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.

Long-Term Trading Simulations for High School Students

Originally posted by Yuval Bar-Or on Oct 04, 2010  

The recent financial market decline devastated investors and provided a harsh reminder of the importance of basic investing literacy.

In recent years there has been a flurry of activity, with many States and counties adding financial literacy to school curriculums. A variety of providers, many of them non-profits, have begun or boosted their financial literacy education offerings. One learning tool in particular has gained in popularity: the stock trading simulation.

These simulation tools are great for giving users a hands-on trading experience. Students can buy and sell financial instruments in near real-time, and are able to manage a portfolio of anywhere from $100,000 to millions of dollars. In many cases the tools are used in competitions, where the individual or team with the highest portfolio value at the end of three or six months is declared the winner, and may be eligible to receive cash or other prizes.

Using these tools is good practice and I recommend that everyone try them out.

There is, however, one deficiency in these arrangements: the exercise or competition tends to last only a few months, on average. This is fine for getting some practice and observing short-term market movements. But such a short experience rarely provides the harsh and humbling lesson that all of us must learn early on in our investing career—that markets can turn in a flash, leading to significant losses and prolonged recessions. Most of those who engage in these trading games don’t have an opportunity to track a portfolio over several years. This deprives them of an important long term lesson: observing bubbles build and then burst.

So here’s my suggestion.

High School (or even middle school students) should all be given access to a trading simulation tool as soon as they begin their studies, and they should continue to manage a portfolio, or several, for their entire school career (a minimum of 4 years in high school, and ideally a few more in middle school). This four (or seven) year-long exercise will give students much more insight into what it means to live through good times and rough times. It will allow them to have a more meaningful set of experiences and a more realistic sense of investing expectations. It will also shape their decision making skills and help them to make an important determination: whether they should become passive investors, seeking long term diversified investments with minimal fees, or whether they have the time and inclination to be active investors.

Gaining this wisdom early on will serve them well when they communicate with financial advisors, pursue higher education, evaluate jobs and retirement plans, and vote for legislators who will ensure a level and stable playing field in future.

The technology exists. Hopefully the inclination also exists among those responsible for our education programs.

Young Investors’ Trauma Likely to Plague them for Long Term

Originally posted by Yuval Bar-Or on Sep 01, 2010  

When disasters occur, the full repercussions sometimes take years to manifest.

One example is the trend among young adults (ages 18-25) to shy away from equity investments. Having come of age during the crisis, and seen firsthand the devastation visited upon their parents and grandparents, this cohort appears to exhibit higher than average risk aversion. The higher aversion means they are investing less in equities, despite the empirical observation that equities outperform other investments over very long periods.

I was recently quoted on this subject by Joe Mont in article “Young Investors Risk More by Risking Less” (August 18, 2010): “For many families, the recent financial crisis and its ongoing challenges are certain to lead to long-term issues … Shunning equities could mean much slower wealth formation, as historically equities have outperformed other asset classes over long periods of time.”

The overreaction by the younger cohort is a normal response to trauma. From a longer-term perspective, however, they may well be avoiding the very returns they need to secure their retirement nest eggs. Even small annual performance differences (say, between stocks and bonds) can lead to very significant wealth creation due to the power of compounding. By shunning equities, young adults, who are ideally positioned to invest for the very long term, are likely depriving themselves of a large amount of potential wealth accumulation.

I urge young adults to explore the literature on the subject. Many books on finance and investing have documented the long-term performance differences across different asset classes (stocks, bonds, and cash). The patterns are compelling and help to establish that diversified equity investments are crucial components of young adults’ long-term investment portfolios.

Do We Need a Consumer Finance Protection Agency?

Originally posted by Yuval Bar-Or on Dec 12, 2009  

There’s been a lot of buzz recently around the proposed consumer finance protection agency. Opponents argue that a new agency will only add to bureaucracy and inefficiency.

We have the Food and Drug Administration to ensure that consumers don’t ingest poisonous or toxic substances. We have the The National Transportation Safety Board to ensure modes of transportation are as safe as possible. Do we spend time arguing that these entities are unnecessary? How many of us are comfortable abolishing these and other consumer protection units? I suspect few of us want to lose the benefits of watchdogs that ensure our food, medicines, airplanes, and trains are as safe as they can be.

Is a consumer finance watchdog so different? We have an agency to protect against toxic substances; why not one to protect against toxic financial securities?

Perhaps the question should be posed from a different perspective. Given what we’ve just experienced, can anyone claim with a straight face that financial institutions have had consumers’ best interests at heart? Is there any realistic reason to believe they will suddenly and voluntarily change to a more constructive mentality?

If financial institutions want to complain about the necessity of an independent consumer protection unit, they need only take a critical look at the way they’ve handled themselves over recent decades. They’ve had ample opportunity to genuinely embrace consumer protections … and they screwed it up!

Why the Small Investor Often Gets Hammered?

Originally posted by Yuval Bar-Or on Jul 22, 2009  

The small or unsophisticated investor loses money for a number of reasons. Here are three:

(1) poor asset selection, (2) poor timing, and (3) excessive fees.

Poor asset selection refers to the tendency to invest in assets which are riskier than initially assumed. Often, novice investors chase financial instruments which have exhibited fast price appreciation in the recent past. This fast appreciation is evidence of high risk. Inevitably, over time the higher risk is realized in the form of fast price declines.

Poor timing refers to the tendency to under-invest in stocks when these are undervalued (investors buy too few cheap stocks), and to over-invest in stocks when these are overvalued (investors buy too many stocks which have already peaked and are destined to decrease in value). Poor timing often occurs because the novice investors watch as stocks appreciate in value, and eventually become worried that they will lose out while everyone else appears to be benefiting. Finally, they decide to ‘go for it’ and buy the now significantly appreciated stock. All too often, their decision to purchase is made just around the time the firm falls out of favor, leading to steep price declines and big losses.

Excessive fees are often paid by novice investors. Unknowingly, they accept investments with relatively high fees when very similar investment vehicles are available at lower cost. Higher fees dramatically undermine wealth accumulation over extended periods of time.

Often, passive investment strategies are the best frameworks for avoiding poor asset selection, poor timing, as well as excessive fees.


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How Risky is the Systemic Risk Regulator?

Originally posted by Yuval Bar-Or on Jul 02, 2009  

In recent weeks the Obama administration unveiled its vision for a systemic risk regulator (SRR).

The first obvious question is: what is systemic risk?

One definition of systemic risk is: the risk that one firm’s economic problems may trigger losses for its counterparties, and that those counterparties in turn may infect others, until a large part of the overall economy (or system) is adversely affected. The second question is: do we need a regulator to deal with systemic risk?

The Obama administration clearly feels the answer is yes. What do others think? Given the many losses suffered by consumers and small investors during the recent economic crisis, it is not surprising that many are demanding a more proactive approach from government, in the form of increased regulation. Many have understandably been horrified at the recklessness of certain market players, including retail and commercial banks, investment banks, hedge funds, asset managers, financial advisors — the list goes on. It is also undeniable that the American regulatory system currently suffers from confusion and inefficiency due to the presence of multiple regulatory agencies and the fact that many of them lack the resources and appropriate skills to meet the challenges of the 21st century.

On the other side of the argument are those who are not convinced the recent upheaval was the direct result of systemic risk. Instead, they argue, the crisis was actually triggered “the old- fashioned way” by financial institutions making very poor risk assessments and entering into investments they should have shunned. As this argument goes, the crisis was not triggered by a sequence of one firm infecting another, and so on down the line, but rather by a simultaneous rush to poor investing habits by many firms. The implication for those who hold this view is that any effort to impose regulation would only reduce the flexibility of markets, thereby hampering innovation and productivity, which in the long term would reduce Americans’ prosperity,

Others are concerned that the government’s choice for SRR regulator, the Federal Reserve, is a poor one, for several reasons: (1) it may conflict with its existing mandate to deal with monetary policy, (2) the Fed has already proven itself to be inadequate in dealing with the existing crisis, or (3) there is concern that no single entity should be given the powers that a SRR will likely need in order to be effective. One alternative they have put forward is a council composed of representatives from the major financial regulatory agencies, which would help the existing agencies coordinate responses to systemic risk(s). While the government administration is in favor of a council, it still insists that the Fed should have ultimate power to make decisions and run the show.

Then there are those who feel that any effort to identify and or contain systemic risk is doomed to failure. After all, they contend, systemic risk is typically only recognized as such during or after a crisis. Creation of a new SRR may not contribute to any foresight that other very intelligent people in positions of power have attempted to achieve unsuccessfully in the past.

Needless to say, the merits of a SRR will be the subject of many future debates.

Some words of caution:

The existence of a SRR may give all market players, including vulnerable consumers and small investors, the false feeling that systematic risk “has been taken care of” and is no longer an issue. This would be a very dangerous outcome. It is unlikely that even a reasonably successful SRR could identify and mitigate all systemic risk. In fact, the more likely scenario is that significant systemic risk will remain in the system. If financial institutions and consumers become convinced that systemic risk is no longer a factor, they may well engage in reckless behavior that will lead to disaster if and when another systemic event occurs, despite the best efforts of the SRR. My advice holds: small investors and consumers should not deviate from the course dictated on this and related sites. They must continue to respect all risks and mitigate them wherever and whenever possible. Relying on others to do so would be highly irresponsible, stripping investors of the very control they should be striving for over their own investments.

Thin Bench Exacerbates Excessive CEO Pay

Originally posted by Yuval Bar-Or on May 07, 2009  

In a time of dramatically falling employment and unprecedented corporate losses, many are questioning seven- and eight-figure CEO pay packages. While there is much less controversy surrounding the pay of CEOs whose efforts have contributed to significant growth and profits, it is difficult to stomach stratospherically high payouts to CEOs who’ve presided over evaporating profits and the gutting of their firms’ stock values.

A relatively small minority (primarily pay consultants who recommend, and board members who approve, the large payouts) defends the controversial payments as necessary to retain relatively scarce CEO talent which might otherwise elect to walk across the street and accept a job with another company. An obvious question that arises is whether a corporation should feel deprived when the person who drove it into the ground decides to leave for greener pastures. “Good riddance” may be the more appropriate reaction.

The argument that there is only a small population or pool of capable CEOs in the United States is worthy of closer examination. Let’s suppose the assertion is accurate: there is a very limited quantity of qualified chief executives in this country. There are two potential remedies: one, seek qualified individuals outside this country – for example, from Canada, the UK or Australia. Not only are chief executives from these countries (among others) accustomed to receiving much more modest pay packages, they also have a greater sense of humility, and as an added bonus most of them speak better English than our homegrown folks. The second remedy is to create a much more robust supply of well-trained executives. The two paths are not mutually exclusive. In fact, in the near term we would have to rely more heavily on the former, as efforts are made to retool our educational institutions and corporate cultures to prepare future cohorts of executives.

The point is that the best way to bring CEO pay back down to earth is not to have the government legislate against high salaries but, rather, to increase the supply of good candidates for these jobs. Surely the laws of supply and demand would reduce CEO pay. Candidate A couldn’t possibly hold out for a twenty million dollar signing bonus when perfectly capable candidate B would be happy to take the job with a lower sense of entitlement and a much higher sense of humility for two million dollars.

The solution, therefore, is not to waste time and energy arguing about pay for the latest crop of under-performing CEOs, but rather to use that energy to ensure it is the last cohort exhibiting these characteristics. Needless to say, we cannot snap our fingers and make better managers magically appear. The recognition that we need to produce better leaders, and the willingness to do something about it, are nevertheless the first steps to recovery. We must institute processes to better select and develop large numbers of leaders, who will perform as professional managers and moral leaders.

The Law of One Number

Originally posted by Yuval Bar-Or on May 02, 2009  

Humans seem to have an ingrained need to simplify, to shorten, and to reduce. In economics we’ve embraced the law of one price, assets with similar return and risk characteristics must have the same price; in religion we’ve largely embraced monotheism, the law of one god; and in relationships many societies have adopted the law of one spouse.

These choices appear to have served us reasonably well over the centuries. Unfortunately, other simplifications have been our undoing. Specifically, our financial risk management efforts have taken oversimplification to an extreme, with an insistence that risk be summarized in one number. A bank CEO may be told that her firm’s portfolio of loans has an unexpected loss of X; the CEO of a brokerage firm may be told that his firm’s portfolio has a Value at Risk of Y; the arranger of an asset backed security may be told that the correlation among underlying assets is Z; an asset manager may summarize the standalone risk for a security by the standard deviation of its historical returns. Non-financial institutions are not exempt: a manufacturing firm’s CEO may be told that the Economic Value Added of a global division is Q.

Each of these examples represents a gross oversimplification – much in the same ways that a sports team or league insists on voting for one MVP, and the Oscars anoint one Best Actress. No single player can achieve greatness without teammates’ active contributions, no precise and objective way exists to differentiate between two or more brilliant acting performances. Similarly, in the risk management field, no single measure of financial risk tells the entire story. We know that a number of systematic (market wide) and idiosyncratic (investment specific) variables contribute in non-linear fashion to the risk of financial investments and strategic business decisions. We know that the outcomes will be manifested from an underlying distribution of events, and we know that no single number contains the rich complexity of all that information. Simply put, we know that oversimplification means the loss of critical information – yet somehow we continue to insist on summarizing a whole swath of critical knowledge into a single, convenient, yet dangerously misleading figure.

Surely we’ve learned the hard way that in some areas, simple is not good enough.

Adding Insult to Injury

Originally posted by Yuval Bar-Or on Apr 25, 2009  

Rising unemployment, record level home foreclosures, and ever-shrinking 401Ks characterize our now gloomy economic state. Investment losses in the trillions of dollars have devastated many households. Adding insult to these injuries, some in the media, government, and business communities have implicated hapless consumers as willing and guilty participants in the debauchery that led us to this humble state.

The most common accusations are based on observations that many consumers willingly accepted loan amounts and loan terms that were well beyond their means, and/or made reckless investments without a proper understanding of underlying risks. In both cases, consumers laid the groundwork for their own financial destruction.

The painful fact is that these accusations are at least partly correct!

Many consumers contributed to their own financial problems through a combination of ignorance and greed. The good news is that the former is relatively easy to remedy. Evolution from ignorance to knowledge is the objective of this blogging platform.

This blog is intended as a first step to equipping the average consumer with a better understanding of:

1. financial markets
2. risk exposures
3. investment strategies

It is not about stock tips.

It is about education.

It is about taking back control of one’s financial future and ensuring the mistakes of the past are not repeated.

This is meant to be the first of several mechanisms intended to improve financial literacy. It is expected that different approaches may be required in order to properly connect with people of different backgrounds and generations.

Please stay tuned for more, and share thoughts about how and what you’d like to learn.

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The Unfought War for the Hearts, Minds, and Futures of Inner City Americans

Originally posted by Yuval Bar-Or on Jan 09, 2009  

At time of writing, America’s war in Iraq had lasted over five years. Thousands of our finest men and women made the ultimate sacrifice, many miles from home, and thousands of others came come home with horrific injuries. On the economic front, our nation’s coffers have been depleted to the tune of many hundreds of billions of dollars, over this distant war. Many experts believe this campaign has not made us safer, raising the painful conclusion that all those lives and dollars have been squandered in a far-off land, representing a severe drain on our national resources.

At the risk of adding to our national agony, imagine what we could have achieved with all those dollars and people back home? Better schools, safer neighborhoods, fewer gutted homes and impoverished families?

Our nation has fought many wars over the centuries. We’ve won some and lost some. But we have been losing the most important war of all: the one waged daily on the streets of our inner cities. This is an insidious war that has consistently reduced our national productivity and growth, taxed our law enforcement, legal systems, and medical facilities, doomed millions to despair and crime, and fed class and race conflicts.

This is not a war that is going away anytime soon. Long ago it reached a self-sustaining state, in which the enemy reproduces with unflinching consistency. Its gang and criminal armies predictably swelled by a never ending line of youth who know nothing but distrust and violence, racism, and lack of opportunity or hope.

We are losing this war because we are unable to break the cycle underlying the violence and desperation. The battles take place in our major population centers, in the ghettos and projects of inner cities and poor neighborhoods. Our efforts treat only symptoms. We try to put more law enforcement officers on the streets to thwart, arrest, or kill criminals. In doing so we continue to antagonize a population which has nothing to live for. It exists under the threats of violence by gangs, individual criminals, frustrated and intimidated law enforcement officers, and with no alternatives in sight, its youth are invariably recruited to the dark side.

What we need are new approaches that allow us to break the cycle of drugs, violence, and poverty, and we need to introduce that break to an entire generation. The solution is to provide an environment to subsequent generations that creates that break and provides alternatives. The most obvious alternative is education.

In this article I touch on seemingly unconnected issues: the negative return on investment in the Iraq war, with its devastating losses of both human and financial capital, as well as the self-sustaining cycles of violence in urban communities. These two concepts do come together, as follows.
When our veterans return home, they will be returning to a devastated economy, with few prospects for employment. We have an obligation to help them get absorbed into civilian society, and we have an opportunity to make a real difference here at home. Over five years these heroes patrolled Kirkuk and Karbala. Imagine the prosperity they can help create by patrolling the inner city streets of Chicago and Detroit. Let’s employ these loyal souls in a cause that makes social, economic, and moral sense.

When our veterans return home, we can provide them with the opportunity to decommission directly into police forces in inner city communities. Their primary mission will be to protect schools and the routes leading to them. Their goal will be to make it impossible for drug dealers and gangs to get anywhere near our children. Soldiers turned police officers can stay in this role for a year or more if they wish, and they will be replaced by other cohorts of returning soldiers, from Iraq and other war theatres. Imagine the cumulative effect of 50,000 or 100,000 police officers protecting children 24 x 7 over the course of five or ten years. For the first time, children in these communities will grow up with hope, opportunities for education, and constructive self-expression. Most importantly, we can break the cycle in which youngsters facing no alternatives are inevitably swept into the gang and criminal violence swirling around them. Our (ex-soldiers’) success will deny criminal footholds within the human capital of disadvantaged communities, allowing them tangible opportunities for renewal.

We have a war at home, which we’re losing, and we have a decommissioning army, ripe for its most patriotic mission. Let’s take our troops and put them where they will have the greatest impact on our security and prosperity. What will our country look like in five years if we allowed children to worry about homework instead of death by stray gang bullets or a knife wielded by a drug dealer inside their school? Let’s employ our troops in protecting the soft underbelly of our nation-the underprivileged who cannot break out of a cycle of deprivation and violence.