograph by Terry McCombs

My writings in this space are usually somewhat academic and what I think is an objective view point, whenever I stray from highly academic topics. A recent article from the Rolling Stone magazine, though, caught my eye. The writer talks about the systematic way in which Wall Street banks touting their financial engineering expertise have expanded their influence into small governments in America. The banks have peddled products that have invariably resulted in huge amount of financial distress for these agencies. See link here.

The phenomenon of bankers behaving badly with small governments or for that matter even with larger ones (state pension funds) is nothing new. The 1994 bankrupting of Orange County by Robert Citron (Citron? for Orange Country?), the county treasurer, is a well-known story. See a really good article about this failure here. Another notable example from the same period is Proctor & Gamble's dalliance with derivatives that resulted in a lot of grief for themselves as well as for Banker's Trust, their investment banking advisers. The human psyche seems particularly frail and susceptible to smooth talking operators, talking interesting numbers and displaying other forms of spreadsheet gadgetry, and promising the moon in return for money. In addition to the banks' rapacity, the people at the customer end - that sought to invest in little understood financial instruments, where the risk of the counterparty is bounded but your own downside is infinite - are as much to blame. Not for the lack of financial savvy, but for getting into a situation where such financial gimmickry needed to be resorted to in the first place.

The primary problem here is the particular weakness of small government bodies to be reckless about spending during good times. In an attempt to do something big and important for their constituents (ascribing the best motives), governmental bodies take on big projects when the economic cycle is positive and tax revenues are abundant. They take on big loans which need servicing even when things go bad - when tax revenues decline or interest rates rise or whatever. And then these agencies find themselves strapped for money and start to resort to financial gimmickry. And fall into the arms of the Wall Street firms.

Reminds me of the famous Roald Dahl story about the old man who has a priceless painting tattooed on his back. And who goes away with a smooth talking stranger who promises to keep him happy for the rest of his life, only if the old man displayed his painting to the stranger's guests at his hotel. Needless to say, but in a few weeks, the painting appears sans the old man in a famous art gallery.

Bank Regulation in the Canadian context - Part 1

The fallout of the 2008-09 Great Recession in terms of failed banks, lost jobs, shuttered plants, bankrupt companies, is news to all by now. What started off as a repayment crisis had an amplified impact on the overall economy - driven by reckless risk-taking by big banks, over-leveraging and ultimately pursuing a path that seems to suggest that they believed they were too big to fail. Which turned out to be the case ultimately. Read bailout of AIG, the arranged marriage for Bear, government takeovers of Fannie and Freddie and so on.

The contagion has not been limited to US banks and institutions by any means. European Banks (UBS, Deutsche and Societe Generale), British banks, Irish and Icelandic banks - all showed similar behaviours, similar disdain for any considerations of their long-term health believing themselves to be too big to fail. One glorious exception in all of this has been large Canadian banks. As compared to some of their US and European rivals, these large banks have been the very paragon of well-managed and well-run financial institutions and have hardly suffered a blip to their profitability or needed any government largesse over the Great Recession to survive. In fact, Canada is the only G7 country to survive the financial crisis without a state bail-out for its financial sector.

(The top 5 Canadian banks are Royal Bank of Canada, Scotiabank, Toronto-Dominion Bank, Bank of Montreal and the Canadian Imperial Bank of Commerce. Besides cornering nearly 90% of the Canadian market, these banks are in reality large international banks with operations in 40-50 countries, and stock listings on multiple exchanges. A quick primer on Canadian banks is here.)

What caused the Canadian banks to survive? An immediate reaction (which incidentally would be wrong) is that Canadians are somehow too nice to participate in the kind of no-holds-barred plundering practiced by the American banks. They play a soft form of capitalism, one that protects the downside but also somehow limits the upside. Hmmmm, not entirely true. The net shareholder returns of Canadian banks have exceeded that of UK and US banks in the last 5 years, as evidenced in the graph below.


What about returns over a larger time period? How do the top Canada banks compare to the top US banks in terms of stockprice performance?

Looking at a 7 1/2 year period from mid-2002, the total returns on a basket of large Canadian banks (the ones mentioned above) was 144%. In the same period, US large banks (Citi, Chase, BofA, Wells, Goldman, Morgan Stanley) had a return of a paltry 2%. OK, the US banks returns were decimated because of the recent credit crisis. The market over-reacted maybe. If you look at returns from a period from Jan 1998 to Dec 2005, when we were having a so-called 'Goldilocks' economy, the story isn't too different. US bank stocks rises to a more respectable 69% but the performance of Canadian bank stocks improves even more to 183%.

Table of stock price performance for top Canadian banks - followed by US banks
(Boom and Bust Period)

	June 2002	Feb 2010
RBC	16.06	50.44
TD	23.19	59.56
CIBC	32.85	59.135
BofM	21.86	48.86
Scotia	17.41	42.87

	June 2002	Feb 2010
Chase	22.25	38.39
Wells	25.2	26.71
BofA	35.18	14.47
Citi	28.68	3.18
Goldman	73.35	152.49
MS	35.62	27.13

Table of stock price performance for top Canadian banks - followed by US banks
(Boom Period only)

	Jan 1998	Dec 2005
RBC	12.15	39.27
TD	17.49	52.55
CIBC	24.02	65.8
BofM	20.22	55.94
Scotia	16.6	39.93

	Jan 1998	Dec 2005
Chase	51.29	48.3
Wells	18.22	35.56
BofA	29.94	46.15
Citi	24.78	48.53
Goldman	73.72	133.26
MS	29.19	56.74

(Goldman Sachs and Bank of Montreal did not have full information over these periods. But having them in the numbers - or taking them out - doesn't change the story.)

SO what can explain the better performance of Canadian banks? What allows them the ability to not only perform better through the cycle but also do so with mininal government handouts? The answer is superior risk management and that will form part of the next part on this subject.

Christya Freeland of FT.com has a fascinating article on the subject and the link is here.

It's been a long time

It's been long since I shared my views on my blog. Excuses are multiple, but none is particularly credible.

But I think this is a great time to start again. In the last 2 years, the world has been painfully exposed to the fallibility of models. From being the engines of modern finance and the economy at large, models have gone to becoming the reason #1 for the economy's collapse. Even worst, model builders have become a bit of a laughing stock in the post-Wall Street society.

Here's an attempt to set models and statistics to back where they belong. So lets see how it goes this time around.