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Thursday, January 18, 2018

Chinese Financial Control Dilemmas

by Roy C. Smith

The Wall Street Journal recently reported that “China’s housing market has defied gravity and government regulations for two years, floating on a tide of bank loans and speculation. Until now.” 

Housing prices in Beijing and Shanghai, having shot up 30% to 40%, respectively, since 2015, have fallen sharply as a result of government controls imposed last year, and are now dropping below their 2015 levels. From the government’s point of view, the good news is that its firm hand can deflate bubbles and cause markets to behave as it wants. The bad news is that heavy-handed controls can have adverse consequences of their own, and market forces can make them worse.
Despite its authoritarian controls, China is not exempt from such market-driven crises. Indeed, in 2014, after a year of monetary easing and government pressure to grow the economy and encourage stock prices so companies could refinance loans, a major effort was made to increase margin loans which grew, in aggregate, to as much as $2 trillion. So, China’s second stock market bubble in a decade suddenly began to form - the Shanghai Composite Index of stock prices rose 150% from November 2014 to a cyclical high of 5,166 in June 2015, before the bubble burst, dropping prices by 43% in a matter of a few weeks. The government intervened forcefully – requiring government controlled investors to buy stocks, and encouraging further margin buying – and the rout was halted, but the market has not fully recovered since then. Investors, fearing the unpredictability of government intervention, chose to invest in residential real estate and other assets instead, moving the speculative destination to other sectors.
Indeed, China’s 250 million “middle class,” aided by continued easy money, piled in again to residential real estate.  There have been other bubbles in real estate over the past several years, but the so-called middle class, which includes China’s growing millionaire class as well, is much larger now than before. There are now approximately $4 trillion residential mortgages outstanding. Since the stock market crash in 2015, these folks have upgraded their residences and bought additional homes as investments. According to the WSJ, “mortgages made up as much as three-quarters of all new loans in 2017.” According to Moody’s Investor Services, the housing sector generates about a third of China’s economic growth.
But the sudden price downturn has affected the resale values of all housing and the value of collateral held by banks. As we know from our own experience after house prices unexpectedly started to decline in late 2006, an avalanche of mortgage problems hit the US housing market and resulted in a major crisis. Underwater mortgages tend to be abandoned, property developers fail, and banks have little choice but to write them off. As a crisis develops, all forms of marketable credit instruments are questioned, and investors run to safer ground. Too much of this and banks get into trouble and may then either fail or have to be bailed out by the government.
If the government has to intervene to forestall a crisis (there is no indication that this is the case in China as yet), then it may have to direct investors to purchase mortgages and other debt instruments, whether they want to or not. It will also have to change mortgage availability and other policies back to what they were before. This, or course, weakens China’s efforts to improve the role of market pricing in its economy, something most analysts agree is necessary for the country to transition to developed status. Doing so also covers up the weakness of many assets on the books of Chinese financial institutions and kicks the can of having to deal with them into the future, where the problem non-performing and risky debts will only be much larger.
Indeed, China already has a large amount of questionable loans on the books of its banks ($30 trillion in assets), shadow banks ($9 trillion) and in the high-yield investment portfolios of middle class investors. Fudging over the mortgage sector could add a considerable sum to this dangerous accumulation of toxic assets. From such accumulations, financial crises arise.
Market-driven crises may be triggered by well-meaning government controls in a fully-self-confident, authoritarian system with little regard for markets. China’s marketable financial assets are about $30 trillion today, but markets are dependent on retail and speculative investors more than institutional ones. Government intervention is the solution to crises, but such periodic intervention can destroy market integrity, which weakens the economic system.
Just as the announcement of housing price declines surfaced, China announced that its annual growth rate for 2017 was 6.9%, up from 6.7% for the prior year. The news was met with considerable skepticism by international observers who considered the results to be managed. The government wants to convey a picture that it is on top of things and all is well, others see an economy that continues to be in slow decline despite many efforts by the government to prop things up.
Growth continues to be essential to the Chinese government. Only with growth can it hope to meet the expectations of its billion or so people who have not yet entered the middle class, and provide the resources required to deal with its aging population and to support its overseas and military agenda. For China, growth means continuous intervention.
Ironically, such intervention promotes price volatility in financial assets that periodically passes capital losses on to the middle class.  It is this group that the government must depend on to be the engine of consumption as the country transitions from an export-led economy to one that is more consumer-led. It is difficult to achieve such long-term objectives, however, when the government has to intervene in the short-term to prop up (and maintain) the weaker elements of the system.

Thursday, December 21, 2017

Season’s Greetings to Global Bankers from Rosy Scenario

By Roy C. Smith

It's a happy time of year, made more so by a Goldman Sachs global economic forecast (entitled “As Good as It Gets”) that predicts 4% growth in 2018, up from 3.6%. It was 5.4% in 2010. Still, all around the world economies are growing again, inflation is lagging so rates are still low, and market analysts all want us to stay fully invested in equities despite the roaring global bull market and all-time highs of the last year.

Indeed, many investors are happy to explain away the rallies (S&P 500, MSCI and FTSE 100, as just catching up to where we ought to be after finally escaping the low-growth grip of the Great Recession. “Total real return” from the S&P 500 index (i.e., including dividends, and adjusted for inflation) from 2000 until now was 3.1%, up from 2.3% through November 2016, so Mr. Trump did make a difference. Even so, the total real return trend line from 1980 until now was 7.9%, so we still have more catching up to do, don’t we?

Overall, the rallies in the US, Europe and Japan have ignored politics and their many antics and implications, despite their being constantly in the news. Mr. Trump is now treated by investors as we treat teen agers – ignore what they say, but watch what they do. As Rosy often points out, Mr. Trump has never been nearly as bad for the world economy as he declared he would be (China, North Korea, NAFTA), and his aggressive domestic agenda has lagged far behind his promises. Investors in Europe also seem to have retained their sangfroid, despite the excitement of Brexit, Catalonia, the amorphous German coalition, uncertain Italian elections, and some backsliding in Austria, Poland and Hungary. Investors are showing confidence in their private sectors, not their governments.

Mr. Trump’s tax bill is a needed political victory with some modest economic benefit. Gary Cohn, Mt. Trump’s chief economic advisor, says growth next year will be 4.0%, but Cohn’s old firm, Goldman Sachs, forecasts tax cuts will increase GDP growth by only 0.2% for only two years, leading to an annual US growth rate of about 2.5% in 2018. But Goldman also says growth will slow again in 2019 (to 1.9%) due to labor and other constraints. Rosy and some other economists believe the momentum from the 3.1% average growth in the second and third quarters of 2017 will carry over into 2018. This must justify the 20% S&P 500 return for this year, doesn’t it?

Brexit remains a mess, but with the $50 billion “divorce settlement” behind it, the rest should fall into line.  Negotiations don’t really have to fall off the cliff, do they? Rosy thinks Mrs. May’s weak coalition will collapse, Labour will get in, and the Brits will have another referendum, only this time explaining the pros and cons more effectively.  Surely, if they understood it better, with the Tory ideologues pushed to the sidelines, the great British people would vote to remain. Recent polls show the opposite result, however.

Rosy says we should relax about Russia and China. Putin is troublesome but unimportant economically. China is important, but its slowing growth rate has stabilized around 6.5%, which is still very strong, and the much-feared credit collapse hasn’t happened. Xi Jinping has established himself as supreme leader and is using his vast centralized power to promote large showcase projects and to manage the economy smoothly, despite increased interference and bullying of the private sector, sheltering of inefficient state-owned enterprises, suppression of migrant workers, and being under huge pressure to improve health care and pension services. China’s stock market was up only 6% in 2017; Rosy thinks it may be a buying opportunity.

Bank regulators are easing up a bit. The terms of Basel IV are now set, though they won’t come into effect until 2027. It has a new capital requirement for “operational risk,” to include large settlements from prosecutions. Banks now seem well enough capitalized and controlled by stress tests, so some of the rest of the pressure applied after the crisis can be relaxed. But, there is nothing going on to repeal or reform Dodd-Frank - the effort to reform it passed by the House of Representatives has gone nowhere in the Senate. Nevertheless, the stock market rally has lifted the prices of US banks, but only JP Morgan (+130%) and Wells Fargo (+70%) are significantly ahead of where they were a decade ago. Citigroup (-85%) and Bank of America (-45%) are both still significantly behind.

However, the stock prices of the top four European capital market banks (Barclays, Credit Suisse, Deutsche Bank and UBS) are all still about 75% below their prices of a decade ago, with most trading well below book value. They are lagging way behind their US competitors and are a long way from returns on equity greater than their cost of equity capital.  Even Rosy acknowledges that their long term economic viability is doubtful.

Rosy has believed for years that each new year will be the one in which a lagging US or European bank will split itself up into more manageable segments, and each year she has been wrong. Maybe 2018 will be different; the new CEOs of Barclays, Credit Suisse and Deutsche Bank have learned how hard it is to be a competitively-significant, globally-integrated investment bank. With stock prices trading well below book value, spin offs still make sense for them.

All in all, Rosy says things will be great in 2-0-1-8. Drink up. It’s as good as it gets.

Tuesday, December 5, 2017

Will the Tax Cut Make a Difference?

By Roy C. Smith

Leaving aside how the sausage got made, the Trump administration got its tax cut and all the bragging rights related to it. But will it boost growth?

Here are some things we know already. The US economy has recovered momentum in the last two quarters, perhaps inspired by Mr. Trump but it is hard to tell. Goldman Sachs is now optimistically forecasting a 2.5% growth rate in 2018, a big improvement from the average of 2% for the last decade. Goldman Sachs includes in its forecast a growth pickup of 0.3% from the tax cuts. This is nice, but seems rather small for a tax cut that, even with dynamic scoring (that takes the new growth into account), still has a price tag of about $1 trillion to be added to the national debt.

There is, however, a lot of uncertainty with this tax bill which favors the corporate sector over consumers. Most of the tax revenues from corporations come from the 3,600 publicly traded corporations and large privately-owned companies that don’t actually pay the 35% maximum rate, but a lower rate that averages around 24%. Cutting the maximum rate to 20% won’t make much difference. The rest of corporate taxes are collected from the 5 million or so small businesses that generally don’t make enough profit, especially after expensing family payrolls and other things, to pay the full rate, so there shouldn’t be that much revenue lost from their cuts. In any event, not all the tax savings will be reinvested in new plant and equipment – some will be used for dividends, stock buybacks or debt reduction that contributes much less to GDP growth. Estimating such things and future corporate tax revenues to the government is done more by modeling than by knowing a lot about how corporations will act. This suggests that both the net benefit and the revenue loss from the corporate tax cuts may be much less than expected.

Further, the “middle-class” taxpayers (those who rank in the upper 50% to 90% of income earned) will receive a mixed bag of benefits and added costs from the tax bill. The wealthier end of this group is likely to lose more in deductions than they gain in cuts. And, 47% of all citizens don’t pay federal income tax at all, so won’t benefit from cuts. How much of a net increase in consumption will result from what Mr. Trump calls the “biggest tax cut is history” is hard to know, but it could be quite modest.

In any case, the tax bill occurs when the economy is experiencing a growth spurt following a decade of slow-growth recovery from the financial crisis. Annualized growth for the last two quarters has averaged 3.2% with unemployment expected to drop below 4%. Adding a stimulus now may boost inflation more than real growth.

More worrisome, however, is the longer-term growth outlook. Even with the tax cuts, several growth forecasts, including Goldman Sachs’, fall off again to the 1.9% area after 2018 due to labor shortages, impeded by tougher immigration policies, and rising inflation and interest rates.

Meanwhile, the federal deficit is increasing because Social Security and Medicare costs are expanding to accommodate the retiring baby-boomers. According to a June 2017 report by the Congressional Budget Office, the fiscal deficit reached 3.7% of GDP (up from 3.0) and is estimated to be 5.2% by 2027. With the tax cuts added, the deficit will reach 5.1% in 2021, according to Goldman Sachs, and total debt will be nearly as high a percentage of GDP (110%) as it was at its peak year in 1945. This would represent a serious increase in the deficit burden that traditionally has been a concern to Republicans, but is not now (except for one Senator, Bob Corker, who is retiring). Of course, if the tax cuts, on balance, don’t reduce revenues as much as expected, the deficit will increase less than otherwise.

The tax cut is mainly a political event. Their economic impact is likely to be less than advertised.

Friday, November 24, 2017

A Parable of a Tax Bill

By Roy C. Smith

An economist, a politician and a Wall Street banker sat down to craft a tax bill.

The politician kicks things off. “Guys, the boss has asked us to come up with a tax cut plan that will fulfill his campaign promises to give the middle class a break and to increase growth and jobs.”

The banker jumps in. ”Right, the markets, which have priced in a tax cut, are booming so we have to deliver.”

The economist, more troubled by the task than the others, says: “it’s not that simple. We are already at full employment (unemployment is 4.1%) with an immigration-impaired workforce that is growing at only 0.5% per year, so where are the workers for the new jobs going to come from? The economy is finally starting to grow out of the slump it has been in for the last decade, so adding stimulus from a tax cut now is likely to produce mainly inflation. But the cost of a tax cut, around $1.5 trillion over ten years, will have to be added to the national debt which is already very high. Anyway, growth and jobs do not always follow stimulus measures. We had ten years of fiscal stimulus under Obama, with low interest rates and aggressive quantitative easing by the Federal Reserve, and, even so, growth only averaged about 2%. A tax cut is just more stimulus; it may push growth above its trend line for a time, but the cost of the tax cuts must be funded with additional government borrowings that involve interest costs that will rise, especially if the total amount of government debt is seen to be too high, or inflation sets it.  Our national debt is now (107% of GDP) almost as large as it was at the end of WWII (118%), which was the highest in our history. When Reagan was president, debt to GPD was only 37% and unemployment was 8.3% when he passed his tax cut in 1983.

The banker says, “so what, interest rates are still low and the government bond market is very strong, despite the downgrading of the US credit rating by Standard and Poor’s in 2011. When folks get nervous, they still buy Treasuries. Of course, there is a limit to how much debt we can have without it hurting us; we don’t know where that limit is, but we’re not at it yet.”

The politician: “Some of our guys say that a tax cut will add $4,000 a year in wage increases for workers. If we keep saying it, maybe it’ll be true. Maybe not, but our voters are expecting it. That’s where the rubber hits our road.”

The banker: “If we fail to get a tax cut through, we will look like we don’t have any economic policy at all and are incapable of governing. That could frighten the markets into a major correction.”

The economist says, “I understand, but wouldn’t it be better to focus instead on a revenue-neutral program of tax reform that would get rid of ancient subsidies, loopholes and preferences that block market forces from determining an optimal allocation of resources to maximize growth and productivity over the long run. The best way to achieve it this to eliminate all deductions and apply the combined savings to an across the board tax reduction of 20% or so. It will be revenue neutral, but the structural changes will enable more growth.”

The politician says, “that would be a terrible idea. Eliminating deductions for mortgages and credit card debt, for state and local taxes and for medical expenses and charitable contributions would be a disaster. People will think you are taking something that is theirs by right away from them. And, they would see it as unfair to some taxpayers and benefitting others disproportionately. Our major donors would desert us. What they want is a real tax cut, without taking anything away.”

“Well,” said the banker, “a corporate tax cut will increase corporate cash flows, improve profits and increase equity valuations. Stocks will rise, so will household wealth and folks will spend more of it. Besides, our corporate rate (35%) is the highest in the world, so lowering it will make us more competitive in the world.”

“Except,” said the economist, “our major corporations, because of large deductions, only really pay about 24% in taxes, about the average for all companies in the industrialized world, so they are not really uncompetitive. Those that do get rate cuts might just spend it on increasing dividends or stock buy-backs ($500 billion in 2017), or on overpriced mergers that result in major cost cutting. But, in any case, the vast majority of the 5.5 million US corporations are small to mid-sized privately-owned companies that have mastered the art of minimizing taxes and don’t pay 35% either. Some use pass-through mechanisms to transfer losses and capital gains to lower their wealthy investors’ tax rates. All corporate taxpayers are good at gaming the system. The best way to address corporate taxes is through reforms that eliminate all corporate deductions and lower all rates from the savings.”

The politician: “There you go again. Our donors don’t want their corporate deductions taken away either.”

The banker adds, “the market likes traditional tax cuts that benefit people who will spend the money or invest more. It doesn’t like complex reforms with a lot of unforeseeable consequences.”

So, the banker and the politician combine forces and brush the economist’s idea aside. They say we need a middle-class tax cut that will put money in just about everyone’s pocket. And, besides, the banker says, it will pay for itself by increasing growth to more than 3%, which will generate a lot of new tax revenues. 

“We still have the deficit problem,” said the economist. Our fiscal deficit today is 3.5% of GDP; the $1.5 trillion cost of the tax cut is up front, so we would have to increase debt early on, taking the debt to GDP ratio up to around 112% and the fiscal deficit about 5.0%. Our fiscal hawks opposed to increasing the debt ceiling won’t like this at all. And, we will need their votes to get this thing through.”

The politician: “The deficit is still important to a lot of our voters. But given a choice between a rising deficit and more money in their pockets, they will usually pick the latter, which is why we have always been for tax cuts. But, it can help a lot if we can persuade them that the economists’ studies are fake, or flawed, or produced by liberals, and not to be taken seriously. They like the idea of a tax cut being something for nothing, even if they know in their hearts that it’s not true.

The economist then added, “there is something in what you say, behavioral economics shows that perceptions can count more than reality. “

“And perceptions are what win elections,” said the politician.

So, they say down and wrote up a list of public perceptions that they wanted to reinforce, and that might help sell a tax bill. The government was helping the middle class and hard-working Americans, it was creating jobs, and making corporations more competitive, all things they had promised to do. Besides, their plan will pay for itself; deficits don’t matter, it's the American entrepreneurial spirit that will Make America Great Again.

Then they went on the write the tax plan they wanted Congress to approve. It was a mess, but it was the best they could do. Sausages are made in sausage factories.

Economists know that tax cuts always add debt to the system, but they don’t always provide the stimulus they are supposed to. Bankers know they can result in a bullish anticipation of results, but yield a bearish response when results are disappointing. But even though politicians know that both may be true, none of it matters if their side isn’t reelected.


Friday, October 20, 2017

Black Monday Recalled

By Roy C. Smith

October 19th is the thirtieth anniversary of “Black Monday,” the great US equities market crash in which the Dow Jones dropped 22.6 %, the largest single day decline then or since, and instantly spread to other markets in the world’s first massive liquidity event .

The event was sparked by the usual suspects – an overvalued five-year bull market (the S&P 500 index was up 44% on the year at its peak in August), some near-the-top volatility, and an early morning panic in Hong Kong that passed through Europe and hit NY like a hurricane.

When it did, it forced aggressive margin calls, revealed structural weakness in US trading systems, and sank the then new computer-based, automatic “program trading” and “index arbitrage” schemes.

The speed at which the crash developed created problems of its own. Price information was hard to get; many NYSE stocks (for which markets were made by “specialists” on the trading floor) failed to open on time, and closing prices from the day before quickly became meaningless. Program trading that required the purchase of futures contracts and simultaneous selling of shares in the cash markets quickly became disorderly and unbalanced, and further accelerated price declines, overwhelming whatever opportunistic buying there was. All this accompanied “defensive” (i.e., panic) selling by traditional institutional investors.

This crash spread instantly to other markets around the world. Global linkages and technology improvements had made this possible, but the consequences were severe. All markets with more-or-less modern trading platforms were affected, and most suffered plunges worse than in the US. Markets were down 27% in the UK, 31% in Spain, 46% in Hong Kong and, surprisingly, down 60% in far off New Zealand. Coping with shocks requires a large and well developed institutional base of investors with liquid reserves, which were scarce. This kind of global market contamination is now baked-in to our global financial system, and has occurred on several other occasions, most notably in 2008.

The crash also halted two related dynamic actvities that had developed during the 1980s, a global mergers and acquisitions boom, and a series of very large privatization sales of stock in nationalized companies by the UK government of Margaret Thatcher.

I was meeting with Sir Patrick Sheehy, CEO of BAT Industries, whom I was advising on a prospective $13 billion takeover offer for Farmers Insurance, a California company whose management and regulators would probably resist the deal. We were devising a price range for the yet unannounced deal and plotting our initial moves. I was nervous about the market that had been turbulent all the prior week. So, I got up periodically to check the office “Quotron” machine (a sort of electronic ticker tape) that was located outside my office. It was clear by early afternoon that all hell was breaking loose, and our merger experts advised me that we should postpone the deal until market conditions improved. This was because we would need the support of M&A arbitrageurs and other institutional investors to buy up stock on the contested deal’s announcement to show support for it. But the arbitrageurs were badly hurt by losses in their existing positions, so they had little room for new ones. My clients were disappointed, and left in a bit of a huff, ending our hopes for completing one of the largest deals of the year that we had been working on for months. (The transaction was completed in the next year).

At the same time, Goldman Sachs was in the middle of leading an underwriting of the US tranche of a $12.2 billion privatization sale of British Petroleum shares. This deal was truly enormous by 1987 standards. It was being conduicted under UK underwriting rules in which a price/per share was fixed at the announcement of the offering, which was followed by a two-week “subscription” period for investors to take up the shares. Any shortfall was left to the underwriters, which in the UK already had been placed with institutional investor sub-underwriters.  But, the crash occurred in the middle of the subscription period, and dropped the market price of BP shares to 224p., about 25% below the subscription price of 330p., which meant that no one would subscribe for the shares and they would all be left with the underwriters. The four US underwriters, under US rules, could not close on stock sales until the end of the subscription period, so they took a loss of about $250 million on this one deal alone, enough to threaten the viability of some of the firms.

There were a lot of other losses that day too, from trading positions and cancelled deals, which was frightening to everyone on Wall Street, but especially so to the partners of Goldman Sachs, a New York partnership with unlimited personal liability of partners, with all their money tied up in the firm.
So, it is understandable that October 19, 1987 was and is still very memorable to me. At the end of the year I retired as the senior international partner of the firm to join New York University as a finance professor, something that had been in the works before the crash.

After the crash, the market recovered quickly and by the end of December closed 2%  above where it had begun in January. (Overseas equity markets, however, recovered much more slowly). The government appoint a commission to consider causes, etc. and some reforms were put in place.  The “Roaring Eighties” did not end, however, until late December in 1989, when there was a mini-crash and a recession began. The merger boom died out then too, after the junk bond market that had financed a large part of it collapsed with the failure of Drexel Burnham, its principal advocate.

As bad as the 1987 crisis was, however, the event did not trigger any significant form of government intervention. The Federal Reserve said it would do its job to provide liquidity to banks wanting to lend to security firms on good collateral, but not much else. The exchanges stayed open, losses were absorbed, wounds licked and business went on. The market’s quick recovery eased the pain considerably.

Indeed, in the case of the massive BP stock offering, the US underwriters did what they could to persuade the UK government to postpone the deal because of force majeure; they had help in this from some sympathetic government officials worried about systemic failure, but Mrs. Thatcher said Absolutely Not! – contracts must be honored in free markets – and the deal went on despite the massive losses. If it had been pulled, then the value of underwriting contracts (especially under the UK system) may have been subject to question.

Thirty years later, we operate in markets that are ten times larger (in today’s dollars) than in 1987. Today’s US equity markets have a market capitalization of $27 trillion; but all the world’s stock, equities and tradable bank loans, according to McKinsey, are valued at over $300 trillion. Liquidity panics and global linkages continue to present a serious systemic risk to the system, as was demonstrated in 2008. New measures to contain such risks have been adopted, but are untested.

Not much is predictable about the future, but another financial crisis probably is.

Roy C. Smith, an Emeritus professor at New York University,  was a partner of Goldman Sachs in 1987.

From: Financial News, Oct 19, 2017

Monday, October 9, 2017

Will Trump Take Half a Loaf on Taxes?

By Roy C. Smith

The Trump $1.5 trillion tax plan is really two-bills-in-one. A good one and a bad one.

The first is a legitimate effort at long overdue reform of the method and effect of collecting taxes from businesses. It would repeal a long out-of-date system of taxing income wherever earned around the world, after deducting local taxes paid, but allowing tax payments to be deferred until the income was brought back into the US. In a time of global business integration and competition, the present system is inefficient because (a) it applies a 35% tax rate to all income, the highest tax rate of any large, developed country, (b) but that tax rate is reduced by the deferment provisions to an average effect rate of about 26%, which happens to be the average corporate rate for OECD countries, (c) however, only a few hundred large global corporations get the benefit of deferral, so the vast majority of America’s 5.5 million corporations pay an exceptionally high rate, which clearly impedes their growth and development.  A rate cut to 25% for smaller and midsized businesses would benefit them a lot.  

By the way, the argument that the cash reflecting the deferred taxes, some $2.5 trillion or so, is “trapped” outside the country and cannot be used to fund domestic investment is phony. Corporations can and do lend money between subsidiaries, or borrow from banks with the deferred cash as collateral.

Two solid reasons for adopting these Trump corporate tax reforms are that it harmonizes the US tax system with those of our global competitors and levels the playing field. And, it will add sufficiently to after-tax cash flows from all `businesses and raise their returns-on-equity to enable more economic growth, a major objective of the Trump plan.

Another reform element of the Trump plan is the abolishment of the estate tax on inherited wealth. This tax is now only paid on wealth greater than $5.45 million ($10.9 million for married couples), but it is then taxed at the rate of 40%. Abolishing the tax would be a huge benefit for the very rich (just 0.2% of taxpayers), which, of course, attracts a lot of political heat. Yes, the heirs of Mr. Trump and much of his cabinet would prosper greatly from such a change, but the numbers are not big on a national scale, as the estate tax represents less than 1% of annual tax revenues. The estate tax was installed in 1916 and has endured since, largely because of the argument that without such a tax a permanent class of enriched “nobility” would emerge that would weaken our democracy. The counter argument to this was the America is the land of opportunity in which wealth could be created from very little, but an estate tax confiscated the fruit of such efforts – constitutionally protected private property on which federal, state and local income and property taxes had already been paid. The present estate tax law, enacted in 2016, is a trade-off between these points of view. There is not much appetite to bring estate taxes up again so soon after the last effort to reform it and eliminating, and, in any case, it won’t affect the economy much

The rest of the Trump tax plan is essentially bad because it will increase the fiscal deficit and probably won’t create much growth. It is a hodgepodge of business and personal tax cuts designed to satisfy traditional republican demands for lower taxes to stimulate growth. Mr. Mnunchin says the plan will pay for itself by increased tax revenues from added growth. Despite the popularity of the “Laffer Curve” that predicted such an outcome from the Reagan era tax cuts, it didn’t happen then and very few economists believe it will this time.

About 47% of tax filers don’t pay federal income taxes, so they won’t be affected.  Analyses to date suggest that the tax cuts for middle income people will be offset by the loss of deductions that leave the average taxpayer about where he or she was. Lower rates on higher income people won’t matter that much, as most wealthy Americans pay much lower effective tax rates than the 39.6% maximum because of allowable deductions and so much of their income is from capital gains that are taxed at 22.8%. Reducing the maximum rate to 35% won’t result in much additional consumption on which incremental growth depends.  The rich don’t spend their tax savings, but instead invest it in (already high-priced) securities. But at very low unemployment (4.2%) and inflation (1.5%), the odds are that whatever new spending there may be from the tax cuts will end up increasing wage inflation more than growth.

One feature of the Trump plan, however, could make a big, if unintended, difference. This is the provision that would allow corporations or individuals to utilize “pass-through” vehicles (limited liability corporations or partnerships) to benefit from a maximum rate of 25%. Pass through vehicles are entities that don’t pay taxes but pass income (and losses) on to shareholders to pay (or deduct) at individual rates. A small business owner can often lower taxes considerably by passing through, but some of the biggest users of these entities are hedge fund and private equity investors and real estate operators like Mr. Trump. If the 25% rate were adopted for pass-throughs, these types of investors would be major beneficiaries along with many wealthy lawyers, doctors, and others who would set up their own entities to channel income to get lower rates. But if the corporate rate is to be lowered to 25%, this provision really is unnecessary.

Certainly, the Trump tax plan has its share of political problems. To get passed, it will have to be presented to the Senate as a “budget reconciliation” measure that can be approved by a simple majority of 51 votes. For this to happen, the Senate must first pass a budget resolution based on the Trump budget submitted earlier this year (the House passed such a resolution last week). According to the bi-partisan Tax Policy Center, the budget will produce a deficit of $2.4 trillion over 10-years, or $240 billion per year (1.2% of today’s GDP, to be added to the existing fiscal deficit of 3.1%). This deficit will then have to be financed by additional government borrowings, which may upset the deficit hawks among Republicans (they have been quiet so far), the future debt ceiling bill that will have to be passed to accommodate it, and raise serious questions as to whether the $2.4 trillion estimate, or the Treasury’s of net deficit reduction is reliable.  The Treasury forecast is based on “dynamic scoring” which assumes incremental tax revenues from a 3%+ annual growth that it says the tax plan will generate. In the past, dynamic scoring forecasts have been very inaccurate -- the amount of derived growth has been less than promised, and the deficits have been greater. Continually missing these forecasts partly explains why the US government’s debt to GDP ratio (107%) has grown to be the highest since WWII. This has been very worrying to many finance experts, debt rating agencies and those fearful of a debasing of the currency, and it should put some serious loyalty stresses on Republican senators who properly understand these issues.

The tax plan is unlikely to attract any support from Democrats, who are in lock-step that the whole thing is a give-away to the rich. It might get through the Republicans, but it will be tough on those Congressmen running for reelection in high-tax states that would lose the deductibility of state and local income and property taxes. The loss of this deduction is one of the last surviving means (after abandonment of the “border tax”) to gather new revenues to pay for the other cuts and increased defense spending.

The best outcome might be for Congress to pass only the good bill, the corporate tax reforms, and let the rest (like health care repeal) go for another time. Doing this could add to growth without growing the deficit. Middle class tax cuts may have been promised, but what would be delivered won’t be that much. Pass-throughs and an aggressive program of accelerated depreciation create distortions and unintended economic consequences that are more trouble than they are worth. Even the rich are resigned to paying some form of estate tax, so its repeal won’t really be missed.

Doing this, of course, would be an example of a half a loaf being better than none, something our present all-or-nothing Congress has been unable to accept as a working principle of governance.

Friday, September 15, 2017

The Troubled Future of Global Banks, Revisited

by Roy C. Smith

In different articles last year, Brad Hintz and I argued that the world’s largest capital market banks faced a troubled future, burdened chiefly by vastly increased regulatory requirements, heavy litigation costs, pressure on margins, and changes in the trading markets.  These burdens resulted in lowered returns on equity, and higher costs of equity capital, such that the net economic valued added (EVA) of these firms was negative and had been for several years.  Our conclusion was that the banks would have to substantially restructure their business models to regain economic viability. The data we used to form our opinion has been consistent since 2009, but the most recent set was as of Dec. 30, 2015. 

Since then, many things have happened. After the election of Donald Trump as President of the US the S&P 500 stock index rose 17.5%, As they continually surpassed record levels, stock markets hummed with speculation about improved economic growth rates, a strong dollar, and a sizeable reduction in US financial and other regulation.  The banking sector was to be a major beneficiary of these positive expectations.

Seven of the top ten capital market banks’ stock prices have gained more than 20% since January 1, 2017, though three (Barclays, Deutsche Bank, and Credit Suisse) posted declines of 20% or more.  The average price-to-book ratio for the top ten banks in Dec. 2015 was 0.75, at the end of the second quarter of 2017 it was 0.99; in 2015, the average EVA (the spread between the banks’ returns on equity and their cost of equity capital) was -8.90%; now it is -2.16%. Though five of the ten banks were in positive EVA territory, two, Deutsche Bank and Credit Suisse posted EVAs of -10.3% and -13.4%, respectively).

Banks have benefitted (in their EVA calculations) from the lowering of their average “beta” (a volatility measure used to calculate cost of equity capital under the Capital Asset Pricing Method) from 1.72 to 1.38. Lowered betas are a direct result of reduction in the risk levels of the banks, which was the main purpose of the increased regulation.

Average returns on equity also improved from 5.36% to 6.64%. Most of this appears to be due to cost cutting, asset sales, and reengineering products and trading platforms. Revenues for the top banks were up 4% for the first two quarters of 2017, but still down 13% from five years ago.

Overall, these data indicate things are getting better for most of the banks. And, the enormous storm of litigation from financial crisis misdeeds that weakened returns and book values for the last several years has apparently run its course. US banks have also done better on the stress tests and been permitted large increases in dividend payouts and stock repurchases.

However, expectations for an economic boost by reforming taxes, infrastructure spending and deregulation have diminished significantly – Republicans are divided and Mr. Trump seems helpless to do much about it. Whatever does happen will be less impactful, and later in arriving, than was thought six months ago. Deregulation is limited to executive orders not requiring Congressional approval, and this, too, has amounted to less than expected. The SEC produced a report in August that said it was unable to tell whether the Volcker rule limiting proprietary trading was effective or not, suggesting it might not be changed. Earlier, a Treasury Department report required by an earlier executive order only recommended five regulatory reforms of the most general nature. When and how these might be produced and become effective is unknown. The Financial Choice Act, meant to neutralize the Dodd Frank Wall Street Reform and Consumer Protection Act, was passed by the House of Representatives in June, but has little chance for passage by the Senate this year. Still, most observers believe that something will happen in the next year or two to soften Dodd Frank, but probably not anything very meaningful to capital market banks.

Dodd Frank is vast and very expensive to comply with, but it is not the chief source of the capital market banks’ regulatory burden.  These come from Basel III (a minimum bank capital adequacy agreement) and the new form of qualitative stress tests that central banks now impose on their global systemically important banks. Most of these measures were adopted by the G-20 group of countries with strong US support.

Basel III effectively doubled the capital adequacy requirement while halving leverage and requiring capital buffers to insure adequate liquidity in a time of crisis. This made trading inventories expensive when trading volumes were soft and margins were under competitive pressure as they still are. Basel III constraints seriously limited the operating field-of-play available to banks.

The stress tests were designed to be impossible to “game,” and the consequences for not meeting them were potentially so severe (in terms of limiting payment of dividends and stock buybacks) that none of the banks tried to do so.  However, the rules of the stress tests change without notice, so the banks’ operating areas were limited further.  Even so, some banks (JP Morgan, Goldman Sachs, and Wells Fargo) , have adapted and been able to generate minimally satisfactory EVAs under this regime (JP Morgan’s is +3.2%, modest but acceptable), but others (Credit Suisse, Deutsche Bank, Barclays, and Citigroup) continue to be unable to do so, despite years of tinkering with their balance sheets and business models.

One thing that hasn’t changed since Dec. 30, 2015 is the unwillingness of the struggling banks to break themselves up. That is, into investment banks or commercial banks in order to specialize in trading and fee businesses, or deposit taking and lending, two very dissimilar businesses.

We presented a case for such breakups last year – when many banks were trading well below book value – as a way of recovering shareholder value. None followed our advice, and now that some banks have seen major increases in their share prices, it is unlikely they will be interested in doing so now. But half of the industry is still in big trouble, still trading below book and earning far less that it costs their investors to hold their stock.

So, despite some signs to the contrary, nothing really has changed, or is likely to soon.  But our original argument still seems valid, so there is still a good argument for breaking up at least some of the worst performing banks.  Institutional and activist investors ought to encourage them to do so.

Published Sept. 13, 2017 in Financial News