2010-1-13 Calyon (Mayo Testimony)
2010-1-13 Calyon (Mayo Testimony)
2010-1-13 Calyon (Mayo Testimony)
The group of companies that comprise CLSA are affiliates of Calyon Securities (USA) Inc.
Chairman Angelides, Vice Chairman Thomas, and Members of the Commission, thank you
for inviting me to testify today about the financial crisis. I currently work for Calyon
Securities (USA) Inc. as a Managing Director and Financial Services Analyst. The views
and opinions expressed in this document and the oral testimony I will provide to the
Financial Crisis Inquiry Commission are solely my own and do not necessarily reflect the
views of my employer or any other institution or person I am currently affiliated with or have
been in the past. Ive submitted almost 200 pages of materials drawn from my research and
sector reports to supplement my comments today, and will also be using and submitting
slides to help illustrate my main points.1
Two decades ago I worked down the street at the Federal Reserve. We were helping banks
recover from crisis, and took great meaning from our efforts. I hope that the Commissions
efforts lead to a system that does not need to save the banks every decade or two.
This is important. To me, Ive been analyzing an industry on steroids whose prior
achievements were artificially enhanced. Benefits were front-loaded and costs were back-
ended. We are now paying the price in what will likely be the biggest taxpayer bailout of US
financial firms in history and, given government borrowing, the biggest wealth transfer to the
current generation from future generations, that is, my children.
Im shocked and amazed that more changes to banks have not taken place. There seems to
be an unwritten premise that a healthy Wall Street as it is constituted today is necessary for
the economy to work. Yet, the economy worked well before inventions of exotic instruments
such as CDOs and with risk that was more obvious and easy to see. Wall St. has done an
incredible job at pulling the wool over the eyes of government and others. Perhaps this
relates to the size of the banks. The four banks that presented this morning have annual
revenues of $300B, or close to the GDP of the 30th largest country, Argentina.
My perspective: Ive analyzed banks since the late 1980s, worked at 6 of the largest
brokerage firms, currently work in affiliation with one of the most independent research
platforms2, and wrote critical research on the banks in excess of 10,000 pages over the past
decade. The more critical issues that I focused on have been the negative implications of
slower economic activity on the growth and quality of bank loans; excessive lending related
1
Main summary is in CLSA reports, The Seven Deadly Sins, April 20, 2009 (first 40
pages). Accounting relaxation is discussed in CLSA reports Relaxing the Rules: Softer
Stance on US Bank Accounting, Nov. 2009 and Weighing in: NPAs and bank balance
sheets, Oct. 2009. Ongoing issues are discussed in the CLSA report Property Pressure
Exposure to Commercial Real Estate Makes Banks Vulnerable, June 11, 2009.
2
Asia Money, Nov. 2009; CLSA has a number one ranking in Asia, the home market.
One enhanced performance with excessive loan growth: Banks and the
financial industry in general grew loans twice as fast as the natural rate,
approaching 8% or about 10% or more adjusting for securitization (pre-crisis),
above nominal GDP of 5%. We consensus strongly believed that nominal
GDP would slow for the past decade, but banks still pushed for loans that
should never have been made. This difference is even greater after adjusting
for securitization of loans, or when banks packaged and sold loans, often with
little if any skin in the game with regard to the loans performance.
Two pumped up profits with higher yielding assets: Higher yields means
higher interest rates and for banks higher interest rates mean higher
profits. To pick two higher risk loan categories, for the last decade, banks
had over 20% average annual loan growth in home equity and over 15%
average annual growth in construction loans, areas with higher than typical
yields. In securities, banks reduced the percentage of low yielding treasuries
from 32% in the early 1990s to under 2% in favor of more risky securities. In
the extreme, the ability of a bank to make higher profits in the short-term is as
easy as making a phone call. The issue is that higher yields get realized
immediately but it comes with higher risk that gets paid later.
Three side effects ignored with concentration of assets: The rush in real
estate was no secret. Of the 11 loan categories listed by the FDIC, all five of
the fastest growing loan categories were real estate related. This is as simple
as the old banking adage, if it grows like a weed, maybe it is a weed or,
perhaps more generally, dont put all your eggs in one basket.
Four higher dosage with higher balance sheet leverage at banks and brokers.
By 2006 before the problems hit the industry U.S. banks had the highest
level of leverage in a quarter of a century. There are many ways to look at
this, but I took tangible capital and reserves for loan losses (source: FDIC).
This data was also not a secret since the data comes directly from bank
regulators. Similarly, leverage in the brokerage industry steadily increased
from 20x in the 1980s to 30x in the 1990s to almost 40x in the past decade
until shortly before the crisis (source: SIFMA).
Six consumers went along for the ride. Consumer debt to GDP has reached
a record level of 100%, versus only 50% 25 years ago. This leveraging
created a false illusion of prosperity that allowed for the purchase of homes,
cars, and other items, many of which should have never been financed and
purchased. It is no secret that everyone from kids, pets, and dead people
received solicitations for loans.
Nine the government doled out some of these steroids. GSEs and their role
in the mortgage market helped to accelerate the growth in housing related
securities via subsidies to banks and consumers whose absence would have
meant less of a housing bubble. The government created more of a command
Ten incentives encouraged the behavior. To still further the analogy, the
system shunted the doctors, that is, those whose job it is to report on the
financial health of companies and the industry, in lieu of those with more
positive outlooks. Compensation of banks steadily tracked revenues for all of
last decade. The problem is that compensation only tracked profits until
losses increased later in the decade, highlighting that prior compensation was
far above normal after incorporating losses that were attributable to prior year
revenues. I saw issues first hand. First, in the past decade (2000-2008), the
stocks in the bank index (BKX) declined by over 40% but industry
compensation failed to decline in a similar amount. Yet, when I wrote about
compensation issues a decade ago, the reaction about me was that these issues
were none of my business3. Second, only 7 months after I testified to
Congress in 2002 about the backlash against analysts who provide unflattering
research, I faced what I saw as backlash by a large bank against me and my
critical views when I had lack of management access similar to others. It
reached a point where I put a disclaimer about this lack of access in my
research reports. My point is that if I face a backlash even after I testify to
Congress on backlashes, how can a loan officer who is under pressure to
produce loans realistically say Maybe we should sell less loans? and keep
their job.
In summary, the banking industry has been on the equivalent of steroids. Performance was
enhanced by excessive loan growth, loan risk, securities yields, bank leverage, and consumer
leverage, and conducted by bankers, accountants, regulators, government, and consumers.
Side effects were ignored and there was little short-term financial incentive to slow down the
process despite longer-term risks.
Part of the solution is as easy as ABC A for accounting, B for bankruptcy, and C for
capital. Let me explain.
The A for accounting: The first and easiest change is to allow banks to more fully reflect
potential loan losses by taking larger reserves for their problems, that is, reverse the impact
of the 1998 decision by the SEC. In other words, let the bank regulators take charge again
and allow banks to fully reserve for their problem loans safety and soundness concerns
supersede other considerations. Thats always been clear to many of us. Also, more
transparency with reserving methodologies would be helpful as well. While all loans are not
created equal in terms of risks and rewards, perhaps some baseline level of reserves would
be helpful.
3
Fortune, 2/5/01, page 132, The Price of Being Right
The B for bankruptcy: The worst precedent was the 1998 rescue of Long-Term Capital
Management. If a hedge fund of that size was going to get bailed out, what would this mean
for other more important firms and the ability to take outsized risks? Bankruptcy is part of
our system, whether for banks, borrowers, or others. Why should the prudent subsidize the
imprudent? Having said this, some of the exceptions were necessitated by unclear rules. It is
time to make the rules clear.
So, of course, this leads to the question of whether banks are or should be too big to fail. I
agree with Jamie Dimons comments before today that bankruptcy needs to be more of a part
of the system. Yet, I also feel that it is unrealistic to think that JP Morgan would ever fail. To
the extent that there are banks with $2T balance sheets that are, in reality, too big to fail (as
opposed to many other entities), there is a question of what price and how these banks should
pay for this special status.
The C for capital. There should not be a question of whether banks have enough capital.
During the crisis, banks were considered as precious as the most important utility. Imagine
turning on the spigot and finding out that the water does not work? Similarly, the capital at
banks should help ensure that failure of banks and the system is beyond any doubt - not a
reasonable one but beyond any doubt as to whether banks will easily open for business on
any given day, even one of the worst in business history.
In other words, capitalism did not cause the problems as opposed to a lack of capitalism,
whether with regard to having good information to make decisions, allowing companies to
fail, ensuring that banks pay for external costs (even contingent ones) that they cause, and
having markets more than government allocate capital, albeit with limits and effective
oversight.
Lastly, one word that is not spoken enough when it comes to our jobs in the financial markets
is meaning. Goldman Sachs has often said that it is long-term greedy, but this too
narrowly states its larger role. This years annual reports could probably give a reminder
about the purpose of financial services to an effective economic system and society. For
evidence, I look no further than my cousin Andy who is going from Iraq and the Army to
business school in the fall.
This sums up the larger purpose of what we do in financial services to improve peoples lives
by moving scarce resources to where they can best get used. I hope that the Commissions
efforts lead to greater awareness of this purpose and facilitates its execution by preventing
future crisis as severe as the current one.
January 2010
The views and opinions expressed in this document and the oral testimony I will provide to the Financial Crisis Inquiry
Commission are solely my own and do not necessarily reflect the views of my employer or any other institution or person I
am currently affiliated with or have been in the past.
13 January 2010 mike.mayo@clsa.com 9
Industry on Steroids
1) Excessive Loan Growth
3) Concentration of Assets
7) Accountants Assisted
8) Regulators Aided
9) Government Facilitated
12%
10%
Securitization (Est.)
8%
6%
4% Loans
2%
0%
GDP Growth Loan Growth
50%
40%
40%
30%
32%
20%
10%
2%
0%
1992 19 94 1996 19 98 2000 2002 2004 2 006 2008
Leases
Agriculture
Farmland
Credit Cards
Total Loans
Home Equity
Page 5
13 January 2010 mike.mayo@clsa.com 13
4) Balance Sheet Leverage
Leverage increased
15 x
Banks
14 x
13 x
12 x
11 x
Tang assets/(Tang equity + reserves)
10 x
19 93 199 5 1997 1 999 20 01 200 3 2005 2 007
Securities Industry
40x
35x
Assets/Total Equity
30x
25x
20x
15x
10x
1980s 1990s 2000s
Page 6
14 mike.mayo@clsa.com 13 January 2010
5) More Exotic Securities
Fees are a larger percentage of revenues
Fees as % of Revenues
45 %
40 %
35 %
30 %
25 %
20 %
15 %
1951
1956
1961
1966
1971
1976
1981
1986
1991
1996
2001
2006
Source: FDIC -All Banks
Household Debt-to-GDP
120%
100%
80%
60%
40%
20%
0%
48
54
60
66
72
78
84
87
90
96
99
02
05
08
45
51
57
63
69
75
81
93
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
20
20
20
Source: Federal Reserve, Bureau of Economic Analysis
Reserves to Loans
2.0%
1.8%
1.6%
1.4%
1.2%
1.0%
1998 2000 2002 2004 2006
Source: FDIC All banks
25 (bps)
20
15
10
0
1935 1941 1947 1953 1959 1965 1971 1977 1983 1989 1995 2001 2007
$3.5
$3.1
$3.0
$2.5
$2.0
$Trillion
$1.5
$1.0
$0.5
$0.5
$0.0
1990 2009_Q3
45%
Compensation/(Revenue less loan losses)
40%
35%
30%
25%
Compensation/Revenue
20%
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Excesses conducted by
Bankers
Accountants
Regulators
Government
Consumers
A for Accounting
B for Bankruptcy
C for Capital
IMPORTANT DISCLOSURES
Analyst certification
I, Mike Mayo, CFA, hereby certify that the views expressed in this research report accurately reflect my own
personal views about the securities and/or the issuers and that no part of my compensation was, is, or will be
directly or indirectly related to the specific recommendation or views contained in this research report. In
addition, the analysts included herein attest that they were not in possession of any material, non-public
information regarding the subject company at the time of publication of the report.
EVA is a registered trademark of Stern, Stewart & Co. "CL" in charts and tables stands for Calyon Securities
(USA) Inc. estimates unless otherwise noted in the Source. Calyon Securities (USA) Inc. does and seeks to do
business with companies in its research reports. As a result, investors should be aware that the firm may have
a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only
a single factor in making their investment decision.RATING RECOMMENDATIONS: Buy = Expected to
outperform the local market by >10%; Outperform (O-PF) = Expected to outperform the local market by
0-10%; Underperform (U-PF) = Expected to underperform the local market by 0-10%; Sell = Expected to
underperform the local market by >10%. Performance is defined as 12-month total return (including
dividends). Overall rating distribution for Calyon Securities (USA) Inc. Equity Universe: Buy / Outperform -
82%, Underperform / Sell - 18%, Restricted - 0%. Data as of 31 December 2009. INVESTMENT BANKING
CLIENTS as a % of rating category: Buy / Outperform - 16%, Underperform / Sell - 16%, Restricted - 0%.
Data for 12-month period ending 31 December 2009. Prior to 25 November 2008, Calyon Securities (USA) Inc.
used an absolute system (based on anticipated returns over a 12-month period): Buy: above 20%; Add:
10%-20%; Neutral: +/-10%; Reduce: negative 10-20%; Sell, below 20% (including dividends). FOR A
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