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Too Big to Regulate? The Warren Debut

posted by Adam Levitin

Elizabeth Warren’s questioning of financial regulators at her first Senate Banking Committee hearing got a lot of attention for her pointed question about when was the last time any of their agencies had taken a large bank to trial.  It was a telling exchange, but I think the attention it received overshadowed her even more interesting second question (here at 04:29):  why is the market capitalization of the major banks lower than their book value?

Typically companies' market cap is above their book value, but for many large banks, it has been below since 2008. JPMorgan Chase, however, has a book value of $195 billion, but a market cap of just $186 billion.  (Market:Book of 95%)  And Bank of America has a book value is $218 billion, but the market cap is only $129 billion.  (Market:Book is just 59%.)  What accounts for the staggering $89 billion gap? To put things in perspective, a bank with $89 billion in assets would be the sixth largest in the US, just behind Goldman Sachs, and just ahead of MetLife and Morgan Stanley. 

Senator Warren proposed two possible (and possibly consistent) answers: that investors think the banks have inflated books or that they're too big to manage. 

(1) Concerns about inflated books.  One reason market cap may be less that book value is that investors believe the banks are not recognizing losses and are carrying assets (like mortgages) at inflated values on their books. If the market is correct, this implies that bank regulators aren't doing their job by forcing the banks to take the write-downs or do the reserving necessary.  And it also dovetails with the mortgage modification and mortgage putback issues.  If banks have to carry mortgages at market values, then modification won't result in such major loss recognition, while if the banks start more realistic putback reserves, they will be perhaps more inclined to settle putback claims. (Before anyone chimes in, yes, I understand very well that write-downs and putbacks are governed by accounting rules, but there is still some judgment involved.)  

(2) Too Big to Manage. The other possibility, Warren suggested, is that there could be a management discount for the banks. The large banks are just unmanageable, so investors are discounting the book value of the assets to reflect the negative management synergies created by large banks. This would imply that for the health of the US banking system, the big banks need to get broken up.  It would also raise the question of why shareholders haven't pushed for the banks' breakup.  

When asked to comment, only Federal Reserve Governor Daniel Tarullo responded.  (There was something fantastic about one former law professor grilling another about bank regulation in a Senate hearing.)  Notably, Tarullo did not disagree with Warren, nor did he say anything about the possibility of inflated books. The nonresponsiveness on that point was telling. Instead, Tarullo suggested a third possible explanation for the maket-book gap:  investor skepticism that the banks would produce sufficient returns on equity.

Tarullo explained that a sufficient return on equity would be something above the return produced by the individual parts of the bank. I don't completely understand what he meant, but I take it as a statement that investors are skeptical that there is any going concern value in the banks. He then went on to tie this to uncertainty--very carefully stating that this is what bank analysts would say, rather than what he would say--about the regulatory environment and the "franchise value" of the institutions and "the environment of economic uncertainty."  

Theoretically, Tarullo is certainly right that market cap might be depressed for the large banks because of regulatory uncertainty. Depending on how big banks are regulated, they may become less attractive investment opportunities. That said, I have trouble believing that this explains all or even most of the market-book gap. First, it would indicate that the market believes there is a considerable chance that the Fed and/or Congress will engage in meaningful regulation of too-big-to-fail. Nobody (query if that includes Governor Tarullo) believes that is likely to happen. To the contrary, there may still be a too-big-to-fail premium, which would be narrowing the maket-book gap. Second, it's not clear why regulatory uncertainty would produce such different market:book ratios for BofA and JPM. (The fact that the market-book gap has shrunk since 2008 might also suggest that the market thinks the likelihood of ending too-big-to-fail is declining.)  

The "franchise value" part of the answer confused me, perhaps because of terminology. I think Tarullo was essentially stating to the too-big-to-manage point, but framing it differently, in that there aren't synergies from being big and diversified operationally. 

As far as "economic uncertainty"-it's hard to know exactly what Tarullo meant, but given that the Fed has told us that rates are going to basically be zero for the next couple of years, one wonders how much uncertainty there really is beyond what always exists. Perhaps this was in reference to continued manufactured federal debt and budget crises. 

Senator Warren's second question was one of the most probing inquires put to banking regulators in the past five years. Basically, they were being asked whether they were coddling too-big-to-fail banks by letting them pretend to be solvent or stronger than they are. In other words, she was asking whether the Emperor has no clothes. The question was technical enough that the media didn't pick up on just what an awkward inquiry is was, but I think it deserves some attention. 

When combined with the question about lack of prosecution, the market-book question points to a deeper underlying concern:  that prudential bank regulators are unwilling to undertake regulatory actions that in any way rile the financial system. Whether this would be because of regulatory capture or a fear of triggering another financial crisis is not clear to me, but it speaks to a fundamentally unregulatable industry, at least as currently structured.

Comments

Another question presents, is market value derived from profits as fees on tangibles or intangibles transaction value? Does it really matter how the next financial crisis is triggered?

Adam:

Thank you for sharing this thoughtful and insightful discussion of Sen. Warren's questions relating to market capitalization.

For those who are younger or who have short memories of financial history, it was precisely this kind of market capitalization issue that exacerbated and extended the Savings & Loan Crisis in the late 1980s and early 1990s.

The first phase of that S&L collapse was largely brought about by interest rate mismatch of S&L assets and deposits. The thrifts were largely invested in fixed rate residential mortgages (or RMBS) with very long maturities and thus long durations (as that term is used to describe interest rate risk).

S&Ls funded these long duration assets using relatively short term time deposits, mostly 1-year, 2-year and 5-year certificates of deposit.

When the Federal Reserve Board drove interest rates much higher to wring inflation out of the economy, the value of the long term fixed rate assets collapsed. Given the relatively thin regulatory capitalization of all depository institutions, essentially ALL of the S&Ls in the United States were insolvent.

The first phase of the S&L collapse was brought about not by reckless lending (or excessive credit risk), but rather by the implicit price risk associated with funding long term fixed rate assets with much shorter term deposits that re-priced much more quickly. That is the problem was PRICE RISK, not credit risk.

Wall Street instantly recognized that the S&Ls were all bleeding losses and cash. Essentially every S&L asset was being funded by CDs bearing not just nominally higher interests, but rates much higher than the yield on the longer term fixed rate mortgage assets, assuring continuing recognized losses every quarter.

Yet because GAAP accounting rules did NOT require ANY of these institutions to "mark to market" -- to reflect losses on the otherwise unrealized decreases in asset values -- regulators left almost ALL of these institutions in business and even sought to cope with the problem by further de-regulation.

The market's recognition that these institutions were insolvent meant the the market capitalization of every thrift was pennies on the dollar when compared to inflated GAAP book values. This, in turn, had a rather remarkable second order effect driving the second and more widely recognized aspect of the collapse.

By leaving the insolvent institutions OPEN speculators and business interests with large capital needs were able to obtain control of a number of insolvent S&Ls for the actual speculative value of these zombie institutions. If the new owners and management had done nothing, after a while each of these entities would have exhausted its regulatory capital through the ongoing GAAP losses, as actually realized. Only by engaging in exceptionally high risk and high reward projects did any of these entities have any hope of surviving. The most unscrupulous also focused on those high risk projects that might be best described as self-dealing. Owners and management behaved generally rationally, if seemingly recklessly or even dishonestly.

My point here is that market capitalization really MATTERS, particularly with respect to taxpayer insured depository institutions. Ironically, at the date of the S&L crisis, NONE of the failed thrifts was "too big to fail". The trouble for regulators was that essentially ALL of these institutions had failed if one applied mark to market accounting. When Congress and the regulators were reluctant to recognize the losses and shut down (or recapitalize) the insolvent entities, the costs of the ultimate day of reckoning were vastly amplified. Kicking the can down the road can be very, very expensive!

Now we have moved from an unwillingness to address a systemic industrywide problem to an unwillingness to put into receivership and break up even a single "too big to fail" entity. Any person of ordinary common sense recognizes that no "too big to fail" depository institution should exist. ALL of these institutions need to be broken up, NOT because these are currently insolvent as was the case during the S&L crisis, but rather because when such entities are in crisis legislative and regulatory cowardice is sure to again prevail, once more sticking the taxpayers with the losses while allowing investors and managers to enjoy the exclusive and undeserved rewards.

Thanks again for your post! I wanted to add a note of historical perspective.

Adam,

It's distressing that any member of the Senate Finance Committee has such a poor understanding of how or why stocks are valued the way they are by the market, but even moreso when someone who's got such an interventionist bent as Sen. Warren.

Stocks of Financial Services firms that are capital intensive (banks/insurers) are often valued as a multiple of Shareholders' Equity and that multiple is frequently correlated with Return on Shareholders' Equity.

Ms. Warren and others have asked for/demanded large banks to hold more equity as a percent of assets than smaller banks. Since large banks have no greater pricing power than small banks, then their returns on equity will be structurally lower than that of smaller banks, and if the P/B to ROE regression holds, will be valued perpetually at lower P/B multiples.

I'm fairly certain Ms. Warren and/or her staff has been briefed on this by representatives of the largest mutual fund firms, so for her to inquire about it at a hearing indicates she either failed to absorb the information that was previously presented to her, or she's grandstanding for political purposes.

m.jed--I don't think this has anything to do with the capital intensive nature of banking and the way bank stocks are valued. The simple matter is that before 2008, market to book ratios were greater than 1 and post-2008 they have been less than 1. The method for valuing bank stocks didn't change, so the question is why is there now a discrepancy between banks' books and their market valuation. This isn't due to leverage limitations, which are applying to all banks equally at this point, not just big ones.

Also, it's Senate Banking, not Senate Finance. That's a separate committee.

Leverage limitations are absolutely greater for big banks - that's what the G-Sifi buffer is. Prior to 2008, there was no such buffer and now there is. Prior to 2008, there was no Volcker Rule and now there is. Both of these lower ROEs for the big banks and don't affect small banks nearly to the same extent, if at all. Further, the securitization markets are much smaller and in some cases have disappeared - which was another way large banks used to boost their ROEs that is no longer possible (though not due to exogenous factors the way Sifi Buffer and Volcker).

You're right that the valuation paradigm hasn't changed, but the structural ROEs of large banks has been impaired.

The G-SIFI capital surcharge doesn't kick in until 2016 (if it ever will), and is quite modest. Even if the market is pricing it in already, it surely doesn't explain BofA's market-book gap.

Analysts are estimating around $1.00 of EPS on a $20 BVPS for BAC this year, which is a Return on Average Equity of less than 5%. According to Google Finance, BAC has a beta of 2.39 - I assume this is a one-year historical beta, but it's not clear. Assuming a forward beta of 1.75, a benchmark expected return of 8% (6% equity risk premium over the 10-year yield of 2%), implies a cost of equity capital of around 12%, which means BAC would have to have EPS of around $2.50 to justify trading at parity with book.

USB, on the other hand, is forecast to have an ROE of 16% has a beta of 1.0, and trades at around 1.9x book value on its equity cost of capital of 8%.

Both valuations are reasonably consistent with basic finance theory, although in this context one could make the case that BAC is expensive and USB is cheap.

m.jed, so far as I can tell you don't actually disagree with Adam at all. That method of pricing should not result in a huge discrepancy between book value and market cap. You've just expressed it differently. Considering the book value of BofA, they should have a significantly higher EPS, such that when EPS is reflected in market cap, the market cap is not significantly less than the book value.

It's like Adam said, "5 + 8 < 20" and you said, "no, Adam, 5 + 8 is really 5 + 5 + 3."

Good discussion. I would add that the market vs. book analysis for the large US banks also needs to consider the banks' HELOC exposures. The top 4 banks hold upwards of $300B of HELOC loans at par, despite the fact that there is very little housing value remaining behind the loans. Ultimately, the 1st mortgages in front of these 2nd may be impaired and pressure will be on the banks to realize significant embedded losses on the 2nds. Other than that, I mostly agree with m.jed, the market is discounting lower future ROEs.

Connor - that method of pricing should and does result in a huge discrepancy of book value - if you earn half you're required cost of capital, you trade at 1/2 book, if you earn double you're cost of capital, your trade at 2x book. That strikes me as a pretty large discrepancy. I used the $2.50 example to point out how far they are from earning their cost of capital - justifying trading at book. There's no way BAC can earn $2.50.

The larger point is that Sen. Warren's rationalized explanation for large discounts to book value failed to take into recognize (a) basic finance theory and (b) that regulators are now, or published regulations that plan to, treat larger banks differently than smaller banks and have removed the ability to earn profits in what has historically been lower capital intensive/higher ROE business lines (e.g., prop trading).

Adam thinks the G-Sifi Buffer isn't that big a deal. The Nomura analyst (per FT Alphaville) estimates that BAC will have to carry around an extra $12.5 bn to comply - that's about another $1.00 of Book Value per share that has no ability to generate additional earnings, so reduces their already paltry ROE by another 25 bps.

I suspect we might be overthinking this a little bit. The big banks have market-book multiples below 1.00 because their shares are trading at historically low levels. Their shares are trading at historically low levels because the market is skeptical about their viability after emerging from a financial crisis where most of them nearly collapsed.

Fascinating discussion here. If I may, I'd like to offer an argument in favor of Warren's #1 and against Tarullo's contra.

In my position as a market participant, BAC and its ilk present a mergers and acquisition concern. Simply put, if BAC's assets were truly worth $218B, then a financier (or, more plausibly, a group) could make an offer on all the public equity of the company at some price between $129B and $218B. Once the company has been taken private, the owners would have the ability to control the company (including disposition of assets) as they see fit. This would work equally well whether the assets were sold or operated as going concerns.

The fact that BAC has been in this situation (P

On the other hand, we might be underthinking it. First, it may be that I'm just not bright enough to be a professor, but what does Tarullo's "third way" add to the discussion other than obfuscation? Is he really claiming regulatory uncertainty has become a substantial and independent bogeyman for investors? I would think that "regulatory uncertainty" is actually an element of Warren's points: 1) Regulations will finally disallow inflated books, so market value will sink; 2) management won't be able to handle new regulations. Tarullo seems to be doing nothing but recharacterizing Warren's points so he can wave the bloody shirt of "over-regulation" to distract everyone from the structural flaws of the industry itself.

(As an aside aimed directly at the focus of this blog, Tarullo's "going concern" comments may have been the most interesting part. Is he stating, or at least implying, that by the time a financial institution gets to this point, there is no going concern value and so no point to the Chapter 11 or quasi-Chapter 11 regimes that have been proposed?)

Second, there is just no way this gap is caused by Glenn Schorr's now two-year-old noodlings on G-Sifi. The proposals have changed, and as Adam has pointed out, it's an open question whether they will ever be implemented. Also, the principle behind the G-Sifi is to create a disincentive to diseconomies of scale, which I can't see as a bad thing (Why do we need disincentives when the diseconomies impose their own penalties? Because the diseconomies obviously do not. Because contrary to m.jed's allegations, the Bigs do have more pricing power than the Smalls simply because they have the political power to distort the market.). Further, the G-Sifi can be gamed through corporate structuring, and if the management for the Bigs can't figure out how, I direct you to Warren's second point. Finally, as Alphaville noted, Schorr left one side of the ledger out of his calculations, namely gains from a more stable financial system.

Third, I'm old enough to remember the S&L debacle, and my memory is good. It's true that the initial problem for S&Ls was pricing, as their revenues from loans could not keep pace with their cost of capital. But the response was what created the avalanche. It was the first sermon from the Gospel of Deregulation that has put us where we are now: Garn-St. Germain. Investment restrictions were removed from the S&Ls, state-chartered thrifts were allowed to offer whatever instruments the nationals were, and ARMs became the new normal. The S&Ls changed overnight from sleepy, little places the Baileys ran five or six hours a day to the first of our modern, financial casinos. The results were predictable. Here in Utah, the state thrifts cratered first (helped greatly by mismanagement of the crisis by the state insurance fund), then everything else followed, and bank consolidation was launched with jet packs, giving birth to the Bigs.

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