Reserve Releases Remind Us that Bad Habits Die Hard in Banking Industry

Originally posted by Yuval Bar-Or on Oct 12, 2012  

It’s earnings season, and this time the focus is on reserve releases at banks. Reserves, as the name implies, are funds set aside to absorb expected losses. Reserve releases occur when banks feel that storm clouds have cleared and that there is no longer a need to maintain such a large buffer of reserves. In “releasing” reserves bank managers are able to redirect freed-up dollars to earnings. According to a Wall Street Journal analysis, “The four biggest U.S. banks have released $18.2 billion of reserves over the past four quarters reported, or 23% of their pretax income.” Among these are Bank of America Corp. (BAC) and Citigroup Inc. (C).

So, are reserve releases a bad thing?

On the face of it, the releasing of reserves (as an economy improves) is a reasonable action. It is typical to observe reserves building up as banks’ expected losses mount, and to see a reversal when the dust settles. But some caution is required.

Finance professionals (institutional investors and analysts) are well aware of the boost to earnings from reserve releases, and they adjust their analyses accordingly. Smaller, less sophisticated investors may not be aware that earnings have been boosted by reserve releases. They may incorrectly interpret the dramatically rising earnings as definitive signs that the economy has turned the corner, signaling clear skies ahead.

In fact, with concerns about Europe and China ongoing, as well as potential conflict in the Middle East, there are still significant clouds on the horizon.

Perhaps most importantly, recent reserve releases are a painful reminder that banks may still not be “getting it” when it comes to risk management best practices. Professional risk managers know that the key to managing risk is to be proactive. Instead of waiting for damage or loss to manifest and then trying to clean up the mess, it is far better to anticipate and take preventive measures in advance. The ongoing reserve releases are a painful reminder that banks took too long to set aside reserves to address significant housing market losses. Instead of being ahead of the curve, banks reacted after the fact. This is especially disturbing considering that reserves are set aside to cover expected losses, i.e., those that bankers are supposed to be able to predict. (In contrast, unexpected losses are addressed through economic capital).

While bankers reactively raised reserves several years ago, they are now proactively (and perhaps prematurely) releasing them.

If the risk management logic is so obviously against this behavior pattern, why do banks persist in exhibiting it?

A simple answer is that bank management teams are following incentives and catering to financial markets’ short term thinking. As a downturn looms, banks are reluctant to increase reserves because such actions lower earnings, potentially depressing stock prices and affecting management bonuses and promotions. When it becomes clear that reserves are urgently needed, the banks must make enormous reserve contributions to catch up. Many of them refer to this as “taking a hit,” and they prefer to take one big hit rather than steady reserve increases because the single big hit is soon forgotten by markets focused on 90-day (quarterly) reporting windows. When markets stabilize, banks waste no time in releasing reserves, seeking to (as soon as possible) improve their earnings picture and benefit from improved bonuses.

No  One Wants to be First

Imagine one bank that decides to do the right thing. As storm clouds gather, the bank increases reserves significantly and proactively. Here’s where this sad story turns truly ironic. Instead of being given credit for responsible, forward-looking risk management, the market concludes that this bank has deeper problems than the rest, otherwise why would it be the only one increasing reserves? And so, the market hammers that bank’s stock price, while the less-responsible competitors are unaffected. Fear of such an outcome, in markets focused on quarterly earnings reports, constrains bank management teams from doing the right thing.

Whenever we see large reserves being released, which is inconsistent with proactive risk management and proper strategic planning, we are reminded that bad habits die hard in the banking industry.

Media Wrongly Suggest Thiel Fellowships Threaten College Education

Originally posted by Yuval Bar-Or on Jan 14, 2012  

The Thiel Foundation is currently processing hundreds of applications for its second class of Thiel Fellowships. Each of twenty winners will receive a $100,000 grant to pursue an entrepreneurial venture and must in turn agree to skip college for at least two years. Some in the media suggest Peter Thiel is using his Fellowships to brazenly challenge and undermine mainstream college education. But they are wrong.

Mr. Thiel has been widely quoted stating his belief that college education is the next bubble. According to Mr. Thiel, students are paying far too much for education and taking on too much debt given the value they are receiving in return. Furthermore, the colleges they are paying all that money to have gotten in the business of credentialing instead of educating, and this threatens to undermine innovation in the United States.

Lots of people have concerns about the declining quality and increasing costs of education. Mr. Thiel’s comments stand out because he is an outspoken libertarian billionaire who has repeatedly put his money where his mouth is. A partner at the Founders Fund, Mr. Thiel was a co-founder of PayPal and the first outside investor in Facebook. Notably, he is a young entrepreneur on the prowl for disruptive technologies. And this is perhaps why the media has piled on, with CNBC’s Maria Bartiromo interviewing Mr. Thiel on December 15, 2011 under the headline “Thiel’s Campaign Against College” and Forbes’ Brian Caulfield stating that the Fellowships are a “jab to the kidneys of the higher education industry.”

I happen to agree with Mr. Thiel that college tuition costs too much and that credentialing is overshadowing education. And we have been suffering from stagnation in the areas of biotechnology and energy innovation, among others. I should clarify that my concern is with the hype around the Fellowships’ potential impact on college education—not the Fellowships themselves. I am also not taking a position on Mr. Thiel’s libertarian views, which have been widely reported and criticized. Setting aside questions about Mr. Thiel’s motives for creating the Fellowships, his gesture is a generous one, and the experience recipients will gain over the course of two years will likely prove quite meaningful for them.

The Fellowships are not a threat to the traditional college education because in themselves they represent less than a drop in the bucket. Fellowships are awarded to 20 students under the age of 20 each year. Compare this to the over 1.5 million students who enroll in or graduate from America’s colleges annually. Convincing 20 students to delay, or drop out of, college, is an insignificant number.

20 under 20 is not a solution to what ails colleges and our education system. It is at most a small scale (but well-hyped) protest. If Mr. Thiel wants to pop the education bubble he’s going to need something scalable. As he himself admitted to George Packer in the New Yorker on November 28, 2011, he wanted to create a university but dropped the idea. He has also openly acknowledged that any of the Fellowship recipients are welcome to pursue or return to college after spending two years on their venture. None of this amounts to a credible attack on the existing system of education.

In much the same way that the potential impact of the Fellowships on education has been misrepresented by the media, the Fellowships’ ultimate success or failure will likely be misinterpreted. Many will measure their success based on the Fellows’ commercial achievements. If any of the Fellows do realize significant success the media will likely proclaim that Thiel has slain the education bubble. The media will have missed the mark because a handful of commercial successes does nothing to fix an educational system tasked with the education of millions. If none of the Fellows hit it big (and the odds are against most of them statistically), there are those who will declare that Thiel’s challenge to the established college order has failed. They too will have missed the point. The correct measure in the education context is not whether the Fellows become billionaires but rather whether they learn and grow. Two years of intense experience working on exciting projects alongside like-minded, enthusiastic people will undoubtedly be a meaningful educational opportunity. Fellows don’t need to become wealthy to have spent their two years well. In this sense the Thiel Fellowships are a slam dunk—a unique opportunity for twenty intelligent and motivated youngsters to learn and grow.

But if Mr. Thiel wants to take a serious swipe at the educational establishment (and it’s not clear that this is his intent)—if he really wants a viable shot at bursting the education or credential bubble, he’s going to need something scalable: an approach that provides a meaningful learning opportunity for 20,000—not just for 20. And if he does seek to bring some disruptive technology to bear on education, he’s going to have to make sure it has surgical precision. This is because the academic community serves several crucial and interrelated functions for society which we don’t want disrupted.

The first of these functions, and the subject of this article, is education. Many agree that the current process is inefficient, outrageously expensive, subject to grade inflation, and possible lack of commitment by administrators and faculty focused more on research, debates about property rights, cost-cutting, the erosion of tenure, etc. (I discuss these in the book “Is a PhD for Me? Life in the Ivory Tower”). For all these reasons and others we do want education constructively “disrupted.” But we don’t want this disruption to lead to unintended consequences for the following two functions:

  1. Maintaining the integrity of the scientific method. Ensuring that scientific experimentation is valid and reliable and that research results are interpreted honestly and not abused by hidden or not so hidden agendas of corporations or politicians.
  2. Promoting freedom of expression. For centuries, universities have been a platform and a battleground for those wishing to speak freely and challenge the established order. Dissident professors and rebellious students have significantly shaped the world. The point of the tenure system, under which a tenured professor cannot be fired, is to protect academicians from political machination and to ensure that they have the freedom to express themselves. This is a cornerstone of the democratic system, alongside aggressive journalism and an independent judiciary.

There is little doubt that the traditional model of college education, which has been in effect for hundreds of years, requires updating for the 21st century. Because this subject is so crucial to development of future innovators, managers and leaders, we must do it properly. Hyping a very focused initiative that applies to a mere 20 people distracts us from the more thoughtful and comprehensive planning that is really needed to make lasting and meaningful change.

Q&A with KBRA

Several months ago I profiled Kroll Bond Rating Agency (KBRA), the new kid on the rating agency block. At the time I concluded that KBRA’s success and its impact on the rating industry remained to be seen and I documented several questions that would likely determine whether KBRA could revolutionize the ratings industry.

Recently, I had an opportunity to pose these questions directly to KBRA’s management: Mr. Jules Kroll, Chairman and CEO, and Mr. James Nadler, President and COO.

Yuval Bar-Or: What do you think would happen (to financial markets, competition, regulation) if the NRSRO designation was abolished?

James Nadler: The issue is that if you abolish the NRSRO designation, what would take its place? … I guess the real sub-question there is: is there something that can easily replace that system and be used that will allow the NRSRO designation to be abolished and for financial markets to continue to move forward.

Yuval Bar-Or: Let’s not worry about predetermining what the replacement would be. Let’s just say that the designation no longer exists … would [there] be market turmoil?

James Nadler: Probably not …

Yuval Bar-Or: Would you support abolishing the NRSRO designation?

James Nadler: I know that Moody’s and S&P and Fitch have historically supported abolishing the NRSRO … I don’t view it as a positive or a negative and we would go about our business whether we had the NRSRO designation or not.

Yuval Bar-Or: How can KBRA displace the incumbent oligopoly and revitalize the industry if it embraces the same embattled and many would say, discredited, issuer pays model?

James Nadler: I certainly understand the notion that in a perfect world it would be great if there were such a thing as an investor pay model because it would remove the conflict … The facts are that the very large complexes that buy fixed income securities don’t need the rating agencies because they do their own work. It is far and away the 80 percent of investors who don’t have the wherewithal to cover all of the various securities that the rating agencies provide that really need rating agencies but also don’t have the wherewithal to pay for the ratings. So it’s a market reality that to have a meaningful platform to talk about issues in the fixed income market to rate bonds in a meaningful way and to really have a meaningful impact and help investors you need to be organized as a rating agency that uses the issuer pays model and I think that that said you need to realize that there are inherent conflicts and you need to organize yourself internally so that you ameliorate those conflicts.

Yuval Bar-Or: Is it physically possible for K2 Global to investigate and monitor enough entities to support KBRA’s intended growth?

James Nadler: K2 global is simply one of the outside groups that we potentially could use on a transaction and so our due diligence capabilities are not limited at all by K2’s capabilities. If for instance K2 didn’t have a particular capability that we needed we would go outside or if they for some reason weren’t staffed to get it done we would go outside so our due diligence capability isn’t limited by K2’s size or growth plan.

Yuval Bar-Or: Would you not then potentially run into problems with inconsistency if different providers use their own techniques or follow their own [investigative] procedures?

James Nadler: You have to have a good idea of how you want the work to be done and guidelines for how you review the output so that you can maintain as much consistency as possible. Now you’re always going to have slight inconsistencies. You’re going to have an inconsistency depending on which analyst you get but hopefully the framework in which you do it ameliorates those inconsistencies and makes them … as small as possible: small enough that they aren’t a big factor in the final output.

Yuval Bar-Or: KBRA insists that once the rating process is set in motion the resulting rating will be published, whether it is favorable or not. Would [issuers] only end up on KBRA’s doorstep if the others provide unsatisfactory ratings? Would KBRA effectively become the rater of last resort?

James Nadler: … you need to spend most of your time working with investors so that they understand your rating criteria. Your rating criteria needs to be transparent and as such it won’t be a surprise to anyone when you come out a certain way but I think the strength the rating agency gets and should get comes from its investors … when you are asked to rate a deal or are bypassed on a particular deal because it’s assumed that you would have a more negative view investors can then make a decision as to whether or not they want to invest in that deal.

Yuval Bar-Or: In the issuer pays model it is the issuers who decide whether to bring business to KBRA. How does catering to investors avoid KBRA becoming the rater of last resort for issuers?

James Nadler: When investors have a strong preference for one particular rating agency it impacts the issuer’s choice as the issuer ultimately needs to sell the bonds to the investors.

Yuval Bar-Or: What do you think of S&P’s recent downgrade of the US Sovereign rating?

Jules Kroll: I have on numerous occasions called into question the ability of these rating agencies to do an effective job on Sovereigns to begin with; whether they really have the capability with the 80 or 90 people that they have … looking at more than 100 countries especially something as complicated as the United States. Specifically regarding S&P I feel that the way they conducted themselves was way out of bounds. For them to take a political position and lay out the ground rules for what had to be done by the US congress and the President in order to maintain the rating was presumptuous, way out of bounds and something that a rating agency has no business doing.

Yuval Bar-Or: Your July 27, 2011 testimony seemed to imply that you feel a rating agency should be able to sniff out fraud.

Jules Kroll: I didn’t mean to imply that we’re going to be sniffing out fraud. What I meant to say was that we are going to conduct certain types of diligence depending on the nature of the corporations that we’re looking at and we’re not going to do it strictly relying on a review of the diligence that is provided to us by issuers but we are going to do some of our own diligence in addition. I didn’t mean to imply that we would look for fraudsters. That level of depth we wouldn’t be going into.

Yuval Bar-Or: In your verbal testimony on July 27th you stated that hiding behind the first amendment is scandalous. What do you view as the correct level of responsibility and accountability that rating agencies should have in future?

Jules Kroll: My view is that the there should be a series of standards, which don’t exist today by the way, that are not all about filling out forms and checklists and the like. There should be a series of standards that rating agencies are expected to do in each of the various categories that they rate. In other words, if you will, standards of care. They don’t have to be in enormous detail and then anybody who does the rating should, just like bankers, auditing firms, lawyers, conduct themselves in a certain way. If they don’t then they should be accountable for that.

Yuval Bar-Or: Your written July 27th testimony indicates significant ownership by 35 pension funds and family offices. How many pension funds and how many family offices have ownership stakes?

Jules Kroll: Our … ownership structure is that our family office and our employees collectively own 60% of the business. The other 40% are owned by other family offices and pension funds. Those pension funds are LPs of several of the Venture Capital firms that invested in this venture. Our co-leads are Bessemer Venture partners and the other co-lead is RRE … and so what you have is public pension funds such as New York State pension fund, New York City pension fund, Michigan pension fund, Pennsylvania, and a number of others and also you actually have … some pension funds outside the United States in a couple of cases. So there are thirty five pension funds who are LPs of the venture capital firms. There’s also a third venture capital firm as well but it’s not one of the leads… in addition we have four other family offices.

Closing Remarks: Having now had the opportunity to communicate directly with KBRA’s management, do I believe the firm will succeed? The answer hinges round one’s definition of success. Mr. Kroll is a very savvy businessman and has surrounded himself with industry insiders. Disenchantment with the incumbents combined with even bigger barriers to entry due to more regulations will likely allow KBRA to carve out a niche and realize success as a commercial venture. Whether the firm’s version of the issuer-pays business model is sufficiently different from the incumbents’ remains an open question. It’s also unclear whether its ownership structure has teeth that will favor rating quality over venture capital profits. So while KBRA may well succeed for its investors, only time will tell whether KBRA will usher in the revolution that will yield a better rating industry.

Note: Space limitations made it necessary to edit the full transcript.

Gold Doesn’t Glitter for Advisors

Originally posted by Yuval Bar-Or on Jun 05, 2011  

I was recently informed by one of my former students that some advisors don’t like to acquire gold for their clients. The stated reason is that they may not be compensated for bullion transactions and are therefore more likely to try to convince clients not to make such purchases. While a decision not to purchase gold for a client may be correct for a variety of reasons (liquidity and diversification come to mind), the decision should not be motivated by the advisor’s compensation mechanism. This is yet another case of potential conflict of interest for advisors.