Is the current financial system encouraging risky behaviors for banks?

Recently, I have noticed from newspaper that there have been serious talks all over the world as to how the governments should regulate commercial banks in an awake of subprime mortgage crisis. Everyone agrees on the fact that there should be a financial reform, but don’t agree to what extent.  First, there’s no doubt that financial intermediaries, such as banks, play a crucial role in our society by transferring money from those who don’t need (e.g. you and me) to those who need most (e.g. entrepreneurs). However, I want to approach the issue from the perspective of fractional reserve system, under which banks are required by law to keep some portion of the depositor’s money before lending out to those who need it.  The ratio as to how much percentage banks should retain is determined and regulated by the government institution, called the Federal Reserve. This ratio is referred to as reserve ratio. Are there any problems with this system? The answer is yes.  This is not my idea, but has been illustrated by some economists in the past. It makes sense to me, so I want to share it with you.

Let’s say we only have three banks (Bank A, Bank B and Bank C) in the world, and assume the reserve ratio set up by the government is 10%.  That is, for every dollar deposited to one of banks from people, like you and me, at least 10 cents should be reserved by law in case that either you or I withdraw some money from checking accounts.  Let’s also assume that Bank A and B are “good” banks that lend money only to excellent projects and reserve more than the required 10% to enhance their liquidity.  On the other hand, let’s say Bank C is a “bad” bank that lends money to very risky projects, and only keep the required amount of reserve, 10%.  What happens if people at some point realize that the Bank C is a bad bank and try to take out all of their money in fear of losing it all?  The Bank C is only able to give out 10% of their money at any given time, so it will go bankrupt. This incident may lead people to panic and try to take out all of their money from “good” banks as well. As a result, Bank A and Bank B will go bankrupt, and financial system would collapse.  One bad apple can easily spoil the barrel.  This is referred to as “Bank Run”.  Currently, we have two preventive measures for Bank Run, but they also create other problems.

The first preventive system is the Discount Window operated by the Federal Reserve.  The Fed functions as “a lender of last resort” when a financially troubled institution can’t borrow money from other financial institutions in the market.  The Bank C in this case can borrow money from the Discount Window by putting up its assets as collateral at a higher rate (i.e. discount rate) than market interest rate (e.g. federal funds rate).

What if the Bank C can’t even borrow from the Discount Window due to reasons such as having too toxic and risky assets for the Fed to accept as collaterals?  In this case, there is the second preventive measure for the bank run, which is the existence of the Federal Deposit Insurance Corporation (FDIC).  By paying a small premium to the FDIC, banks can lower the cost of borrowing from you and me significantly. 

For example, if you want to open a bank account, you don’t really need to consider whether or not the bank will go bankrupt in near future because your money is insured by the FDIC up to a certain amount. That is to say, your money is backed by the full faith of the US government. Then, which bank would you go to deposit your money? You would go to a bank that pays the highest interest, regardless of the fundamental economy strengths of the bank. Then, which bank would pay the highest interest?  It is the one that is willing to lend money to highly risky projects to compensate for the high interest rate paid to you. As a result, risky banks are rewarded more in terms of profits, and attract more customers. The problem doesn’t appear when times are good. Companies with risky projects make a good return, and are able to return the interest and principal payments on time. As time goes by, the “bad” bank draws more customers, grows bigger and bigger, and invests the money even riskier projects, and so on. The problem, however, will start to appear and become apparent when the economy turns sour.  The “bad” bank can wreak havoc on the whole society since the risky projects tend to be vulnerable to the economy ups and downs. What’s worse is that it’s really hard for the government to ignore the financial difficulties of big banks because their operations are so interconnected with all parts of our society.

Don’t get me wrong. There are a number of well-functioning big banks with well-disciplined lending practices and policies that have made a huge contribution to the society.  As I said, however, one bad apple can spoil the barrel in the financial world.  In the fractional banking system, banks are so highly leveraged and interconnected with one another that one failure can take down the whole society. The simply, but not easy, way that I can think of to fix is to raise the raise the required reserve ratio for banks in combination of putting back off-the-balance-sheet items to their financial statements.  The other way can be for the FDIC to receive much higher premiums from banks with toxic and risky assets to compensate for the higher risk, as compared to other banks.

Why is economy recovery so slow?

Due to the US housing market bubble bursting and various financial instruments that bet on the bubble, we have experienced an economically difficult time over the last three years.  In economic terms, short-term equilibrium of real GDP has been somewhere below full-employment equilibrium, and the difference is referred to as recessionary gap. 

In attempt to bring the equilibrium point back to full-employment point where long-term aggregate supply curve is located, over the last two years, the government has used 1) expansionary monetary policy and 2) expansionary fiscal policy, both of which attempt to shift up aggregate demand curve.

Let’s look at the expansionary monetary policy.  Simply put, it means making a lot of money available in the market, which gives downward pressure on interest rate.  In theory, if the interest goes down, then the followings will go up:
- Business investment,

- Consumers’ consumption,

- Net exports
If these events occur as planned, it will shift up the aggregate demand to full-employment point.  Then, why are we experiencing such a high unemployment rate and still in this mess?  My short answer is that it takes time.

In theory, business investment (e.g. factories, machines and inventories) will go up since they can borrow money at a low interest rate.  That is, their opportunity cost is low.  However, what are the main reasons that they are willing to invest in the first place?  It is because they have confidence that there will be enough demand for their products in the future, which will make the investment profitable.  If they expect that the recession will last long, then they will tend to hold back their investment decisions until they are certain of economy recovery.

By the same token, consumers will, more or less, react in anticipation of future economy status.  In theory, in the case of the low interest rate, consumers’ consumption will go up due to low future accumulated wealth from saving (i.e. substitution effect). However, people have to worry about whether or not they can work in the near future.  There’s a high probability that they get laid off from their companies in recession, which makes them save more and spend less (i.e. income effect).

What about the net exports?  In theory, if domestic interest is low, then money invested in the domestic market will be taken out to invest in another foreign markets where interest rate is high, which makes domestic / foreign current exchange rate low.  This in turn will make exports cheaper to foreign consumers, increasing the net exports.  Is this the case now?  I would say no for the current market.  The investment uncertainty has been higher than ever before during this financial crisis.  What we witnessed was that people flocked to the safest asset, the US government securities instead of moving away from it.  In addition, the world-wide financial crisis made other developed countries implement the same expansionary monetary policy, which made their interest rate low as well.

If neither consumers nor corporations, then who is the one willing to spend in anticipation of possibly long recession?  The answer is the government.  This brings our attention to the second topic, expansionary fiscal policy.  However, it is subject to debate as to whether it should be done in the form of tax reduction or direct government spending.  There are pros and cons on both policies.  For the government spending, it should be carried out quickly enough to stimulate the economy, and should also be used effectively, which is arguably not the government’s strong suit.  On the other hand, the tax reduction should be implemented in a way that it gives enough incentive to beneficiaries to spend it.  If they hold back the tax benefits for the reasons as in consumers and corporations mentioned above, it will only contribute a little to the expansionary policy.

From my perspective, the occurrences of economy booms and recessions are, to a large extent, attributed to two human emotions; greed and fear.  Whether it be recession or boom, the government plays an important role in an era of high uncertainty when nobody is willing to take the initiative, and the timing is also crucial.  But, it just takes time to take effect for those expansionary policies.  Rather than looking at the situation as the end of the world and holding back their cash in fear, individuals and corporations should also see it as once-in-a-life-time opportunity to invest.

Insurance Company Analysis

By Hyun Jun Kim, kim813@illinois.edu

Summary

- Demand Side
Primary insurance is a commodity-like product. In general, consumers of primary insurers care mainly about price and service only and therefore, there is not much product differentiation within the industry. In many cases, this environment creates extensive price competitions and inadequate pricing of their policies in a short term.
Reinsurance, however, can have product differentiation power if it has capacity of paying out a large amount of claims by its available funds when it is most needed (e.g. mega-catastrophic hurricane/terrorism attack).

- Supply Side
Insurance companies have funds available to invest from three sources: 1. Policy holders, 2. Debt holders, and 3. Equity holders (i.e. Insurer’s investment is roughly equal to “Float” plus Debts plus Shareholders’ Equity.) In analyzing operation performance of an insurer, the main focus should be on the policy holder money (i.e. “float”) and its cost (i.e. underwriting performance) over a long period of time.


Key Determinants

- Operation Side
* Float = Policy holder money held – Policy holder money not held yet
= [loss and loss adjustment reserves + unearned premium + fund held under reinsurance assumed + other policy holder liabilities] – [premium receivables + loss recoverable + deferred policy acquisition costs + deferred charges on reinsurance + prepaid taxes]
* Combined ratio = (Incurred Losses + Expenses) / Earned Premium

“Float”, or available reserve, is policyholder money held, but not owned, by insurers, which comes about because there exist time intervals between received premiums and incurred losses to be paid out, usually more than a year. During that time, the money can be invested for insurers. Under a good management, insurance companies can have negative cost of funds, while other depository institutions such as banks always have positive cost of funds, regardless of management quality. If an insurer operates under underwriting profits, it means the cost of float is free (i.e. combined ratio = 100), or even negative (combined ratio < 100). In other words, insurers are paid to use the float. In this case, the float, defined as liability on the balance sheet, functions as an asset, which determines the value of the insurer. However, if the cost of the float is more than the cost that the company otherwise incurs to borrow the money, it is no value to the company. In an insurance operation, the combined ratio equal to 111 is, more or less, the break-even point, depending on its investment performance and environment.

- Investment Side
As in other depository institutions, insurance firms should invest funds intelligently. Bonds-to-equity ratio in its investment gives an idea of how conservatively managers allocate available capital. Long-term investment performance shows profitability of the float.


Long-term Top Performers and Valuation Metrics

Due to extensive price competitions among thousands of insurers, most of insurers in the United States could not keep up with long-term (more than 5 years) underwriting profits. However, there are a small number of top performers that have managed underwriting profits and in addition, have increased float at an attractive rate in the past. If the managements stick with the same disciplined pricing and quality of service in the future, it is likely that they will continue to make companies profitable in the long term.

In the event of subprime mortgage crisis, market value of these fundamentally excellent companies has plummeted along with mediocre insurers. It created opportunities to purchase good insurance businesses at a discount, compared to its intrinsic value. For the purpose of the valuation, Market Cap / Float (M/F) can be used after screening insurers by their long-term underwriting performance. The M/F ratio below 0.5 is extremely undervalued since the float of these companies functions as assets, or even better. In other words, the M/F may be roughly considered the same as Market-to-Book under two conditions: 1. Long-term underwriting profits and 2. No shrinkage of the float.

What to buy: Quality of Management

In order for a stock to be a huge winner in the long term, one of the most important aspects is the quality of the management. They should have unquestionable integrity and competitive management ability.

Without breaking any laws, there are infinite ways in which those in control can benefit themselves at the expense of shareholders. For example, in the presence of stock options as a compensation package, they can retain a big portion of earnings for unattractive projects and investments for the purpose of boosting up stock price. In this case, shareholders would be better off getting a dividend. Another is to adjust estimates and assumptions on the financial statement to meet the expectation of Wall Street and get rewarded for their “performance”. With complex accounting rules and operations, some of the misconducts are literally impossible for investors to detect. Therefore, if management has any history of misconducts and crimes, the investors had better stay away from the stock regardless of other matters.

In terms of the management ability, there are three main areas that should be focused on. First, you need to know how well the management runs their day-to-day operations, compared to their competitors. A good manager doesn’t get up one day and say, “I will improve the condition of my firm”. Truly outstanding managers are the ones who do it on a daily basis without even realizing that they are doing it.  They should be able to break down its overall costs into small pieces (e.g. costs of different products and divisions) so as to know where they need to pay attention the most.  The worst case is that management may not be aware that some of their supposed-to-be-profitable operations are run at a loss, which results in decrearsing rather than increasing the overall profits.

Second, management should be long-term oriented. As mentioned above, many managers are compensated for their short-term performance, which makes them short-term oriented. Outstanding firms are the ones that deliberately hold back maximum immediate profits if it has greater overall profits over a period of years. If you are a long-term investor who seeks for more than 1000% long-term profits at the expense of 20% short-term increase, the management should also do the same thing.

Third, management must be equipped with excellent capital allocation skills. In many cases, outstanding managers climb up the hierarchy with little knowledge about investing. Over many years of experience under their belts, they are the experts of running the firm, but not managing money. Thus, they leave what they earn from the operation to institutional investors, hire a CFO, etc. If those in charge of the capital allocation decisions are incapable, it is the same as pouring water into a basket that has a hole at the bottom. One day, you might scratch your head and wonder why it takes so long for the basket (i.e. stock price) to be full (i.e. rise).

Equity Analysis: Earning Curve

One of the key drivers of stock movement is earnings of the business. More importantly, what determines your investment success is future earning curve rather than that of the past.

Then, what can you do to predict the future earning curve? Many investment professionals have put increasing importance on the trend of earnings where future earnings are estimated by projecting the past trend into the future. It may seem like a sound analysis, but it may not. While the past trend is a fact, the future trend is only an assumption. Therefore, too much emphasis on the trend is prone to creating errors in overvaluation or undervaluation since how far ahead the trend should be projected varies depending on analysts. From my point of view, it is always good for an analyst to fully understand the earning structure of the firm and to be as conservative as possible to mitigate the errors of possible overvaluation.

Another thing that an analyst should watch out is the fact that accounting rules give firms wide discretion in calculating their earnings. More often than not, managements get rewarded primarily based on short-term measures such as annual earnings and return on invested capital. Within the legal boundary, the management has the incentive and capability to “make” the number by exploiting the accounting rules. For investors, it is always safe to avoid companies that use a lot of estimates and assumptions, and for analysts, it is their responsibilities to read and understand the footnotes of annual reports in addition to the financial statement.

Equity Analysis: P/E Ratio

The P/E ratio is used probably as the most common ratio to value a business because it is easy and quick. Roughly speaking, buying the P/E of 10 means that it takes 10 years for the company to pay back your investment, provided that its annual earning remains the same during that period. Many professional investment analysts like to compare it for one firm with that of others in the same industry.

As far as I am concerned, however, it can be only used as a crude yard stick that may give you a hint that the company is selling relatively cheap or expensive. Without further research, such figures can be misleading.

One reason is that quality of earning is not the same from company to company. For some, much of what they earn must be reinvested back to the business to sustain their competitive position in the industry. For others, only a little amount is needed. The main culprit is capital expenditure. Many capital-intense companies on average should spend a lot more as capital expenditure than what they depreciate on the book. This makes the quality of their earnings go down by the difference. If you buy, say, an oil drilling company just because its P/E ratio is low, it may be a mistake.

In addition, the earning should be durable and should come from its main business operation. If the earning comes from one-time profit or accounting gimmicks (for example by adjusting inventory, predicting bad debts, forecasting unusual gains or losses improperly, etc), it is not the true earning. Thus, it should not be used as a measure of valuation.

Lastly, you should also keep in mind the future growth of the earning. If there is enough room for the earning to grow in the near future, a high P/E ratio may be justified. However, you should watch out for a high P/E company only with rosy prospects and without fundamentals.

With the frequent and easy use of database, it has become increasingly hard to find undervalued companies just by plugging in such ratios as P/E and B/M in a computer. Based on my experience, many great buys appeared where P/E ratio looked very expensive. For example, a company with excellent underlying economy may experience a temporary difficulty in generating the earning, which results in the very high P/E temporarily.

What to buy: Quality of Product

In this day and age, it is almost impossible to escape your eyes from seeing stock ticker symbols and quotes since they are everywhere on the Internet, TV, blackberry, etc. As far as I am concerned, however, it is not the price to which you should pay attention first when it comes to looking for what to buy. It is what they sell. The stock price is important at the end of your valuation to be compared with the intrinsic value that you estimate, not the beginning of your valuation, unless it is a clear arbitrage opportunity.

Many people often forget that a piece of stock represents a piece of ownership to the company. In the short term, the arbitrage opportunities can be profitable if implemented with caution, although it is just a one-time profit. In order to make a successful investment decision in the long term that will give you repetitive compounding profits, it is crucial for you to look at and understand what they sell first.

There are countless companies selling various products and services, but there are relatively a few firms selling quality products.
What I mean by the quality products is as follows:

1. Maintainable Monopoly Power
Monopoly is bad for the society, but excellent for the company. A firm to be a long term winner should have some sort of monopoly that is maintainable against competitors and that doesn’t violate the law. It may come from geography, brand name, know-how, technology, low-cost operation, etc.

2. Repeat Customers
A product needed only once in a lifetime is excellent for customers, but bad for the company. The product should have the intrinsic quality that makes the customers buy over and over in the future.

3. Benefits customers, suppliers, and employees
To sum up, everyone should be happy. If customers are not happy, but the firm is profitable because of the monopoly power, the firm becomes soon susceptible to political pressure and regulations. People know that the consequences of frequent and prolonged strikes are obviously detrimental to the firm.
What people may not recognize is that the firm’s degree of profitability that resulted from happy customers and good personnel relations is far greater than the direct cost of regulations and strikes. Although it is hard to quantify the firm’s success in this area, you can ask your friends and families (i.e. customers), and you can also get a feel by visiting stores. In terms of the quality of labor policies, you can look at labor turnover in one company as against another in the same industry, and the size of the waiting list of job applicants.