When speaking to a group of endowment officers recently, I asked whether they had equity exposure to the too-big-to-fail banks. All nodded their heads as if it were a given. Indeed, most institutions that benchmark against any major index have exposure to these firms.
Then I asked whether the investors had exposure to hedge funds. Many said yes, although they cited reservations about transparency and the returns the investments have produced.
My next statement drew blank stares: That in 2008, the only investments less transparent than hedge funds were financial stocks and financial stocks haven't reformed at all.
Bear Stearns blew up because of its undisclosed exposure to hedge funds. The firm later was sued for that lack of disclosure. At the very least, investors in Madoff knew they were putting their money with Madoff. Investors in Bear Stearns lost all of their money and didn't even know they were exposed to hedge funds.
The cardinal rule of investing is, “know what you are buying.” In no other asset class do investors so plainly ignore this rule as with the equity of banking conglomerates.
Every time the issue of banking transparency comes up, the discussion immediately turns to the need for better regulation. Surprisingly, I never hear discussions about divestment, although almost every allocator has direct exposure to these firms. A discussion about regulation without divestment is akin to saying, “I eat poison every day. I strongly believe the government should regulate the poison industry because it's becoming very unhealthy for me.”
Those investors who intend to wait for better regulation should be prepared to wait for a long time. The banks are in such disarray that they aren't even clear about what assets they hold on their books.
As J.P. Morgan Chase & Co. CEO Jamie Dimon stated in testimony before the Senate Banking Committee on June 13, investments by the bank chief investment office “morphed into something I can't justify that was just too risky for our company.”
If a CEO can't even figure out what's in his portfolio, midlevel SEC overseers don't stand a chance.
Not surprisingly, the same problems abound as if the 2008 crisis never happened.
In addition to J.P. Morgan Chase's multibillion debacle this year, MF Global managed to “lose” $1.6 billion in customer funds late last year in the epic equivalent of misplacing your wallet. Around the same time, UBS lost $2.3 billion in a “rogue” trade. The $1 billion-plus losses become headlines, but they are just the most glaring symptoms of the extreme risk-taking going on at these banks, most of which we don't see.
In the wake of the recent scandal involving LIBOR rate-rigging, Joseph Dear, the chief investment officer of the $239.3 billion California Public Employees' Retirement System, Sacramento, made a strong statement against banks,
“Once again, the financial services industry demonstrated that it cannot be trusted to make decisions in the long-term interests of investors,” Mr. Dear was quoted as saying July 16.
Puzzlingly, CalPERS still had $5 billion invested in too-big-to-fail bank equity, according to its latest report for the year ended June 30, 2011. Allocators recognize the incredible shortcomings of the financial services industry yet still readily invest in this pile of grenades. Much of the CalPERS exposure is through passive investment, but passivity is ultimately a poor excuse for placing pensioner funds in such dire risk.
The structural problems of the industry are reflected in its performance. The numbers are both abysmal and consistent. Over the past 20 years ended June 30, the Standard & Poor's 500 index total return on a cumulative basis has outperformed the banking industry subindex total return by 198.48 percentage points. Over the past 10 years, the S&P 500 outperformed banks by 101.18 percentage points on a cumulative basis. The lackluster returns are an agglomeration of the countless high-profile blow-ups and near misses that have affected almost every major bank in the nation.
My call for attention to the banking industry applies to active and passive allocators. Passivity isn't an excuse to place capital in a consistently poisonous industry; it's simply a negative byproduct of a choice to be passive. Ultimately it still comes down to choice, and at some point a line must be drawn. There is a difference between passively allocating to reasonably transparent and straightforward industries vs. industries that have proven to be chronically opaque and untrustworthy. A rogue trader at a fast-food company will never push a button and make $2 billion worth of hamburgers disappear, nor will he reclassify $5 billion worth of chicken as a Level 3 asset, or hard-to-value asset, revalue it upward, then use the enhanced balance sheet position to make a levered bet on Europe. It just won't happen.
From a fiduciary perspective, the response to a lack of investment transparency should be to remove capital until risk can be visibly brought under control. The regulators will not help. In order to mend the industry, banks need to be starved of capital by investors looking out for their own self-interests. In the meantime, their valuations need to be adjusted for the nearly unlimited risk they are placing on their shareholders.
A well-known joke sums up the sorry state of the banking industry: “What do you call a rogue trader who makes $2 billion? Managing director.”
Nathan Anderson is a director at Tangent Capital PartnersLLC and CEO of ClaritySpring Inc., both in New York.