We Don't Hold Bank Stocks..Why so?

Australian retail investors love financial stocks. Almost everyone we know who own stocks have shares in one or more of the big four banks. The most common question we get asked is "Should I buy XYZ bank shares?" especially after a stock market correction because prices appear cheap. Our answer is always the same, which is, we are not certified financial advisers so we cannot give specific investment advice, however, after doing our own research on how banks operate, our SMSF has made a conscious decision not to own any bank shares. Some of our reasons are:

1. High use of leverage
2. Unknown quality of bank assets
3. Unknown off-balance sheet liabilities

High use of leverage
Before the GFC, I used to think that banks only loaned out a portion of what they received as deposits. It was only after the spectacular collapse of investment products like Collateral Debt Obligations (CDOs) that I learned that loans are typically securitised i.e. packaged together as an investment product and sold so banks can get more capital to do more lending.

Banks can also borrow to lend. Most banks are very highly leveraged which in good times was highly profitable.

Let me give you a simple example of the power of leverage. If you can buy a house with 10 percent of your own money and fund the other 90 percent with borrowings, you can make a 100 percent profit if the price of the house goes up by 10 percent.

However, if the house price goes down by 10 percent, you will have a 100 percent loss.

Many banks are leveraged by 20 to 1 i.e. they only own 5 percent of the assets they control.

If the value of the assets fall by 5 percent, the banks are technically insolvent. Some US banks were leveraged 40 to 1.

That is why we saw many financial institution collapse overnight when a small part of their loan portfolio went bad.

Unknown quality of bank assets.
The main assets for banks is debt i.e. various consumer and business loans. Debt is a good asset if the borrower is a credit worthy entity who is able to service the debt properly i.e. pay interest and principal back over time. It is not a good asset if the borrower is not credit worthy. If the borrower defaults, the lender will lose some or all of the value of this asset. During the subprime crisis, many of the financial institutions who gave loans to subprime borrowers got into trouble when these borrowers defaulted on their loans.

In 2008 many financial institutions in the US had balance sheet problems because their assets fell dramatically in value when borrowers defaulted. Most loans are backed with a collateral like a house in the case of a residential mortgage loan. When house prices crashed, the value of the loan was frequently worth more than what the house was worth so even if the bank sells the collateral, they cannot recover the full value of the loan. Until March 2009, all banks had to mark their assets to market prices so when house prices tumbled, so did the value of the banks' balance sheets. To save banks from going under, the Financial Accounting Standards Board allowed the accounting rules for inactive assets to be changed. From April 2009, banks no longer had to mark the value of their inactive assets to market. Suddenly the banks who previously needed bailouts to recapitalise their balance sheets were making huge profits again.

Without the mark to market rule, there is no way of knowing how much bank assets are really worth. Let me give you a personal example of what this means. We own Great Southern (who is currently under voluntary administration) woodlots which we paid $50,000 for. If we mark this to market value, the value would be zero. However, if we mark it to our purchase price, then our balance sheet assets would increase by $50,000.

The same problem happened in Europe recently with the Greek debt crisis. When it was clear that Greece was unable to service their debt, credit rating agencies like Fitch downgraded Greek bonds to junk (non-investment) grade because there is a high risk of default. The stock price of many French and German banks fell heavily because they held a lot of Greek debt. If Greece defaults, they would lose a lot of money. Junk grade bonds are normally not accepted by the European Central Bank (ECB) as collateral when a bank wants to borrow money. When Greek bonds got downgraded to junk status, the ECB changed the rules to allow Greek bonds to be accepted as collateral.

Instead of revaluing assets at their true market values, and forcing banks to recognise their losses, the regulatory bodies have simply changed the rules so that the problems can be masked. The problems are still there and one day the banks will have to face the consequences.

Unknown off-balance sheet liabilities
Not every liability appears on the balance sheet that is disclosed to investors. Many banks have off-balance sheet liabilities. By exploiting a clever loophole engineered by Goldman Sachs, Greece was able to show a healthy balance sheet that enabled it to be accepted into the Eurozone. Enron also showed a healthy balance sheet until it collapsed due to off-balance sheet liabilities.

Most investors know about the problems I mentioned above but think that it is only true for US and European banks. Australian banks are supposed to be a lot safer but this presentation from Steve Keen's website shows that we may have the same problems with Australian banks. Some highlights from the presentation (on slide 23) together with my own observations are:

1. CBA is leveraged around 20 times. If 6.6 percent of their total loans go bad, 100 percent of its shareholder equity will be wiped out.
2. As of December 2009, 60 percent of CBA's lending book are mortgages. If there is a major correction in the housing market, CBA's asset values will heavily impacted. While our housing market is still riding high, auction rates have fallen significantlyin capital cities ever since the government back flipped on the Foreign Investment rules in April 2010. After six interest rate rises, many first home buyers are under mortgage stress so a fall in property prices may happen sooner than we think. The Australian Accounting Standards Board will probably follow its American counterpart and change the accounting rules for valuing inactive assets if this happens.
3. According to data from the Reserve Bank, Australian banks have $13 trillion of off-balance sheet liabilities.